                        T.C. Memo. 2003-180



                      UNITED STATES TAX COURT



          RAY W. AND MARILYN S. SOWARDS, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10025-99, 11144-00.          Filed June 19, 2003.



     David M. Kirsch, for petitioner Ray W. Sowards.

     Basil J. Boutris, for petitioner Marilyn S. Sowards.

     Andrew R. Moore, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:   These cases were consolidated by motion of the

parties for purposes of trial, briefing, and opinion.    Respondent

determined deficiencies in petitioners’ Federal income taxes,
                                   - 2 -

additions to tax pursuant to section 6654,1 accuracy-related

penalties pursuant to section 6662(a), and fraud penalties

pursuant to section 6663 for the taxable years 1995, 1996, and

1997, in the following amounts:

                        Additions to Tax           Penalties
Year       Deficiency      Sec. 6654       Sec. 6662(a)   Sec. 6663

1995       $98,690            --           $19,738.00         --

1996        61,038          $305.73          1,150.80       $41,463.00

1997        24,818            66.23            774.60       15,708.75

       After a concession by respondent the issues to be decided

are as follows:

       (1) Whether funds deposited into a bank account held in the

name of a purported trust are taxable income for the taxable

years 1995, 1996, and 1997 in the respective amounts of $58,057,

$149,774, and $58,622;

       (2) Whether petitioners failed to report $7,725 as

additional income in 1997 relating to petitioner Ray Sowards’s

law practice;

       (3) Whether respondent erroneously disallowed deductions for

expenses allegedly incurred in 1996 and 1997 relating to

petitioner Ray Sowards’s law practice;




       1
      All section references are to the Internal Revenue Code in
effect for the taxable years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
                               - 3 -

     (4) Whether respondent erroneously disallowed deductions for

expenses allegedly incurred in 1996 relating to petitioner

Marilyn Sowards’s purported organizational consulting business;

     (5) Whether petitioner Ray Sowards is liable for fraud

penalties pursuant to section 6663 for the taxable years 1996 and

1997;

     (6) Whether petitioners are liable for accuracy-related

penalties pursuant to section 6662(a) for the taxable years 1995,

1996, and 1997;2

     (7) Whether petitioners are liable for additions to tax for

failure to pay estimated tax pursuant to section 6654 for the

taxable years 1996 and 1997;3 and

     (8) Whether petitioner Marilyn Sowards is entitled to relief

from joint and several liability pursuant to section 6015 for the

taxable years at issue.

                          FINDINGS OF FACT

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

The stipulation of facts, the second stipulation of facts, the

stipulation of settled issues, and the attached exhibits are


     2
      Respondent determined a negligence penalty pursuant to sec.
6662(a) for 1995 premised upon the entire amount of the
deficiency. With respect to 1996 and 1997, respondent determined
negligence penalties as an alternative to the fraud penalty and
for the deficiency amounts related to lack of substantiation.
     3
      Petitioner Ray Sowards concedes the applicability of this
addition to tax based upon the Court’s opinion and computation
under Rule 155.
                                - 4 -

incorporated herein by this reference.    At the time of filing the

petition, petitioners resided in San Jose, California.

Petitioners have been married to each other since 1969.    At the

time of filing the petition, petitioners were in the process of

dissolving their marriage; they have lived in separate abodes

since 1997.

     Petitioner Ray Sowards (Mr. Sowards) worked for Pacific Gas

and Electric (PG&E) until he became disabled in the mid-1980s. He

received disability income from PG&E during the years at issue.

Mr. Sowards graduated from Lincoln Law School in 1985.     He was a

licensed attorney in the State of California at the time the

returns at issue were filed.    Additionally, during the

aforementioned period, Mr. Sowards was admitted to practice

before this Court.

     After graduating from law school, Mr. Sowards opened a law

practice.   His practice concentrated on what he described as

asset protection.    In or about the end of 1993 or 1994, Mr.

Sowards became acquainted with Robert Strong (Mr. Strong).      Mr.

Strong operated a business entity known as System Two Limited

(STL).   STL was in the tax and financial services business, and

it prepared tax returns.    As part of this business, STL promoted

business trusts.    STL’s promotion activities included seminars.

Mr. Sowards participated in these promotion activities.    During

the years at issue, Mr. Sowards worked at an office located at
                                - 5 -

STL’s place of business.    Mr. Sowards went to his STL office on a

regular basis.

     Mr. Sowards, STL, and Mr. Strong had a close business

relationship.4   Mr. Sowards, Mr. Strong, and STL referred clients

among themselves.    Mr. Sowards performed legal services for STL

and advised many of STL’s clients.5     Mr. Sowards traveled and

assisted Mr. Strong with seminars promoting STL’s services

conducted in Ohio, Hawaii,6 Alaska, and Texas.    STL reimbursed

Mr. Sowards for business and travel expenses.     STL also provided

Mr. Sowards with an American Express credit card.

     On or about June 1, 1994, Mr. Sowards, with the assistance

of Mr. Strong, purportedly created an intervivos trust named

Wealth Preservation Assistance (WPA).     Mr. Sowards was the sole

grantor of WPA.7    The trust document states that WPA’s business

purpose is “diversification of business activities and business

assets for planned constructive growth.”



     4
      Petitioner Marilyn Sowards (Ms. Sowards) testified that Mr.
Strong and her husband had a contract relationship.
     5
      Mr. Sowards testified that he performed these legal
services as a courtesy and on a pro bono basis.
     6
      In one of the years at issue, Mr. Sowards traveled to
Hawaii as many as nine times to assist Mr. Strong with the STL
seminars.
     7
      Mr. Sowards testified that there were three main reasons
for establishing WPA: (1) For use in doing charitable, pro bono
legal work; (2) for use on some minor business transactions; and
(3) for use in estate planning. WPA was never used for
charitable purposes or as a business entity.
                                 - 6 -

     Mr. Sowards purportedly assigned certificates of beneficial

interest in WPA to his wife, Ms. Sowards, and their six

children.8    Mr. Sowards did not inform his wife or children of

their purported beneficial interests in WPA.

     Mr. Sowards opened and maintained a bank account under the

WPA name at the Bank of Milipitas, account No. 1109898 (WPA’s

bank account).    He had sole signatory authority over WPA’s bank

account.     During the relevant years, Mr. Sowards controlled and

made all day-to-day decisions regarding WPA.    Ms. Vera Morris

(Ms. Morris) was named sole trustee of WPA.    Ms. Morris was an

employee of STL and the mother-in-law of Mr. Strong.    WPA did not

file Federal income tax returns for 1995, 1996, or 1997.

