                               T.C. Memo. 2017-55



                         UNITED STATES TAX COURT



              CAIPING ZANG AND TAO LIU, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 246-13.                           Filed April 3, 2017.



      Robert M. Kane, Jr., and Sandra Veliz, for petitioners.

      Melanie E. Senick, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      KERRIGAN, Judge: Respondent determined the following deficiencies in

and accuracy-related penalties with respect to petitioners’ Federal income tax for

tax years 2006, 2007, and 2008 (tax years in issue):
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[*2]

                                                                Penalty
               Year                  Deficiency               sec. 6662(a)

               2006                   $448,309                  $89,662
               2007                    311,021                   62,204
               2008                     27,493                    5,499

       Unless otherwise indicated, all section references are to the Internal

Revenue Code in effect for the tax years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure. We round all monetary amounts to

the nearest dollar.

       The issues for consideration are: (1) whether Tao Liu (petitioner husband)

received and failed to report wage income of $7,350 for 2006; (2) whether Caiping

Zang (petitioner wife) received and failed to report wage income of $11,395 and

$42,354 for 2006 and 2007, respectively; (3) whether petitioners received and

failed to report rental income of $11,072 and $24,190 for 2006 and 2007,

respectively; (4) whether petitioners received and failed to report gambling

winnings of $18,419 and $25,119 for 2006 and 2008, respectively; (5) whether the

$1,274,091, $870,672, and $129,506 that petitioners received from Longyuan

USA Seafood Co. (Longyuan) during the tax years in issue, respectively, were

bona fide loans to petitioners or, instead, income that petitioners improperly failed
                                         -3-

[*3] to report for the tax years in issue; and (6) whether petitioners are liable for

section 6662(a) accuracy-related penalties for all tax years in issue.

                                FINDINGS OF FACT

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

facts and the attached exhibits are incorporated herein by this reference.

Petitioners are a married couple who resided in the State of Washington when they

timely filed the petition.

Background on Petitioners’ Business

      Longyuan and Qingdao

      Petitioners moved from China to the United States in 2002. During the tax

years in issue petitioners were employees of Longyuan, a business incorporated

and with its principal place of business in the State of Washington. Forms 1120,

U.S. Corporation Income Tax Return, filed for Longyuan (corporate tax returns)

reported its primary business activity as the import and export of seafood products.

      Longyuan was a wholly owned subsidiary of Qingdao Jiayuan Group Co.,

Ltd. (Qingdao), a Chinese company. Both petitioners had previously worked for

Qingdao, and they moved to the United States at the direction of Qingdao’s

management to manage Longyuan. Petitioner husband’s father was 96% owner of
                                        -4-

[*4] Qingdao. Petitioners did not either individually or jointly own an interest in

Longyuan or Qingdao.

      Petitioners’ Duties and Wages

      Petitioner wife and petitioner husband served as Longyuan’s sole officers

during the tax years in issue. Petitioner wife was president and chief executive

officer, and petitioner husband was vice president of the company. Petitioner

wife’s responsibilities included overseeing Longyuan’s finances, including the

writing of corporate checks and the filing of corporate tax returns, and maintaining

the company’s financial records. Petitioner husband oversaw the import of raw

seafood products by Longyuan and was responsible for sales of finished products

and maintaining relationships with customers. Longyuan also employed a

bookkeeper during the tax years in issue who assisted petitioner wife in creating

and maintaining QuickBooks records for the company.

      Longyuan paid petitioners wages during the tax years in issue. Longyuan’s

corporate tax return for each of its fiscal years ending March 31, 2006, 2007, and

2008 (Longyuan’s tax years 2005-07), reported compensation of $72,000 paid to

petitioner wife and $60,000 paid to petitioner husband. Petitioners reported on

their jointly filed Form 1040, U.S. Individual Income Tax Return (joint tax return),

for each of the tax years in issue combined wage income of $132,000. On the
                                       -5-

[*5] basis of Longyuan’s canceled checks for payments made to petitioners during

the tax years in issue respondent determined that Longyuan paid petitioner wife

total wages of $83,395, $114,354, and $67,109, respectively, and paid petitioner

husband total wages of $67,350, $35,571, and $55,929, respectively, during the

tax years in issue.

      Longyuan’s Financial Difficulties

      Longyuan’s business struggled financially during the tax years in issue. For

each of Longyuan’s tax years 2005-07, the company’s expenses exceeded its gross

receipts. Longyuan’s corporate tax returns filed for its tax years 2005-07 reported

net losses of $35,817, $91,824, and $264,247, respectively.

Petitioners’ Principal Residence and Rental Property

      Principal Residence

      During the tax years in issue petitioners owned a property in Newcastle,

Washington (Newcastle property), which was their principal residence.1 On

August 23, 2006, petitioner wife wrote a check from Longyuan payable to

petitioner husband for $200,000, which petitioners used to refinance the

Newcastle property.


