Garavaglia v. Comm'r

T.C. Memo. 2011-228

UNITED STATES TAX COURT

CHARLES L. GARAVAGLIA, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

MARY ANN T. GARAVAGLIA, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 2500-07, 14693-09. Filed September 26, 2011.

Joseph Falcone and Fred A. Foley, for petitioners.

Alexandra E. Nicholaides, John J. Comeau, and Robert M.

Romashko, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: These consolidated cases concern the 1989 and

1990 Federal income taxes of Charles L. Garavaglia (Mr.

Garavaglia) and Mary Ann T. Garavaglia (Ms. Garavaglia)
 -2-

(collectively, the Garavaglias or petitioners). Respondent

determined deficiencies in Mr. Garavaglia’s 1989 and 1990 Federal

income taxes of $97,070 and $114,435 and fraud penalties under

section 6663(a) of $72,803 and $85,826, respectively.1

Respondent amended the answer to assert deficiencies in Mr.

Garavaglia’s 1989 and 1990 Federal income taxes of $96,640 and

$138,290 and fraud penalties of $72,480 and $103,717 pursuant to

section 6663(a), respectively; or alternatively, a deficiency of

$114,435 in Mr. Garavaglia’s 1990 Federal income tax and a fraud

penalty of $85,827 under section 6663(a). Respondent contends

that the deficiencies and penalties purportedly due from Mr.

Garavaglia stem from Mr. Garavaglia’s participation in a scheme

to defraud workers’ compensation insurance companies (insurance

companies) and the U.S. Treasury (Treasury). Mr. Garavaglia

disavows his participation in such a scheme during 1989 and 1990.

Respondent also determined deficiencies of $99,179 and

$117,557 in Ms. Garavaglia’s 1989 and 1990 Federal income taxes

and accuracy-related penalties under section 6662(a) of $19,836

and $23,511, respectively. Ms. Garavaglia ascribes error to

respondent’s determinations as to the fraud of Mr. Garavaglia,

and asserts that (1) the period of limitations for assessment has

1
Unless otherwise indicated, section references are to the
applicable version of the Internal Revenue Code (Code), and Rule
references are to the Tax Court Rules of Practice and Procedure.
Some dollar amounts are rounded.
 -3-

expired as to 1989 and 1990; and (2) she is entitled to relief

from joint and several liability under section 6015(b) and (f).

Respondent counters that the period of limitations for assessment

as to 1989 and 1990 is on account of the alleged fraud of Mr.

Garavaglia, or alternatively on account of the claimed fraud of

petitioners’ return preparers. Respondent also contends that Ms.

Garavaglia is jointly and severally liable for any deficiencies

determined to be due from Mr. Garavaglia.

After concessions,2 the primary issues for decision are:

(1) Whether either of two corporations partially owned by Mr.

Garavaglia qualifies as an electing small business corporation (S

corporation) in 1989 and 1990. We hold that neither does;3 (2)

whether Mr. Garavaglia omitted income of $326,815 and $386,324 in

1989 and 1990, respectively. We hold he did to the extent stated

herein; (3) whether Mr. Garavaglia is liable for fraud penalties

under section 6663. We hold he is; (4) whether the period of

limitations for assessment of petitioners’ 1989 and 1990 taxes is

2
Mr. Garavaglia contends that he is entitled to a “refund of
his excess social security tax payments”. He offers no argument,
explanation, or legal authority to support his position, and we
treat his claim to a refund as improperly raised. See Figuero-
Rubio v. INS, 108 F.3d 110, 112 (6th Cir. 1997).
3
Given our holding on the first issue, respondent abandons
his primary determination that Mr. Garavaglia’s distributable
share of income and/or loss from these corporations should be
increased for 1989 and 1990.
 -4-

open on account of the fraud of Mr. Garavaglia. We hold it is;4

(5) whether Ms. Garavaglia is jointly and severally liable for

deficiencies determined to be due from Mr. Garavaglia. We hold

she is; (6) whether Ms. Garavaglia is liable for accuracy-related

penalties under section 6662(a). We hold she is not; (7) whether

Ms. Garavaglia is entitled to relief from joint and several

liability under section 6015(b) or (f). We hold she is not; and

(8) whether the Criminal Investigation Division (CID) of the

Internal Revenue Service (IRS) violated Mr. Garavaglia’s Fifth

Amendment right to due process. We hold it did not.

FINDINGS OF FACT

I. Preliminaries

The parties submitted to the Court numerous stipulations of

fact and accompanying exhibits. The Court also deemed some facts

and exhibits established pursuant to Rule 91(f). The stipulated

facts and exhibits submitted therewith are incorporated herein by

this reference. We find the stipulated facts accordingly.

Petitioners, husband and wife, resided in Michigan when they

filed their respective petitions.

4
Because we find fraud on the part of Mr. Garavaglia, we
need not consider respondent’s alternative position that the
period of limitations for assessment is open on account of the
fraud of petitioners’ return preparers.
 -5-

II. Mr. Garavaglia

Mr. Garavaglia was born in Detroit, Michigan. He graduated

from high school, and he has some college education. He was an

active duty member of the U.S. Army from July 1, 1957, until July

12, 1959, and served as a supply clerk. Mr. Garavaglia has been

known by many aliases including, among others, Timothy Sullivan,

Robert Burton, and Albert Little.

In the early-to-mid-1960s Mr. Garavaglia began working as a

labor consultant for Central Transport, Inc. (Central). From

1966 to 1975 he was director of insurance and safety. As such,

he established a claims department, developed investigative

procedures, and prepared guidelines for claims settlements. From

1975 to 1986, as vice president of industrial relations and

security, he developed security procedures, negotiated labor

agreements, and directed the labor departments of U.S. and

Canadian divisions and subsidiaries. Mr. Garavaglia was fired

from Central in approximately October 1986. Pursuant to a

settlement agreement with Central, he was paid an annual

consulting fee of $50,000. That fee was paid to Mr. Garavaglia’s

wholly owned S corporation.

Since the early-to-mid-1960s Mr. Garavaglia has developed

expertise in the insurance, employee leasing, trucking, and labor

industries. During 1989 and 1990 he owned and operated one labor
 -6-

consulting firm and various employee leasing companies, all of

which were within the trucking industry.

III. C&G Consultants

Mr. Garavaglia was the president and 100-percent owner of

C&G Consultants, Inc. (C&G Consultants), an S corporation.

Through C&G Consultants, Mr. Garavaglia provided labor consulting

services and received payments from the employee leasing

companies which he owned and operated.

IV. Ms. Garavaglia

Ms. Garavaglia graduated from high school without further

education. She married Mr. Garavaglia in September 1961, gave

birth to a child shortly thereafter, and was a homemaker until at

least 1988. As of the end of 1988, the Garavaglias had financial

assets of approximately $1 million. At all relevant times, the

Garavaglias were married.

Throughout 1989 Ms. Garavaglia worked as a secretary with a

temporary staffing company. She also worked as a secretary for

at least one of Mr. Garavaglia’s employee leasing companies, and

was paid a weekly salary of $500 for her services. Ms.

Garavaglia was the treasurer of C&G Consultants, and she attended

the meeting of the board of directors of that company.

V. Mr. Rogers

George Rogers (Mr. Rogers) worked at Central for 11 years,

initially as a truck driver and later in the operations division.
 -7-

In the early 1980s Mr. Rogers began to manage at least one of

Central’s employee leasing companies. He grew independent of

Central over time, and he eventually came to own and operate at

least four employee leasing companies.

Messrs. Garavaglia and Rogers met while at Central. At

first Mr. Garavaglia advised Mr. Rogers on the resolution of

labor-related issues such as the filing of union grievances. In

1985 that relationship developed into a business partnership that

continued until 1989.

VI. Sentury

Mr. Rogers was the 100-percent owner of Sentury Services,

Inc. (Sentury), an S corporation. Mr. Rogers, through Sentury,

provided consulting services to his employee leasing companies.

Mr. Rogers owned at least two of these employee leasing companies

jointly with Mr. Garavaglia.

VII. The Yarnell Family and LTD Accounting

During 1985 and 1986 Douglas Yarnell (Mr. D. Yarnell) and

Leroy Yarnell (Mr. L. Yarnell) worked in the accounting

department of D&S Leasing (D&S), an employee leasing company

which Mr. Rogers owned. Mr. L. Yarnell helped to implement a

computer-based payroll system and assisted in the preparation of

various tax returns, including Forms 941, Employer’s Quarterly

Federal Tax Return. Mr. L. Yarnell was not a certified public

accountant, though he represented to others, including Mr.
 -8-

Garavaglia, that he was. In July 1986 Mr. D. Yarnell left D&S to

form LTD Accounting, Inc. (LTD Accounting), with his father, Mr.

L. Yarnell, and his brother, Tim Yarnell (Mr. T. Yarnell).5 LTD

Accounting or members of the Yarnell family performed various

accounting and tax duties for petitioners, C&G Consultants, and

certain employee leasing companies owned by Mr. Garavaglia.

VIII. Overview of Employee Leasing Companies

Mr. Garavaglia, either with Mr. Rogers or Mr. L. Yarnell,

owned and operated at least three employee leasing companies. An

employee leasing company is a business which agrees to place

employees of a client company on the leasing company’s payroll,

usually for a fee. Through this leasing arrangement, the

employee leasing company typically becomes the primary employer

of record and performs a number of personnel and administrative

functions with respect to the leased employees. Among the

services typically provided by the employee leasing company were

issuing paychecks, payroll management, Federal and State income

tax withholding, Federal and State employment tax reporting, and

maintaining workers’ compensation insurance. See, e.g., Bealor

v. Commissioner, T.C. Memo. 1996-435. The client companies paid

workers’ compensation insurance premiums (premiums) and taxes to

5
The Yarnell family owned and operated two accounting firms
named LTD Accounting, which we collectively refer to as LTD
Accounting. We also collectively refer to Mr. L. Yarnell, Mr. D.
Yarnell, and Mr. T. Yarnell, as the Yarnell family.
 -9-

the employee leasing company, with portions of the funds being

allocated among various payees, including insurance companies,

and Federal and State taxing authorities.

Premiums due to the insurance companies were generally due

at the beginning of a specified policy period (e.g., from May

until the following April). The premiums were self-reported and

determined, at least in part, by worker classification, payroll

wages, and the State in which the leased employee worked.

Because Mr. Garavaglia’s employee leasing companies serviced the

trucking industry, the relevant worker classifications included

drivers, maintenance workers, and office staff. Worker

classifications with a higher risk of injury (e.g., drivers)

generally required higher premiums than those with a lower risk

of injury (e.g., office staff). Because the numbers and types of

workers varied over a specified policy period, employee leasing

companies prospectively estimated their payroll for the policy

period.

Given the self-reporting nature of the employee leasing

business, there was risk to the insurance companies that the

employee leasing company might underreport its payrolls and the

premiums due. To mitigate this risk, the insurance companies

often used audits to ensure that the employee leasing company’s

payrolls were accurately reported. The audits were intended to

balance the estimated premiums paid and the actual premiums due
 -10-

by reconciling the payrolls as estimated by the employee leasing

company against the actual payrolls as determined by an auditor.

The auditor, who was sometimes an employee of the insurance

company, examined various documentation to verify the employee

leasing company’s actual payroll. Documents typically examined

included Forms 941, Employer’s Quarterly Federal Tax Return,

worker classifications, State unemployment payroll taxes, various

classifications of the policy, and proof of payment as to those

classifications. To the extent that the auditor determined a

deficit between the client company’s audited and estimated

payrolls, the employee leasing company was required to satisfy

the shortfall. To the extent that the auditor determined an

overpayment, the insurance company credited the employee leasing

company.

During 1989 and 1990 Mr. Garavaglia’s employee leasing

companies underreported their actual payrolls by approximately 75

percent. As a result, these employee leasing companies also

understated the premiums due to the insurance companies and the

employment taxes due to Federal and State taxing authorities.

For financial accounting purposes, however, these employee

leasing companies expensed 100 percent of the premiums as if the

full payrolls of the client companies had been reported. For

Federal tax purposes, these employee leasing companies reported

deductions equal to the higher premium expenses recorded for
 -11-

financial accounting purposes. The difference between the

amounts which the employee leasing company collected from its

client companies and the amounts actually remitted to the

insurance companies and taxing authorities was distributed to

owners of the employee leasing companies; namely, Mr. Garavaglia,

and either Mr. Rogers or Mr. L. Yarnell. The amount of each

distribution was generally proportionate to the owner’s interest

in the company.

IX. Trans Continental

By 1988 Mr. Garavaglia and Mr. Rogers were each 50-percent

owners in Trans Continental Leasing, Inc. (Trans Continental), an

employee leasing company. In late 1988 or early 1989 Trans

Continental underwent a workers’ compensation audit which Mr. D.

Yarnell handled. The auditor determined a shortfall of as much

as $1 million in the premiums which Trans Continental owed to the

insurance company. As of March 31, 1989, Trans Continental had

accrued premium expenses of $59,087 though it had paid premiums

to the insurance companies of only $21,102. Thus, as of March

31, 1989, Trans Continental had overstated its workers’

compensation expense for 1989 by $37,985 ($59,807 less $21,102).

Trans Continental did not pay the amounts determined to be

due following the audit. Rather, Messrs. Garavaglia and Rogers

closed Trans Continental in March 1989 and continued their
 -12-

employee leasing business under a parallel company; namely, Trans

International Services, Inc. (Trans International).

