                              T.C. Memo. 2019-115



                        UNITED STATES TAX COURT



                 BENAVIDES & CO., P.C., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

        AL BENAVIDES AND LOUISE A. BENAVIDES, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 6761-14, 6840-14.                Filed September 9, 2019.


      Al Benavides (an officer), for petitioner Benavides & Co., P.C.

      Al Benavides and Louise A. Benavides, pro sese.

      David W. Sorensen, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      PUGH, Judge: In these consolidated cases respondent determined the

following deficiencies and penalties in notices of deficiency issued to Benavides
                                        -2-

[*2] & Co., P.C. (BCO), and Mr. and Mrs. Benavides (petitioners) on January 3,

2014:1

Docket No. 6761-14

                                                                  Penalty
           Year                     Deficiency                  sec. 6663(a)
           2003                       $46,725                     $35,044
           2004                        86,402                      64,802
           2005                        92,962                      69,722

Docket No. 6840-14

                                                                  Penalty
           Year                     Deficiency                  sec. 6663(a)
           2003                       $77,597                     $27,029
           2004                        81,092                      19,221
           2005                        91,173                      27,170

      The issues for decision are whether: (1) BCO had unreported income from

an accounting and tax preparation business of $195,359, $102,584, and $215,580

for tax years 2003, 2004, and 2005, respectively; (2) BCO is entitled to a net

operating loss (NOL) carryforward from 2003; (3) petitioners received


      1
        Unless otherwise indicated, section references are to the Internal Revenue
Code of 1986, as amended, in effect for the years in issue. Rule references are to
the Tax Court Rules of Practice and Procedure, and monetary amounts are rounded
to the nearest dollar.
                                        -3-

[*3] constructive dividends of $195,359, $132,584,2 and $215,580 for tax years

2003, 2004, and 2005, respectively, to account for gross receipts that were

“diverted” from BCO to other accounts or entities they owned and controlled;

(4) petitioners had unreported income from Sunrise, a partnership that they owned,

of $123,931, $88,593, and $66,628 for tax years 2003, 2004, and 2005,

respectively; (5) Mr. Benavides had self-employment income to reflect his shares

of partnership income from Sunrise of $42,219, $110,332, and $82,591 for tax

years 2003, 2004, and 2005, respectively; (6) Mrs. Benavides had self-

employment income to reflect her shares of partnership income from Sunrise of

$40,564, $106,006, and $79,352 for tax years 2003, 2004, and 2005, respectively;

(7) BCO is liable for fraud penalties under section 6663(a) of $35,044, $64,802,

and $69,722 for tax years 2003, 2004, and 2005, respectively, with respect to its

unreported taxable income; (8) petitioners are liable for fraud penalties under

section 6663(a) of $27,029, $19,221, and $27,170 for tax years 2003, 2004, and

2005, respectively, with respect to unreported constructive dividends from BCO;

      2
       The difference between BCO’s unreported income and petitioners’
constructive dividends determined by respondent for 2004 is attributable to
respondent’s failure to include in BCO’s unreported income a payment of $30,000
from Jeff Sorg that petitioners reported on a different entity’s return (Sunrise
Management and Development, LLC (Sunrise), discussed below). Respondent
determined that this was a payment to BCO but failed to include it in unreported
income when calculating BCO’s deficiency.
                                        -4-

[*4] and (9) assessment and collection of the tax deficiencies are barred by the

statute of limitations.

                               FINDINGS OF FACT

I. Background

      Some of the facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference. BCO’s principal office was in

Montana during the years in issue. Petitioners lived in Washington when they

timely filed their petition.

      Mr. Benavides graduated from Washington State University with a degree

in accounting in 1971 and became a certified public accountant (C.P.A.) in 1976.

He was engaged in the business of preparing income tax returns and providing tax

advice from 1976 through the years in issue. Petitioners married before the years

in issue and remained married at the time of trial.

      Mr. Benavides organized BCO as a professional services corporation in

1991 under the laws of Montana and was the sole owner and manager. A

subchapter C corporation, BCO filed Forms 1120, U.S. Corporation Income Tax

Return, since its organization. During the years in issue it offered various tax and

accounting services, including the preparation and filing of Federal income tax

returns, accounting and advisory services, and tax advisory services. These
                                        -5-

[*5] services were performed by Mr. Benavides and three staff accountants who

worked under him and at his direction during the years in issue. Mrs. Benavides

performed clerical work at BCO, including data entry and some bookkeeping.

      Petitioners formed Sunrise in 2000 as a partnership under the laws of

Montana with Mr. Benavides as a 51% partner and Mrs. Benavides as a 49%

partner. Sunrise was a real estate management and development business in

Kalispell, Montana. It also acted as a bill-paying entity for three or four of BCO’s

clients. They would pay Sunrise, and Sunrise would pay vendors and contractors

for services related to those individuals. Sunrise reported the payments it received

as income and the payments it made as business expenses. Sunrise performed this

same function for petitioners when they remodeled and made improvements to

their home and obtained other services, paying the personal service providers for

petitioners and deducting the payments as business expenses. But petitioners did

not reimburse Sunrise for these expenses. Respondent determined that Sunrise

paid vendors and other third parties $190,045, $208,156, and $268,609 in 2003,

2004, and 2005, respectively, for goods and services provided to petitioners or for

their personal residence and for other items determined to be for petitioners’

personal use or personal expenses.
                                         -6-

[*6] Mr. Benavides also owned or controlled other LLCs and partnerships that

held real property in and around the Kalispell area, including an entity called La-

Jam Properties, L.P. (La-Jam). La-Jam was a partnership owned by petitioners

that acquired eight acres of land adjacent to petitioners’ residence in 2004. In

2004 Sunrise paid for construction of a 3,500-square-foot shop on La-Jam’s land

that petitioners used for storage. Apart from holding the land, La-Jam did not

conduct any business activities.

      In 2011 Mr. Benavides entered a guilty plea to one count of assisting in the

preparation of a false or fraudulent income tax return in violation of section

7206(2). The offer of proof filed by the U.S. Attorney for the District of Montana

in Mr. Benavides’ criminal case stated that Mr. Benavides, through BCO,

collected “fees for services” from a client, purchased a personal item for the client,

and then assisted in preparing the client’s tax return claiming a business expense

deduction for the cost of the personal item mischaracterized as “fees.” Mr.

Benavides was imprisoned for 12 months and one day, was on supervised release

for one year, and paid a $25,000 fine.

II. BCO’s Tax Returns and Respondent’s Determinations

      BCO filed Forms 1120 for the years in issue. Sunrise filed Forms 1065,

U.S. Return of Partnership Income, for the years in issue. Mr. Benavides or a
                                       -7-

[*7] BCO employee working at his direction prepared the Forms 1120 and 1065

for 2003 and 2004; Brien Kreps, a C.P.A. who worked for BCO as its chief

financial officer, prepared the Forms 1120 and 1065 for 2005. BCO reported

income and expenses on the cash basis for income tax purposes. It used the

accounting software Practice Time Billing Software (PACS) to account for all

accounts receivable and payments. It used the Accountant’s Trial Balance (ATB)

program to determine its income for tax purposes.

      BCO did not report as taxable income all of the payments it received for the

services it provided to clients. It reported payments that were deposited into BCO

accounts and entered into the ATB program; it did not report payments allocated

to Mr. Benavides individually or to Sunrise or other entities that Mr. Benavides

owned or controlled.

      The mechanics of the payment allocations were simple. First, Mr.

Benavides would decide what a client should be billed for that month (for what

work and at what rate). When payments were received, Mr. Kreps would record

them in PACS. Mr. Benavides reviewed all payments received and decided which

payments were to be deposited into BCO accounts and which payments were to be

deposited into other accounts owned or controlled by petitioners. Amounts

deposited into BCO accounts then were recorded in the ATB program, typically by
                                        -8-

[*8] Mrs. Benavides. She also typically would prepare deposit slips for the

various accounts although sometimes other clerical staff prepared them.