      1
      The Newcastle property is also referred to as being in Renton, Washington,
on some of the exhibits.
                                        -6-

[*6] Rental Property

      On July 11, 2007, petitioners purchased a second property, in Bellevue,

Washington (Bellevue property). Petitioners purchased the Bellevue property to

become the offices of Longyuan. On June 6, 2007, petitioner wife wrote a check

from Longyuan payable to petitioner husband for $160,000, which petitioners

used for the downpayment to purchase the Bellevue property.

      Petitioners leased the Bellevue property to Longyuan during the tax years in

issue, and the property served as the company’s offices and as a place to greet

customers. For the tax years in issue petitioners reported on Schedules E,

Supplemental Income and Loss, attached to their joint tax returns rents received of

$21,000, $38,451, and $68,760, respectively. On the basis of Longyuan’s

canceled checks for payments made to petitioners during the tax years in issue

respondent determined that Longyuan paid petitioners total rents of $32,072,

$62,641, and $48,070 during the tax years in issue, respectively. On October 29,

2015, petitioners sold the Bellevue property and received proceeds of $164,894.

Longyuan’s and Petitioners’ Banking Activity

      Longyuan’s Accounts

      Longyuan maintained several bank accounts during the tax years in issue: a

U.S. Bank checking account, a Bank of America checking and savings account,
                                        -7-

[*7] and a Wells Fargo checking account (corporate accounts). Cash in the

corporate accounts was generally used to meet Longyuan’s business expenses.

Petitioner wife and petitioner husband were the only individuals with authorized

access to Longyuan’s corporate accounts and the only individuals authorized to

issue checks from those accounts during the tax years in issue. According to

petitioner wife, she usually recorded the issuance of corporate checks in

QuickBooks registers that she maintained with the assistance of Longyuan’s

bookkeeper.

      Payments From Longyuan to Petitioners

      During the tax years in issue petitioners regularly issued themselves checks

from Longyuan’s corporate accounts for their wages and rent payments and to

reimburse themselves for various business expenses. Petitioners also issued

themselves numerous other checks drawn on the corporate accounts that were not

for wages, rent, or reimbursement of business expenses. In most cases petitioner

wife wrote and signed these other checks on behalf of Longyuan and made them

payable to petitioner husband. Petitioners did not report the amounts that they

received from these other checks as income on their joint tax returns for the tax

years in issue.
                                        -8-

[*8] Petitioners also made frequent cash withdrawals from Longyuan’s corporate

accounts during the tax years in issue. Petitioners made the cash withdrawals

either in person at bank branches or, more frequently, at ATMs. Petitioners did

not report the cash withdrawals from the corporate accounts as income for the tax

years in issue.

      Petitioners had no systematic way of recording these unreported check

payments or the cash withdrawals from Longyuan’s corporate accounts during the

tax years in issue. On some of the checks that she issued from Longyuan,

petitioner wife testified that she wrote the word “Loan” or a variation thereof in

the checks’ “memo” lines. However, on other checks petitioner wife left the

“memo” lines blank.

      By reviewing copies of Longyuan’s canceled checks for the tax years in

issue respondent determined that in addition to the checks that they received for

their wages, rent, and reimbursement of business expenses, petitioners received

checks from Longyuan for amounts totaling $653,168 and $616,085 during 2006

and 2007, respectively.2 On the basis of detailed banking statements for

Longyuan’s corporate accounts for the tax years in issue respondent determined

      2
        These amounts include the $200,000 check that petitioners used for the
refinancing of the Newcastle property in 2006 and the $160,000 check that
petitioners used for the down payment on the Bellevue property in 2007.
                                        -9-

[*9] that petitioners’ cash withdrawals from the corporate accounts totaled

$620,923, $254,587, and $129,506 during the tax years in issue, respectively.

Respondent determined that petitioners received total unreported payments from

Longyuan’s corporate accounts, that were not payments for wages, rent, or

reimbursements, of $1,274,091, $870,672, and $129,506 during the tax years in

issue, respectively. totaling $2,274,269.

      According to petitioners, petitioner husband’s father knew of the additional

checks that petitioners issued themselves and the cash withdrawals that they made

during the tax years in issue and petitioner husband’s father “authorized”

petitioners to withdraw these amounts for their personal use from Longyuan’s

corporate accounts. According to petitioners they used most of these checks and

cash withdrawals for gambling at casinos.

Petitioners’ Gambling Activity

      Petitioners were prolific gamblers during the tax years in issue. Records

kept by the Muckleshoot Indian Casino in Auburn, Washington, showed that both

petitioners gambled there and won at least one “jackpot” on nearly every single

day in 2006. For 2006 petitioners were issued more than 2,000 Forms W-2G,

Certain Gambling Winnings.
                                        - 10 -

[*10] Petitioners reported on their joint tax returns for the tax years in issue

gambling winnings of $7,795,492, $5,528,213, and $479,689, respectively. On

the basis of third-party information returns received by the Internal Revenue

Service (IRS) respondent determined that petitioners received gambling winnings

of $7,813,911, $5,525,850, and $504,808 during the tax years in issue,

respectively. For the tax years in issue petitioners’ total gambling losses exceeded

their total winnings.