X. Trans International

A. History of Trans International

On or about March 6, 1989, Messrs. Garavaglia and Rogers

incorporated Trans International as an employee leasing company.

Mr. Garavaglia and Mr. Rogers each became 50-percent shareholders

in Trans International, and they shared equally in all decisions

related to that company.

B. The Continuation of Trans Continental’s Operations

By early April 1989, Trans International was a fully

operating employee leasing company, complete with assets,

employees, customers, payables, receivables, and accruals. The

ending balances of Trans Continental’s expense accounts for

Michigan, Ohio, and Indiana became Trans International’s starting

balances for their accrued workers’ compensation accounts. For

example, as of March 31, 1989, Trans Continental had ending

balances in its accrued workers’ compensation expense account for

Michigan, Ohio, and Indiana, of $17,974, $4,799, and $36,315,

respectively. Those ending balances became Trans International’s

beginning balances for April 1, 1989. Thus, the $37,985

shortfall which Messrs. Garavaglia and Rogers avoided by closing

Trans Continental was transferred to Trans International.
 -13-

C. Payroll Misstatements

On or sometime after April 1, 1989, Mr. T. Yarnell prepared

and forwarded to Mr. Rogers two payroll summaries which Trans

International used to calculate its premiums. The first summary

listed Trans International’s “actual” payroll for the first

quarter of 1989, and the second summary listed Trans

International’s “modified” payroll for the same period. The

modified payroll summary was calculated by applying a 25-percent

factor to the actual payroll; i.e., Trans International reported

only 25 percent of its actual payroll. The actual payroll

summary reported that Trans International owed $60,416 in

workers’ compensation insurance liabilities for the first quarter

of 1989. Of that amount, $36,799 was allocable to workers in

Indiana, $18,751 was allocable to workers in Michigan, and $4,866

was allocable to workers in Ohio. The modified payroll summary,

on the other hand, reported that Trans International owed $15,104

in workers’ compensation insurance liabilities for the first

quarter of 1989. Of that amount, $9,200 was allocable to workers

in Indiana, $4,688 was allocable to workers in Michigan, and

$1,216 was allocable to workers in Ohio.

Mr. T. Yarnell also prepared payroll summaries for the last

two quarters of 1989 which “[scaled] down” Trans International’s

payroll to 25 percent of actual. These scaled-down summaries

were used by Trans International to calculate its premiums and
 -14-

were reported to the insurance companies. At some point on or

before January 31, 1990, Mr. T. Yarnell sent to Mr. Garavaglia

the following letter:

Premiums for Ohio Workman’s Compensation are due by
January 31, 1990. Please review the schedules I have
prepared for Branch [International] and * * * [Trans
International] and let me know if you agree with the
figures. The only classification I did not scale down
to 25% was the * * * [Trans International] drivers
because of the low amount that we carry in Ohio for
this classification. The highlighted Reported * * *
[Workers’ Compensation] is the amounts I am proposing
to pay into the Ohio Bureau of * * * [Workman’s
Compensation].

Attached to that letter was a schedule which reported Trans

International’s actual and modified payroll wages as follows:

Period Drivers Maintenance Office Total

July 1989 $1,530 $11,043 $11,138 $23,711
Aug. 1989 1,704 13,769 11,890 27,363
Sept. 1989 2,013 16,507 14,045 32,565
Oct. 1989 1,740 15,047 11,187 27,974
Nov. 1989 1,727 13,135 11,040 25,902
Dec. 1989 3,576 24,683 18,421 46,680
Total wages1 12,289 94,184 77,721 184,194

Reported wages $12,289 $23,546 $19,430 $55,265

Actual workers’
compensation
billed to
customers $1,789 $11,359 $163 $13,311

Reported workers’
compensation $1,735 $1,907 $121 $3,763
1
The sum for the periods may not equal the total wages on
account of rounding.

In the foregoing table, the term “total wages” means the wages

which Trans International actually paid to its employees. The
 -15-

term “reported wages” means the wages which Trans International

reported to the insurance companies as being paid to its

employees. The phrase “actual workers’ compensation billed to

customers” means the actual workers’ compensation billed to Trans

International’s client companies. The term “reported workers’

compensation” means the liability which Trans International

reported as due to the insurance companies. Between July and

December 1989 Trans International underreported its payroll wages

by up to 75 percent and understated its premiums by as much as 83

percent.6

D. Books and Records

From January through March 1989 LTD Accounting kept Trans

International’s books and records under Trans Continental’s name.

After April 1, 1989, the books and records of Trans International

were kept in that company’s name.

E. Accrual of Workers’ Compensation Expense

Trans International maintained an accrued workers’

compensation expense account on its books. That account recorded

amounts which Trans International actually paid to the insurance

companies as a payable account to Trans International for amounts

6
Trans International paid its maintenance staff wages of
$94,184 but reported payroll wages paid of $23,546, which is 25
percent of $94,184. Trans International billed its client
companies $11,359 for workers’ compensation expenses related to
its maintenance staff but reported a liability due to the
insurance companies of $1,907, approximately 17 percent of
$11,359.
 -16-

owed to the insurance companies. When premiums were paid to the

insurance company, the accrued workers’ compensation account was

credited and the cash account was debited.

F. Payment of Premiums to Wholly Owned S Corporations

Trans International billed and collected from its client

companies on the basis of the actual payroll but paid the

insurance companies on the basis of the modified payroll. The

difference between the actual amount billed and the modified

amount paid was retained by Trans International and distributed

to C&G Consultants and Sentury. As reflected in Trans

International’s general ledger, in 1989 Trans International paid

to C&G Consultants, Mr. Garavaglia, Sentury, and Mr. Rogers

$99,090, $11,033, $90,662, and $11,033, respectively. Trans

International debited these payments from its accrued workers’

compensation account.

G. Payment of Consulting Fees to C&G Consultants

Trans International also paid consulting fees of $60,233 to

C&G Consultants during 1989. These payments were recorded on

Trans International’s general ledger, were generally made weekly,

and ranged in amounts between $420 and $8,112.

H. Attempted Subchapter S Election

On March 7, 1989, Trans International filed with the IRS a

Form 2553, Election by a Small Business Corporation, electing to

be treated as an S corporation effective January 1, 1989.
 -17-

Specifically, that Form 2553 was signed by Mr. L. Yarnell in his

capacity as Trans International’s secretary. The consent

statement was signed by Mr. D. Yarnell in his alleged capacity as

Trans International’s sole shareholder. By letter dated June 14,

1989, the IRS notified Trans International that its Form 2553

could not be processed because additional information was needed.

That letter stated that Trans International needed to submit (1)

a consent statement for each shareholder and (2) a signature and

title of an officer. On July 11, 1989, Mr. L. Yarnell sent to

the IRS a letter which stated that he was returning the IRS’

letter of June 14, 1989, and a completed Form 2553. The record

does not contain a copy of the Form 2553 purportedly included

with this letter.

I. Federal Income Tax Returns

1. 1989 Trans International Return

Trans International filed a 1989 Form 1120S, U.S. Income Tax

Return for an S Corporation, on or about March 14, 1990 (1989

Trans International return). The 1989 Trans International return

reported gross receipts or sales of $5,527,339, cost of goods

sold and/or operations of $4,713,931, other income of $1,556, and

total income of $814,964. The 1989 Trans International return

also reported total deductions of $810,373, including $78,716 for

officer compensation, $423,750 for payroll taxes, $183,433 for

employee benefits programs, $161 for advertising, and $124,313
 -18-

for other deductions. After netting its income and deductions,

Trans International reported ordinary income from trade or

business activities for 1989 of $4,591. The 1989 Trans

International return was prepared by Mr. T. Yarnell.

2. 1990 Trans International Return

Trans International filed a 1990 Form 1120S on or about

March 5, 1991 (1990 Trans International return). The 1990 Trans

International return reported gross receipts or sales of

$1,226,186, cost of goods sold of $1,072,369, and total income of

$153,817. The 1990 Trans International return also reported

total deductions of $163,292, including $126,088 for payroll

taxes and $37,204 for other deductions. After netting its income

and deductions, Trans International reported an ordinary loss

from trade or business activities for 1990 of $9,475. The 1990

Trans International return was prepared, but not signed, by

“Central Mich. Computer Support”.

J. Winding Up of Trans International

Trans International operated until approximately March 1990.

Before the 1989 Trans International return was filed, Messrs.

Garavaglia and Rogers had a “falling out”. Mr. Garavaglia

accused Mr. Rogers of embezzling money from Trans International,

and Mr. Rogers claimed that members of the Yarnell family had set

him up. Following that dispute, Mr. Garavaglia and the Yarnell

family sided with each other and continued to do business with
 -19-

each other under a parallel employee leasing company; namely,

Branch International Services, Inc. (Branch International).

XI. Branch International

A. History of Branch International

On or about March 29, 1989, Mr. Garavaglia and Mr. L.

Yarnell incorporated Branch International. That company was

owned 70 percent by Mr. Garavaglia and Ms. Garavaglia, and 30

percent by Mr. L. Yarnell and his wife.

B. Payroll Misstatements

As discussed above, at some point on or after January 30,

1990, Mr. T. Yarnell sent to Mr. Garavaglia a letter which stated

that Branch International’s payroll as reported to the insurance

companies was “[scaled] down” to 25 percent of actual. Attached

to that letter was a schedule reporting Branch International’s

actual and modified payroll wages as follows:

Period Drivers Maintenance Office Total

July 1989 -0- -0- -0- -0-
Aug. 1989 -0- -0- -0- -0-
Sept. 1989 $25,024 $9,046 $8,461 $42,531
Oct. 1989 35,495 10,572 11,710 57,777
Nov. 1989 41,983 11,864 11,279 65,125
Dec. 1989 45,848 12,956 15,835 74,638
Total wages1 148,350 44,437 47,285 240,071

Reported wages $37,087 $11,109 $11,821 $60,018

Actual workers’
compensation
billed to
customers2 $22,316 $2,206 $113 $24,635
 -20-

Reported workers’
compensation $5,235 $900 $74 $6,209
1
The sum for the periods may not equal the total wages
because of rounding.

As with Trans International, the term “total wages” means the

total wages which Branch International actually paid its

employees. The term “reported wages” means the wages which

Branch International reported to the insurance companies. The

phrase “actual workers’ compensation billed to customers” means

the actual workers’ compensation that Branch International billed

to Branch International’s client companies. By reporting the

lower figure to the insurance companies, Branch International

understated the premiums due to the insurance companies.

C. Accrual of Workers’ Compensation Expense

Like Trans International, Branch International maintained an

accrued workers’ compensation account on its books. This account

represented a payable to Branch International for amounts owed to

the insurance companies. When the payment was made to the

insurance companies, the accrued workers’ compensation account

was credited and cash was debited. During December 1989 Branch

International paid by check $21,000 to C&G Consultants, or 70

percent of the amounts debited to the accrued workers’

compensation account for that month. Also in December 1989

Branch International paid by check to Mr. L. Yarnell, Mr. T.
 -21-

Yarnell, or LTD Accounting $9,000 or 30 percent of the amounts

debited to the accrued workers’ compensation account.

D. Payment of Premiums to Wholly Owned S Corporations

Branch International also billed and collected from its

client companies on the basis of the actual payroll but paid

insurance companies on the basis of the modified payroll. The

difference between the amounts billed and the amounts paid was

distributed from Branch International to C&G Consultants and LTD

Accounting, Mr. L. Yarnell, or Mr. T. Yarnell.

Between May 4 and December 27, 1989, Mr. L. Yarnell, Mr. T.

Yarnell, or Mr. Garavaglia endorsed about 39 checks totaling

$71,645 from Branch International to C&G Consultants. These

checks ranged from $1,120 to $8,500 and were generally paid

weekly. During the same period Branch International paid $29,389

through 39 separate checks to LTD Accounting, Mr. L. Yarnell, or

Mr. T. Yarnell. These checks ranged from $235 to $3,000 and were

generally paid weekly. In general, checks issued to C&G

Consultants, LTD Accounting, Mr. L. Yarnell, or Mr. T. Yarnell

were paid on the same date and reflected Branch International’s

ownership structure; i.e., 70 percent was paid to C&G Consultants

and 30 percent was paid to LTD Accounting, Mr. L. Yarnell, or Mr.

T. Yarnell.
 -22-

During 1990 Branch International endorsed 96 checks totaling

$329,805 to C&G Consultants. The amounts of those checks ranged

from $750 to $10,000, and they were generally drafted weekly.

E. Subchapter S Election

On November 10, 1989, Branch International filed with the

IRS a Form 2553 electing to be treated as an S corporation

effective September 15, 1989. Mr. T. Yarnell signed that Form

2553 as an officer of Branch International. The consent

statement was signed by Mr. Garavaglia and Mr. T. Yarnell in

their alleged capacities as Branch International’s sole

shareholders.7 Branch International received notice that the

election to be treated as an S corporation was accepted on or

about January 29, 1990. The IRS revoked Branch International’s

election to be treated as an S corporation without explanation on

or about April 23, 1990.

F. Federal Income Tax Return for Branch International

1. 1989 Branch International Return

Mr. T. Yarnell filed a 1989 Form 1120S on behalf of Branch

International on or about March 9, 1990 (1989 Branch

International return). The 1989 Branch International return

reported gross receipts or sales of $1,206,271, cost of goods

sold and/or operations of $1,040,888, and total income of

7
We observe that Mr. T. Yarnell was not a shareholder of
Branch International.
 -23-

$165,383. The 1989 Branch International return also reported

total deductions of $169,401, consisting of $78,716 for officer

compensation, $83,804 for payroll taxes, and $85,597 for other

deductions. The 1989 Branch International return thus reported

an ordinary loss from trade or business activities of $4,018.