     For the tax years at issue, STL issued checks to WPA

approximately every week.    On an approximately weekly basis, Mr.

Sowards submitted statements to STL for the WPA payments he

received.    The dated statements read “To: System Two Limited,”

“From: WPA,” “For: Legal Compliance” and list an amount “Due”.

The statements for 1996 and 1997 list total amounts due to WPA

from STL of $131,700 and $46,853.52, respectively.




     8
      Mr. Sowards purportedly assigned the following percentages
of beneficial interest in WPA to the following members of his
family, 25 percent to his wife and 12.5 percent to each of his
six children: Jared V. Sowards, Benjamin J. Sowards, Rachel H.
Sowards, Emily M. Sowards, Nicolas L. Sowards, and Julie A.
Sowards.
                                 - 7 -

Additionally, Mr. Sowards submitted reimbursement requests to STL

for expenditures for gasoline.

     During 1995, STL issued 65 checks made payable to WPA in the

total amount of $65,833.    All the aforementioned checks were

deposited into WPA’s bank account.       During 1996, STL issued 56

checks made payable to WPA in the total amount of $128,000.       All

the aforementioned checks were deposited into WPA’s bank account.

During 1997, STL issued 19 checks in the total amount of $50,345

made payable to WPA.   All the aforementioned checks were

deposited into WPA’s bank account.

     In 1995, 1996, and 1997, Mr. Sowards wrote checks totaling

$51,484.84, $121,685.21, and $62,876.44, respectively, from WPA’s

bank account.   Most of the checks written on WPA’s bank account

were used to pay for his family’s expenses.       For example, Mr.

Sowards wrote checks to his wife, Ms. Sowards, to the family’s

church, to a telephone company, to a mortgage lender, etc.

Additionally, in 1995, 1996, and 1997, Mr. Sowards wrote checks

made payable to cash in the total amounts of $2,800, $18,404.74,

and $7,430, respectively.

     Mr. Sowards also maintained a bank account at the Bank of

the West, account No. 240547269 and a personal joint checking

bank account with his wife at First Interstate Bank, account No.


     9
      From the transactions stipulated by the parties, Mr.
Sowards appears to have used this bank account for his law
practice.
                               - 8 -

684-0-18497 (the joint checking account).10    Some of the funds

deposited into WPA’s bank account were subsequently transferred

via checks to the joint checking account.     Petitioners used the

funds in their joint checking account to pay for their living

expenses.

     In 1995, Mr. Sowards wrote 39 checks totaling $12,995 from

WPA’s bank account to Ms. Sowards.     In 1996, Mr. Sowards wrote 59

checks totaling $17,538 from WPA’s bank account to Ms. Sowards.

In 1997, Mr. Sowards wrote 28 checks totaling $12,047.20 from

WPA’s bank account to Ms. Sowards.     Ms. Sowards deposited the

aforementioned checks into the joint checking account.     In 1997,

petitioners borrowed $30,000 from a third-party lender.     Part of

the loan proceeds was deposited into the joint checking account

and used to pay, inter alia, credit card bills and home

improvement expenses.11

     On their 1996 return, petitioners included a Schedule C,

Profit or Loss From Business, for “business consulting” that Ms.

Sowards allegedly operated.   Respondent denied all the expenses

associated with this business for lack of substantiation.     During

respondent’s examination, Revenue Agent Terry Daleiden (Agent

Daleiden) questioned Mr. Sowards about this business and these


     10
      Wells Fargo bank took over First Interstate Bank, and
petitioners’ account number changed to 0515-660033.
     11
      On Apr. 16, 1997, $13,000 of the loan proceeds was also
deposited into WPA’s bank account.
                               - 9 -

expenses.   Mr. Sowards represented to Agent Daleiden that his

wife performed paralegal services associated with his law

practice.   Similarly, in responding to respondent’s interrogatory

concerning the substantiation of the business consulting

expenses, Mr. Sowards answered: “All of petitioners’ financial

and tax data for the years in dispute were destroyed in a fire on

April 8, 1998.”   In his second set of interrogatories, respondent

asked Mr. Sowards to “State what duties Marilyn Sowards performed

as an organizational consultant during 1996.”   Mr. Sowards

responded: “Marilyn Sowards performed light filing and mailing.”

However, Ms. Sowards never had a consulting business.   Mr.

Sowards fabricated the business.12

     On their 1996 and 1997 returns, petitioners included

Schedules C for Mr. Sowards’s law practice.   On these Schedules

C, petitioners claimed deductions for expenses of $11,197 and

$14,805 for 1996 and 1997, respectively.    Respondent denied all

of petitioners’ claimed deductions for lack of substantiation.

Additionally, respondent imputed additional income of $7,725 in

1997 to petitioners from the law practice utilizing the bank

deposits method of income reconstruction.


     12
      Mr. Sowards testified at trial that the income and
expenses shown on his wife’s Schedule C were from his law
practice and that he reported them on his wife’s Schedule C to
get credit for Social Security purposes. Ms. Sowards did not
know of the claimed existence of “her” fabricated organizational
consulting business until the Internal Revenue Service (IRS)
commenced the examination of petitioners’ returns.
                              - 10 -

     Ms. Sowards graduated from Brigham Young University in 1969

and thereafter attended Cal-State Hayward for 2 years.    She has

never taken an accounting course.   During the years at issue, Ms.

Sowards was a stay-at-home mother and homemaker.    Her work

history consists of 2 years of teaching primary school in or

about 1969, 2 years as a reading specialist in a primary school

after petitioners’ separation in 1997, and 2 months as a nanny in

2000.

     Ms. Sowards knew little of her husband’s business affairs.

Her husband refused to provide and discuss with her any

information concerning his finances.   For example, she had no

knowledge of the alleged loan agreement by and between Mr.

Strong/STL and her husband.   She was unaware that WPA was a trust

of which she and her children were the named beneficiaries.    As

both petitioners testified, she was never given a copy of the

shares of beneficial interest.   Her husband told her that WPA was

the name he gave his law practice’s “operating” bank account.13

She believed that the approximately weekly checks written to her

from the WPA account were drawn on the law firm’s business

account.   She testified that she never knew how much money her

husband was making and that the family lived “month-to-month”.

She had no access to WPA bank account statements.    She did know,


     13
      Ms. Sowards testified that upon questioning her husband
about the name, “he just said that WPA would mean something to
the elderly, something from the war days.”
                                - 11 -

however, that her husband would separately write WPA checks for

her children’s needs such as tuition, rent, etc.