      On some occasions petitioner husband’s father and executives or officers of

Qingdao who were visiting the United States accompanied petitioners to the

casinos. According to petitioners they gave some of the money from the

unreported additional check payments and cash withdrawals from Longyuan’s

corporate accounts to these individuals for them to use for gambling.

Preparation of Petitioners’ and Longyuan’s Tax Returns

      For the tax years in issue a certified public accountant (C.P.A.) prepared

Longyuan’s corporate tax returns and petitioners’ joint tax returns. To aid in the

preparation of Longyuan’s corporate tax returns petitioners would meet with the

C.P.A. and provide her with a QuickBooks register of checks that Longyuan had

issued, as well as canceled checks, the company’s banking statements, sales

records, and information regarding inventory, accounts payable, and accounts
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[*11] receivable. Petitioners provided the C.P.A. with Forms W-2, Wage and Tax

Statement, Forms 1098, Mortgage Interest Statement, and Forms W-2G to prepare

their joint tax returns.

       From reviewing Longyuan’s banking statements the C.P.A. became aware

of the substantial amounts that petitioners were withdrawing from the corporate

accounts for their personal use. When asked about the additional checks issued

and the cash withdrawals made from the corporate accounts that were not for

Longyuan’s business expenses, petitioners represented to the C.P.A. that these

withdrawals were loans from Longyuan to them. Petitioners represented that

petitioner husband’s father authorized the loans.

       The C.P.A. testified that the amounts petitioners took from Longyuan’s

corporate accounts during the tax years in issue were “too huge compared to the

company’s assets.” Given Longyuan’s financial struggles, the C.P.A. was

concerned that unless petitioners repaid the company it would have difficulty

supporting itself and continuing its business operations. When discussing

petitioners’ personal withdrawals from the corporate accounts with them during

the tax years in issue, the C.P.A. encouraged petitioners to start making

repayments to Longyuan.
                                        - 12 -

[*12] The C.P.A. was not convinced by petitioners’ assertions that they, as

officers of Longyuan, had the authority to advance themselves loans from the

company. The C.P.A. did not report the additional checks or the cash withdrawals

that petitioners received for their personal use as an account receivable or other

asset on Longyuan’s corporate tax returns. Instead the C.P.A. treated these

amounts withdrawn from the corporate accounts as if the amounts had been paid to

Longyuan’s parent company, Qingdao, and then lent by Qingdao to petitioners.

These amounts that petitioners received were reflected ultimately on Longyuan’s

corporate tax returns as a reduction in the corporation’s account payable to

Qingdao.

Promissory Notes

      Note Executed by Petitioners (Qingdao Note)

      Petitioners did not individually or jointly execute any promissory notes

payable to Longyuan during the tax years in issue to account for any of the checks

or cash withdrawals that they received from Longyuan’s corporate accounts. On

July 23, 2010, petitioners executed a note payable to Qingdao of $2,227,330

(Qingdao note), following the start of an IRS examination.

      The Qingdao note does not provide for a repayment schedule and does not

provide for the payment of interest. The Qingdao note states that the principal
                                        - 13 -

[*13] sum of the note is to be repaid by petitioners’ sales of the Newcastle and

Bellevue properties. The Qingdao note further states that “in the case of any

unpaid balances * * * [petitioners] will have their wages retained by their

employment.” The Qingdao note is not secured by any of petitioners’ personal

property.

      Between December 2010 and October 2014 petitioners wrote 11 personal

checks payable to Longyuan and made three cash deposits into Longyuan’s

corporate accounts for varying amounts. Petitioner wife testified that petitioners

wrote the personal checks and made the cash deposits “to pay the company back

the loans.” Petitioner wife also testified that on four occasions petitioners

“returned” their normal salary and rent checks to Longyuan. Petitioner wife

testified that the “returned” payments were also “to repay the company back for

the loans.”

      After petitioners sold the Bellevue property in October 2015, they wrote

three personal checks to Longyuan totaling $165,000, approximately their

proceeds. Petitioner wife testified that these checks were “to pay back the

company for the loan we borrowed.” As of the time of trial petitioners still resided

in the Newcastle property.
                                        - 14 -

[*14] Notes Previously Executed by Petitioner Husband’s Father

      Petitioner husband’s father executed four notes in 2008 promising to repay

amounts that he received from petitioner husband or that were withdrawn and

advanced to him directly from Longyuan’s corporate accounts. Petitioner wife

drafted these notes, and petitioner husband requested that his father sign them.

According to petitioner wife, she drafted notes on these occasions because she

wished to keep a record of these transactions. The notes reflected that petitioner

husband’s father received a total of $63,600.

      On December 29, 2010, Qingdao made a wire transfer of $459,985 to

Longyuan’s corporate account at Wells Fargo. According to petitioner wife,

petitioner husband’s father directed the wire transfer and the wire transfer was to

repay funds that he borrowed from Longyuan during the tax years in issue.

Respondent’s Examination and the Notice of Deficiency

      Approximately in March 2010 respondent’s agent began an examination of

petitioners’ 2006 joint tax return, which later expanded to include petitioners’ joint

tax returns for 2007 and 2008. On March 26, 2010, respondent’s agent issued a

Form 4564, Information Document Request, requesting, among other things,

documentation of any loans that petitioners obtained during the relevant period.