      BCO also received merchandise or services from clients in exchange for its

accounting services. The merchandise or services were used by Mr. Benavides or

other staff members. These were referred to as “trades” and were recorded in

PACS as reductions in the client’s account receivable. They were not recorded in

the ATB program.

      Monthly and annually, Mr. Kreps prepared spreadsheets that reconciled the

accounts receivable from the two accounting systems to each client’s payments.

He recorded all cash receipts that were not deposited into corporate accounts but

instead were deposited elsewhere or cashed. And he tracked the payments via

trades and whether the trades were used by petitioners or BCO staff.

      On January 3, 2014, respondent issued a notice of deficiency to BCO for tax

years 2003, 2004, and 2005. Respondent determined that BCO understated its

gross income by failing to report the funds diverted from BCO to petitioners and

entities they owned or controlled, as well as the trade items petitioners converted

to personal use, in the following amounts: $195,359 for 2003, at least $102,584
                                        -9-

[*9] for 2004,3 and $215,580 for 2005 (collectively, diverted gross receipts).

Respondent determined the amounts of the diverted gross receipts by performing a

bank deposit analysis of BCO’s bank records, reviewing its corporate and

financial records, and interviewing its clients and employees. BCO’s adjusting

journal entries from its general ledger showed that it had retained earnings of at

least $49,977 for 2003 and $65,639 for 2004 without taking into account the

diverted gross receipts.

      BCO claimed NOL deductions of $114,280 and $50,026 for 2004 and 2005,

respectively. At the beginning of 2002 BCO reported accumulated NOL

carryovers of $70,822 attributable to NOLs in 1996 and 1997. BCO claimed

increases in NOLs of $43,513 for 2002 and $61,859 for 2003. Through a bank

deposit analysis respondent determined that BCO had underreported its income by

$131,994 for 2002, which would have eliminated the NOL that BCO claimed for

that year and also extinguished the accumulated NOL carryovers from 1996 and

1997. Likewise the underreported income for 2003 from the diverted gross

receipts would have eliminated the NOL that BCO claimed for that year. In the

notice of deficiency respondent disallowed the NOL carryover deductions claimed

      3
        Respondent did not seek to increase the deficiency to include in BCO’s
2004 unreported income the $30,000 payment from Jeff Sorg to BCO that was
diverted to Sunrise.
                                        - 10 -

[*10] for 2004 and 2005. Additionally, respondent determined section 6663(a)

fraud penalties of $35,044, $64,802, and $69,722 for 2003, 2004, and 2005,

respectively.

      The largest recipient of BCO’s diverted gross receipts was Sunrise.

Respondent, in the notices of deficiency issued to petitioners, reduced Sunrise’s

income by $98,986, $136,648, and $203,489 for 2003, 2004, and 2005,

respectively, to remove the amounts he determined had been diverted from BCO

to Sunrise. Respondent did not remove deposits from clients using Sunrise as a

bill-paying entity or disallow business expense deductions for Sunrise’s payments

on behalf of those individuals.

III. Petitioners’ Tax Returns and Respondent’s Determinations

      Petitioners timely filed Forms 1040, U.S. Individual Income Tax Return, for

the years in issue. Mr. Benavides prepared those returns, and petitioners signed

them under penalty of perjury. Petitioners reported adjusted gross income of

$157,656, $194,882, and $236,032 for tax years 2003, 2004, and 2005,

respectively. Petitioners did not report the diverted gross receipts from BCO as

qualified dividends on their joint returns.

      The Internal Revenue Service (IRS) audited petitioners’ joint returns for the

years in issue. In the course of the audit the agent examining petitioners’ returns
                                       - 11 -

[*11] determined that section 6663(a) fraud penalties were warranted and prepared

a Form 11661, Fraud Development Recommendation--Examination,

recommending fraud penalties for 2003, 2004, and 2005.4 The Form 11661

describes the alleged fraud, including that Mr. Benavides “purposefully did not

report the income * * * [diverted from BCO] on the appropriate tax returns in

order to evade the personal service corporate tax and the additional tax on

dividends to him from the corporation.” The “Plan of Action” on the Form 11661

was to “[c]omplete 30 day letter writeup, including civil fraud penalty.” The Form

11661 referred only to Mr. Benavides. The agent prepared a separate Form 11661

for BCO although it does not specify preparation of a 30-day letter as a part of the

action plan.

      On October 26, 2011, the examining agent’s supervisor signed the Forms

11661, indicating approval of the recommended fraud penalties. Respondent

issued revenue agent reports (RARs) on January 25, 2012, to BCO and to

petitioners, communicating the section 6663(a) fraud penalties. Those RARs were

later amended.




      4
        We explain why we are reopening the record to include certain exhibits
relevant to respondent’s penalty determination infra pp. 40-47.
                                       - 12 -

[*12] On January 3, 2014, respondent issued the notice of deficiency to petitioners

for tax years 2003, 2004, and 2005. Respondent determined that petitioners

understated their gross income by failing to report the diverted gross receipts from

BCO as dividends of $195,359, $132,584, and $215,580 for the tax years 2003,

2004, and 2005, respectively. In addition respondent determined that petitioners

understated their income from Sunrise, making four adjustments: (1) decreasing

Sunrise’s gross income by the amounts determined to be diverted to Sunrise from

BCO, (2) disallowing Sunrise’s depreciation deductions that respondent

determined were for assets not shown to be used in an active trade or business,

(3) disallowing Sunrise’s section 179 expense deductions for 2004 and 2005

because the assets were not shown to be used in conducting an active trade or

business, and (4) disallowing certain business expense deductions claimed by

Sunrise that respondent identified as petitioners’ personal expenses paid by

Sunrise. Together these adjustments resulted in increased flowthrough income

from Sunrise to petitioners. Respondent then adjusted petitioners’ self-

employment income to account for these adjustments in ordinary income flowing

from Sunrise to petitioners. Respondent also made corresponding computational

adjustments to petitioners’ adjusted gross income, itemized deductions, and

exemptions. Lastly, respondent determined section 6663(a) fraud penalties of
                                       - 13 -

[*13] $27,029, $19,221, and $27,170, for tax years 2003, 2004, and 2005,

respectively, with respect to the unreported constructive dividends from BCO.

                                    OPINION

I. Burden of Proof

      The taxpayer generally bears the burden of proving that the Commissioner’s

determinations in a notice of deficiency are erroneous. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). For unreported income, however, the Court

of Appeals for the Ninth Circuit, where these cases are appealable absent a

stipulation to the contrary, generally requires that the Commissioner introduce

some evidence linking the taxpayer with income-producing activity or demonstrate

that the taxpayer actually received unreported income. See Rapp v.

Commissioner, 774 F.2d 932, 935 (9th Cir. 1985); Edwards v. Commissioner, 680

F.2d 1268, 1270 (9th Cir. 1982). Once the Commissioner makes this required

threshold showing, the taxpayer must prove by a preponderance of the evidence

that the Commissioner’s determinations are arbitrary or erroneous. Helvering v.

Taylor, 293 U.S. 507, 515 (1935); Rapp v. Commissioner, 774 F.2d at 935;

Tokarski v. Commissioner, 87 T.C. 74 (1986). Taxpayers also bear the burden of

proving entitlement to any deductions claimed. INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
                                       - 14 -

[*14] (1934). BCO and petitioners do not contend, and the evidence does not

establish, that the burden of proof should shift to respondent under section 7491(a)

as to any issue of fact.

II. BCO’s Arguments

      A. Unreported Income of BCO

      The first issue is whether BCO had unreported income from its accounting

and tax preparation business of $195,359, $102,584, and $215,580 for tax years

2003, 2004, and 2005, respectively. Respondent asserts that Mr. Benavides

diverted gross receipts from BCO in these amounts during the respective years in

issue and therefore BCO failed to report and pay Federal corporate income tax on

these amounts.