       Ms. Sowards did not participate in the preparation of the

couple’s tax returns except for a few conversations with the tax-

return preparer concerning, for example, the number of charitable

deductions.     She never reviewed the tax returns; her husband told

her to simply sign the returns.    Petitioners expended no moneys

on lavish items.

       In the spring of 1997, STL moved its offices to a new

location in Fremont, California.    Mr. Sowards did not move with

STL.    After STL moved its offices, Mr. Sowards performed no

further business services for STL and ceased receiving STL checks

written to WPA.14

       Mr. Jesus Flores (Mr. Flores) prepared petitioners’ 1995 and

1997 returns.    Petitioners’ 1996 return was prepared by American

Tax Professional.    Mr. Sowards never mentioned WPA or STL to Mr.

Flores.

                                OPINION

A.   Burden of Proof and Section 7491(a)

       Mr. Sowards15 argues that respondent bears the burden of

proof with respect to factual matters because:    (1) The


       14
      Ms. Sowards testified that her husband lost his contract
with STL.
       15
      Ms. Sowards did not advance any argument concerning the
applicability of sec. 7491.
                                - 12 -

examination of petitioners’ returns commenced after July 22,

1998; (2) Mr. Sowards introduced credible evidence as to all

contested issues; (3) he complied with all substantiation

requirements; and (4) he cooperated with respondent’s reasonable

requests.    Respondent argues that with regard to petitioners’

1995 return, section 7491 is inapplicable since the examination

commenced prior to the effective date.     Respondent relies upon

Agent Daleiden’s testimony that the first contact letter was sent

to petitioners in April of 1998.     With respect to 1996 and 1997,

respondent argues that petitioners have failed to comply with the

requirements of section 7491(a)(2)(A) and (B).     For the reasons

detailed below, we find the burden of proof does not shift to

respondent.

     Generally, a determination made by the Commissioner in a

notice of deficiency issued to the taxpayer is presumed correct,

and the taxpayer bears the burden of proving that determination

incorrect.    Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933).     However, section 7491(a)(1) provides that if the

taxpayer introduces credible evidence with respect to any factual

issue relevant to ascertaining the tax liability of the taxpayer,

the burden of proof shifts to the Commissioner with respect to

that issue.     Section 7491(a) was added to the Code by the

Internal Revenue Service Restructuring and Reform Act of 1998

(RRA 1998), Pub. L. 105-206, sec. 3001, 112 Stat. 726.
                                 - 13 -

     Section 7491(a)(1) applies in court proceedings arising only

in connection with examinations commencing after July 22, 1998.16

See RRA 1998 sec. 3001(c), 112 Stat. 727.        Agent Daleiden’s first

contact letter regarding 1995 was mailed to petitioners in April

1998.      Accordingly, respondent’s examination of petitioners’

1995 return commenced prior to the effective date of section

7491.     Seawright v. Commissioner, 117 T.C. 294 (2001).     Thus, we

find section 7491 inapplicable to petitioners’ 1995 return.

     Since the examination of petitioners’ 1996 and 1997 returns

commenced after the effective date of section 7491, we must

consider the provisions of that section.        The burden of proof

will shift to the Commissioner only after the taxpayer introduces

“credible evidence” with respect to a factual issue relevant to

ascertaining the taxpayer’s income tax liability.        See sec.

7491(a).     The statute fails to define what constitutes “credible

evidence”.     The conference committee report assists in

determining its intended meaning:




     16
          The House conference report states:

     An audit is not the only event that would be considered
     an examination for purposes of this provision. For
     example, the matching of an information return against
     amounts reported on a tax return is intended to be an
     examination for purposes of this provision. Similarly,
     the review of a claim for refund prior to issuing that
     refund is also intended to be an examination for
     purposes of this provision. [H. Conf. Rept. 105-599, at
     242 (1998), 1998-3 C.B. 747, 996.]
                              - 14 -

     Credible evidence is the quality of evidence which,
     after critical analysis, the court would find
     sufficient upon which to base a decision on the issue
     if no contrary evidence were submitted (without regard
     to the judicial presumption of IRS correctness). A
     taxpayer has not produced credible evidence for these
     purposes if the taxpayer merely makes implausible
     factual assertions, frivolous claims, or tax protestor-
     type arguments. The introduction of evidence will not
     meet this standard if the court is not convinced that
     it is worthy of belief. If after evidence from both
     sides, the court believes that the evidence is equally
     balanced, the court shall find that the Secretary has
     not sustained his burden of proof. [H. Conf. Rept.
     105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995.]

See Higbee v. Commissioner, 116 T.C. 438 (2001).   In support of

his position that amounts received from STL were loans, Mr.

Sowards offered only his self-serving testimony and an alleged

loan document.   We find that Mr. Sowards was not a credible

witness; his testimony was vague, inconsistent, and implausible.

Further, as detailed infra, we find that the payments from STL

were received for services that Mr. Sowards rendered.    Mr.

Sowards also failed to present credible evidence that other

deposits to his bank accounts were not taxable income or that

deductions disallowed by respondent should be allowed.    As such,

we find that Mr. Sowards failed to present credible evidence.

See Higbee v. Commissioner, supra; Tokh v. Commissioner, T.C.

Memo. 2001-45, affd. 25 Fed. Appx. 440 (7th Cir. 2001).

     In addition, the application of section 7491(a)(1) is

limited by section 7491(a)(2), which provides in pertinent part:

          SEC. 7491(a). Burden Shifts Where Taxpayer
     Produces Credible Evidence.--
                               - 15 -

               *     *     *      *     *    *      *

               (2). Limitations.--Paragraph (1) shall apply
          with respect to an issue only if--

                    (A) the taxpayer has complied with the
               requirements under this title to substantiate
               any item;

                    (B) the taxpayer has maintained all
               records required under this title and has
               cooperated with reasonable requests by the
               Secretary for witnesses, information,
               documents, meetings, and interviews * * *

One of the issues to be decided in this case is whether

petitioners have adequately substantiated those expenses claimed

on their returns and disallowed by respondent.   The legislative

history of section 7491 explicates:

          Nothing in the provision shall be construed to
     override any requirement under the Code or regulations
     to substantiate any item. Accordingly, taxpayers must
     meet applicable substantiation requirements, whether
     generally imposed or imposed with respect to specific
     items, such as charitable contributions or meals,
     entertainment, travel, and certain other expenses.
     Substantiation requirements include any requirement of
     the Code or regulations that the taxpayer establish an
     item to the satisfaction of the Secretary. Taxpayers
     who fail to substantiate any item in accordance with
     the legal requirement of substantiation will not have
     satisfied the legal conditions that are prerequisite to
     claiming the item on the taxpayer’s tax return and will
     accordingly be unable to avail themselves of this
     provision regarding the burden of proof. Thus, if a
     taxpayer required to substantiate an item fails to do
     so in the manner required (or destroys the
     substantiation), this burden of proof provision is
     inapplicable. [H. Conf. Rept. 105-599, supra at 241,
     1998-3 C.B. at 995; fn. refs. omitted; emphasis added.]