The 1989 Branch International return was prepared but not signed

by LTD Accounting.

2. 1990 Branch International Return

Mr. Garavaglia filed a 1990 Form 1120, U.S. Corporation

Income Tax Return, on behalf of Branch International on or about

April 18, 1991 (1990 Branch International return). The 1990

Branch International return reported gross receipts or sales of

$8,973,319, cost of goods sold and/or operations of $8,542,264,

and total income of $431,055. The 1990 Branch International

return also reported total deductions of $443,639, consisting of

$600 for repairs, $10,100 for rents, $17,987 for interest,

$42,231 for depreciation, and $372,721 for other deductions. The

1990 Branch International return thus reported taxable income of

negative $12,584. The 1990 Branch International return was

prepared by “Central Mich. Computer Support” and signed by a

member of the Yarnell family.
 -24-

G. The Yarnell Family Withdraws From Branch International

On January 31, 1991, Mr. L. Yarnell ceased being an officer

of Branch International, and on March 28, 1991, Mr. L. Yarnell

worked for Branch International on a “contract type basis”.

XII. Payments From C&G Consultants to Mr. Garavaglia

In 1989 Mr. Garavaglia wrote himself more than 50 separate

checks from C&G Consultants totaling $104,939. The amounts

endorsed on these checks ranged from $550 to $13,250. In 1990

Mr. Garavaglia wrote approximately 40 separate checks totaling

$204,818 payable from C&G Consultants to himself. The amounts

endorsed on these checks ranged from $250 to $14,000. The 90

checks endorsed from C&G Consultants to Mr. Garavaglia in 1989

and 1990 were written almost weekly.

XIII. Petitioners’ Joint Returns

A. 1989 Joint Return

Petitioners filed a joint Form 1040, U.S. Individual Income

Tax Return, for 1989 (1989 joint return). The 1989 joint return

reported total wages of $84,531, including $74,223 of wages which

Mr. Garavaglia earned from Trans International. Attached to the

1989 joint return was Schedule E, Supplemental Income and Loss,

which reported a $23,265 loss from C&G Consultants, a $2,813 loss

from Branch International, and income of $2,295 from Trans

International. The 1989 joint return was prepared by Mr. L.

Yarnell.
 -25-

B. 1990 Joint Return

Petitioners filed a joint Form 1040 for 1990 (1990 joint

return). The 1990 joint return reported total wage income of

$47,935, consisting of wages paid to Mr. and Ms. Garavaglia by

(1) Branch International in the amounts of $18,000 and $13,000,

respectively and (2) Trans International in the amounts of $7,786

and $9,149, respectively. Attached to the 1990 joint return was

Schedule E, which reported $6,059 in income from C&G Consultants,

a $4,737 loss from Branch International, and a $2,295 gain from

Trans International. The 1990 joint return also reported

unemployment compensation of $7,150. The 1990 joint return was

prepared, but not signed, by “Central Mich. Computer Support”.

XIV. C&G Consultants’ Returns

A. 1989 C&G Consultants Return

Mr. Garavaglia filed a 1989 Form 1120S on behalf of C&G

Consultants (1989 C&G Consultants return). The 1989 C&G

Consultants return reported $50,000 of gross receipts or sales,

$23,268 of other income, total deductions of $96,533, and total

ordinary losses of $23,265. The 1989 C&G Consultants return did

not report any income from Trans or Branch International. That

return was prepared by Mr. T. Yarnell of LTD Accounting.

B. 1990 C&G Consultants Return

Mr. Garavaglia filed a 1990 Form 1120S on behalf of C&G

Consultants (1990 C&G Consultants return). The 1990 C&G
 -26-

Consultants return reported $50,000 of gross sales or receipts,

other income of $33,889, total deductions of $77,830, and total

ordinary income of $6,059. The 1990 C&G Consultants return was

prepared, but not signed, by “Central Mich. Computer Support”.

Attached to the 1990 C&G Consultants return was Schedule K-1,

Shareholder’s Share of Income, Credits, Deductions, Etc., which

reported the pro rata share of C&G Consultants’ $6,059 ordinary

income as fully allocable to Mr. Garavaglia. The 1990 C&G

Consultants return did not report any income from Trans

International or Branch International. The 1990 C&G Consultants

return was prepared by Mr. L. Yarnell.

XV. Criminal Investigation of Mr. Garavaglia

A. Tipoff of Mr. Garavaglia’s Criminal Activity

In November 1991 a confidential informant contacted CID with

information that Mr. Garavaglia evaded taxes through two separate

schemes which were perpetrated by at least three corporations

partially owned by Mr. Garavaglia. In late 1991 or early 1992,

CID contacted Messrs. D. and L. Yarnell regarding their knowledge

of any wrongdoing regarding unreported income by Branch

International and Mr. Garavaglia. Mr. L. Yarnell did not tell

Mr. Garavaglia that CID had contacted him.

B. Preliminary Meetings With the IRS

In early 1992 special agents with CID held a meeting with

Mr. L. Yarnell and Mr. D. Yarnell. During that meeting, Mr. L.
 -27-

Yarnell stated that he had prepared Federal income tax returns

for Mr. Garavaglia and C&G Consultants. Mr. L. Yarnell also

stated that he did not think that those returns were accurate or

that Mr. Garavaglia reported all of his income on those returns.

Sometime in April 1992, special agents with CID held a

second meeting with Mr. L. Yarnell and Mr. D. Yarnell. That

meeting was tape recorded. During that meeting CID offered Mr.

L. Yarnell immunity for information which was offered during the

question and answer portion of the second meeting. At that

meeting, CID’s special agents presented various tax returns from

Mr. Garavaglia’s corporations to Mr. L. Yarnell and questioned

him on those returns. Although various corporate returns were

presented to Mr. L. Yarnell, the CID special agents’ focus was

Mr. Garavaglia and C&G Consultants.

C. Wiretap

The IRS conducted telephone monitoring of conversations

between Mr. Garavaglia and Mr. L. Yarnell on July 14 and 16,

1992. Mr. Garavaglia was unaware that these conversations were

being taped.

D. Execution of Warrants

On July 14, 1992, the U.S. District Court for the Eastern

District of Michigan (the District Court) issued four search

warrants for the IRS to search properties believed to house tax

and accounting records for, among others, petitioners, C&G
 -28-

Consultants, Trans Continental, Trans International, and Branch

International. These properties were the office buildings of

Messrs. Garavaglia and Rogers and the personal residence of Mr.

Garavaglia. The IRS executed the search warrants and seized more

than 100 storage boxes of documents contained in storage cabinets

and desks and around the searched premises.8 In total, CID

inventoried more than 2,500 items, including payroll information,

invoices, quarterly reports, check registers, medical files,

insurance records, State tax records, personnel files, canceled

checks, wage reports, and payroll registers. Many of these

documents related to C&G Consultants, Trans Continental, Trans

International, and Branch International.

Following the seizures, agents with CID inventoried the

items seized, matched the inventories to the boxes in which they

were stored, and secured those documents in a grand jury room,

which was a room designated for those records. A log was kept on

the grand jury room as to the individuals who had access to the

room. At some point after the grand jury was convened, the

records were moved to an IRS building.

8
By letter dated July 14, 2008, respondent’s counsel
confirmed that Mr. Garavaglia’s counsel received 28 boxes from
respondent.
 -29-

XVI. Criminal Prosecution of Mr. Garavaglia

A. Grand Jury Indictment

Following CID’s investigation, a Federal grand jury in the

District Court returned a 19-count indictment against Mr.

Garavaglia on April 10, 1996 (indictment). The indictment

charged Mr. Garavaglia with mail fraud in violation of 18 U.S.C.

sec. 1341, conspiracy to defraud the United States in violation

of 18 U.S.C. sec. 371, making and subscribing false individual

and corporate income tax returns in violation of section 7206(1),

and willful failure to file heavy vehicle use tax forms in

violation of section 7203. The indictment also charged that Mr.

Garavaglia’s fraudulent activities began in the latter part of

1988 and continued until April 1992.

B. Plea Agreement

Mr. Garavaglia subsequently entered into a plea agreement

(plea agreement) with the U.S. Attorney for the Eastern District

of Michigan on or about January 29, 1997. See Fed. R. Crim. P.

11(c). Mr. Garavaglia pleaded guilty to one count of mail fraud

for a fraudulent check mailed on June 28, 1991, and one count of

conspiracy to defraud the United States Government by filing a

false corporate income tax return for Branch International on or

about March 31, 1992.9

9
The plea agreement references B.I.S., which, from the
context of the discussions, we understand to be Branch
(continued...)
 -30-

In the plea agreement, Mr. Garavaglia stipulated that he

knowingly participated in a scheme to defraud insurance companies

by obtaining workers’ compensation insurance for Branch

International’s employees using false information reported to the

insurance companies concerning the amount of payroll per

classification that Branch International expected to pay its

employees, thus significantly reducing the premiums for Branch

International. Mr. Garavaglia also stipulated that he and

several of his business associates agreed to defraud the IRS by

falsely claiming substantially higher deductions for expenses

than actually paid to the insurance companies on income tax

returns for his employee leasing businesses, thus falsely

reducing the tax liabilities of those businesses. Mr. Garavaglia

also stipulated that the agreement continued through April 1992

and that on or about March 31, 1992, he signed a false corporate

income tax return for Branch International. Mr. Garavaglia also

agreed that the “tax loss” resulting from the charged tax

offenses might be at least $207,000, an amount which he agreed to

pay as restitution before sentencing.

C. Sentencing Hearings

Between September 17, 1997, and April 9, 1988, the District

Court held sentencing hearings for Mr. Garavaglia. See United

9
(...continued)
International.
 -31-

States v. Garavaglia, 178 F.3d 1297 (6th Cir. 1999). At the

sentencing hearing on September 17, 1997, Mr. Garavaglia’s

attorney argued that Mr. Rogers and certain members of the

Yarnell family were primarily responsible for any criminal

violations and that the criminal enterprise had begun before Mr.

Garavaglia was involved in the scheme.

D. Plea Hearing

The District Court conducted a thorough plea colloquy under

rule 11 of the Federal Rules of Criminal Procedure. On April 15,

1998, Mr. Garavaglia was sentenced to a prison term of 27 months

and placed on supervised release upon release from prison. The

District Court ordered Mr. Garavaglia to pay $500,000 in

restitution equally to three insurance companies, at least

$207,000 to the IRS, $50,000 in fines, and an assessment of $100.

XVII. Mr. Rogers’ Guilty Plea to Income Tax Fraud

Mr. Rogers was indicted along with Mr. Garavaglia. On March

25, 1996, Mr. Rogers pleaded guilty to one count of willfully

making a false Federal income tax return for 1989. See sec.

7206(1). As a condition of that plea agreement, Mr. Rogers filed

Forms 1040X, Amended U.S. Individual Income Tax Return, for the

1988, 1989, and 1990 taxable years (1988 through 1990 amended

returns, respectively). The 1988 amended return added $11,000 of

previously omitted income from Trans Continental. The 1989 and

1990 amended returns added $102,000 and $12,000 of previously
 -32-

omitted income from Trans International, respectively. On the

basis of his amended 1988, 1989, and 1990 Federal income tax

returns, Mr. Rogers’ Federal income tax liabilities increased by

$3,075, $33,660, and $3,960, respectively. Mr. Rogers was also

required to pay a fine of approximately $10,000 to the IRS.

XVIII. Destruction of the Seized Records

After Mr. Garavaglia and Mr. Rogers entered their respective

guilty pleas, one of CID’s special agents contacted Mr. Rogers.

He asked whether Mr. Rogers wanted the documents from Trans

International returned to him, to which Mr. Rogers replied that

the documents should be “[burned]”.

Mr. Garavaglia brought a claim against CID’s special agents

under the Supreme Court’s decision in Bivens v. Six Unknown Named

Agents, 403 U.S. 388 (1971). That cause of action alleged that

CID’s special agents coerced or encouraged Mr. L. Yarnell to

obtain Branch International’s tax documents under the pretense of

preparing an amended Federal tax return for Branch International.

See Garavaglia v. Budde, 43 F.3d 1472 (6th Cir. 1994). Mr.

Garavaglia further alleged that the detention of Mr. Garavaglia,

Mr. Rogers, and Mr. Garavaglia’s daughter during CID’s execution

of the search warrants was unconstitutional. See id. The

District Court summarily dismissed Mr. Garavaglia’s cause of

action in favor of CID’s special agents, and the U.S. Court of

Appeals for the Sixth Circuit affirmed. See id.
 -33-

XIX. Notices of Deficiency

A. Mr. Garavaglia’s Notice of Deficiency

By notice of deficiency dated October 31, 2006, respondent

determined deficiencies in Mr. Garavaglia’s 1989 and 1990 Federal

income taxes of $97,070 and $114,435, respectively, and fraud

penalties under section 6663(a) of $72,803 and $85,826,

respectively. The deficiencies arose from three adjustments.

First, respondent determined that Mr. Garavaglia received wages

from C&G Consultants of $106,709 and $208,738 in 1989 and 1990,

respectively. Second, respondent determined that Mr.

Garavaglia’s distributable shares of income and/or loss from C&G

Consultants for 1989 and 1990 were increased by $220,160 and

$177,586, respectively, to reflect payments from Trans and Branch

International to C&G Consultants. Third, respondent determined

computational adjustments of $1,440 and $3,220 in Mr.