      A C corporation is a separate entity for Federal income tax purposes so long

as it engages in some legitimate business activity. Moline Props., Inc. v.

Commissioner, 319 U.S. 436, 438-439 (1943). As an independent taxable entity, a

C corporation is subject to Federal income tax on its taxable income. Sec. 11(a).

The C corporation’s taxable income is its gross income--which includes fees for

services--less allowable deductions. Secs. 61(a)(1) and (2), 63(a).

      Petitioners do not dispute that the gross receipts were BCO’s income; Mr.

Benavides readily admits he “redirected” gross receipts from BCO to put “right
                                        - 15 -

[*15] away” into his other entities. Thus, the diverted income--$195,359,

$102,584, and $215,580 for 2003, 2004, and 2005, respectively--in the form of

checks, cash payments, or trades is gross income of BCO.

      Mr. Benavides argues, however, that we should ignore these transfers

because he would have “stripped” the profits out anyway as deductible

compensation. We disagree. While BCO could have taken the gross receipts into

account as income and paid them out as compensation, by Mr. Benavides’ own

admission it did not. The diverted gross receipts therefore are properly

characterized as distributions, not compensation.

      A taxpayer may not avoid Federal income tax on earned income simply by

assigning it to another. Helvering v. Horst, 311 U.S. 112, 119 (1940) (“The

dominant purpose of the revenue laws is the taxation of income to those who earn

or otherwise create the right to receive it and enjoy the benefit of it when paid.”);

Floyd v. Scofield, 193 F.2d 594, 596 (5th Cir. 1952) (holding a corporation liable

for corporate tax on income from the sale of oil and gas despite liquidation plan

that distributed accounts receivable to shareholders when checks were delivered

before dissolution). We hold that the diverted gross receipts were the unreported

taxable income of BCO for the years in issue. See, e.g., United Mercantile

Agencies, Inc. v. Commissioner, 23 T.C. 1105, 1112 (1955) (“[D]iverted funds are
                                        - 16 -

[*16] taxable as income to the corporation and are taxable as dividends to the

extent of earnings and profits to the officer-stockholders receiving them.”),

remanded on other grounds sub nom. Drybrough v. Commissioner, 238 F.2d 735

(6th Cir. 1956); Mazzocchi Bus Co. v. Commissioner, T.C. Memo. 1993-43

(sustaining the Commissioner’s deficiency determination when the controlling

shareholder diverted corporate income to himself that the corporation failed to

report on its tax return), aff’d, 14 F.3d 923 (3d Cir. 1994).

      B. BCO’s Claimed NOL Deductions

      A taxpayer generally may deduct, as an NOL for a taxable year, an amount

equal to the sum of the NOL carryforwards and carrybacks to that year. Sec.

172(a). An NOL is the excess of deductions over gross income, computed with

certain modifications specified in section 172(d). Sec. 172(c). Absent an election

under section 172(b)(3), an NOL for any taxable year first must be carried back 2

years and then carried forward 20 years. Sec. 172(b)(1)(A), (2) and (3).

      Taxpayers bear the burden of establishing both the existence of NOLs from

prior years and the amounts that may be carried forward to the tax years in issue.

See Rule 142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000). We have

jurisdiction to determine the correct amount of taxable income or NOL for a year

not in issue as a preliminary step in determining the correct NOL carryover to a
                                        - 17 -

[*17] year before us. Lone Manor Farms, Inc. v. Commissioner, 61 T.C. 436, 440

(1974), aff’d without published opinion, 510 F.2d 970 (3d Cir. 1975).

      The only evidence BCO offered to substantiate its NOLs consisted of its tax

returns for the tax years in issue with attached statements briefly describing how it

calculated its NOL carryovers, a handwritten summary of its historical gross

receipts and NOLs that Mr. Benavides prepared shortly before trial, and Mr.

Benavides’ vague testimony that he disagreed with respondent’s position.

      We did not find Mr. Benavides’ testimony credible in any respect. And

BCO’s tax returns for the years in issue are merely statements of its position.

They cannot be used to substantiate a claimed deduction including the amount of

an NOL to be carried forward. See Sparkman v. Commissioner, 509 F.3d 1149,

1156-1157 (9th Cir. 2007), aff’g T.C. Memo. 2005-136; Wilkinson v.

Commissioner, 71 T.C. 633, 639 (1979); Hawks v. Commissioner, T.C. Memo.

2005-155, 2005 WL 1503686, at *3. BCO therefore failed to substantiate the

NOLs for 1996, 1997, and 2002. Nor did BCO show that these alleged NOLs

were not already exhausted before the years in issue. See Jones v. Commissioner,

25 T.C. 1100, 1104 (1956), rev’d and remanded on other grounds, 259 F.2d 300

(5th Cir. 1958); Power v. Commissioner, T.C. Memo. 2016-157, at *13-*14

(“Petitioners must prove not only that Mr. Power incurred NOLs in 1999-2002 but
                                        - 18 -

[*18] also that the NOLs were not absorbed during the period beginning with

1997 (the earliest carryback year) and ending with 2006 (the last year before the

first taxable year in issue).”); Leitgen v. Commissioner, T.C. Memo. 1981-525,

1981 WL 10937 (“The burden is on petitioners to prove their incomes for 1969,

1970, and 1971 in order to show that there was any part of the alleged 1972 loss

that would not have been absorbed in the three preceding years and that could

have been carried over to the years in issue.”), aff’d, 691 F.2d 504 (8th Cir. 1982).

The evidence shows that BCO’s diverted gross receipts, if reported for 2003,

would have produced taxable income, not an NOL. The IRS examiner’s bank

deposit analysis showed that BCO had unreported gross receipts for 2002 as well

that, if reported, would have produced taxable income for 2002, even after fully

exhausting the claimed--but unsubstantiated--NOL carryovers from 1996 and

1997. Accordingly, we sustain respondent’s disallowance of BCO’s NOL

carryover deductions to 2004 and 2005.

III. Petitioners’ Arguments

      A. Diverted Gross Receipts as Constructive Dividends

      When a C corporation distributes money or property to a shareholder out of

the corporation’s earnings and profits (E&P), the amount of the distribution

constitutes a dividend that must be included in the shareholder’s taxable income.
                                        - 19 -

[*19] Secs. 61(a)(7), 63, 301(a), (c), 316. If the distribution exceeds the

corporation’s E&P, the excess generally represents a nontaxable return of capital

to the extent of the shareholder’s basis in the stock, and any remaining amount is

taxable to the shareholder as a gain from the sale or exchange of property. Sec.

301(c); Truesdell v. Commissioner, 89 T.C. 1280, 1294-1295 (1987).

      Dividends for tax purposes are not always declared in the formal sense;

courts have identified constructive dividends when a C corporation confers an

economic benefit upon a shareholder without a corresponding expectation of

repayment. See Hood v. Commissioner, 115 T.C. 172, 179-180 (2000); Cordes v.

Commissioner, T.C. Memo. 2002-124, 2002 WL 1023173, at *10 (citing Ireland v.

United States, 621 F.2d 731, 735 (5th Cir. 1980) (“There is no requirement that the

dividend be formally declared or even intended by the corporation.”) and

Wortham Mach. Co. v. United States, 521 F.2d 160, 164 (10th Cir. 1975)).

Similarly, when a shareholder diverts earned income from his closely held C

corporation for his personal use, courts have held that the diverted income

constitutes a constructive distribution to the shareholder. Simon v. Commissioner,

248 F.2d 869, 876-877 (8th Cir. 1957) (“The corporation is liable for a substantial

tax upon the diverted income it failed to report. Further tax will be collected from
                                       - 20 -

[*20] taxpayers under the constructive dividend theory.”), rev’g T.C. Memo.