As we find infra, petitioners failed to adequately substantiate

those deductions claimed on their returns.
                                 - 16 -

      Accordingly, we find that the burden of proof with respect

to the underlying deficiencies remains on petitioners.17

B.   Reconstruction of Petitioners’ Income

      Unreported Income

      In the notices of deficiency, respondent determined that

petitioners had additional income for 1995, 1996, and 1997 of

$58,057, $149,774, and $66,347, respectively.     In the case of

1995, all additional income is attributable to money that STL

transferred to WPA.18     For 1996 and 1997, the vast majority of

the additional reconstructed income is attributable to STL

payments to WPA.

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

whatever source derived.”     Every person liable for income tax

must maintain books and records sufficient to establish the

amount of his gross income.     Sec. 6001; DiLeo v. Commissioner, 96

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

Secretary is authorized and has great latitude in reconstructing

income in accordance with any reasonable method that accurately

reflects actual income.     Secs. 446(b), 6001; Petzoldt v.


      17
      Of course, with regard to the fraud penalty, respondent
bears the burden of proof. Secs. 7491(a)(3), 7454(a); see
discussion, infra.
      18
      Although the evidence for 1995 shows total STL deposits
into WPA’s bank account of $65,833, in the notice of deficiency,
respondent only determined additional unreported income of
$58,057. Respondent is not seeking an increase in the deficiency
amount for 1995.
                             - 17 -

Commissioner, 92 T.C. 661, 687 (1989); Meneguzzo v. Commissioner,

43 T.C. 824, 831 (1965); see Taglianetti v. United States, 398

F.2d 558, 562 (1st Cir. 1968), affd. on other grounds 394 U.S.

316 (1969); Ramsey v. Commissioner, T.C. Memo. 1980-59; Bolton v.

Commissioner, T.C. Memo. 1975-373.     The reconstruction of a

taxpayer’s income need only be reasonable in light of all

surrounding facts and circumstances.     Giddio v. Commissioner, 54

T.C. 1530, 1533 (1970); Schroeder v. Commissioner, 40 T.C. 30, 33

(1963).

     To reconstruct petitioners’ gross income, respondent

utilized the bank deposits method.    The bank deposits method of

income reconstruction has long been sanctioned by the courts.

Clayton v. Commissioner, 102 T.C. 632, 645 (1994); Estate of

Mason v. Commissioner, 64 T.C. 651, 656 (1975), affd. 566 F.2d 2

(6th Cir. 1977); Bolton v. Commissioner, supra.

     Bank deposits constitute prima facie evidence of income.19

Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).     This method of

determining a taxpayer’s income assumes that all the money

deposited into a taxpayer’s bank accounts during a specific

period constitutes taxable income.     Price v. United States, 335

F.2d 671, 677 (5th Cir. 1964).   Of course, “the Government must



     19
      “If the taxpayer feels that the Government’s method of
computation is unfair or inaccurate, the burden is on him to show
such unfairness or inaccuracy.” DiLeo v. Commissioner, 96 T.C.
858, 871 (1991), affd. 959 F.2d 16 (2d Cir. 1992).
                                   - 18 -

take into account any non-taxable source or deductible expense of

which it has knowledge.”     Id.    Furthermore, “The fact that the

Commissioner was not completely correct does not invalidate the

method employed.”     DiLeo v. Commissioner, supra at 868.

     Respondent determined an increase in petitioners’ taxable

income by analyzing funds deposited into two bank accounts.

First, respondent analyzed deposits made in 1997 into Mr.

Sowards’ law firm “operating” bank account.       Secondly, respondent

analyzed the deposits made into the WPA bank account for all

the years at issue.

             (a) Unreported Income - Law Firm Account

     On their 1997 Federal tax return, petitioners reported gross

receipts of $23,575 from Mr. Sowards’s law practice.        On the

basis of deposits made into Mr. Sowards’s law firm operating bank

account, respondent determined that petitioners had additional

income from this business of $7,725.

     At trial, Revenue Agent Anoush Mahallati (Agent Mahallati)

explained that in reconstructing petitioners’ income, she took

into account all obvious and known nontaxable items.        See Price

v. United States, supra at 671.       On brief,20 Mr. Sowards argues

that respondent failed to account for several nontaxable items.

Respondent counters and explains that, as his calculation

demonstrates, all but one of the contested items were treated as


     20
          Petitioners failed to question Agent Mahallati.
                              - 19 -

nontaxable.   The only contested deposit that respondent did not

deduct as a nontaxable item was a $3,000 payment from Mr.

Sowards’s “client trust” bank account to his wife.21   The check

to Ms. Sowards states “paralegal service” on the memo line.

     Given the fact that this check is from another account

related to Mr. Sowards’s law practice ostensibly payable to his

wife for paralegal services and Mr. Sowards admitted that he

falsely reported his income on a Schedule C for a fabricated

organizational consulting business in his wife’s name, it can be

inferred that this check represents legal fees earned by Mr.

Sowards which were diverted to his wife.   On the basis of the

entire record, including Mr. Sowards’s consistent failure to

report income from STL (see infra), we find there is clear and

convincing evidence that petitioners had additional taxable

income of $7,275 in 1997.22


     21
      Apparently, in addition to a law firm “operating” bank
account, which was the subject of the 1997 bank deposits
analysis, Mr. Sowards maintained a “client trust” bank account.
Check no. 142 made payable to petitioner “Marilyn Sowards” dated
Dec. 13, 1997, for $3,000, was drawn against an account at U.S.
Bank, account No. 9280006496, which was held in the name of “Ray
Sowards Atty. Attorney Client Trust Account”.
     22
      The amount respondent determined in the notice of
deficiency as additional, unreported income is $7,725. However,
on brief, respondent lists the amount as $7,275. It appears that
the amount stated in the notice of deficiency suffers from a
scrivener’s error. The total amount deposited into this bank
account in 1997 was $43,557.37. Respondent identified and
subtracted nontaxable items of $12,707. The difference results
in net taxable deposits of $30,850.37. Petitioners reported
                                                   (continued...)
                                - 20 -

             (b) STL Checks to WPA

     In 1995, 1996, and 1997, STL issued checks to WPA in the

total amounts of $65,833,23 $128,000, and $50,345, respectively

which were deposited into the WPA account.     The pattern of STL’s

periodic payments (weekly), the amounts of the payments, the

frequent statements Mr. Sowards provided to STL for “amounts

due,” and the fact that Mr. Sowards rendered services to STL and

its customers throughout the period of time that STL was making

payments to WPA, establish that Mr. Sowards received remuneration

for services he rendered to STL, its customers, and/or Mr.