At the time of petitioners’ first scheduled meeting with respondent’s agent on
                                         - 15 -

[*15] April 29, 2010, petitioners provided no promissory notes or other documents

evidencing loan agreements between them and any other party.

      Sometime between July and November of 2010 respondent’s agent received

a copy of the Qingdao note from petitioners. Respondent’s agent requested

additional documentation from petitioners showing how the amount of the

Qingdao note had been calculated. Petitioners provided copies of Longyuan’s

canceled checks for payments made to petitioners for the tax years in issue.

Petitioner wife testified that before providing the copies of Longyuan’s canceled

checks she altered an unspecified number of checks that had been issued to

petitioner husband by handwriting the word “Loan” in the “memo” lines of the

checks. Petitioner wife testified that she altered the checks “right before I gave

* * * [them] to the IRS just so the IRS knows * * * [they are] for [a] loan.”

      Petitioners provided respondent’s agent with QuickBooks registers

purporting to summarize the checks issued from Longyuan to petitioners during

the tax years in issue. According to petitioners these registers showed the check

portions of the loans. Petitioner wife testified that she also altered the

QuickBooks registers and entries for certain checks in the registers to identify

entries as loans.
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[*16]                                OPINION

I.      Burden of Proof

        Generally, the Commissioner’s determinations in a notice of deficiency are

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

determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111,

115 (1933). In unreported income cases, however, the Commissioner bears the

initial burden of producing at least minimal evidence linking the taxpayer with the

tax-generating activity or the receipt of funds before the general presumption of

correctness attaches to a determination. Rapp v. Commissioner, 774 F.2d 932, 935

(9th Cir. 1985). Once the Commissioner produces a minimal evidentiary

foundation with respect to the items of unreported income, the burden of

persuasion remains with the taxpayer to prove that he or she did not receive the

alleged income or that the Commissioner’s deficiency calculations were arbitrary

or erroneous. Id. Respondent’s determinations in the notice of deficiency are

based on substantive evidence linking petitioners with the income at issue.

        Respondent provided computer-generated IRPTRN transcripts and Wage

and Income Transcripts (IRS transcripts) for petitioners for tax years 2006 and

2008. The IRS transcripts reflect third-party information returns received by the

IRS, including Forms W-2G, that reported gambling winnings paid to petitioners
                                        - 17 -

[*17] for those years. Petitioners have raised no reasonable dispute with respect to

the accuracy of the information returns that are reflected on the IRS transcripts.

See sec. 6201(d).

      With respect to respondent’s income adjustments for payments that

petitioners received from Longyuan (including wages, rents, and the additional

checks and cash withdrawals), petitioners failed to maintain adequate records of

these payments for the tax years in issue. See sec. 6001. The records of specific

payments that petitioners did provide were sparse, and petitioners testified that

they created or altered many of these records in 2010 for the purpose of an IRS

examination. Respondent was therefore authorized to reconstruct petitioners’

income by any method that “does clearly reflects income.” Sec. 446(b); Petzoldt

v. Commissioner, 92 T.C. 661, 693 (1989); sec. 1.446-1(b)(1), Income Tax Regs.

The Commissioner’s reconstruction of a taxpayer’s income need only be

reasonable in the light of all the surrounding facts and circumstances. See Giddio

v. Commissioner, 54 T.C. 1530, 1532-1533 (1970); Schroeder v. Commissioner,

40 T.C. 30, 33 (1963). The specific-item method is an indirect method of income

reconstruction that consists of evidence of specific amounts of income received by

a taxpayer and not reported on the taxpayer's return. See Estate of Beck v.

Commissioner, 56 T.C. 297, 353-354, 361 (1971).
                                        - 18 -

[*18] The stipulated exhibits included copies of Longyuan’s canceled checks as

well as copies of bank statements for Longyuan’s corporate accounts for the tax

years in issue. Respondent used these records to identify specific checks issued to

and cash withdrawals made by petitioners from the corporate accounts. Each of

the checks identified by respondent was made payable to either petitioner husband

or petitioner wife, and petitioners testified that they were the only individuals

authorized to make cash withdrawals from the corporate accounts during the tax

years in issue. Respondent’s specific-item method shows that petitioners

withdrew substantial sums of money from Longyuan’s corporate accounts that

they did not report as income on their joint tax returns for the tax years in issue.

The specific items respondent identified are prima facie evidence of income that

petitioners received.

      Respondent has carried the burden of production with respect to the

unreported income adjustments, and the presumption of correctness may therefore

attach to respondent’s deficiency determinations. Petitioners bear the burden of

establishing that the unreported items “should be excluded from income or

allowed as deductions.” Gemma v. Commissioner, 46 T.C. 821, 833 (1966).

      Under section 7491(a)(1), the burden of proof may shift to the

Commissioner if the taxpayer produces credible evidence with respect to any
                                        - 19 -

[*19] factual issue relevant to ascertaining the taxpayer’s liability. See Higbee v.