1955-194; Truesdell v. Commissioner, 89 T.C. at 1300-1301.

      Petitioners bear the burden of proving that BCO had insufficient E&P to

support the amounts of constructive dividends respondent determined for the tax

years in issue. E.g., Truesdell v. Commissioner, 89 T.C. at 1295-1296; Pittman v.

Commissioner, T.C. Memo. 1995-243, 1995 WL 329854, at *12, aff’d, 100 F.3d

1308 (7th Cir. 1996). They failed to present credible evidence showing that BCO

lacked sufficient E&P to support dividend treatment. At trial petitioners pointed

to a handwritten summary of BCO’s retained earnings from 1996 to 2008, and Mr.

Benavides testified, consistent with that summary, that BCO never had retained

earnings during that period. We did not find Mr. Benavides credible, and we are

not required to accept his self-serving testimony. See Ruark v. Commissioner, 449

F.2d 311, 312 (9th Cir. 1971), aff’g T.C. Memo. 1969-48; Monahan v.

Commissioner, 109 T.C. 235, 257 (1997). Moreover, other evidence refutes his

bald assertion.

      Adjusting journal entries in 2003 and 2004 showed that BCO had retained

earnings of at least $49,977 as of 2003 and $65,639 as of 2004 even without

taking into account the diverted gross receipts. This, coupled with the bank

deposit analysis showing that BCO had significant unreported income for 2002, is
                                       - 21 -

[*21] persuasive evidence that BCO began the tax years in issue with accumulated

E&P. And the diverted gross receipts, if properly reported as BCO’s income for

the years in issue, would have generated current E&P during those years. See sec.

1.312-6(b), Income Tax Regs. Therefore, we hold that the diverted gross receipts

from BCO of $195,359, $132,584, and $215,580 are taxable to petitioners as

constructive dividends for 2003, 2004, and 2005, respectively. See sec. 316;

Pittman v. Commissioner, 1995 WL 329854, at *13-*14.

      B. Unreported Income From Sunrise

      Next, respondent determined that petitioners had unreported income from

Sunrise of $123,931, $88,593, and $66,628 for tax years 2003, 2004, and 2005,

respectively, arising from four adjustments. We consider each adjustment in turn.

            1. Gross Receipts Adjustments

      Respondent determined that Sunrise erroneously reported the diverted gross

receipts from BCO as its own gross income for each tax year, which then flowed

through to petitioners as partners. To avoid double-counting, respondent reduced

the gross income flowing from Sunrise to petitioners for each year by the amount

determined to be BCO’s gross receipts. At trial Mr. Benavides admitted to

diverting gross receipts from BCO to Sunrise for each tax year but stated that the

amounts diverted were different from respondent’s determination, asserting that
                                       - 22 -

[*22] respondent gave petitioners too much of a reduction in income from Sunrise.

Mr. Benavides was not a credible witness, and no credible evidence supports a

change to respondent’s determinations.

            2. Disallowed Deductions

      A taxpayer may deduct “all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or business”. Sec. 162.

But personal, living, and family expenses are not deductible. Sec. 262. For an

expenditure to be an ordinary and necessary business expense, generally the

taxpayer must show a bona fide business purpose for the expenditure and a

proximate relationship between the expenditure and the business of the taxpayer.

See Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 660-661 (1962); see also

sec. 1.162-1(a), Income Tax Regs.

      Taxpayers are required to maintain sufficient records to establish the

amount and purpose of any deduction. Sec. 6001; Higbee v. Commissioner, 116

T.C. 438, 440 (2001); sec. 1.6001-1(a), (e), Income Tax Regs. At trial Mr.

Benavides made a disorganized and confusing presentation that often left us

struggling to identify the specific expenditure he intended to explain. He

presented the general ledgers of Sunrise and depreciation schedules but did not

offer any supporting records for any of the expenses or deductions. See Lyseng v.
                                        - 23 -

[*23] Commissioner, T.C. Memo. 2011-226, 2011 WL 4389644, at *3 (“In

general, taxpayers must substantiate claimed deductions with evidence such as

invoices or receipts that establish that the expenses were actually incurred[.]”).

Repeatedly, Mr. Benavides challenged adjustments made by the IRS in RARs that

predated the notice of deficiency (and had been conceded in that notice) instead of

directing the Court to evidence of the remaining expenses. He fell back on his

excuse that he was not represented by counsel, yet when confronted by questions

from respondent he demonstrated a sophisticated appreciation for the issues. And,

as noted above, in general, we did not find Mr. Benavides to be a credible witness.

                   a. Disallowed Depreciation and Section 179 Expenses

      Petitioners assert that respondent incorrectly disallowed depreciation

deductions that flowed through to their returns from Sunrise of $32,872, $17,085,

and $11,498 for 2003, 2004, and 2005, respectively, and section 179 deductions

that flowed through from Sunrise of $34,961 and $55,016 for 2004 and 2005,

respectively.

      A reasonable depreciation deduction may be allowed for the “exhaustion,

wear and tear” of property used in a trade or business. Secs. 161, 167(a)(1). To

substantiate entitlement to a depreciation deduction, a taxpayer not only has to

show that the property was used in a business but also must establish the
                                        - 24 -

[*24] property’s depreciable basis by showing the cost of the property, its useful

life or recovery period, and its previously allowable depreciation. See, e.g., Cluck

v. Commissioner, 105 T.C. 324, 337 (1995). A taxpayer with no capital

investment in property has no right to depreciation deductions with respect to that

capital asset. Miller v. Commissioner, 68 T.C. 767, 775 (1977).

      Certain taxpayers may elect instead to treat the cost of certain property used

in an active trade or business as a current expense in the year that property is

placed in service. Sec. 179(a), (d). If the property is used for both business and

other purposes, then the portion of the cost that is attributable to the business use

is eligible for expensing under section 179 but only if more than 50% of the use is

for business purposes (predominant use requirement). See sec. 1.179-1(d), Income

Tax Regs.

      Heightened substantiation requirements apply to deductions for certain

assets. Sec. 274(d); see, e.g., Mears v. Commissioner, T.C. Memo. 2013-52,

at *22 (considering section 274(d) “listed property” requirements with respect to

applicable section 167 deductions); Singh v. Commissioner, T.C. Memo. 2009-36,

2009 WL 349745, at *1 (considering listed property requirements with respect to

an applicable section 179 deduction). Passenger automobiles and other property

used as a means of transportation are listed property. Sec. 280F(d)(4)(A)(i)
                                       - 25 -

[*25] and (ii). Listed property also broadly includes any property of a type

generally used for entertainment, recreation, or amusement. Sec.

280F(d)(4)(A)(iii). To deduct expenses related to listed property taxpayers must

support their own statements with additional substantiation that adequately

establishes the amount, time, place, and business purpose of each expenditure.

Sec. 274(d)(4); see also sec. 1.274-5T(b)(6), (c)(1) and (2), Temporary Income

Tax Regs., 50 Fed. Reg. 46016-46017 (Nov. 6, 1985).

      At trial petitioners presented a depreciation schedule that summarized assets

depreciated or expensed under section 179 for the tax years in issue. The assets

include several trucks, an all-terrain vehicle (ATV), lawn maintenance equipment,

a camping trailer, and assorted equipment. Petitioners offered no documentary

evidence to support their depreciation schedule. For instance, no evidence before

us establishes who purchased the assets, when they were purchased, what they

cost, and whether depreciable bases remained during the tax years in issue.

      What is more, petitioners failed to establish that these assets were

predominantly used in Sunrise’s real estate management and development

business. Mr. Benavides was vague. He testified, for instance, that the ATV was

used to show real property for sale, but there is no evidence that Sunrise ever

marketed, showed, or even listed property for sale during the years in issue. Mr.
                                         - 26 -

[*26] Benavides also asserted that the trucks on the depreciation schedule were

related to Sunrise’s business because people “don’t buy big trucks just for sport”.