Strong.     That remuneration was in the form of the STL checks to

WPA which were deposited into the WPA account.

     Mr. Sowards contends that all the checks STL wrote to WPA

were nontaxable loans.     In support, Mr. Sowards introduced a one-

page document.     Because this document is the fulcrum of Mr.

Sowards’s position, we quote it in its entirety:

     This memorializes our oral agreement of January 3,
     1995:

     This agreement between us is never to [sic] revealed to
     Jan Strong or Marilyn Sowards.

     Robert Strong Trustee, acting with full authorized
     authority on behalf of System Two, will loan Ray
     Sowards, from System Two, beginning January 1, 1995 to
     December 31, 2001, the sum to which we mutually agreed,


     22
      (...continued)
gross receipts of $23,575.     The difference then is $7,275.37.
     23
          See supra note 18.
                        - 21 -

not to exceed Ten Thousand ($10,000.00) Dollars per
month. The loans will be advanced weekly, and Ray
Sowards agrees to provide System Two proof of receipt
on a weekly basis in the form of a statement or invoice
for the weekly loaned amount. The Checks will be
payable to Wealth Preservation Assistance.

Interest shall accrue at the rate of Ten percent per
annum. Robert Strong will reconcile the account
balance at the end of each year with Ray Sowards.

Robert Strong agrees that any and all liabilities, tax
or otherwise, that arise from this memorialized
transaction, will be born by System Two, Ltd. and/or
Robert Strong personally.

The Loans and accrued interest shall be repaid
according to the following terms and conditions:

1. Upon the retirement of Robert Strong on December
31, 2001, Ray Sowards will take over the management of
System Two, Ltd., and ownership of System Two’s
Financial Services business, and repay the loans at the
rate of Ten Thousand Dollars ($10,000.00) per month,
plus the accrued interest thereon, until the funds are
depleted, limited to no more than twenty Per Cent (20%)
of the gross proceeds generated by the Financial
Services Business. In the event of the demise of
Robert Strong after these payments begin, the balance
will be transferred to a trust to be created by Ray
Sowards, the terms and conditions of which are private
between Robert Strong and Ray Sowards, and not to be
disclosed. The Payments to Robert Strong will commence
January 1, 2002.

2. Upon the Demise of Robert Strong prior to January
1, 2002, the Account balance, at the time of demise,
will be transferred to a trust to be created by Ray
Sowards, the terms and conditions of which are private
between Robert Strong and Ray Sowards, and not to be
disclosed. Payments to the created trust will be on
the same basis as paragraph 1, above, beginning January
1, 2002.

3. Upon the demise of the Financial services Business
of System Two, Ltd., or System Two, or loss of control
of the business by Robert Strong, prior to January 1,
2001, the Account balance, at the time of demise, will
                                    - 22 -

       be transferred to a trust to be created by Ray Sowards,
       the terms and conditions of which are private between
       Robert Strong and Ray Sowards, and not to be disclosed.
       Payments to the created trust will be on the same basis
       as paragraph 1, above, beginning January 1, 2002.

       An American Express Card will be furnished to Ray
       Sowards, and all legitimate expenses will by [sic]
       Systems Two/Robert Strong for Travel Expenses.

       This agreement may be modified by the two parties only
       in writing.

       Dated: January 6, 1996[24]

There are what appear to be signatures at the bottom of the

document.25

       In challenging respondent’s imputation of additional taxable

income, Mr. Sowards argues that all the moneys received from STL

were loans and, thus, nontaxable.

       The characterization of advances as loans must be distilled

from all the evidence.       Dixie Dairies Corp. v. Commissioner, 74

T.C. 476, 493 (1980).       “Loans are identified by the mutual

understanding between the borrower and lender of the obligation

to repay and a bona fide intent on the borrower’s part to repay

the acquired funds.”       Collins v. Commissioner, 3 F.3d 625, 631

(2d Cir. 1993) (emphasis in original omitted), affg. T.C. Memo.

1992-478.       The ultimate question is whether there was a “genuine



       24
            We note that this date is after the 1995 payments from
STL.
       25
      Only Mr. Sowards testified that the document bore his and
Mr. Strong’s signatures.
                               - 23 -

intention to create a debt, with a reasonable expectation of

repayment, and did that intention comport with the economic

reality of creating a debtor-creditor relationship”.     Litton Bus.

Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

     In support of his “loan” argument, Mr. Sowards relies only

upon the one-page document and his testimony.   Of course, “It is

well settled that we are not required to accept petitioner’s

self-serving testimony in the absence of corroborating

evidence.”26   Jacoby v. Commissioner, T.C. Memo. 1994-612; see

Geiger v. Commissioner, 440 F.2d 688, 689 (9th Cir. 1971), affg.

per curiam T.C. Memo. 1969-159; Niedringhaus v. Commissioner, 99

T.C. 202, 212 (1992).   The mere declaration of intent does not

establish, without additional substantiating evidence, the

existence of a bona fide debt.   Turner v. Commissioner, 812 F.2d

650, 654 (11th Cir. 1987), affg. T.C. Memo. 1985-159; Cordes v.

Commissioner, T.C. Memo. 1994-377.

     The document, which is at best ambiguous, states that

certain of its terms and conditions are to remain secret.    In the

event of Mr. Strong’s death, Mr. Sowards is to create a trust to

which will be transferred the “Account balance” of the principal

and accrued interest under “the terms and conditions of which are

private between Robert Strong and Ray Sowards, and not to be



     26
      Mr. Sowards testified that he did not know the exact
amount that he allegedly borrowed from STL/Mr. Strong.
                                  - 24 -

disclosed.”27      At trial, Mr. Sowards failed to state the terms

and conditions of the alleged trust he was to create.         The books

and records of STL were not presented to the Court to assist in

determining how STL characterized these payments.28        There was no

collateral for these purported loans.        Mr. Sowards indicated that

he had no present means of paying back the amounts purportedly

borrowed.

     The sole testimony of Mr. Sowards is not sufficient to

establish the existence of an actual indebtedness.        On this

record, we are convinced that the funds transferred from STL/Mr.