Garavaglia’s 1989 and 1990 Federal income taxes, respectively.

With respect to the second adjustment, respondent determined

adjustments to C&G Consultants’ 1989 and 1990 distributable

shares of income as follows:

Adjustments to
ordinary, distributable
net, or taxable income 1989 1990

Gross sales or receipts--
Trans International $159,323 -0-
Gross sales or receipts--
Branch International 71,645 $309,380
Compensation of officers (106,709) (208,738)
Other expenses 95,901 76,944
 -34-

Total adjustments to
ordinary, distributable
net, or taxable income 220,160 177,586

1. Gross Sales or Receipts From Trans International

Respondent first determined that C&G Consultants’

distributable share of income for 1989 should be increased by

$159,323 to reflect income paid from Trans International to C&G

Consultants. The proposed adjustment to C&G Consultants’

distributable share of income arises from Trans International’s

payment to C&G Consultants of consulting fees of $60,233 and

accrued workers’ compensation expenses of $99,090.

2. Gross Sales or Receipts From Branch International

Respondent next determined that C&G Consultants’

distributable shares of income for 1989 and 1990 should be

increased by $71,645 and $309,380, respectively, on account of

income paid to C&G Consultants by Branch International.

3. Compensation of Officers

Respondent further determined that C&G Consultants’

distributable shares of income for 1989 and 1990 should be

reduced by $106,709 and $208,738. Respondent asserts that to the

extent that we determine that Mr. Garavaglia received wages or

officer’s compensation from C&G Consultants, then C&G Consultants

is entitled to deductions for like amounts.
 -35-

4. Other Expenses

a. 1989

C&G Consultants deducted and respondent disallowed expenses

on the 1989 C&G Consultants return as follows:

Amount claimed Amount allowed Amount
Expense on return by IRS disallowed

Repairs $4,120 -0- $4,120
Rents 5,400 -0- 5,400
Taxes 3,398 -0- 3,398
Depreciation 7,610 -0- 7,610
Advertising 2,494 -0- 2,494
Accounting 27,000 -0- 27,000
Auto 12,148 -0- 12,148
Bank charges 310 $148 162
Dues and
subscriptions 160 59 101
Insurance 4,860 -0- 4,860
Legal 3,168 -0- 3,168
Miscellaneous 2,704 -0- 2,704
Outside
services 2,595 -0- 2,595
Postage 240 -0- 240
Supplies 3,330 6 3,324
Telephone 2,382 420 1,962
Travel 11,191 -0- 11,191
Utilities 3,423 -0- 3,423
Total1 96,533 632 95,901
1
The sum of the items may not equal the total on account of
rounding.

b. 1990

C&G Consultants deducted and respondent disallowed expenses

on the 1990 C&G Consultants return as follows:

Amount claimed Amount allowed Amount
Expense on return by IRS disallowed

Taxes $3,395 -0- $3,395
Depreciation 13,649 -0- 13,649
Advertising 510 -0- 510
 -36-

Accounting 2,400 -0- 2,400
Auto 9,914 $760 9,154
Bank charges 322 -0- 322
Dues and
subscriptions 186 -0- 186
Gifts 165 -0- 165
Insurance 16,056 -0- 16,056
Legal 3,925 -0- 3,925
Office expense 627 36 591
Outside
services 6,710 -0- 6,710
Postage 328 -0- 328
Supplies 4,344 -0- 4,344
Telephone 2,580 91 2,489
Travel 10,053 -0- 10,053
Utilities 1,541 -0- 1,541
Arbitration Fee 1,125 -0- 1,125
Total1 77,830 886 76,944
1
The total amount allowed by the IRS may not equal the sum
of the items on account of rounding.

B. Ms. Garavaglia’s Notice of Deficiency

By notice of deficiency dated May 22, 2009, respondent

determined deficiencies in Ms. Garavaglia’s 1989 and 1990 Federal

income taxes of $99,179 and $117,557 and accuracy-related

penalties under section 6662(a) of $19,836 and $23,511,

respectively. Respondent determined income tax deficiencies of

$99,179 and $117,557 and accuracy-related penalties under section

6662(a) of $19,836 and $23,511, respectively. Most of the

deficiencies arose from the adjustments determined with respect

to Mr. Garavaglia.

C. Differences in Notices of Deficiency

The differences between the notices of deficiency issued to

Mr. Garavaglia and to Ms. Garavaglia are: (1) The notice of
 -37-

deficiency issued to Ms. Garavaglia increased C&G Consultants’

1989 share of distributable income from Trans International by

$166,865, whereas the notice of deficiency issued to Mr.

Garavaglia increased C&G Consultants’ 1989 share of distributable

income from Trans International by $159,323; (2) the notice of

deficiency issued to Ms. Garavaglia increased C&G Consultants’

1990 share of distributable income from Branch International by

$320,530, whereas the notice of deficiency issued to Mr.

Garavaglia increased C&G Consultants’ distributable share of

income from Branch International by $309,380; and (3) the notice

of deficiency issued to Ms. Garavaglia determined accuracy-

related penalties under section 6662(a), whereas the notice of

deficiency issued to Mr. Garavaglia determined fraud penalties

under section 6663(a).

XX. Trial

A trial in these cases was held in Detroit, Michigan. The

evidence consists of the uncontested pleadings, the trial

testimony of 13 fact witnesses, approximately 300 stipulated

facts, and almost 300 stipulated exhibits.

OPINION

I. Perception of Witnesses

Our resolution of these cases depends, in part, on whether

we believe that Mr. Garavaglia was uncorrupted amidst a sea of

fraud. During the course of the trial, we heard the testimony
 -38-

and observed the demeanor of 13 fact witnesses, including the

Garavaglias. We observe the truthfulness, sincerity, and

demeanor of each witness to evaluate his or her testimony. We

then assign weight to that testimony for the primary purpose of

finding disputed facts based on the record as a whole. HIE

Holdings, Inc. v. Commissioner, T.C. Memo. 2009-130. In the

light of that testimony, we weigh the evidence, make appropriate

inferences, and find what we believe to be the truth. Kropp v.

Commissioner, T.C. Memo. 2000-148. We are “careful to avoid

making the courtroom a haven for the skillful liar or a quagmire

in which the honest litigant is swallowed up.” Diaz v.

Commissioner, 58 T.C. 560, 564 (1972); Hawkins v. Commissioner,

T.C. Memo. 1993-517, affd. without published opinion 66 F.3d 325

(6th Cir. 1995).

We generally found the testimony of Mr. Garavaglia to be

self-serving, evasive, conflicted, and at times improbable. We

found material aspects of Ms. Garavaglia’s testimony to be

implausible. We found the testimony of Messrs. Rogers, D.

Yarnell, T. Yarnell, and Cheri Ghent Koehn (Ms. Koehn) to be

generally straightforward and corroborated by the documentary

evidence. The testimony of the remaining seven witnesses was

credible but mostly unhelpful in resolving issues of material
 -39-

fact.10 To the extent that we have disregarded or discounted any

testimony in these cases, we did so because we perceived the

witness offering that testimony to be untrustworthy in giving

that testimony or considered the testimony to be self-serving,

vague, elusive, uncorroborated, and/or inconsistent with

documentary or other reliable evidence.11 We need not accept

uncontroverted testimony where we find that testimony improbable,

unreasonable, or questionable. See Conti v. Commissioner, 39

F.3d 658, 664 (6th Cir. 1994), affg. in part and remanding in

part 99 T.C. 370 (1992) and T.C. Memo. 1992-616.

II. Status of Trans International and Branch International as S
Corporations

Pursuant to section 6214(a) and Rule 41(a), respondent

amended the answer to assert that Trans International and Branch

International were S corporations in 1989 and 1990.12 Proceeding

along this line, respondent argues in the main that Mr.

10
These witnesses include Marie Wilhelm, Charles Gottlieb,
James Budde, Suzanne M. Carene, Sarah Stinson, Alexandra
Nicholaides, and Joseph Ellery.
11
Nor do we rely heavily on the transcripts of testimony
given by various witnesses in prior proceedings which were
included in the record and stipulated by the parties. Because we
were not able to observe those witnesses during that testimony,
we decline to accept that prior testimony merely on the basis of
the written words. We have, however, given that testimony proper
regard in finding the facts of these cases and do not simply
reject that testimony entirely.
12
Respondent concedes on brief that Branch International was
not an S corporation in 1990.
 -40-

Garavaglia omitted distributable income in 1989 from Trans

International and Branch International of $124,383 and $104,535,

respectively. Respondent bears the burden of proof with respect

to these newly pleaded matters. See Rule 142(b).

A. Compliance With Section 1362

Section 1362(a) provides that a “small business corporation”

may elect to be taxed as a passthrough entity under subchapter S

of the Code. The term “small business corporation” generally

means an eligible domestic corporation with one class of stock

and 35 or fewer shareholders, all of whom are resident

individuals or qualified estates and trusts. Sec. 1361(b). A

small business corporation makes an election to be taxed under

subchapter S of the Code (S election) by filing with the IRS a

completed Form 2553. Sec. 1.1362-6(a)(2), Income Tax Regs.

Before an S election is valid, all shareholders as of the date

the election is made must consent to that election. Sec.

1362(a)(2). A shareholder consents to an S election by signing

and dating the Form 2553 submitted by the S corporation, see sec.

1.1362-6(b)(3)(i), Income Tax Regs., or by separately submitting

to the IRS a signed consent statement which sets forth certain

information, see sec. 1.1362-6(b)(1), Income Tax Regs.13

13
The consent statement must set forth the name, address,
and taxpayer identification number of the shareholder, the number
of shares of stock owned by the shareholder, the date or dates on
which the stock was acquired, the date on which the shareholder’s
(continued...)
 -41-

1. Trans International

There is no question that Messrs. Garavaglia and Rogers

intended for Trans International be taxed as an S corporation in

1989 and 1990. Consistent with that intent, Trans International

filed with respondent Form 2553 and the 1989 and 1990 Trans

International returns on Forms 1120S. Respondent, however,

determined that Trans International’s attempted S election was

defective, and respondent stated as much by letter dated June 14,

1989. The record does not contain a copy of a properly executed

Form 2553, and in the absence of such evidence, we presume that

none existed. See Wichita Terminal Elevator Co. v. Commissioner,

6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).

Trans International’s S election was thus invalid.

2. Branch International

There is similarly no question that Messrs. Garavaglia and

L. Yarnell intended for Branch International be taxed as an S

corporation in 1989. The corporate minute book and a statement

of organizational resolutions for Branch International each

evince a clear intent that Branch International be taxed as an S

corporation. True to that intent, Branch International filed

with respondent Form 2553 and the 1989 Branch International

13
(...continued)
taxable year ends, the corporation’s name, the corporation’s
taxpayer identification number, and the election to which the
shareholder consents. See sec. 1.1362-6(b)(1), Income Tax Regs.
 -42-

return on Form 1120S. Respondent, however, determined that

Branch International’s attempted S election was defective and

revoked that election by letter dated April 23, 1990. Thus,

Branch International’s S election was not valid.

B. Judicial Doctrines

Despite separate letters to Trans International and Branch

International rejecting or denying their S elections, respondent

urges the Court to apply judicial doctrines to overcome their

failure to comply with the requirements of section 1.1362-

6(b)(3)(i), Income Tax Regs. Respondent asserts that Trans

International and Branch International ignore their form in

disavowing their S corporation status and that the duty of

consistency estops petitioners from denying the S corporation

status of Trans International and Branch International.

Petitioners counter that neither Trans International nor Branch

International was an S corporation because the S elections which

they attempted to file with respondent were rejected.

1. Form of Trans and Branch International

As a general rule, taxpayers are bound by the form of the

transaction they have chosen, and they may not in hindsight

recast that transaction to obtain tax advantages. See Maloof v.

Commissioner, 456 F.3d 645, 651 (6th Cir. 2006) (quoting Harris

v. United States, 902 F.2d 439, 443 (5th Cir. 1990)), affg. T.C.

Memo. 2005-75. To determine the form of the transaction, we
 -43-

examine the parties’ intentions when the transaction was entered

into and the economic realities as then perceived by the parties.

See Groetzinger v. Commissioner, 87 T.C. 533, 542 (1986).

There is no question that Mr. Garavaglia manifested the

requisite intent for Trans International and Branch International

to be treated as S corporations, but the question is whether the

law gives effect to that intent. It does not. Section

1362(a)(2) provides that an initial election to become an S

corporation is valid “only if all persons who are shareholders

* * * on the day on which such election is made consent to such

election.” Sec. 1362(a)(2). Courts have strictly construed the

requirements for electing to be taxed as an S corporation. See,

e.g., Brutsche v. Commissioner, 585 F.2d 436, 443 (10th Cir.

1978) (shareholders were not individually liable for deficiency

because Form 2553 did not comply with the requirements for S

corporation status), remanding 65 T.C. 1034 (1976); Feldman v.

Commissioner, 47 T.C. 329, 334 (1966) (“where Congress has

specifically set out the procedure that must be followed in order

for a corporation to obtain the benefits of subchapter S, and the

corporation does not follow such procedure, the courts cannot

supply what the taxpayer has failed to do”).

Trans International filed a Form 2553 consent statement

which reported that Mr. D. Yarnell was the sole shareholder of

that company. However, Mr. D. Yarnell was not the sole
 -44-

shareholder of Trans International; Messrs. Garavaglia and Rogers

were equal shareholders of that company. Similarly, Branch

International filed a Form 2553 consent statement which reported

that Messrs. Garavaglia and T. Yarnell were equal shareholders in

that company. However, Messrs. Garavaglia and T. Yarnell were

not equal shareholders in Branch International; Messrs.