That assertion defies logic. He admitted to personal use of some of the assets,

such as the lawn equipment and the camping trailer. Not only did petitioners fail

to satisfy the strict substantiation requirements for their listed property; they failed

to offer enough evidence to substantiate their deductions under a general standard.

We, therefore, sustain respondent’s disallowance of the depreciation and section

179 expense deductions.

                    b. Disallowed Business Expense Deductions

      Respondent disallowed other business expense deductions claimed by

Sunrise that respondent identified as expenditures for petitioners’ personal use or

as unsubstantiated. The amounts disallowed were $190,045, $208,156, and

$268,609 for 2003, 2004, and 2005, respectively.

      Petitioners argue that respondent incorrectly disallowed deductions for

Sunrise’s legitimate operating expenses and expenses incurred for paying bills for

others (bill-paying expenses). All we have in support of petitioners’ claims are

Mr. Benavides’ muddled testimony and Sunrise’s general ledgers, which contain

limited information and are unsupported by any other evidence. The record is

devoid of receipts, invoices, canceled checks, or other business records to
                                        - 27 -

[*27] substantiate the reported deductions or petitioners’ claimed reimbursements

even though Mr. Benavides’ demeanor at trial indicated that he understood the

need to have such backup. Frustrating us further, petitioners repeatedly tried to

prove their entitlement to these deductions by pointing out problems with RARs

that preceded the notice of deficiency and were addressed in the notice of

deficiency.

      First, petitioners assert that respondent incorrectly disallowed some of

Sunrise’s operating expense deductions for each year, including automobile

expenses, insurance, property taxes, and payroll expenses. Petitioners did not

describe in sufficient detail the specific nature of the various operating expenses,

let alone substantiate them with any records. For example, Mr. Benavides testified

to paying wages to an employee, but the individual worked for BCO, not Sunrise.

Without credible records, we cannot conclude that petitioners are entitled to claim

deductions for any of these alleged expenses.

      Second, petitioners assert that Sunrise was paying the construction costs for

some of BCO’s clients, for La-Jam, and for petitioners themselves, for which

Sunrise would be reimbursed but would not profit. Petitioners argue that

respondent incorrectly disallowed some of Sunrise’s bill-paying expense

deductions because Sunrise later would be reimbursed, reimbursement income and
                                       - 28 -

[*28] expenses for the years in issue “should wash”, and respondent failed to

match up all income and expenses in the audit. Mr. Benavides testified that some

of Sunrise’s expenses that respondent identified as petitioners’ personal expenses

and disallowed as deductions for 2004 were amounts that Sunrise paid for the

construction of La-Jam’s shop, but he did not identify the exact expenditures or

their amounts or provide credible evidence that Sunrise was reimbursed by La-Jam

or petitioners.

      The evidence shows that respondent allowed the bill-paying expense

deductions except as they relate to petitioners’ personal expenses or to La-Jam’s

expenses. And there is no evidence that petitioners (or La-Jam) reimbursed

Sunrise. In any event, petitioners’ argument that everything “should wash” is not

a substitute for showing that they did wash or substantiating the business expenses

Sunrise reported. Petitioners provided no documentary evidence to prove what

these alleged expenses were, their various amounts, or when, or even if, they were

actually incurred. Moreover, petitioners failed to show that the disallowed bill-

paying expense deductions bore any relation to Sunrise’s trade or business. Many

of the bill-paying expenses are personal, such as the hundreds of thousands of

dollars spent to remodel petitioners’ principal residence, as well as the money

spent to build La-Jam’s shop directly adjacent to petitioners’ home. Accordingly,
                                       - 29 -

[*29] we will sustain respondent’s disallowance of Sunrise’s business expense

deductions of $190,045, $208,156, and $268,609 for tax years 2003, 2004, and

2005, respectively.

      C. Self-Employment Income Adjustments

      The next issue is whether Mr. Benavides had unreported self-employment

income in the amounts of his shares of partnership income from Sunrise of

$42,219, $110,332, and $82,591 for tax years 2003, 2004, and 2005, respectively;

and similarly, whether Mrs. Benavides had unreported self-employment income in

the amounts of her shares of partnership income from Sunrise of $40,564,

$106,006, and $79,352 for tax years 2003, 2004, and 2005, respectively.

      Section 1401 imposes a tax upon a taxpayer’s self-employment income.

Self-employment income means the “net earnings from self-employment” derived

by an individual during the taxable year. Sec. 1402(b). Subject to exceptions, the

“net earnings from self-employment” include a partner’s distributive share of

partnership trade or business income. Sec. 1402(a).

      Because Mr. and Mrs. Benavides own Sunrise as partners (51% and 49%,

respectively), all of Sunrise’s trade or business income flows to them on account

of their partnership interests. Secs. 701 and 702(a). Accordingly, all such income

for any taxable year generally, subject to limitations of section 1402(b), would be
                                        - 30 -

[*30] subject to self-employment taxes. Secs. 1401(a) and (b), 1402(a) and (b);

Norwood v. Commissioner, T.C. Memo. 2000-84, 2000 WL 267779, at *1 (citing

Cokes v. Commissioner, 91 T.C. 222, 229-230 (1988)). At trial petitioners agreed

that the adjustments to self-employment income would depend upon our rulings

with respect to the other joint return determinations and did not advance any

separate argument--at trial, on brief, or otherwise--concerning their self-

employment income or respondent’s determinations. As we have sustained

respondent’s determinations that petitioners had additional income from Sunrise

for each year in issue, that additional income constitutes self-employment income.

See secs. 1401(a) and (b), and 1402(a) and (b). Accordingly, we will sustain

respondent’s determinations concerning self-employment taxes for each year.

IV. Fraud

      A. Section 6663(a) Fraud Penalty

      Section 6663(a) provides: “If any part of any underpayment of tax required

to be shown on a return is due to fraud, there shall be added to the tax an amount

equal to 75 percent of the portion of the underpayment which is attributable to

fraud.” Fraud, for Federal tax purposes, is an intentional wrongdoing on the part

of a taxpayer with the specific purpose to evade a tax believed to be owed. Sadler

v. Commissioner, 113 T.C. 99, 102 (1999). The fraud penalty is a civil sanction
                                        - 31 -

[*31] provided primarily as a safeguard for protection of revenue and to reimburse

the Government for the heavy expense of investigation and the loss resulting from

the taxpayer’s fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938); Sadler v.

Commissioner, 113 T.C. at 102.

      Respondent determined section 6663(a) fraud penalties of $35,044,

$64,802, and $69,722 for 2003, 2004, and 2005, respectively, with respect to

BCO’s unreported taxable income for those years. Respondent determined section

6663(a) fraud penalties of $27,029, $19,221, and $27,170 for 2003, 2004, and

2005, respectively, with respect to petitioners’ failure to report dividends from

BCO for those years. Respondent bears the burden of proving fraud by clear and

convincing evidence. See sec. 7454(a); Rule 142(b). Respondent must satisfy his

burden separately for each petitioner filing the joint returns. See sec. 6663(c);

Hicks Co. v. Commissioner, 56 T.C. 982, 1030 (1971), aff’d, 470 F.2d 87 (1st Cir.

1972); Said v. Commissioner, T.C. Memo. 2003-148, 2003 WL 21205252, at *6

(“Under section 6663(c), the fraud penalty is imposed on each spouse separately,

even when a joint return is filed[.]”), aff’d, 112 F. App’x 608 (9th Cir. 2004).

      To carry his burden of proof, respondent must show, for each year, that:

(1) an underpayment of tax exists and (2) some portion is attributable to fraud.