Commissioner, 116 T.C. 438, 442-443 (2001). Petitioners contend that the burden

of proof as to whether the additional unreported check payments and cash

withdrawals that they received from Longyuan were (or were not) bona fide loans

should be shifted to respondent, because petitioners “complied with all reasonable

requests for witnesses, information, documents, meetings, and interviews.” We

find that petitioners’ evidence regarding the nature of these payments is not

credible and does not justify shifting the burden of proof under section 7491(a)(1).

The burden of proof on this issue remains with petitioners.

II.   Gross Income

      Section 61(a) defines gross income as “all income from whatever source

derived”. Gross income includes compensation for services, rent, and gambling

winnings. See sec. 61(a)(1), (6); Campodonico v. United States, 222 F.2d 310,

314 (9th Cir. 1955). Gross income includes any funds that the taxpayer receives

lawfully or unlawfully, without the consensual recognition, express or implied, of

an obligation to repay. See James v. United States, 366 U.S. 213, 219 (1961).

However, it does not include loans. Commissioner v. Tufts, 461 U.S. 300, 307

(1983).
                                        - 20 -

[*20] A.     Unreported Wages, Rents

      Respondent used the specific-item method to determine that petitioner

husband received unreported wages for 2006, that petitioner wife received

unreported wages for 2006 and 2007, and that petitioners received unreported

rents for 2006 and 2007. From the copies of Longyuan’s canceled checks for the

tax years in issue respondent identified specific checks issued to petitioners that

stated “salary” or “rent” in the checks’ “memo” lines.

      Petitioners did not provide their own computations of their wages and rents

for 2006 and 2007 based on Longyuan’s canceled checks. Petitioners did not

provide evidence showing that respondent’s computations based on these records

were arbitrary or erroneous. Accordingly, we hold that petitioners have failed to

meet their burden of proof, and we sustain respondent’s determinations that

petitioners received unreported wages and rents for 2006 and 2007.

      B.     Gambling Winnings

      The IRS transcripts substantiate respondent’s determinations of petitioners’

gambling winnings for 2006 and 2008. Petitioners provided no evidence to

contradict the amounts reflected on the IRS transcripts or to show that they did not

receive those amounts. We sustain respondent’s determinations that petitioners

received and failed to report gambling winnings for 2006 and 2008.
                                        - 21 -

[*21] C.     Purported Loans From Longyuan

      Petitioners contend that the additional checks they received that were not for

wages, rent, or reimbursements, and the cash withdrawals they made from

Longyuan’s corporate accounts during the tax years in issue were loans from the

company and that those amounts should not be included in their gross income. The

proceeds of a bona fide loan are not includible in gross income because the receipt

of money is offset by a corresponding obligation to repay. See Commissioner v.

Tufts, 461 U.S. at 307. For a bona fide loan to exist the parties to the transaction

must have had an actual, good-faith intent to establish a debtor-creditor

relationship at the time the funds were advanced. Beaver v. Commissioner, 55

T.C. 85, 91 (1970). An intent to establish a debtor-creditor relationship exists if

the debtor intends to repay the loan and the creditor intends to enforce the

repayment. Id.; Fisher v. Commissioner, 54 T.C. 905, 909-910 (1970).

      Objective factors are considered to determine the parties’ intent and whether

a bona fide loan occurred, and no single factor is dispositive. See Welch v.

Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121;

Frierdich v. Commissioner, 925 F.2d 180, 182 (7th Cir. 1991), aff’g T.C. Memo.

1989-393. We examine the following factors to determine whether the additional

checks and cash withdrawals that petitioners received were loans:
                                       - 22 -

[*22] (1) the ability of the borrower to repay;

      (2) the existence or nonexistence of a debt instrument;

      (3) security, interest, a fixed repayment debt, and a repayment schedule;

      (4) how the parties’ records and conduct reflect the transaction;

      (5) whether the borrower has made repayments;

      (6) whether the lender had demanded repayment;

      (7) the likelihood that the loans were disguised compensation for services;

and

      (8) the testimony of the purported borrower and lender.

Welch v. Commissioner, 204 F.3d at 1230; see also Kaider v. Commissioner, T.C.

Memo. 2011-174.

             1.    The Ability of the Borrower To Repay

      The parties’ lack of any intent that the funds be repaid after they were

advanced suggests that the parties did not intend a bona fide loan. See

Commissioner v. Makransky, 321 F.2d 598, 600 (3d Cir. 1963), aff’g 36 T.C.

446(1961). Courts assess the ability to repay by whether there was “a reasonable

expectation of repayment in light of the economic realities of the situation.”

Fisher v. Commissioner, 54 T.C. at 910.
                                        - 23 -

[*23] On their joint tax returns for the tax years in issue petitioners reported

combined wage income of $132,000 each year and rental income of $21,000,

$38,451, and $68,760, respectively. Petitioners’ gambling losses equaled or

exceeded their gambling winnings for the tax years in issue. Petitioners assert that

they borrowed $1,274,091, $870,672, and $129,506 during the tax years in issue,

respectively, a total of more than $2.2 million over that period. Petitioners could

not have reasonably expected to be able to repay those amounts on the basis of

their regular sources of income.