Strong to petitioners/WPA were not loan proceeds.        Indeed, the

evidence clearly establishes that the payments from STL to WPA

were taxable income to Mr. Sowards.

             (c)   Other Deposits into WPA’s Bank Account

     In 1996 and 1997, funds were deposited into the WPA bank

account in addition to STL moneys.         In 1996, an additional

$21,773.86 was deposited into the WPA bank account.29        Examples

of the additional items are:      (1) A check from Alan D. Telebaum



     27
          Accrued interest was not due until the principal was due.
     28
      Clearly, such information would be helpful since the
intent of the parties is “perhaps the ultimate question.” Dixie
Dairies Corp. v. Commissioner, 74 T.C. 476, 495 (1980).
     29
      In fact, a total of $152,317.86 was deposited into the WPA
bank account. Of that, $2,544 represents nontaxable deposit
items since Mr. Sowards transferred those sums from a different
account.
                                - 25 -

dated February 20, 1996, for $450, on which the memo line states

“Attorneys fees”; (2) a check from Nhu-Hanh Duong dated June 13,

1996, for $446.54, on which the memo line states “Deposition for

Kevin Holt and pictures;” and (3) a check from Edward R. Gallegos

dated October 1, 1996, for $1,000, on which the memo line states

“partial retainer tax audit”.

     In 1997, an additional $8,277 was deposited into the WPA

bank account.30   The additional deposits included those items as:

(1) Check No. 2011 from Preferred Capital for $50 dated February

7, 1997, on which the memo line states “Attorney advice”; and (2)

check No. 902 from Advanced Strategies for $2,400 dated May 27,

1997, on which the memo line states “Trust Preparation”.    Mr.

Sowards provided no evidence whatsoever regarding these

additional deposits.

     The record clearly establishes that Mr. Sowards regularly

rendered services to STL, billing it via weekly statements, for

which he regularly received remuneration.    The amounts STL paid

to WPA, which were deposited into WPA’s account, constitute

taxable income to petitioners.    Thus, we hold that additional

income shall be imputed to petitioners for 1995, 1996, and 1997,

in the respective amounts $58,057, $128,000, and $50,345.

Additionally, we are convinced that the amounts deposited in



     30
      In fact, in 1997 $74,121.55 was deposited into the WPA
account of which $15,500 is nontaxable items.
                              - 26 -

excess of the STL transfers to WPA’s bank account in 1996 and

1997 in the respective amounts of $21,774 and $8,277 also

constitute additional, unreported taxable income to petitioners.

     We also disagree with petitioners’ claim that WPA was a

valid trust.   Even if a trust were legally created under State

law, we are not required to respect it as a separate entity for

Federal tax purposes.   Markosian v. Commissioner, 73 T.C. 1235,

1245 (1980).   Whether a trust is a sham entity lacking in

economic substance is a question of fact.   United States v.

Cumberland Pub. Serv. Co., 338 U.S. 451, 454 (1950); Paulson v.

Commissioner, 992 F.2d 789, 790 (8th Cir. 1993), affg. T.C. Memo.

1991-508.   The record clearly demonstrates that WPA engaged in no

business or charitable activities during the relevant period.

Mr. Sowards generally used WPA only as a receptacle into which he

deposited income received from STL and out of which moneys flowed

for his personal use.

     In deciding whether a purported trust lacks economic

substance, we consider the following factors:   (1) Whether the

taxpayer's relationship, as grantor, to property purportedly

transferred into trust differed materially before and after the

trust's formation; (2) whether the trust had a bona fide

independent trustee; (3) whether an economic interest in the

trust passed to trust beneficiaries other than the grantor; and

(4) whether the taxpayer honored restrictions imposed by the
                               - 27 -

trust or by the law of trusts.    See Markosian v. Commissioner,

supra at 1243-1245.

       Here, Mr. Sowards’s relationship to the property purportedly

transferred to the trust was not changed by virtue of the

creation of WPA.    The record demonstrates that despite being

named the sole trustee of WPA, Ms. Morris had no further

involvement with WPA after its creation.     Mr. Sowards had sole

control over WPA’s bank account.    The only “operations” in which

WPA engaged were the receipt and payment of moneys.     No economic

interest was transferred to WPA’s beneficiaries.     Indeed, the

purported beneficiaries had no knowledge of their interest in

WPA.    Furthermore, Mr. Sowards admitted at trial that WPA “was

never used as a trust.”    We find that WPA was simply a paper

entity wholly without economic substance.     See Paulson v.

Commissioner, supra; Chase v. Commissioner, 926 F.2d 737 (8th

Cir. 1991), affg. T.C. Memo. 1990-164.

C.   Schedules C - Deductions for Expenses

       In the notice of deficiency, respondent disallowed all

petitioners’ Schedules C expense deductions for want of adequate

substantiation.31   Mr. Sowards testified that he in fact incurred

the expenses listed on the 1996 Schedule C for his wife’s



       31
      Respondent disallowed deductions from the Schedules C for
1996 and 1997 for Mr. Sowards’s law practice. Additionally,
respondent disallowed deductions from the 1996 Schedule C for his
wife’s purported organizational consulting business.
                                - 28 -

purported organizational consulting business.     He claims that

these expenses should have been reported on the 1996 Schedule C

for his law practice.

     Generally, ordinary and necessary expenses paid or incurred

in the carrying on of a trade or business are deductible.     Sec.

162(a); sec. 1.162-1(a), Income Tax Regs.     “The determination of

whether an expenditure satisfies the requirements of section 162

is a question of fact.”     Shea v. Commissioner, 112 T.C. 183, 186

(1999).

     All deductible expenses are subject to substantiation.

Secs. 6001, 274(d).     The general substantiation requirement is

set forth in section 6001 and states in pertinent part: “Every

person liable for any tax imposed by this title, or for the

collection thereof, shall keep such records * * * and comply with

such rules and regulations as the Secretary may from time to time

prescribe.”    The regulations provide that “any person subject to

tax * * * shall keep such permanent books of account or records *

* * as are sufficient to establish the amount of * * *

deductions”.   Sec. 1.6001-1(a), Income Tax Regs.    In the event

that a taxpayer establishes that a deductible expense has been

paid, but he is unable to substantiate the precise amount, the

Court may estimate the amount of the deduction bearing heavily

against the taxpayer.     Cohan v. Commissioner, 39 F.2d 540, 543-

544 (2d Cir. 1930).     However, the Court cannot make such an
                               - 29 -

estimate unless the taxpayer presents sufficient evidence to

provide a reasonable basis upon which the estimate is made.32

Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).