Garavaglia and L. Yarnell owned 70 percent and 30 percent of that

company, respectively. Thus, Trans International and Branch

International’s S elections did not comply with the requirements

of section 1.1362-6(b)(3)(i), Income Tax Regs.

2. The Duty of Consistency

The duty of consistency, or quasi-estoppel, is an equitable

doctrine which prevents a taxpayer from benefiting in a later

year from an error or omission in an earlier year which cannot be

corrected because the limitations period for the earlier year has

expired. Estate of Letts v. Commissioner, 109 T.C. 290, 296

(1997), affd. without published opinion 212 F.3d 600 (11th Cir.

2000). Absent a written stipulation to the contrary, an appeal

in this case would lie in the Sixth Circuit. Sec. 7482(b)(1)(A).

The Court of Appeals for the Sixth Circuit has held that for

the duty of consistency to apply, the following requirements must

be met: (1) The taxpayer by his or her conduct knowingly makes a

representation or conceals a material fact which the taxpayer

intends or expects will be acted upon by the Commissioner in
 -45-

determining the taxpayer’s liability; (2) the true or concealed

material facts are unknown to the Commissioner or the

Commissioner lacks a means of knowledge equal with the

taxpayer’s; (3) the Commissioner relies on the taxpayer’s

representation or concealment; and (4) an attempt by the taxpayer

after the statute of limitations has run to change the previous

representation or to recharacterize the facts in such a way

causes loss of taxes to the Government. Crosley Corp. v. United

States, 229 F.2d 376, 380-381 (6th Cir. 1956); see also Temple v.

Commissioner, 62 Fed. Appx. 605, 609 (6th Cir. 2003), affg. T.C.

Memo. 2000-337. Where each of the foregoing requirements is met,

taxpayers are estopped from asserting positions contrary to their

earlier representations, and the Commissioner may treat those

representations as true even though they are not. Herrington v.

Commissioner, 854 F.2d 755, 758 (5th Cir. 1988), affg. Glass v.

Commissioner, 87 T.C. 1087 (1986).

The requirements for applying the duty of consistency have

not been met. First, petitioners did not materially misrepresent

or conceal the status of Trans International and Branch

International as S corporations. In 1989 each corporation filed

its Form 1120S under the mistaken belief that the attempted S

election was valid. Second, respondent was aware that Trans

International and Branch International intended to be taxed as S

corporations, but did not give effect to that intent until
 -46-

amending the answer. In this regard, the status of Trans

International and Branch International was one of law and not

fact. The duty of consistency does not apply where the

inconsistent positions asserted by the taxpayer involve questions

of law arising out of a defined factual situation. See Crosley

Corp. v. United States, supra at 380. Third, respondent did not

rely on the defective election made by Trans International or

Branch International. The notices of deficiency issued to Mr.

and Ms. Garavaglia did not treat Trans International or Branch

International as an S corporation. Fourth, treating Trans

International and Branch International as C corporations does not

affect the period of limitations for assessment. That period is

either open on account of fraud, or it is closed. The status of

Trans International or Branch International as an S corporation

has no bearing on this issue.

Neither the form chosen by Trans International and Branch

International nor the duty of consistency usurps the failure of

those companies to satisfy the strict requirements for electing

subchapter S status. Trans International and Branch

International attempted to elect S corporation status, and

respondent properly denied that request. Respondent cannot now

expect this Court to supply what petitioners have failed to do

themselves, especially after declining to give effect to that

intent in the first place.
 -47-

III. Omitted Income

Having failed to persuade us that Trans International or

Branch International was an S corporation, respondent proceeds

under his alternative theory that Mr. Garavaglia omitted income

of $326,815 and $386,324 in 1989 and 1990, respectively.

Specifically, respondent asserts that (1) Mr. Garavaglia omitted

income from C&G Consultants in 1989 and 1990 of $106,709 and

$208,738, respectively; and (2) Mr. Garavaglia’s shares of C&G

Consultants’ shares of distributive income for 1989 and 1990 are

increased by $220,160 and $177,586, respectively.14 Petitioners

counter that (1) the books and records on which these

determinations were based are inherently unreliable, and (2)

payments between Mr. Garavaglia, C&G Consultants, Trans

International, and Branch International, were nontaxable loan

repayments.

A. Burden of Proof

The Commissioner’s determinations in a notice of deficiency

are generally presumed correct, and the taxpayers bear the burden

of proving that those determinations are erroneous. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). In the context of

unreported income, the Court of Appeals for the Sixth Circuit has

held that before the notice of deficiency is entitled to a

14
Respondent also made computational adjustments to Mr.
Garavaglia’s 1989 and 1990 itemized deductions of $1,440 and
$3,220, respectively.
 -48-

presumption of correctness, such determinations must be supported

by at least a “minimal” factual predicate or foundation of

substantive evidence linking the taxpayer to the income-producing

activity or to the receipt of funds. See United States v.

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

Commissioner, T.C. Memo. 2006-69, affd. 509 F.3d 736 (6th Cir.

2007). Once the Commissioner meets his burden of production, the

burden of proof shifts to the taxpayers to prove that they did

not earn the income attributable to them or of presenting an

argument that the adjustments offered by the Commissioner are not

grounded in a minimal evidentiary foundation. Richardson v.

Commissioner, supra. Where taxpayers establish by a

preponderance of the evidence that the Commissioner’s

determinations are arbitrary and excessive, then the notice of

deficiency is no longer presumed correct. Helvering v. Taylor,

293 U.S. 507, 515 (1935); Traficant v. Commissioner, 884 F.2d

258, 263 (6th Cir. 1989), affg. 89 T.C. 501 (1989).

Respondent introduced admissible, substantive evidence

linking Mr. Garavaglia to payments received in connection with a

scheme to defraud insurance companies and the Treasury. The

evidence included canceled checks and/or accounting ledgers which

reflected payments between Mr. Garavaglia, C&G Consultants, Trans

International, and Branch International. We are satisfied that

respondent has produced evidence that Mr. Garavaglia earned the
 -49-

income with which he is charged. Thus, petitioners bear the

burden of proving that respondent’s determinations are arbitrary

and excessive.

Although petitioners “reserve the issue” of whether the

notice of deficiency issued to Mr. Garavaglia was arbitrary, we

understand petitioners to advance two theories to meet their

burden. First, petitioners assert that the payments between Mr.

Garavaglia, C&G Consultants, Trans International, and Branch

International were loan repayments. Second, petitioners contend

that the books and records of Trans International and Branch

International are inherently unreliable and cannot serve as the

basis for determining income earned by Mr. Garavaglia. For the

reasons discussed below, petitioners have not met their burden.

B. Guiding Principles

Section 61(a)(2) defines gross income as all income from

whatever source derived, including gross income derived from

business. Section 61 is broad, requiring that gains from lawful

and unlawful activities be included as income. See, e.g., Rutkin

v. United States, 343 U.S. 130, 137 (1952) (“An unlawful gain, as

well as a lawful one, constitutes taxable income when its

recipient has such control over it that, as a practical matter,

he derives readily realizable economic value from it.”); see also

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

taxpayer has received income where he or she gains complete
 -50-

dominion and control over the money or other property and

realizes an economic benefit.

A taxpayer is required to maintain sufficient records to

enable the Commissioner to determine his or her correct tax

liability. Sec. 6001. Where a taxpayer fails to maintain

adequate books and records, the Commissioner is empowered to

determine the existence and amount of the taxpayer’s income by

any method that clearly reflects income. Sec. 446(b); Petzoldt

v. Commissioner, 92 T.C. 661, 686-687 (1989). The Commissioner’s

reconstruction of a taxpayer’s income need only be reasonable in

the light of the surrounding facts and circumstances. Parks v.

Commissioner, 94 T.C. 654, 658 (1990). The Commissioner is not

held to mathematical exactitude because to do so “‘would be

tantamount to holding that skillful concealment is an invincible

barrier to proof.’” Llorente v. Commissioner, 74 T.C. 260, 266

(1980) (quoting United States v. Johnson, 319 U.S. 503, 517-518

(1943)), affd. in part and revd. in part 649 F.2d 152 (2d Cir.

1981).

Respondent determined that petitioners underreported income

and overstated deductions following a criminal investigation and

prosecution of Mr. Garavaglia. Respondent also determined that

petitioners did not maintain books and records which accurately

reflected transactions between Mr. Garavaglia, C&G Consultants,

Trans International, and Branch International. We agree that
 -51-

petitioners did not maintain sufficient records from which

respondent could determine their tax liabilities. Accordingly,

respondent is given broad power to compute petitioners’ taxable

income. See Petzoldt v. Commissioner, supra at 693.

C. Distributions From C&G Consultants

Respondent determined adjustments to Mr. Garavaglia’s 1989

and 1990 income of $106,709 and $208,738, respectively. To

arrive at these adjustments, respondent’s auditor analyzed and

prepared a summary of checks endorsed by C&G Consultants to Mr.

Garavaglia during 1989 and 1990. The summary designated the

date, check number, payee, amount, and any notations made on the

checks. Respondent attached the summary to the notice of

deficiency and treated all amounts distributed from C&G

Consultants to Mr. Garavaglia during 1989 and 1990 as income to

Mr. Garavaglia. Respondent thoroughly corroborated that summary

at trial with copies of almost all of the canceled checks on

which the adjustments were based. It is well settled that a bank

deposit is prima facie evidence of income where that deposit is

made from or to an account controlled by the party charged with

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

Accordingly, we find respondent’s method to be reasonable.

We have examined the checks presented by respondent at trial

and generally agree with respondent’s conclusions. In 1989 Mr.

Garavaglia wrote himself more than 50 checks from C&G Consultants
 -52-

totaling $104,939.15 In 1990 Mr. Garavaglia wrote himself 40

checks from C&G Consultants totaling $204,818.16 These checks

were written almost weekly. As evidenced by petitioners’

financial assets of more than $1 million, Mr. Garavaglia

exercised dominion and control over these funds, and he derived

economic benefit from them. Accordingly, we hold that Mr.

Garavaglia had income of $104,939 and $204,818 in 1989 and 1990,

respectively.

D. Schedule E Income

During 1989 and 1990 Mr. Garavaglia operated as a labor

consultant through C&G Consultants. C&G Consultants reported

15
Whereas respondent’s auditor determined that Mr.
Garavaglia received $106,709 in payments from C&G Consultants, we
limit the amount of income paid to Mr. Garavaglia to $104,939.
The difference between the amount determined by respondent and
that determined by the Court resulted because respondent’s
auditor included as income check Nos. 1236, 1238, and 1239, each
of which was purportedly in the amount of $2,520, for a total of
$7,560. The checks respondent submitted, however, did not
include check No. 1236, 1238, or 1239. Instead, respondent
submitted at trial check No. 1223 in the amount of $5,790. The
difference between these amounts is $1,770 ($7,560 less $5,790),
which is also the difference between the amount determined by
respondent ($106,709) and the amount determined by the Court
($104,939).
16
Whereas respondent’s auditor determined that Mr.
Garavaglia received $208,738 in payments from C&G Consultants, we
limit the amount of income paid to Mr. Garavaglia to $204,818.
The difference between the amount determined by respondent and
that determined by the Court resulted because respondent’s
auditor included as income (1) $2,520 apparently paid on check
No. 1256, and (2) $1,400 designated as “CC”. The records
respondent submitted did not include check No. 1256 or otherwise
clarify what the payment “CC” related to. Accordingly, we reduce
the income as determined by respondent by $3,920.
 -53-

gross receipts of $50,000 on each of the 1989 and 1990 returns,

amounts which were paid pursuant to an independent contractor

agreement with Central. The 1989 and 1990 C&G Consultants

returns, however, did not report as gross receipts or sales

income from Trans International or Branch International, even

though those companies made regular and sizable payments to C&G

Consultants.

Respondent determined adjustments of $220,160 and $177,586

to Mr. Garavaglia’s 1989 and 1990 distributable shares of income,

respectively. Specifically, respondent determined adjustments to

C&G Consultants’ 1989 and 1990 returns as follows: (1) An

increase of $159,323 from Trans International’s 1989 gross sales

or receipts; (2) increases of $71,645 and $309,380 from Branch

International’s 1989 and 1990 gross sales or receipts,

respectively; (3) decreases of $106,709 and $208,738 for

officer’s compensation; and (4) increases of $95,901 and $76,944

for other expenses. We consider each adjustment in turn.

1. Gross Sales or Receipts From Trans International

Respondent determined an adjustment to C&G Consultants’ 1989

gross receipts or sales from Trans International of $159,323.

This adjustment was figured from Trans International’s general

ledger because canceled checks between Trans International and

C&G Consultants were unavailable. Given the circumstances of

this case, we find respondent’s method for calculating payments
 -54-

between Trans International and C&G Consultants to be reasonable.

See sec. 446(b).

We have confirmed the accuracy of respondent’s analysis and

found that Trans International’s general ledger recorded that C&G

Consultants was paid (1) $60,233 of consulting fees, and (2)

$99,090 of premiums collected from Trans International’s client

companies and distributed to C&G Consultants. Mr. Garavaglia

does not dispute that C&G Consultants received these payments and

we treat them as income to C&G Consultants. Accordingly, we hold

that C&G Consultants’ 1989 gross receipts or sales are increased

by $159,323.