See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983). An underpayment for a
                                        - 32 -

[*32] year is attributable to fraud if petitioners intended to conceal, mislead, or

otherwise prevent the collection of taxes known or believed to be owing. See Katz

v. Commissioner, 90 T.C. 1130, 1143 (1988). If respondent establishes that any

portion of the underpayment for a year is attributable to fraud, the entire

underpayment for that year shall be attributable to fraud and subject to a 75%

penalty, except with respect to any portion that petitioners establish (by a

preponderance of the evidence) is not attributable to fraud. See sec. 6663(a)

and (b).

             1. Underpayment of Tax

      First, respondent must meet his burden of showing an underpayment of tax

for each of the years in issue. Respondent alleges fraudulent underpayments of tax

by BCO and petitioners with respect to tax owed as a consequence of the diverted

gross receipts from BCO. At trial Mr. Benavides admitted to diverting $100,489,

$92,764, and $167,225 of BCO’s gross receipts to Sunrise in 2003, 2004, and

2005, respectively,5 and we have held supra pp. 14-16 (BCO) and pp. 18-21

      5
        We note that Mr. Benavides admitted to diverting gross receipts in
amounts slightly different from those determined by respondent (and found by this
Court), but the critical point is that petitioners did not dispute BCO’s diverted
gross receipts. Computations attached to the notices of deficiency show that those
diverted gross receipts resulted in some underpayments of tax at the corporate and
shareholder levels. Form 4549B, Income Tax Examination Changes, issued to
                                                                         (continued...)
                                        - 33 -

[*33] (petitioners) that those diverted gross receipts are taxable income to BCO

and taxable constructive dividends to petitioners. Hence it is not difficult to

conclude that respondent has carried his burden of showing some underpayments

of tax with respect to BCO and petitioners. Specifically, respondent showed that

BCO understated its taxable income by failing to report the diverted gross receipts

as corporate income of $195,359, $102,584, and $215,580 for 2003, 2004, and

2005, respectively, and by erroneously claiming NOL carryforward deductions for

2004 and 2005; and petitioners understated their taxable income by failing to

report the diverted gross receipts from BCO as constructive dividends of

$195,359, $132,584, and $215,580 for 2003, 2004, and 2005, respectively.

Consequently, respondent has established that both BCO and petitioners underpaid

their tax for 2003, 2004, and 2005.

             2. Fraudulent Intent

      Next, we must determine whether BCO and petitioners had fraudulent

intent. The existence of fraud is a factual question, resolved upon consideration of

the entire record. King’s Court Mobile Home Park, Inc. v. Commissioner, 98 T.C.

      5
        (...continued)
petitioners shows that even after reducing Sunrise’s gross receipts by the amounts
of the diverted dividends petitioners underreported income flowing through from
Sunrise. That underreported income was added to the underreported income from
the constructive dividends from BCO.
                                          - 34 -

[*34] 511, 516 (1992). Fraud may not be presumed or based upon mere suspicion.

Petzoldt v. Commissioner, 92 T.C. 661, 699-700 (1989). But because direct

evidence of fraudulent intent is seldom available, fraud may be proven by

circumstantial evidence and reasonable inferences drawn from the facts. Bradford

v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601;

Niedringhaus v. Commissioner, 99 T.C. 202, 210 (1992). The taxpayer’s entire

course of conduct may be indicative of fraudulent intent. DiLeo v. Commissioner,

96 T.C. 858, 874 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); Stone v.

Commissioner, 56 T.C. 213, 224 (1971).

      Courts routinely consider whether the following “badges of fraud” are

present: (1) understating income, (2) maintaining inadequate records, (3) failing

to file tax returns, (4) giving implausible or inconsistent explanations of behavior,

(5) concealing assets, (6) failing to cooperate with tax authorities, (7) engaging in

illegal activities, (8) attempting to conceal illegal activities, (9) dealing in cash,

and (10) failing to make estimated payments. See, e.g., Spies v. United States, 317

U.S. 492, 499 (1943); Bradford v. Commissioner, 796 F.2d at 307; Recklitis v.

Commissioner, 91 T.C. 874, 910 (1988); see also McGraw v. Commissioner, 384

F.3d 965, 971 (8th Cir. 2004) (citing Spies, 317 U.S. at 499, and Bradford v.

Commissioner, 796 F.2d at 307-308), aff’g Butler v. Commissioner, T.C. Memo.
                                        - 35 -

[*35] 2002-314. This list is nonexclusive, and no single factor is dispositive,

although the combination of several factors may constitute persuasive evidence of

fraud. Petzoldt v. Commissioner, 92 T.C. at 700.

      A corporation acts only through its officers and cannot escape responsibility

for their acts in that capacity. DiLeo v. Commissioner, 96 T.C. at 875. Whether

BCO’s intent was fraudulent therefore depends upon the intent of Mr. Benavides,

its sole owner and manager. See Ruidoso Racing Ass’n, Inc. v. Commissioner,

476 F.2d 502, 506 (10th Cir. 1973) (fraud of majority shareholder imputed to

corporation because corporation received tax benefit from shareholder’s

fraudulent acts to understate corporate gross income), aff’g in part, remanding in

part T.C. Memo. 1971-194; DiLeo v. Commissioner, 96 T.C. at 875; Federbush v.

Commissioner, 34 T.C. 740, 749 (1960) (fraud of shareholder-officers in diverting

corporate income to evade corporate tax imputed to corporation when officers

owned five-sixths of stock), aff’d, 325 F.2d 1 (2d Cir. 1963); Door Control Servs.

Inc. v. Commissioner, T.C. Memo. 1996-508 (corporate taxpayer fraudulently

intended to underpay taxes when it substantially understated its tax liability by

failing to report income diverted to its only two shareholders who were also its

only officers).
                                        - 36 -

[*36]               a. BCO and Mr. Benavides

        We now turn to the badges of fraud. First, the diverted gross receipts from

BCO demonstrate a pattern of consistent underreporting of income by both BCO

and Mr. Benavides, evidencing their intent to evade both corporate tax and tax on

dividends. And while a “mere understatement of income alone is not sufficient to

prove fraud, the consistent and substantial understatement of income is, by itself,

strong evidence of fraud.” Truesdell v. Commissioner, 89 T.C. at 1302 (finding

fraud when sole shareholder diverted corporate funds to shareholder’s personal

use during three tax years and failed to report on corporate or individual returns);

Otsuki v. Commissioner, 53 T.C. 96, 107-108 (1969) (holding that a pattern of

omission of gross receipts for five years was “strong evidence of an attempt to

defraud the Government”); see also Potter v. Commissioner, T.C. Memo. 2014-18,

at *9 (“A pattern of substantially underreporting income for multiple years is

strong evidence of fraud[.]”) (citing Vanover v. Commissioner, T.C. Memo. 2012-

79, 2012 WL 952871, at *4).

        Second, BCO and petitioners failed to maintain adequate records. BCO

maintained two sets of books to track payments BCO received--one for tracking

accounts receivable and one for tax reporting--and the diverted amounts were not

reported on the books used for BCO’s tax reporting or BCO’s tax returns. Mr.
                                        - 37 -

[*37] Benavides was instrumental in BCO’s double bookkeeping practices and its

failure to deposit all of its gross receipts into BCO accounts and petitioners’

failure to report the resulting dividends from BCO.

      Third, the two sets of books also indicate an effort to conceal taxable

income. Potter v. Commissioner, at *11 (stating that double bookkeeping at

corporate taxpayer was used to conceal shareholder’s diverting corporate receipts

and was “clear circumstantial evidence of fraudulent intent”).