     Mr. Sowards testified that he and Ms. Cheryl Nunn (Ms.

Nunn), a financial planner, were working together on a few cases.

He testified that one day, Ms. Nunn came to his office and

mistakenly took two bankers boxes of documents from a chair.

According to Mr. Sowards’s testimony, Ms. Nunn took the boxes to

her cabin in the Santa Cruz mountains where they were destroyed

by a fire.    Mr. Sowards testified that among those items

destroyed were the documents which substantiate the expenses

claimed on the returns and also documents concerning the alleged

loan between Mr. Strong and Mr. Sowards.    For support, Mr.

Sowards introduced a fire department’s report that the fire

occurred.

     The record before us is conspicuously devoid of any credible

evidence or testimony substantiating the alleged deductions

claimed.    Petitioners presented no evidence (not even Mr.

Sowards’s testimony) substantiating any item of deduction.     There

was no testimony as to what car and truck expenses were incurred,



     32
      The Court’s ability to estimate reasonably the amount of a
deduction is curtailed in the case of certain classes of
expenses. Sec. 274(d) limits the Court’s estimating ability.
Sanford v. Commissioner, 50 T.C. 823, 827 (1968), affd. per
curiam 412 F.2d 201 (2d Cir. 1969); see Golden v. Commissioner,
T.C. Memo. 1993-602.
                                - 30 -

what business property was leased or rented, or what items were

being depreciated.     Mr. Sowards did not call Ms. Nunn, the

alleged bailee of petitioners’ financial records, as a witness in

this matter.    Furthermore, we disagree with Mr. Sowards’s

contention that “no disallowed deduction is subject to the

substantiation requirements of section 274(d)”.     In fact, in 1995

and 1996, petitioners claimed depreciation deductions for

computer equipment.     Computer equipment is a “listed property”

under section 280F(d)(4).     Here, however, Mr. Sowards does not

present a scintilla of evidence that the claimed expenses were in

fact incurred.    On this record, we sustain respondent’s

disallowance of all deductions claimed as stated in the notices

of deficiency.

D.   Fraud Penalties

      Respondent determined fraud penalties for the taxable years

1996 and 1997.    Respondent applied the fraud penalties to the

unreported income deposited into the WPA account and the

unreported income deposited into Mr. Sowards’s law practice

account.   The Commissioner bears the burden of proving by clear

and convincing evidence that an “underpayment exists for the

years in issue and that some portion of the underpayment is due

to fraud.”     Sec. 7454(a); Rule 142(b); Niedringhaus v.

Commissioner, 99 T.C. at 210; Temple v. Commissioner, T.C. Memo.

2000-337, affd. 62 Fed. Appx. 605 (6th Cir. 2003).
                              - 31 -

     1.   Clear and Convincing Evidence of Underpayment

     To prove an underpayment, the Commissioner must establish

that the taxpayer received unreported income that resulted in a

tax deficiency.   United States v. Campbell, 351 F.2d 336, 338 (2d

Cir. 1965); Elwert v. United States, 231 F.2d 928, 931 (9th Cir.

1956); United States v. Bender, 218 F.2d 869, 871-72 (7th Cir.

1955); Langworthy v. Commissioner, T.C. Memo. 1998-218.

     When the allegations of fraud are based on reconstructed

income, respondent can satisfy his burden of proving the

underpayment in one of two ways:   (1) By proving a likely source

of the unreported income; or (2) where the taxpayer alleges a

nontaxable source, respondent may meet his burden by disproving

the taxpayer’s alleged nontaxable source.   DiLeo v. Commissioner,

96 T.C. at 873-874.

     Mr. Sowards alleged that the funds transferred by STL to WPA

were loans and that the unreported law firm income was composed

of nontaxable items.   As we have previously found, respondent

proved that the payments from STL were income, that there was no

valid loan agreement between Mr. Sowards and Mr. Strong/STL, that

WPA was a sham, and that there were no nontaxable items for which

respondent did not account.   Thus, respondent has met his burden

of proving an underpayment by clear and convincing evidence.
                               - 32 -

     2.   Intent To Defraud

     We now turn to whether Mr. Sowards’s failure to report

income was an effort to fraudulently evade his tax liability.

“Fraud is the intentional wrongdoing on the part of a taxpayer to

evade a tax believed to be owing.”      Temple v. Commissioner,

supra; see DiLeo v. Commissioner, supra at 874; Profl. Servs. v.

Commissioner, 79 T.C. 888, 930 (1982).     “The required state of

mind is one which, ‘if translated into action, is well calculated

to cheat or deceive the government.’” Zell v. Commissioner, 763

F.2d 1139, 1143 (10th Cir. 1985) (quoting 10 Mertens, Law of

Federal Income Taxation, sec. 55.10, at 46 (1984)), affg. T.C.

Memo. 1984-152.   A taxpayer’s background and the context of the

events in question may be considered in determining fraudulent

intent.   Plunkett v. Commissioner, 465 F.2d 299 (7th Cir. 1972),

affg. T.C. Memo. 1970-274.    Furthermore, a taxpayer’s level of

education is relevant to the inquiry.      Temple v. Commissioner,

supra.

     Because it is difficult to prove fraudulent intent by direct

evidence, fraud can be inferred from various kinds of

circumstantial evidence.   Courts describe these “badges of fraud”

as including the following:   (1) Understatement of income; (2)

failing to maintain adequate records; (3) failure to file tax

returns; (4) implausible or inconsistent explanations; (5)

concealment of assets; (6) failure to cooperate with tax
                              - 33 -

authorities; (7) the filing of false documents; (8) making of

false and inconsistent statements to revenue agents; (9)

concealing income from a taxpayer’s tax preparer; and (10)

extensive dealings in cash.   Bradford v. Commissioner, 796 F.2d

303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601; Parks v.

Commissioner, 94 T.C. 654, 664 (1990); Temple v. Commissioner,

supra.   No single factor is necessarily dispositive; however, a

combination of several factors is persuasive circumstantial

evidence of fraud.   Petzoldt v. Commissioner, 92 T.C. at 699.     “A

pattern of consistent underreporting of income, particularly when

accompanied by other circumstances exhibiting an intent to

conceal, justifies an inference of fraud.”   Posnanski v.