2. Gross Sales or Receipts From Branch International

Respondent also determined adjustments to C&G Consultants’

gross receipts or sales from Branch International in 1989 and

1990 of $71,645 and $309,380, respectively. To compute these

adjustments, respondent’s auditor analyzed canceled checks

between Branch International and C&G Consultants. Respondent

treated all payments from Branch International to C&G Consultants

as income to C&G Consultants. He also corroborated the proposed

adjustments at trial by submitting copies of most of the checks

on which the adjustments were based.

We have verified respondent’s analysis and generally agree

with his determinations. In 1989 Branch International endorsed

39 separate checks to C&G Consultants totaling $71,645. In 1990
 -55-

Branch International endorsed 98 separate checks to C&G

Consultants totaling $329,805. These payments were routinely

made, and Mr. Garavaglia does not dispute that C&G Consultants

received these payments. Although the record reflects that

Branch International paid C&G Consultants $329,805, we limit the

amount of the deficiency to the amounts respondent determined.

Consequently, we hold that C&G Consultants’ gross receipts or

sales from Branch International in 1989 and 1990 are increased by

$71,645 and $309,385, respectively.

3. Compensation of Officers

Respondent determined that C&G Consultants was entitled to

deductions for officers compensation in 1989 and 1990 of $106,709

and $208,738, respectively. Respondent’s opening brief is

consistent with this position in that respondent asserts that C&G

Consultants is entitled to a deduction in an amount equal to the

distributions that C&G Consultants made to Mr. Garavaglia.

Section 162(a)(1) allows as a deduction all the ordinary and

necessary expenses of a business, including a reasonable

allowance for salaries or other compensation for personal

services actually rendered.17 We have determined that Mr.

Garavaglia received from C&G Consultants income of $104,939 and

$204,818 during 1989 and 1990, respectively. These amounts were

17
Respondent does not assert that the compensation is not
reasonable. See, e.g., Alpha Med., Inc. v. Commissioner, 172
F.3d 942, 945-947 (6th Cir. 1999), revg. T.C. Memo. 1997-464.
 -56-

the equivalent of wages or salaries paid between C&G Consultants

and Mr. Garavaglia. We thus hold that C&G Consultants is

entitled to deductions for officers’ compensation of $104,939 and

$204,818 in 1989 and 1990, respectively.

4. Other Expenses

Respondent disallowed expenses of $95,901 and $76,944 which

C&G Consultants claimed as deductions on its 1989 and 1990

returns. It is well settled that deductions are a matter of

legislative grace, and that a taxpayer bears the burden of

producing sufficient evidence to substantiate any deduction that

would otherwise be allowed by the Code. Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Although

petitioners submitted numerous receipts showing that expenses

were paid by C&G Consultants, they provided no explanation that

those expenses were ordinary and necessary to C&G Consultants’

labor consulting trade or business. See sec. 162(a).

Accordingly, we sustain respondent’s determination that C&G

Consultants may not deduct other expenses of $95,901 and $77,830

in 1989 and 1990, respectively.

F. Petitioners’ Contentions

1. Reliability of Books and Records

Petitioners contend that members of the Yarnell family are

“master embezzlers” who manipulated the books and records of

Trans International and Branch International such that the books
 -57-

and records of those companies are unreliable. According to

petitioners, members of the Yarnell family “throw around journal

entries like they are trinkets at Mardi Gras”. Petitioners seek

to muddy the waters in an obvious attempt to divert the Court’s

attention from their own wrongdoing. We are not persuaded.

Petitioners refer the Court to minor flaws in the books and

records of Branch International as proof that members of the

Yarnell family could have written checks to themselves that did

not appear on the books and records of Trans International and

Branch International. We decline to treat the books of Trans and

Branch International as unreliable simply to reflect the

possibility of fabrication. As the Supreme Court stated in

United States v. Biceglia, 420 U.S. 141, 145 (1975): “our tax

structure is based on a system of self-reporting. There is legal

compulsion, to be sure, but basically the Government depends upon

the good faith and integrity of each potential taxpayer to

disclose honestly all information relevant to tax liability.”

Nor are we persuaded by petitioners’ attempts to cast doubt

on Mr. Garavaglia’s liability under the pretense that members of

the Yarnell family were “master embezzlers”. As early as

December 1, 1990, Mr. Garavaglia was aware that Mr. L. Yarnell

and his wife “received double payment of remuneration” of $9,000.

According to the corporate records of Branch International Mr.

Garavaglia and Mr. L. Yarnell agreed that Mr. L. Yarnell would
 -58-

repay these amounts. Moreover, Mr. Garavaglia was vice president

of security at Central from 1975 through part of 1986. We doubt

that Mr. Garavaglia would not have recognized the claimed

embezzlement by members of the Yarnell family especially given

that he recognized an overpayment as small as $9,000.

The books and records of Trans International and Branch

International show in detail the transfers to C&G Consultants,

Sentury, LTD Accounting, or members of the Yarnell family. Many

of the entries in these books and records are corroborated by

canceled checks between the respective entities. We lend greater

weight to this documentary evidence than to Mr. Garavaglia’s

self-serving testimony.

2. Purported Loans

Petitioners assert that distributions between Mr.

Garavaglia, C&G Consultants, Trans International, and Branch

International were nontaxable loan repayments. Specifically,

petitioners assert that C&G Consultants lent (1) $75,000 and

$117,000 to Trans International in 1988 and 1989, respectively,

and (2) $70,000 to Branch International in 1989.18 Petitioners

18
Mr. and Ms. Garavaglia’s briefs are inconsistent in the
amounts which they claim was lent to Trans International. In
particular, Ms. Garavaglia contends that C&G Consultants made two
additional loans not considered by Mr. Garavaglia. We reject Ms.
Garavaglia’s claim that these loans were made, for the reasons
stated elsewhere in this opinion.
 -59-

bear the burden of proving that the transferred funds were loan

repayments. See Rule 142(a).

For a bona fide loan to exist, the parties to the loan must

have intended to establish a debtor-creditor relationship when

the funds were advanced. Berthold v. Commissioner, 404 F.2d 119,

122 (6th Cir. 1968), affg. T.C. Memo. 1967-102; Haag v.

Commissioner, 88 T.C. 604, 615-617 (1987), affd. without

published opinion 855 F.2d 855 (8th Cir. 1988). Loans between

related parties, such as a shareholder and a closely held

corporation, are subject to particular scrutiny “because the

control element suggests the opportunity to contrive a fictional

debt.” United States v. Uneco, Inc., 532 F.2d 1204, 1207 (8th

Cir. 1976) (quoting Cuyuna Realty Co. v. United States, 180 Ct.

Cl. 879, 382 F.2d 298, 300-301 (1967)). Because the intentions

of parties to a loan are often unclear, courts rely upon

objective factors to distinguish between loans and disguised

dividends. These factors include: (1) Whether the promise to

repay is evidenced by a note or other instrument; (2) whether

adequate interest was charged; (3) whether a fixed repayment

schedule was established; (4) whether collateral was given to

secure payment; (5) whether repayments were made; (6) whether the

borrower had a reasonable prospect of repaying the loan and

whether the lender had sufficient funds to advance the loan; and

(7) whether the parties conducted themselves as if the
 -60-

transaction was a loan. See Dietrick v. Commissioner, 881 F.2d

336, 340 (6th Cir. 1989), affd. T.C. Memo. 1988-180.

To meet their burden, petitioners rely upon Mr. Garavaglia’s

testimony and at least six loan agreements between Mr.

Garavaglia, C&G Consultants, Trans International, or Branch

International.19 We reject petitioners’ characterization of the

distributions as loan repayments. First, petitioners submitted

notes which purport to be loan agreements between C&G

Consultants, Trans International, and Branch International.

However, this evidence was seriously undermined by the testimony

of Messrs. Rogers and L. Yarnell and Ms. Koehn. Mr. Rogers

testified that he and Mr. Garavaglia met to execute loan

documents after CID executed its search warrants. Mr. Rogers

also testified that he was unaware that Mr. Garavaglia made any

loans to Trans International and that he would have known if such

loans had been made because Mr. Rogers controlled Trans

International’s bank accounts. Mr. L. Yarnell and Ms. Koehn each

19
Petitioners also present seven letters or loan documents
which state that between Mar. 15, 1986, and Sept. 10, 1989, Mr.
Garavaglia lent $231,000 to C&G Consultants. Two of these
purported loan documents are marked “Paid” as of Dec. 29, 1988.
One claimed loan document is an unsigned page of an agreement
which may or may not be a loan agreement. The four remaining
loan documents do not prescribe a stated rate of interest, the
posting of collateral, or a fixed repayment schedule. We
conclude that none of these six documents memorialized a bona
fide loan.
 -61-

identified documents which purport to bear their signature but

which they did not in fact sign.

Second, petitioners claim that distributions which they

received from Trans International in the form of consulting fees

were actually loan repayments from Trans International to C&G

Consultants. However, Trans International deducted these

consulting fees as expenses on the 1989 Trans International

return. We doubt that Trans International would have deducted

loan repayments as consulting fees given that Trans

International’s general ledger also treated these payments as

consulting fees.

Third, Branch International’s books and records do not

reflect loan repayments in the amounts offered by petitioners.

Branch International maintained an account titled “Note Payable--

C&G Consultants” (note payable account). If Branch International

regarded those distributions as loan repayments, one might expect

that Branch International would have recorded these transactions

in its note payable account. For example, Mr. Garavaglia

contends that he lent Branch International $30,000 for startup

costs in May 1989. Yet Branch International’s books and records

credited the note payable account only $8,310. This loan was

repaid by check on October 19, 1988, and was accounted for as a

loan in the calculations of respondent’s auditor. The

distributions which petitioners claim are loan repayments were
 -62-

not debited to the note payable account. Instead, these

distributions were charged to the consulting fees and/or premium

expense account.

Fourth, distributions from Trans International to C&G

Consultants and Sentury were generally proportionate to the

ownership interest of Messrs. Garavaglia and Rogers. Similarly,

distributions from Branch International to C&G Consultants and

LTD Accounting or members of the Yarnell family were generally in

proportion to the ownership interests of Mr. Garavaglia and Mr.

L. Yarnell. Respondent contends, and we agree, that the

distributions between C&G Consultants, Trans International, and

Branch International represented Mr. Garavaglia’s share of the

proceeds from perpetrating a fraud upon the insurance companies.

The evidence as a whole makes suspect Mr. Garavaglia’s claim

that he lent money to C&G Consultants, Trans International, and

Branch International. He is faced with the contradictory

testimony of three witnesses who allege that he falsified

documents and never made the loans which he claims to have made.

We decline to credit Mr. Garavaglia’s testimony given the

consistent testimony of three witnesses and the strong proof of

fraud against him. See, e.g., Frierdich v. Commissioner, 925

F.2d 180, 185-186 (7th Cir. 1991) (treating a taxpayer’s

explanation of the existence of a loan as plausible but
 -63-

insufficient to establish a bona fide debt), affg. T.C. Memo.

1989-103 as amended by T.C. Memo. 1989-393.

IV. Fraud Penalty

Section 6663(a) imposes a 75-percent penalty on the portion

of any underpayment of tax attributable to fraud. Section

6663(b) provides that where the Commissioner establishes that any

portion of an underpayment of tax is attributable to fraud, the

entire underpayment is treated as attributable to fraud except

with respect to the portion of the underpayment that the taxpayer

establishes, by a preponderance of the evidence, is not

attributable to fraud. Section 6663(c) specifies that in the

case of a joint return, the 75-percent penalty imposed by section

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

underpayment is attributable to the fraud of that spouse.

The Commissioner bears the burden of establishing fraud by

clear and convincing evidence. Sec. 7454(a); Rule 142(b). Clear

and convincing evidence is:

“that measure or degree of proof which will produce in
the mind of the trier of facts a firm belief or
conviction as to the allegations sought to be
established. It is intermediate, being more than a
mere preponderance, but not the extent of such
certainty as is required beyond a reasonable doubt as
in criminal cases. It does not mean clear and
unequivocal.” * * *

Ohio v. Akron Ctr. for Reprod. Health, 497 U.S. 502, 516 (1990)

(quoting Cross v. Ledford, 120 N.E.2d 118, 123 (Ohio 1954)); see

also Hobson v. Eaton, 399 F.2d 781, 784 n.2 (6th Cir. 1968). To
 -64-

carry his burden, the Commissioner must prove for each year in

which fraud is alleged that (1) an underpayment of tax existed,

and (2) a portion of the underpayment is attributable to fraud.

Petzoldt v. Commissioner, 92 T.C. at 698.

A. Underpayment of Tax

The Commissioner may satisfy his burden of proving an

underpayment of tax attributable to unreported income in either

of two ways: (1) By proving a likely source of the unreported

income; or (2) by disproving any alleged nontaxable source of

that income. DiLeo v. Commissioner, 96 T.C. 858, 873-874 (1991),

affd. 959 F.2d 16 (2d Cir. 1992). Respondent has proven by clear

and convincing evidence that Mr. Garavaglia earned unreported

income of more than $850,000 by virtue of income received from

C&G Consultants and an increase in C&G Consultants’ distributable

share of income from Trans International and Branch

International. We thus find that respondent has clearly and

convincingly satisfied the first element of section 6663(a).

B. Fraudulent Intent

Whether a portion of the underpayment of tax is attributable

to fraud is a question of fact to be resolved on the basis of the

record as a whole. Parks v. Commissioner, 94 T.C. at 660. Fraud

is defined as the intentional commission of an act or acts for

the specific purpose of evading tax believed to be owing.