      Fourth, Mr. Benavides’ criminal conviction--while not identical to the fraud

alleged here--is nonetheless indicative of his fraudulent intent vis-a-vis the IRS

and Federal income taxes. In 2011 Mr. Benavides pleaded guilty and was

convicted of assisting in the preparation of a false or fraudulent income tax return

in violation of section 7206(2). The parties stipulated the offer of proof, which

states that Mr. Benavides used BCO to collect “fees for services” from a client,

purchased a personal item for the client, then assisted in preparing the client’s tax

return claiming a business expense deduction for the cost of the personal item

mischaracterized as “fees”. Here too Mr. Benavides intentionally used BCO’s

operations to avoid taxes--this time for BCO’s and petitioners’ benefit--diverting

BCO’s income to hide it from the IRS.
                                        - 38 -

[*38] Lastly, BCO and Mr. Benavides provided inconsistent and implausible

explanations for their actions. For example, Mr. Benavides disavows any

fraudulent intent, arguing that, while he may have “redirected” BCO’s gross

receipts, the income was reported “somewhere”--whether on petitioners’ joint

returns or the returns of one of petitioners’ businesses. This, Mr. Benavides

argues, indicates a lack of fraudulent intent. Mr. Benavides also protests that it is

“rather silly” to suggest that petitioners were trying to evade corporate tax because

he was just paying reasonable compensation to himself--a process he described to

the Court as “stripping” the taxable income out of BCO.

      Mr. Benavides admits to “hurried, short-circuited bookkeeping practices,”

but argues that he intended only to engage in legitimate tax planning by paying

himself a reasonable salary. But BCO’s principal business was tax preparation

and accounting services; Mr. Benavides--as a C.P.A. with an accounting degree

and decades of experience in tax matters--thus should know he cannot just ignore

the separate existence of BCO. See Solomon v. Commissioner, 732 F.2d 1459,

1461-1462 (6th Cir. 1984) (holding that taxpayer’s knowledge and experience as a

C.P.A. whose business was handling tax matters for others supported a finding of

fraud), aff’g per curiam T.C. Memo. 1982-603; Franke v. Commissioner, T.C.

Memo. 2011-10 (stating that taxpayer’s business experience as a tax preparer for
                                          - 39 -

[*39] several years was a relevant consideration in determining whether he had

fraudulent intent).

         To suggest that taxpayers who made a living handling the tax and

accounting matters of others should escape the fraud penalty because of sloppy

bookkeeping--itself a badge of fraud--is risible. The “reasonable compensation”

argument advanced by Mr. Benavides is a dog that will not hunt. He did not

report the diverted gross receipts on his personal returns as compensation from

BCO or pay applicable self-employment taxes. He cannot ignore reality or rewrite

history now that he has been caught out. Mr. Benavides’ intentioned steps to

lower BCO’s taxable income (as well as his own) are clear and convincing

evidence of the requisite fraudulent intent for BCO and Mr. Benavides alike. We

find ample indicia of fraud for BCO and Mr. Benavides for each of the tax years in

issue.

                      b. Mrs. Benavides

         Although Mrs. Benavides filed joint returns with Mr. Benavides, to

establish her liability for the fraud penalties respondent must show that some

portions of the underpayments were due to her fraud. See sec. 6663(c). The

record shows that her involvement with BCO and Sunrise was more limited.

Unlike her husband, Mrs. Benavides was not a C.P.A. with decades of tax
                                       - 40 -

[*40] experience, nor was she an owner or manager of BCO. During the years in

issue she performed clerical tasks at BCO, such as data entry and bookkeeping,

making entries in the ATB program, preparing deposit slips, and depositing funds

into BCO’s and other “various” accounts. While these tasks, together with her

relationship with Mr. Benavides, suggest that she may have known of the diverted

gross receipts, we will not presume so without additional indicia of fraud.

Therefore, we hold that respondent has not carried his burden of showing by clear

and convincing evidence that Mrs. Benavides had fraudulent intent.

      B. Section 6751

      For certain penalties asserted against individual taxpayers, including fraud,

the Commissioner must show that he complied with the procedural requirements

of section 6751(b)(1). Sec. 7491(c); Graev v. Commissioner (Graev III), 149 T.C.

485, 492-493 (2017), supplementing and overruling in part Graev v.

Commissioner (Graev II), 147 T.C. 460 (2016). Section 6751(b)(1) requires the

Commissioner to show that the initial determination of certain penalties was

“personally approved (in writing) by the immediate supervisor of the individual

making such determination”. See Graev III, 149 T.C. at 493; see also Chai v.

Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev’g in part T.C.

Memo. 2015-42.
                                        - 41 -

[*41] Trial was held, and the record was closed before the issuance of our Opinion

in Graev III, which overruled in part our decision in Graev II and held that the

Commissioner’s burden of production under section 7491(c) includes showing

supervisory approval as required by section 6751(b)(1). In the light of the Court’s

decision in Graev III, we ordered the parties to address the effect of section

6751(b)(1) on these cases and to direct the Court to any evidence of section

6751(b)(1) supervisory approval in the record. Respondent was unable to direct

the Court to any evidence in the record that satisfies his burden of production with

respect to section 6751(b)(1) and filed a motion to reopen the record to include a

completed Form 11661, signed by the examining agent’s supervisor, a Penalty

Approval Form signed by the supervisor, and declarations by the revenue agent

who recommended the penalties and the revenue agent’s supervisor who approved

them. Petitioners objected to respondent’s motion.

      We first must determine whether to reopen the record to admit the

additional evidence that respondent offered. The decision to reopen the record to

admit additional evidence is within our broad discretion. Zenith Radio Corp. v.

Hazeltine Research, Inc., 401 U.S. 321, 331-332 (1971); see Nor-Cal Adjusters v.

Commissioner, 503 F.2d 359, 363 (9th Cir. 1974) (“[T]he Tax Court’s ruling

[denying a motion to reopen the record] is not subject to review except upon a
                                        - 42 -

[*42] demonstration of extraordinary circumstances which reveal a clear abuse of

discretion.”), aff’g T.C. Memo. 1971-200. We “will not grant a motion to reopen

the record unless, among other requirements, the evidence relied on is not merely

cumulative or impeaching, the evidence is material to the issues involved, and the

evidence probably would change the outcome of the case.” Butler v.

Commissioner, 114 T.C. 276, 287 (2000); see also SEC v. Rogers, 790 F.2d 1450,

1460 (9th Cir. 1986) (trial court “should take into account, in considering a motion

to hold open the trial record, the character of the additional * * * [evidence] and

the effect of granting the motion”), overruled on other grounds by Pinter v. Dahl,

486 U.S. 622 (1988). We also balance the moving party’s diligence against the

possible prejudice to the nonmoving party. In particular we consider whether

reopening the record after trial would prevent the nonmoving party from

examining and questioning the evidence as it would have during the proceeding.

Estate of Freedman v. Commissioner, T.C. Memo. 2007-61, 2007 WL 831802,

at *12; Megibow v. Commissioner, T.C. Memo. 2004-41, 2004 WL 309153, at *7.

      We agree with respondent that the Form 11661 is not cumulative, is material

to the penalty issues in this case, and probably would change the outcome.

See Butler v. Commissioner, 114 T.C. at 287. Reopening the record here serves

the interests of justice because the record was closed in this case before we issued
                                        - 43 -

[*43] Graev III and because petitioners never raised section 6751(b)(1) as an issue

before the record was closed. We also agree with respondent that the Form 11661

is a record kept in the ordinary course of business activity and is authenticated by

the declarations. See Fed. R. Evid. 803(6), 902(11). This form is the type of

evidence we routinely admit at trial solely on the basis of declarations such as

those proffered.

      Petitioners objected to the granting of respondent’s motion but did not point

to any specific issues or errors with respect to the Form 11661. Rather, petitioners

argue that because Chai was decided six weeks before trial and section 7491(c)

has long put the burden of production on the Commissioner with respect to

penalties, respondent should have known that he needed to put on this evidence at

the time of trial. Petitioners also objected on equitable grounds, arguing that

respondent acted in bad faith by objecting to petitioners’ motion for continuance,

that petitioners were prejudiced by proceeding pro sese, and that respondent

proceeded in bad faith by making evidentiary objections at trial and technical legal

arguments on brief. We disagree. While the Court of Appeals for the Second

Circuit did publish its opinion in Chai a short time before the trial in these

consolidated cases, it was not binding in the Ninth Circuit and contradicted this
                                       - 44 -

[*44] Court’s own precedent in Graev II. We do not expect parties to anticipate

when this Court will overrule its precedent.