      Petitioners assert that their ability to repay was based predominantly on the

equity in their personal residence and rental property, and the Qingdao note states

that repayment is to be made from the sale of the Newcastle and Bellevue

properties. However, the suggestion that the sale of these properties would be

enough to satisfy fully, or even a significant portion of, petitioners’ purported

obligation to Qingdao ignores the actual amount of debt that petitioners

purportedly incurred.

      When petitioners sold the Bellevue property in October 2015, they obtained

proceeds of $165,000, which they testified they paid to Longyuan, presumably as

payment on the Qingdao note. This amount hardly exceeded the $160,000 that

petitioners purportedly borrowed from Longyuan to purchase the Bellevue
                                         - 24 -

[*24] property and represented less than 10% of the amount due on the Qingdao

note. As of the time of trial petitioners still had not sold the Newcastle property.

Petitioners provided no evidence that the proceeds that could be obtained from the

future sale of the Newcastle property would be enough to significantly offset the

unpaid amount of the Qingdao note, which by petitioners’ own calculations

currently exceeds $1.8 million.

             2.     Existence or Nonexistence of Debt Instrument

      No contemporaneous promissory notes were drafted to memorialize the

purported loans that petitioners received from Longyuan. Petitioners executed the

Qingdao note in July 2010, 4-1/2 years after their first purported borrowing and

after the start of the IRS examination of their joint tax returns for the tax years in

issue. This lack of contemporaneous promissory notes weighs against petitioners’

argument that the parties intended bona fide loans at the time that petitioners

issued themselves the additional checks and made the cash withdrawals for their

personal use from Longyuan’s corporate accounts.

             3.     Security, Interest, a Fixed Repayment Debt, and a Repayment
                    Schedule

      Interest and a fixed schedule for repayment are characteristics of a true

debtor-creditor relationship. See Frierdich v. Commissioner, 925 F.2d at 183-184;
                                        - 25 -

[*25] Haag v. Commissioner, 88 T.C. 604, 616 (1987), aff’d, 855 F.2d 855 (8th

Cir. 1988). The Qingdao note provides for no interest rate and no fixed schedule

for repayment.

      The Qingdao note identifies the proceeds of the sales of the Newcastle and

Bellevue properties as the primary means of repayment, and petitioners assert that

“the parties viewed this provision as a security interest in the properties.”

Regardless of how the parties “viewed” the provision concerning the sales of the

Newcastle and Bellevue properties, petitioners provided no evidence of any

legally enforceable security interests held by Qingdao or Longyuan in either of the

properties. Even if we were to view the provision as creating a security interest in

the proceeds of the sales of the properties, the evidence does not show that those

proceeds would cover more than a small amount of the purported debt shown on

the Qingdao note.

             4.     How the Parties' Records and Conduct Reflect the Transaction

      The parties’ conduct and what few records they kept of the transactions

suggest that there was no intent for Longyuan to make bona fide loans to

petitioners when the funds were advanced. Petitioners have not established by any

convincing evidence that they were authorized to lend themselves funds from

Longyuan’s corporate accounts for gambling or any other personal uses.
                                        - 26 -

[*26] Petitioners testified that petitioner husband’s father gave his authorization to

petitioners to withdraw the unreported check and cash amounts from Longyuan’s

corporate accounts, but they presented no evidence corroborating their testimony.

Petitioner husband’s father did not testify at the trial. Petitioners and respondent

presented conflicting evidence about how and when Qingdao’s management

became aware of the amounts that petitioners withdrew from Longyuan’s

corporate accounts.

      Petitioners contend that the parties’ failure to observe “formalities” such as

promissory notes, interest rates, and fixed repayment schedules, is explained by

“the relationship between father and son” as well as the parties’ “ethnic Chinese

culture”, which they contend regards promissory notes “as unnecessary”.

However, petitioners insisted that petitioner husband’s father execute promissory

notes for amounts that he withdrew from Longyuan’s corporate accounts in 2008.

Petitioner wife testified that she drafted these documents in order to keep a formal

record of the transactions “for bookkeeping purposes.” This conduct, as well as

other portions of petitioner wife’s testimony, convince us that petitioners were

cognizant of the need to observe certain formalities when sums were withdrawn

from the corporate accounts, if for no other reason than “bookkeeping purposes.”
                                        - 27 -

[*27] Petitioners’ contention that they were ignorant of the need for formalities in

connection with their purported borrowing is undermined by the credible

testimony of their C.P.A. The C.P.A. testified that “every time” she met with

petitioners during the tax years in issue she expressed concern about the large

amounts being withdrawn from Longyuan’s corporate accounts and she advised

petitioners to begin “taking care of it.” The C.P.A. testified that she advised

petitioners to “have a payment schedule * * * so * * * the company can still

support itself”. Petitioners repeatedly ignored the C.P.A.’s advice during the tax

years in issue and ultimately took no action to “take care of” their purported debts

to the company until after the start of the IRS examination.