Petzoldt v. Commissioner, supra at 698. Fraud implies bad faith,
 -65-

intentional wrong doing and a sinister motive. Davis v.

Commissioner, 184 F.2d 86, 87 (10th Cir. 1950), remanding a

Memorandum Opinion of this Court. Fraud is never imputed or

presumed but must always be established by independent evidence

that establishes fraudulent intent. Petzoldt v. Commissioner,

supra at 699. Because fraud is rarely admitted, alleged tax

fraud may be proven by circumstantial evidence that is “so strong

that no other conclusion can be reached”. Biggs v. Commissioner,

440 F.2d 1, 5 (6th Cir. 1971), affg. T.C. Memo. 1968-240; see

also Richardson v. Commissioner, 509 F.3d 736, 743 (6th Cir.

2007), affg. T.C. Memo. 2006-69. We may infer fraud from “any

conduct, the likely effect of which would be to mislead or

conceal.” United States v. Walton, 909 F.2d 915, 926 (6th Cir.

1990).

Courts often rely upon certain “badges” of fraud in deciding

whether a taxpayer had the requisite fraudulent intent to support

a penalty under section 6663(a). These indicia of fraud include:

(1) Understatements of income, (2) destruction of records, (3)

implausible or inconsistent explanations of behavior, (4)

concealment of income or assets, (5) failure to cooperate with

tax authorities, (6) participation in illegal activities, (7) the

credibility of the taxpayer’s testimony, (8) filing false

documents, (9) failure to file accurate tax returns, (10) failing

to furnish the Government with access to the taxpayer’s records,
 -66-

and (11) intention to mislead which may be inferred from a

pattern of activity. See Spies v. United States, 317 U.S. 492,

499 (1943); Solomon v. Commissioner, 732 F.2d 1459, 1461-1462

(6th Cir. 1984), affg. T.C. Memo. 1982-603; Niedringhaus v.

Commissioner, 99 T.C. 202, 211 (1992). Although no one factor is

dispositive, the existence of several indicia is competent

evidence of fraud. Solomon v. Commissioner, supra at 1461;

Niedringhaus v. Commissioner, supra at 211.

1. Direct Evidence of Fraud

On or before January 31, 1990, Mr. T. Yarnell sent to Mr.

Garavaglia a letter which stated that amounts due from Trans

International and Branch International to the Ohio Bureau of

Workman’s Compensation were generally “[scaled] down” to 25

percent of the actual amounts due. Attached to that letter were

schedules showing “actual” and “modified” payrolls for Trans and

Branch International. This letter and the accompanying schedules

serve as persuasive direct evidence that as of January 31, 1990,

Mr. Garavaglia knew that Trans International and Branch Interna-

tional had understated their workers’ compensation liability.

This letter and the accompanying schedules were received by Mr.

Garavaglia before the 1989 and 1990 Trans International and

Branch International returns were filed, and we therefore believe

that Mr. Garavaglia knew of the underreporting of premiums when
 -67-

he filed the 1989 Trans International and Branch International

returns. This factor favors a finding of fraudulent intent.

2. Understatement of Income

A pattern of consistently and substantially underreporting

income over several years is evidence of fraud. Holland v.

United States, 348 U.S. 121, 137-139 (1954). Petitioners failed

to report or account for more than $850,000 of income paid to Mr.

Garavaglia or C&G Consultants over 2 years. The evidence clearly

and convincingly establishes that Mr. Garavaglia underreported

his taxable income for 1989 and 1990. The failure to report this

income is strong evidence of fraudulent intent. See Kurnick v.

Commissioner, 232 F.2d 678 (6th Cir. 1956), affg. T.C. Memo.

1955-31.

3. Destruction of Records

Although we look to Mr. Garavaglia’s actions at the time he

filed the 1989 and 1990 joint returns, we may consider his

actions after the tax filings to determine his earlier state of

mind. Richardson v. Commissioner, supra at 743-744. Mr.

Garavaglia’s behavior after CID executed its search warrants made

a bad situation worse. In a telephone conversation with Mr. L.

Yarnell on July 14, 1992, Mr. Garavaglia advised Mr. L. Yarnell

to destroy Branch International’s records, canceled checks, Forms

941, and worksheets used in the workers’ compensation audits.

Soliciting another to destroy books and records is indicative of
 -68-

fraudulent intent to evade taxes. See, e.g., Spies v. United

States, supra at 499.

4. Implausible or Inconsistent Explanations

The implausible behavior exhibited by Mr. Garavaglia began

with Trans Continental in March 1989. The auditor assigned to

Trans Continental’s audit in 1989 determined a shortfall in that

company’s premiums. Rather than contest that deficiency or make

whole the insurance company, Messrs. Garavaglia, Rogers, and L.

Yarnell avoided the shortfall by forming Trans International as a

parallel employee leasing company. Trans Continental’s ending

balances on its books and records became Trans International’s

beginning balances. Trans Continental’s workers’ compensation

liability was thus transmitted to Trans International, and Trans

International’s formation was grounded in fraud by early 1989.

The implausible behavior of Mr. Garavaglia continued at

Trans International and Branch International throughout 1989 and

1990. As evidenced by the letter from Mr. T. Yarnell to Mr.

Garavaglia on January 30, 1990, Trans International and Branch

International scaled down their payrolls to 25 percent of actual.

The actual and modified payrolls were used to bill client

companies and compute the premiums payable to the insurance

companies. The differences between the amounts billed to the

client companies and the amounts paid to the insurance companies

were distributed to, among others, Mr. Garavaglia.
 -69-

Underreporting Trans International’s and Branch International’s

payrolls caused the premiums they owed to the insurance companies

to be understated by approximately 75 percent. The

understatements deprived the insurance companies of working

capital and exposed them to unnecessary and unmanageable risk.

Also implausible is Mr. Garavaglia’s conduct in reporting

the activities of C&G Consultants, Trans International, and

Branch International. The tax scheme perpetrated by Mr.

Garavaglia is inextricably related to the insurance scheme. By

accruing an expense larger than actually paid, Trans

International and Branch International also deducted expenses

greater than they paid. For book and tax purposes, these

accruals were never adjusted to reflect the actual premiums paid

to the insurance companies. Mr. Garavaglia therefore overstated

premium deductions on the 1989 and 1990 Trans International and

Branch International returns, while omitting substantial income.

Mr. Garavaglia’s explanation of his behavior is similarly

implausible and inconsistent. He explained at trial that he

acted “in good faith” when he “low-[balled]” the insurance

companies because it was common practice to do so. He explained

that he expected the insurance companies to be made whole during

the audit. However, he took no affirmative steps to ensure that

the insurance companies were made whole, and he actively hid and
 -70-

concealed his misdeeds. We find fraudulent intent from Mr.

Garavaglia’s implausible behavior and inconsistent explanations.

5. Concealment of Income or Assets

Fraud is evidenced by proof that the taxpayer intended to

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

mislead, or otherwise prevent the collection of taxes. Rowlee v.

Commissioner, 80 T.C. 1111, 1123 (1983). Respondent received a

tip that Mr. Garavaglia had perpetrated a fraud upon insurance

companies and the Treasury from a confidential informant. That

tip was corroborated by members of the Yarnell family, who

explained the nuances of Mr. Garavaglia’s fraudulent activities.

CID executed search warrants and conducted telephone surveillance

of Mr. Garavaglia to learn the details of Mr. Garavaglia’s

elaborate fraud. When Mr. Garavaglia learned that CID had

implicated him in illegal activity, he went to great efforts to

conceal and mislead the Government about his misdeeds. At no

time was Mr. Garavaglia honest or straightforward about his

wrongdoing. This factor suggests fraudulent intent.

6. Failure To Cooperate With Tax Authorities

The failure to cooperate with tax authorities demonstrates

fraudulent intent. See Powell v. Granquist, 252 F.2d 56, 61 (9th

Cir. 1958). Mr. Garavaglia’s interaction with CID and opposing

counsel was evasive and devious. He encouraged Mr. L. Yarnell to

destroy records before CID could access them. At trial Mr.
 -71-

Garavaglia evaded simple and direct questions from respondent’s

counsel. This factor favors a finding of fraudulent intent.

7. Participation in Illegal Activities

Mr. Garavaglia pleaded guilty to and was convicted of one

count of mail fraud for a fraudulent check mailed on June 28,

1991, and one count of conspiracy to defraud the United States

Government by filing a false corporate income tax return for

Branch International in violation of section 7206(1). Although

that conviction does not collaterally estop Mr. Garavaglia from

denying that he fraudulently understated petitioners’ income tax

liabilities, that conviction is a probative fact that may be

considered persuasive evidence of fraudulent intent. Wright v.

Commissioner, 84 T.C. 636, 643-644 (1985).

Upon entering his guilty plea, Mr. Garavaglia stipulated

that he knowingly participated in a scheme to defraud insurance

companies through Branch International. He also stipulated that

he and several of his business associates agreed to defraud the

IRS by claiming deductions in excess of the expenses actually

paid. He also agreed that the “tax loss” resulting from the

charged tax offenses might be at least $207,000, an amount which

he agreed to pay as restitution before sentencing. Mr.

Garavaglia’s illegal activities indicate fraudulent intent.
 -72-

8. Failure To File Accurate Tax Returns

Fraudulent intent may be inferred where a taxpayer files a

return intending to conceal, mislead, or otherwise prevent the

collection of tax. Spies v. United States, 317 U.S. at 499.

Almost all tax filings undertaken by Mr. Garavaglia, C&G

Consultants, Trans International, and Branch International were

improperly filed. The 1989 and 1990 joint returns understated

income earned by Mr. Garavaglia from C&G Consultants. Trans

International’s Form 2553 reported Mr. D. Yarnell as the sole

shareholder of that company, even though he was not. Branch

International’s Form 2553 reported Mr. T. Yarnell as that

company’s shareholder, even though he was not a shareholder at

all. The 1989 and 1990 Trans International returns and the 1989

Branch International return were filed on Forms 1120S, even

though these companies had not made valid elections to be taxed

as S corporations. This factor favors a finding of fraud.

C. Effect of Fraud

After our review of the record as a whole in the light of

the foregoing factors, we are convinced that portions of the

underpayments of tax on the 1989 and 1990 joint returns were

attributable to Mr. Garavaglia’s fraud. Where the Commissioner

establishes that any portion of an underpayment is attributable

to fraud, the entire underpayment is treated as attributable to

fraud, except to the extent that the taxpayer establishes
 -73-

otherwise. See sec. 6663(b); Hagaman v. Commissioner, 958 F.2d

684, 696 (6th Cir. 1992), affg. and remanding T.C. Memo. 1990-

655. Mr. Garavaglia has failed to establish that any portions of

the underpayments were not attributable to fraud. Accordingly,

we hold that Mr. Garavaglia is liable for fraud penalties in 1989

and 1990 in amounts to be determined under Rule 155.

V. Accuracy-Related Penalty

Section 6662(a) and (b)(2) imposes a 20-percent accuracy-

related penalty on that portion of an underpayment of tax due to

a substantial understatement of income tax. Section 6662(b)

provides that a section 6662(a) accuracy-related penalty does not

apply to any portion of an underpayment of tax subject to the

fraud penalty under section 6663. Where a joint return is filed

and one spouse is found liable for the fraud penalty, imposing

the accuracy-related penalty on the other spouse constitutes

impermissible stacking. Foxworthy, Inc. v. Commissioner, T.C.

Memo. 2009-203; Talmage v. Commissioner, T.C. Memo. 2008-34,

affd. 391 Fed. Appx. 660 (9th Cir. 2010); Said v. Commissioner,

T.C. Memo. 2003-148, affd. 112 Fed. Appx. 608 (9th Cir. 2004).

Petitioners filed joint returns for 1989 and 1990.

Respondent imposed the accuracy-related penalty on Ms. Garavaglia

for underpayments of tax upon which the Court found Mr.

Garavaglia liable for the fraud penalty. Therefore, we find that

imposing the accuracy-related penalty would result in
 -74-

impermissible stacking. Accordingly, we hold that Ms. Garavaglia

is not liable for the section 6662(a) accuracy-related penalty.

VI. Statute of Limitations

Petitioners assert that the period of limitations on

assessment has expired with respect to 1989 and 1990. Respondent

counters that the period of limitations for assessment is open on

account of the fraud of Mr. Garavaglia, or alternatively, on

account of the fraud of petitioners’ paid return preparers.

As a general rule, the Commissioner must assess the amount

of tax against an individual taxpayer within 3 years after a tax

return is filed. Sec. 6501(a) and (b)(1); Mecom v. Commissioner,

101 T.C. 374, 382 (1993), affd. without published opinion 40 F.3d

385 (5th Cir. 1994). In the case of the filing of a false or

fraudulent return with the intent to evade tax, however, the tax

may be assessed at any time. Sec. 6501(c)(1). If any part of a

return is determined to be the result of fraud, a taxpayer may

not assert as a defense that the period of limitations has

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

affg. T.C. Memo. 1960-32. In the case of a joint return, proof

of fraudulent intent as to either joint taxpayer lifts the bar of

the statute of limitations as to both taxpayers. See Hicks Co.

v. Commissioner, 56 T.C. 982, 1030 (1971), affd. 470 F.2d 87 (1st

Cir. 1972). We have found that Mr. Garavaglia filed the 1989 and

1990 joint returns fraudulently with the intent to evade tax. It
 -75-

follows that the period of limitations on assessment is open as

to both years as to Mr. and Ms. Garavaglia. See Colestock v.

Commissioner, 102 T.C. 380, 385 (1994).