      Petitioners’ equitable arguments are particularly weak. Petitioners were

granted two continuances in these cases, giving them two additional years to

prepare for trial. While the Court is sympathetic to health problems faced by

petitioners’ former attorney, those health problems had been noted in the second

motion for continuance and do not excuse the lack of progress in these cases over

the two years they were continued. Objecting to a motion for continuance does

not constitute bad faith, nor do evidentiary objections or technical arguments. We

found Mr. Benavides to be a trained tax professional capable of representing

himself and BCO, and on the basis of his trial testimony we concluded that he

understood substantiation requirements. And while we reject his stripping

argument, that argument confirms that he understands the tax rules that we applied

above.

      For the reasons stated above, we believe that justice favors exercise of our

discretion to reopen the record. We therefore will grant respondent’s motion in

part and reopen the record and admit the Form 11661 into evidence. We also will

admit the declarations into evidence for the purpose of authentication under rule

902(11) of the Federal Rules of Evidence. See Clough v. Commissioner, 119 T.C.
                                       - 45 -

[*45] 183, 190-191 (2002). (As we explain below, we also will deny respondent’s

motion in part and will not admit the Penalty Approval Form.)

             1. Supervisory Approval for Mr. Benavides

      The Form 11661 evinces supervisory approval for the section 6663(a) fraud

penalties before the formal communication of the initial determination to assess

these penalties against Mr. Benavides. See Clay v. Commissioner,152 T.C. __,

__ - __ (slip op. at 44-45) (Apr. 24, 2019). The Form 11661 was signed by the

examining agent’s supervisor before the first RAR was issued to petitioners and

expressly contemplated that a 30-day letter would be prepared at some point. On

the record before us we conclude that the approval came before respondent sent to

BCO or petitioners any formal communication of penalties. Id. We, therefore,

hold that respondent has satisfied his burden of showing supervisory approval

under section 6751(b)(1) for the section 6663(a) fraud penalties determined

against Mr. Benavides. See Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152

T.C. __, __ - __ (slip op. at 17-18) (Feb. 28, 2019).

             2. Supervisory Approval for Mrs. Benavides

      With respect to Mrs. Benavides, however, we held above that respondent

has not carried his burden of showing by clear and convincing evidence that she

had fraudulent intent. Therefore, we need not address compliance with section
                                       - 46 -

[*46] 6751(b)(1). The Penalty Approval Form will not change the result as to

Mrs. Benavides, and it is cumulative as to Mr. Benavides. We therefore will deny

respondent’s motion in part and not admit the Penalty Approval Form into the

record.

            3. Supervisory Approval for BCO

      Respondent does not bear the burden of showing compliance with section

6751(b)(1) for the section 6663(a) fraud penalties determined against BCO

because BCO is a corporation, not an individual. See sec. 7491(c); Dynamo

Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 231-232 (2018).

Nevertheless, with his motion to reopen the record respondent offered a similar

Form 11661 for the section 6663(a) fraud penalties determined against BCO that

was signed by the examining agent’s supervisor before an RAR was issued to

BCO. The Form 11661 was authenticated by the same declarations we have

admitted into the record. It is not clear from the record whether BCO put

supervisory approval under section 6751(b)(1) in issue, but we will deem BCO to

have done so. We will therefore admit the Form 11661 into the record for

purposes of showing requisite supervisory approval of the initial determination to

assess the section 6663(a) penalties determined against BCO. On the basis of this
                                        - 47 -

[*47] Form 11661 and the declarations we have already admitted, we hold that

respondent complied with section 6751(b)(1) with respect to BCO.

      C. Summary

      Because respondent has shown by clear and convincing evidence that the

underpayments attributable to the diverted gross receipts for each of the tax years

in issue are attributable to fraud, we sustain respondent’s determinations imposing

fraud penalties under section 6663(a) on BCO’s and Mr. Benavides’

underpayments of tax relating to diverted gross receipts.6 With respect to Mrs.

Benavides, however, respondent failed to show by clear and convincing evidence

that she had fraudulent intent; therefore, Mrs. Benavides is not liable for the

section 6663(a) fraud penalties. See sec. 6663(c).

V. Limitations

      Finally, petitioners also raise a statute of limitations argument, asserting that

because respondent’s fraud allegation is limited to underpayments of tax

      6
        Respondent determined that some portions of the underpayments of tax by
petitioners were not attributable to fraud and did not determine fraud penalties on
those amounts. These portions are attributable to the various disallowed
deductions flowing from Sunrise to petitioners that increased Sunrise’s income.
As we explain below, the mere fact that respondent determined that only a portion
of the underpayments was attributable to fraud (the constructive dividends
resulting from diverting BCO’s gross receipts) does not mean that respondent is
barred by the statute of limitations from assessing the portions of the
underpayments that were not attributable to fraud.
                                        - 48 -

[*48] attributable to the gross receipts diverted from BCO, the other deficiencies

are outside the limitations period. A deficiency in tax generally must be assessed

within three years from the date on which the return was filed. See sec. 6501(a).

However, if a taxpayer files a false or fraudulent return with the intent to evade

tax, the tax may be assessed at any time. Sec. 6501(c)(1). And in the case of a

joint return, fraud by either taxpayer suspends the period of limitations indefinitely

for both taxpayers. See Ballard v. Commissioner, 740 F.2d 659, 663 (8th Cir.

1984), aff’g in part and rev’g in part T.C. Memo. 1982-466; Hicks Co. v.

Commissioner, 56 T.C. at 1030; Evans v. Commissioner, T.C. Memo. 2010-199,

2010 WL 3564727, at *5, aff’d, 507 F. App’x 645 (9th Cir. 2013).

      Respondent bears the burden of proving by clear and convincing evidence

that this exception to the limitations period applies. See Gould v. Commissioner,

139 T.C. 418, 431 (2012), aff’d, 552 F. App’x 250 (4th Cir. 2014). Respondent’s

burden is the same as his burden under section 6663(a) to prove the applicability

of the fraud penalty: Respondent must show that there is an underpayment of tax

for each year, and that some portion of each underpayment is attributable to fraud.

Id. As discussed above, respondent has carried his burden under section 6663(a)

as to both BCO and Mr. Benavides. Therefore, we hold that he has carried his

burden under section 6501(c)(1) with respect to BCO and petitioners.
                                         - 49 -

[*49] Because the limitations period has not closed with respect to the tax years in

issue, respondent may assess and collect the tax he determined to be owing for

those years, whether or not attributable to fraud. See sec. 6501(c)(1); Lowy v.

Commissioner, 288 F.2d 517, 520 (2d Cir. 1961) (“[I]f a return be fraudulent in

any respect with intent to evade a tax, it deprives the taxpayer of the bar of the

statute for that year, and permits a general reaudit of the return throughout, and

will toll the Statute of Limitations on the reaudit of any item of the tax.”), aff’g

T.C. Memo. 1960-32.

VI. Conclusion

      In sum, because we found clear and convincing evidence of fraud with

respect to BCO’s diverted gross receipts for each year in issue, respondent’s

deficiency determinations set forth in the notices of deficiency may be assessed

against both BCO and petitioners, except that the section 6663(a) fraud penalties

may not be assessed separately against Mrs. Benavides.

      We have considered all of the arguments made by the parties and, to the

extent they are not addressed herein, we find them to be moot, irrelevant, or

without merit.
                                  - 50 -

[*50] To reflect the foregoing,


                                           An appropriate order and decisions

                                  will be entered.