      The way the purported loans were reflected on Longyuan’s corporate tax

returns also evidences a lack of intent to establish a genuine debtor-creditor

relationship with petitioners. The C.P.A. testified that she did not “feel

comfortable” with petitioners’ representations that they had the authority to lend

themselves such large sums of money from Longyuan, a company to which

petitioners owed a fiduciary duty as officers. The C.P.A. testified that Longyuan

could not afford to extend loans of that magnitude during the tax years in issue. In

order to avoid reporting the withdrawals as loans to petitioners, the C.P.A.

reported petitioners’ withdrawals as decreases in Longyuan’s account payable to
                                        - 28 -

[*28] Qingdao, which she testified was an attempt to “directly link * * *

[petitioners] to the China company.”

      Petitioners’ conduct following the start of the IRS examination suggests an

effort to cover up their previous intent with respect to the amounts that they

withdrew from the corporate accounts for gambling. Petitioner wife testified that

she altered Longyuan’s canceled checks and the company’s QuickBooks records

before providing them to respondent’s agent “[b]ecause * * * [she] wanted to let

them know * * * it’s actually money we borrowed from the company.” We

conclude that petitioners’ alterations of the business records were attempts to

mislead rather than clarify. Similarly, petitioners’ execution of the Qingdao note

in July 2010 was a belated attempt to create documentary evidence of a debtor-

creditor relationship where previously none existed.

             5.    Whether the Borrower Has Made Repayment

      Petitioners provided evidence of two cash deposits made into Longyuan’s

corporate account at U.S. Bank in April and May of 2006 for $6,000 and $1,000,

respectively. Petitioner wife testified that she made these deposits and that they

were to “pay back the loans we borrowed.” These cash deposit slips are

petitioners’ only evidence of any payments that they made into Longyuan’s

corporate accounts during the tax years in issue.
                                        - 29 -

[*29] Petitioners testified that they began making payments to Longyuan in

December 2010 and that the payments were “to pay the company back for the

loans.” Payments that petitioners made starting in 2010 do not show that

petitioners intended a bona fide debtor-creditor relationship to exist at the time

that they received the unreported funds from Longyuan.

             6.    Whether the Lender Had Demanded Repayment

      Petitioners were the sole executive officers of Longyuan. On brief

petitioners assert that petitioner husband had to discuss the matter of the purported

loans with Qingdao’s management and that Qingdao’s management has requested

information about petitioners’ plans to repay. Requesting information about plans

to repay is not a demand for repayment. Petitioners presented no evidence that

Longyuan, Qingdao, or petitioner husband’s father ever made demands on

petitioners to repay any checks issued or cash withdrawals made from Longyuan’s

corporate accounts.

             7.    The Likelihood That the Loans Were Disguised Compensation
                   for Services

      Petitioners received numerous checks from Longyuan for “salary” during

the tax years in issue. Respondent does not assert that the additional unreported

check payments and cash withdrawals that petitioners received were payments to
                                       - 30 -

[*30] compensate petitioners for their services to the company. We do not

conclude that the payments were disguised compensation for services.

             8.    The Testimony of the Purported Borrower and Lender

      Petitioner wife and petitioner husband testified that when they issued

themselves the additional checks and made the cash withdrawals from Longyuan

for their personal use they intended to pay back the money to the company.

Petitioners did not testify as to how and when they planned to make repayment.

Petitioners testified generally that they had the authority to make the purported

loans from Longyuan to themselves, but they also testified that frequently

petitioner husband’s father would not give his authorization until after the funds

had already been withdrawn.

      Petitioner husband’s father did not testify on behalf of Qingdao. No other

person familiar with Qingdao’s business testified about whether petitioners had

the authority to make loans to themselves from Longyuan for personal purposes or

whether Qingdao intended to establish a debtor-creditor relationship with

petitioners at the time that petitioners made the withdrawals from Longyuan’s

corporate accounts.

      Petitioners testified that they wrote numerous checks and made numerous

cash withdrawals from Longyuan’s corporate accounts at the direction of
                                        - 31 -

[*31] petitioner husband’s father, who took the money for his own gambling.

Petitioners contend that a significant portion of the unreported checks and cash

withdrawals that respondent determined were income to them for the tax years in

issue were actually loans to petitioner husband’s father and not amounts received

by them. Petitioners failed to corroborate their testimony to this effect with any

convincing evidence. Petitioners’ testimony was self-serving, and we need not

and do not accept it. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

      Petitioners provided two QuickBooks spreadsheets, one purporting to

summarize the checks and the other the cash withdrawals that they contend were

loans to petitioner husband’s father. However, each of the checks listed on the

spreadsheet titled “[Petitioner Husband’s Father’s] Check Loan Report” was made

payable to petitioner husband, and petitioner wife testified that she and petitioner

husband were the only two individuals who could make cash withdrawals from the

corporate accounts. Apart from their testimony, petitioners provided no evidence

establishing that petitioner husband’s father received the proceeds of the checks

and cash withdrawals shown on the spreadsheets. Petitioner wife testified that she

created the spreadsheets in 2010 after the start of the IRS examination. As with

the other business records that petitioners altered following the start of the
                                        - 32 -

[*32] examination, we have serious reservations about the credibility of the

spreadsheets.