VII. Ms. Garavaglia’s Entitlement to Innocent Spouse Relief

Under section 6013(d)(3), a husband and wife filing a joint

Federal income tax return are generally jointly and severally

liable for all taxes determined to be owing. Ms. Garavaglia

asserts that she is entitled to relief from joint and several

liability under section 6015(b) and (f). Respondent argues that

Ms. Garavaglia is not entitled to such relief because she knew or

should have known of the income giving rise to the deficiency,

and that it is equitable to hold her liable for that deficiency.

Except as otherwise provided in section 6015, Ms. Garavaglia

bears the burden of proving her entitlement to such relief. See

Rule 142(a); Alt v. Commissioner, 119 T.C. 306, 311 (2002), affd.

101 Fed. Appx. 34 (6th Cir. 2004).

A. Section 6015(b)

Ms. Garavaglia may be granted relief under section 6015(b)

if the following requirements are met for each year: (A) A joint

return was made, (B) on that return there is an understatement of

tax attributable to erroneous items of one petitioner filing the

joint tax return, (C) Ms. Garavaglia establishes that in signing

the return she did not know, and did not have reason to know,

that there was an understatement of tax, (D) taking into account
 -76-

all of the facts and circumstances, it is inequitable to hold Ms.

Garavaglia liable for the deficiency in tax for the taxable year

attributable to the understatement; and (E) Ms. Garavaglia

elected innocent spouse relief no later than 2 years after the

date respondent began collection activities with respect to Ms.

Garavaglia. See sec. 6015(b)(1). The requirements of section

6015(b)(1) are stated in the conjunctive, and therefore the

failure to satisfy any one of the requirements precludes relief

under that section. Alt v. Commissioner, supra at 313.

The parties agree that the only factors in dispute are

whether Ms. Garavaglia knew or should have known that there were

understatements of tax in filing the 1989 and 1990 joint returns

and whether it would be equitable to hold her liable for the

understatements. We answer both questions in the affirmative and

therefore find that Ms. Garavaglia is not entitled to relief

under section 6015(b).

1. Ms. Garavaglia’s Knowledge

With respect to the knowledge requirement of section

6015(b)(1)(C), a spouse has “reason to know” of an understatement

if a reasonably prudent taxpayer in her position at the time she

signed the return could be expected to know that the return

contained the understatement. Factors to be considered in

analyzing whether the alleged innocent spouse had “reason to

know” of the understatement include: (1) The spouse’s education;
 -77-

(2) the spouse’s involvement in the couple’s business and

financial affairs; (3) the presence of unusual or lavish

expenditures inconsistent with the couple’s past levels of

income, standard of living, and spending patterns; and (4) the

evasiveness and deceit of the nonrequesting spouse concerning the

couple’s finances. See Greer v. Commissioner, 595 F.3d 338, 346-

347 (6th Cir. 2010) (citing Price v. Commissioner, 887 F.2d 959,

963 (9th Cir. 1989)), affg. T.C. Memo. 2009-20.

a. Education

Ms. Garavaglia has a high school education.

b. Involvement in Business and Financial Affairs

Ms. Garavaglia contends that she was not involved in the

family’s financial affairs. Being a homemaker and lacking

sophistication in financial affairs does not alone relieve a

taxpayer of joint and several tax liability. Shea v.

Commissioner, 780 F.2d 561, 566 (6th Cir. 1986), affg. in part

and revg. in part T.C. Memo. 1984-310. Nor does failing to

inquire into the family’s financial and tax situation, especially

where such an inquiry would have required minimal effort on the

part of the requesting spouse. See id. Ms. Garavaglia contends

that she looked only at the tops of the pages of the 1989 and

1990 joint returns; she testified that she did not “look through

any of the workings”. It is well settled that the requesting

spouse cannot bury his or her head in the sand or turn a blind
 -78-

eye to the couple’s tax filings. See, e.g., Greer v.

Commissioner, supra at 351 (and cases cited thereat).

Participation in a spouse’s business affairs ordinarily

negates an innocent spouse claim. See Shea v. Commissioner,

supra at 566. Ms. Garavaglia was an officer of C&G Consultants

and a part owner in Branch International. She attended the

meetings of the board of directors of C&G Consultants and

recorded the minutes for those meetings. She testified regarding

the alleged loans which Mr. Garavaglia made to C&G Consultants,

Trans International, and Branch International. As evidenced by a

telephone conversation with Mr. L. Yarnell on July 16, 1992, she

also had unique knowledge of the location of financial records

for Branch International. We thus find that Ms. Garavaglia was

more knowledgeable in the financial and business affairs of Mr.

Garavaglia than she leads us to believe.

c. Unusual or Lavish Expenditures

The lavish lifestyle enjoyed by petitioners placed Ms.

Garavaglia on further notice that the 1989 and 1990 joint returns

underreported petitioners’ income. Although petitioners earned

modest incomes in 1989 and 1990, they had financial assets of

more than $1 million. They also owned a lake house through C&G

Consultants which they used for parties, picnics, union meetings,

and storage.
 -79-

d. Deceit of Mr. Garavaglia

Although Mr. Garavaglia perpetrated fraud on insurance

companies and the Treasury, he clearly trusted Ms. Garavaglia.

He named her an officer of C&G Consultants, made her a part owner

in Branch International, and employed her as a secretary. He

presented the 1989 and 1990 joint returns to Ms. Garavaglia for

signing and she signed those returns of her own free will. At

trial Messrs. Rogers, T. Yarnell, and D. Yarnell testified that

Mr. Garavaglia never discussed workers’ compensation issues with

Ms. Garavaglia. However, this does not mean that Ms. Garavaglia

did not have reason to know of Mr. Garavaglia’s fraudulent

activities. See Shea v. Commissioner, supra at 565-566.

e. Summary

On the basis of the foregoing factors and the record as

whole, we conclude that Ms. Garavaglia knew or had reason to know

of the understatements on the 1989 and 1990 joint returns.

2. Equitable Considerations

With respect to equitable concerns under section

6015(b)(1)(D), we evaluate all of the facts and circumstances to

determine whether it would be inequitable to hold Ms. Garavaglia

liable for the deficiencies of Mr. Garavaglia. The factors we

consider in determining inequity for purposes of section

6015(b)(1)(D) are the same factors that we consider in

determining inequity for purposes of section 6015(f). Alt v.
 -80-

Commissioner, 119 T.C. at 316. The IRS has enumerated seven

threshold conditions which must be satisfied before we consider a

request for relief under section 6015(f). See Rev. Proc. 2003-

61, sec. 4.01, 2003-2 C.B. 296, 297. The factors most commonly

considered are (1) whether there has been a significant benefit

beyond normal support to the spouse claiming relief, and (2)

whether the failure to report the correct tax liability on the

joint return results from concealment, overreaching, or any other

wrongdoing on the part of the nonrequesting spouse. Hayman v.

Commissioner, 992 F.2d 1256, 1262-1263 (2d Cir. 1993), affg. T.C.

Memo. 1992-228.

In view of the circumstances surrounding petitioners’

understatements of tax, petitioners have failed to persuade us

that Ms. Garavaglia should not be held jointly and severally

liable for deficiencies related to petitioners’ 1989 and 1990

Federal income taxes. Ms. Garavaglia knew or should have known

that petitioners underreported their income where distributions

were made from companies which she either owned or served as an

officer. The 1989 and 1990 joint returns omitted approximately

$850,000 of income which Mr. Garavaglia received from C&G

Consultants. These assets directly benefited Ms. Garavaglia, and

far exceeded normal support. She willingly signed the 1989 and

1990 joint tax returns without further questioning. Ms.

Garavaglia chose to turn a blind eye on tax and financial
 -81-

matters, and she may not now claim ignorance. Such is especially

so because she significantly benefited from the income omission.

Accordingly, we hold that Ms. Garavaglia is not entitled to

relief under section 6015(b).

B. Section 6015(f)

For the reasons stated above, we conclude that Ms.

Garavaglia is not entitled to relief under section 6015(f).

VIII. Alleged Violations of Constitutional Guaranties

On brief, petitioners assert that the Government violated

their Fifth Amendment right to due process when CID seized but

failed to return petitioners’ records after the closure of the

criminal proceedings against Mr. Garavaglia. Petitioners urge

the Court to dismiss this case, or alternatively, shift the

burden of proof as to all issues to respondent. We decline to

grant either form of relief.

Whether due process is violated when evidence is destroyed

in a criminal proceeding is governed by two Supreme Court cases:

California v. Trombetta, 467 U.S. 479 (1984), and Arizona v.

Youngblood, 488 U.S. 51 (1988). As described in Trombetta, the

Due Process Clause requires criminal prosecutions to comport with

prevailing notions of fundamental fairness and, under this

standard, criminal defendants are to be afforded a meaningful

opportunity to present a complete defense. Under California v.

Trombetta, supra at 488-489, the Government has a duty to
 -82-

preserve evidence which (1) “possesses an exculpatory value that

was apparent before the evidence was destroyed,” and (2) “be of

such a nature that the defendant would be unable to obtain

comparable evidence by other reasonably available means.”

Criminal defendants must satisfy a threshold requirement

before a reviewing court considers the constitutional materiality

of the evidence in question. Jones v. McCaughtry, 965 F.2d 473,

477 (7th Cir. 1992). In Youngblood, the Supreme Court held that

“‘unless a criminal defendant can show bad faith on the part of

the police, failure to preserve potentially useful evidence does

not constitute a denial of due process of law.’” See Jones v.

McCaughtry, supra at 477 (quoting Arizona v. Youngblood, supra at

58). As the U.S. Court of Appeals for the Seventh Circuit noted

in Jones:

to demonstrate a due process violation under Youngblood
and Trombetta, Petitioner must first show bad faith on
the part of the government in the destruction of the
* * * [evidence]. If he can satisfy this burden, he
must then show the evidence possessed exculpatory value
apparent before it was destroyed and that it was of
such a nature that he was unable to obtain comparable
evidence by other means. * * * [Id.]

The requirements for determining whether due process is

violated where evidence is destroyed in the context of a civil

proceeding is less clear.20 The Fifth Amendment mandates that

20
In Ferguson v. Roper, 400 F.3d 635, 638 (8th Cir. 2005),
the U.S. Court of Appeals for the Eighth Circuit held that
Arizona v. Youngblood, 488 U.S. 51 (1988), does not apply to
(continued...)
 -83-

“No person shall * * * be deprived of life, liberty, or property,

without due process of law”. U.S. Const. amend. V. In Daniels

v. Williams, 474 U.S. 327, 328 (1986), the Supreme Court decided

whether the negligence of a Government official violated an

inmate’s due process rights in the context of 42 U.S.C. sec.

1983. The Supreme Court stated that the Due Process Clause of

the Fourteenth Amendment “is simply not implicated by a negligent

act of an official causing unintended loss or injury to life,

liberty, or property.” We read Daniels as equally applicable in

the context of an alleged violation of the Fifth Amendment Due

Process Clause. Daniels stands for the proposition that a

“deprivation” of life, liberty, or property can not result from

the mere negligence of an official’s conduct. However, where the

Government official’s conduct is intentional, reckless, or

grossly negligent, a deprivation of life, liberty, or property

may exist. See County of Sacramento v. Lewis, 523 U.S. 833, 834

(1998) (whether due process is violated when “culpability falls

between negligence and intentional conduct is a matter for closer

calls”). Thus, whether petitioners’ due process rights were

20
(...continued)
claims that evidence was lost or destroyed after trial. The
Court of Appeals for the Sixth Circuit apparently considered but
did not decide whether Youngblood is applicable in the civil
setting in Burch v. U.S. Dept. of Agric., Food & Nutrition Serv.,
174 Fed. Appx. 328, 331 (6th Cir. 2006).
 -84-

violated turns on the conduct of CID’s special agents in

destroying those records.

We are satisfied that petitioners’ due process rights were

not violated under Youngblood or Daniels. Two special agents

assigned to Mr. Garavaglia’s criminal investigation testified

that they destroyed documents seized from Trans International.

That testimony revealed that the decision to destroy those

documents was made only after consultation with Mr. Rogers, the

owner of those documents by virtue of his ownership interest in

Trans International. Mr. Rogers advised the special agents to

“burn” the documents seized. We credit the special agents’

testimony and do not find bad faith, recklessness, or gross

negligence on their part. See United States v. LaVallee, 439

F.3d 670, 699 (10th Cir. 2006) (where tapes of correctional

officers were routinely destroyed in the ordinary course of

business approximately two years after their creation, the

destruction of those tapes was not done in bad faith); United

States v. Garza, 435 F.3d 73, 75-76 (1st Cir. 2006) (where

evidence is destroyed in the course of implementing routine

procedures militates against a finding of bad faith); see also

United States v. Branch, 537 F.3d 582, 590 (6th Cir. 2008). This

result is consistent with those reached by other Federal courts.

See, e.g., Althouse v. Hill, No. CIV.A.3:02-CV-1263-D (N.D. Tex.

July 25, 2002) (stating that the court was not convinced that the
 -85-

unintentional destruction of records whose production might later

be requested in a civil lawsuit gives rise to a due process

violation); Larison v. City of Trenton, 180 F.R.D. 261, 268 n.9

(D.N.J. 1998) (bad faith is a necessary element in order to

establish a prima facie case of intentional spoliation of

evidence in the civil context).

IX. Epilogue

In reaching the holdings herein, we have considered all

arguments raised by the parties; and to the extent not discussed

herein, we find them to be irrelevant, moot, or without merit.

To reflect the foregoing,

Decisions will be entered

under Rule 155.