       We reject petitioners’ contentions that some portion of the unreported

checks issued and cash withdrawals made from Longyuan’s corporate accounts

were loans to petitioner husband’s father. The greater weight of the evidence

supports our conclusion that petitioners received these amounts.

             9.     Conclusion

       We conclude that petitioners did not in good faith intend to repay the

purportedly borrowed amounts at the time that they received them, and neither

Longyuan nor Qingdao intended to enforce repayment. Because there was no

genuine intent at that time to establish a debtor-creditor relationship between the

parties, we agree with respondent’s determination that the additional checks issued

and the cash withdrawals made from Longyuan’s corporate accounts during the

tax years in issue were not bona fide loans to petitioners and should be included in

income.

III.   Accuracy-Related Penalties

       Respondent determined that for each tax year in issue petitioners are liable

for an accuracy-related penalty pursuant to section 6662(a). Under section

7491(c) the Commissioner bears the burden of production with regard to penalties
                                        - 33 -

[*33] and must come forward with sufficient evidence indicating that it is

appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. at 446.

However, once the Commissioner has met the burden of production, the burden of

proof remains with the taxpayer, including the burden of proving that the penalty

is inappropriate. Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

      Section 6662(a) imposes a 20% penalty on any portion of an underpayment

of tax attributable to, among other things, negligence or disregard of rules or

regulations within the meaning of subsection (b)(1), or any substantial

understatement of income tax within the meaning of subsection (b)(2).

Respondent asserts both that petitioners had underpayments due to substantial

understatements of income tax and that they were negligent in their

underpayments for the tax years in issue. Only one accuracy-related penalty may

be applied with respect to any given portion of an underpayment, even if that

portion is subject to the penalty on more than one of the grounds set out in section

6662(b). Sec. 1.6662-2(c), Income Tax Regs.

      An “understatement” is defined as the excess of the tax required to be

shown on the return over the tax actually shown on the return, less any rebate.

Sec. 6662(d)(2)(A). An understatement of income tax is “substantial” if it exceeds

the greater of 10% of the tax required to be shown on the return or $5,000. Sec.
                                        - 34 -

[*34] 6662(d)(1)(A). Respondent has met the initial burden of production because

our conclusions as to the deficiencies result in the following substantial

understatements of income tax:

                                 10% Of tax required
               Year                 to be shown             Understatement

               2006                    $47,094                 $448,309

               2007                     33,434                   311,021
               2008                      4,546                    27,493

The burden is on petitioners to prove that the penalties are inappropriate.

      The section 6662(a) penalty does not apply with respect to any portion of

the underpayment for which it is shown that the taxpayer had reasonable cause and

acted in good faith. Sec. 6664(c)(1). A taxpayer may establish reasonable cause

and good faith by showing reliance on professional advice. Sec. 1.6664-4(b)(1),

Income Tax Regs. Petitioners contend that they relied on the advice of their

C.P.A. To establish good faith and reasonable cause through reliance on

professional advice, a taxpayer must prove by a preponderance of the evidence

that (1) the adviser was a competent professional who had sufficient expertise to

justify reliance; (2) the taxpayer provided necessary and accurate information to

the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s
                                        - 35 -

[*35] judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

      Petitioners informed the C.P.A. that the large sums that they withdrew from

Longyuan’s corporate accounts for their personal use during the tax years in issue

were loans and that they intended to repay these loans. On the basis of

information from petitioners the C.P.A. did not report the sums as income on

petitioners’ joint tax returns. We concluded that petitioners did not intend to

establish a bona fide debtor-creditor relationship. Petitioners were not

forthcoming with the C.P.A. about their intentions with respect to the additional

checks and the cash withdrawals that they received. They failed to provide the

C.P.A. with necessary and accurate information that she needed to properly assess

their Federal income tax liability.

      The C.P.A. advised petitioners on multiple occasions that they needed to

establish a repayment schedule and start making repayments to Longyuan for the

amounts that they purportedly borrowed. The record shows that petitioners

ignored the C.P.A.’s advice until the IRS started an examination of their joint tax

returns. Petitioners did not act with reasonable cause and in good faith for the

portions of the underpayments attributable to the purported loans.
                                        - 36 -

[*36] Petitioners have not shown that they provided all necessary and accurate

information to the C.P.A. regarding their wages and rental income from Longyuan

or their gambling winnings for the tax years in issue. Petitioners failed to establish

that they acted with reasonable cause and in good faith for the portions of the

underpayments attributable to those items.

      Petitioners are liable for the accuracy-related penalties determined by

respondent under section 6662(a). Because petitioners are liable for the penalties

on the basis of substantial understatements, we need not address whether

petitioners were negligent in their failure to report the purported loans and other

amounts as income for the tax years in issue.

      Any contentions we have not addressed are irrelevant, moot, or meritless.

      To reflect the foregoing,


                                                 Decision will be entered

                                       for respondent.