Commissioner, T.C. Memo. 2001-26; see Holland v. Commissioner,

348 U.S. 121, 137 (1954).

     In this case, the record discloses multiple “badges of

fraud” which clearly and convincingly justify the imposition of

fraud penalties.   In 1996 and 1997, there was a significant

understatement of income.   We find Mr. Sowards’s testimony that

the funds transferred by STL were loans was false.   Except for

Mr. Sowards’s self-serving testimony and an alleged loan

document, all the evidence refutes the existence of a debtor-

creditor relationship.   The pattern of STL’s periodic payments

(weekly), the amounts of the payments, the frequent statements

Mr. Sowards provided to STL for “amounts due,” and the fact that
                               - 34 -

Mr. Sowards rendered services to STL and its customers throughout

the period of time that STL was making payments to WPA, establish

that Mr. Sowards received remuneration for services he rendered

to STL, its customers, and/or Mr. Strong.    That remuneration was

in the form of the STL checks to WPA which were deposited into

the WPA account.   We find that the understatement of this income

to be clear and convincing evidence of fraudulent intent.

     Mr. Sowards failed to maintain records of income.   His

allegation of their alleged destruction is not believable.     Ms.

Nunn did not testify that Mr. Sowards’s financial documents were

destroyed in a fire at her house.    We find the absence of

records, given the circumstances of this case, to be strong

evidence of fraudulent intent.

     Mr. Sowards concealed assets and income from petitioners’

tax return preparer.   Petitioners’ return preparer for 1995 and

1997 testified that he was not aware of WPA or STL.    Mr. Sowards

failed to disclose the significant sums of money flowing from STL

to WPA and the fact that all these sums were used for his

personal needs.    We find this failure to inform the return

preparer, given the circumstances of this case, to be strong

evidence of fraudulent intent.

     Mr. Sowards failed to cooperate with tax authorities.     He

made numerous false and inconsistent statements to respondent’s

employees.   When interviewed and questioned on September 30,
                               - 35 -

1998, Mr. Sowards failed to disclose the existence of the WPA

bank account.   In a February 23, 1999, telephone interview, Mr.

Sowards stated that he knew very little about WPA.     When

respondent’s employee indicated that he had information linking

Mr. Sowards with STL, Mr. Sowards stated that WPA was set up for

the retirement of Mr. Strong, and the funds transferred were

loans.33   Mr. Sowards indicated that there was no written

contract between himself and Mr. Strong.     However, at the August

10, 1999, interview with the Revenue Agent, Mr. Sowards produced

for the first time the alleged loan document.

     Mr. Sowards falsely represented that his wife had an

organizational consulting business.     He maintained this

representation throughout this litigation until trial when he

admitted that he had fabricated this business.     See DiLeo v.

Commissioner, 96 T.C. at 874 (“The taxpayer’s entire course of

conduct can be indicative of fraud.”).

     We find all the above to be clear and convincing evidence

that Mr. Sowards fraudulently understated his tax for 1996 and

1997.34




     33
      Mr. Sowards purported to have assigned beneficial
interests in WPA to his wife and family, not to Mr. Strong.
     34
      Since we sustain respondent’s fraud penalties,
respondent’s alternative accuracy-related penalty pursuant to
sec. 6662 is moot. On brief, Mr. Sowards conceded additions to
tax under sec. 6654.
                              - 36 -

E.   Negligence Penalties

      In the notices of deficiency, respondent determined

accuracy-related penalties pursuant to section 6662 in the

amounts of $19,738.00,35 $1,150.80, and $774.60 for the taxable

years 1995, 1996, and 1997, respectively.   The 1995 penalty is

based upon petitioners’ failure to report WPA income.    The 1996

and 1997 penalties are premised upon respondent’s disallowance of

expense deductions for Mr. Sowards’s law practice and for the

fabricated organizational consulting business.

      Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment of tax attributable to, inter alia, negligence

and/or a substantial understatement of income tax.   “Negligence”

is defined as “any failure to make a reasonable attempt to comply

with the provisions of this title” and “disregard” means “any

careless, reckless, or intentional disregard.”   Sec. 6662(c).

Similarly, case law defines negligence as a lack of due care or

“the failure to do what a reasonable and ordinarily prudent

person would do under the circumstances.”   Freytag v.

Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v.



      35
      It appears from the notice of deficiency that the amount
of the negligence penalty that respondent calculated for 1995 is
premised upon, inter alia, the inclusion of $209,141 of
additional, unreported income. As indicated previously,
respondent conceded this issue. See supra note 2. Thus, in
accordance with this opinion and the concession of the parties,
the amount of the negligence penalty must necessarily be
recalculated.
                              - 37 -

Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), affg. on this

issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299), affd. 904 F.2d

1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).   Pursuant to the

regulations, “‘Neglience’ also includes any failure by the

taxpayer to keep adequate books and records or to substantiate

items properly.”   Sec. 1.6662-3(b)(1), Income Tax Regs.

     Section 6664(c) provides an exception to the penalty imposed

under section 6662(a).   “No penalty shall be imposed under this

part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

Sec. 6664(c)(1).   The determination of whether the taxpayer acted

with reasonable cause and in good faith is made on a case-by-case

basis, contemplating all of the relevant facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.

     Given the record before us, we sustain the negligence

penalties.   Mr. Sowards was not a credible witness; he offered

inconsistent and implausible explanations to respondent’s

employees and this Court.   He intentionally disregarded the tax

laws by attempting to surreptitiously characterize payments by

STL to WPA as nontaxable loans.   The failure to keep books and

substantiate claimed deductions justifies the imposition of the

penalties.   See sec. 1.6662-3(b)(1), Income Tax Regs.
                                - 38 -

Accordingly, on this record, we sustain respondent’s imposition

of negligence penalties.

F.   Relief From Joint and Several Liability

      If a joint return is filed, the liability with respect to

income tax is normally joint and several as between husband and

wife.    Sec. 6013(d)(3).   Ms. Sowards argues that she is entitled

to relief from such joint income tax liability.      Ms. Sowards is

seeking relief under section 6015(b), (c), or (f), but her

primary argument is that she should be relieved from all

liability pursuant to section 6015(c).

      Section 6015(c)

      Section 6015(c) grants relief from joint and several tax

liability for electing individuals who filed a joint return and

are no longer married, are legally separated, or are living

apart.    Congress intended that such relief from liability be

available for tax attributable to items of which the electing

spouse had no knowledge.    S. Rept. 105-174, at 55 (1998), 1998-3

C.B. 537, 591.    Generally, this road to relief treats spouses,

for purposes of determining tax liability, as if separate returns

had been filed.    Sec. 6015(d)(3)(A); Grossman v. Commissioner,

182 F.3d 275, 278 (4th Cir. 1999), affg. T.C. Memo. 1996-452;

Charlton v. Commissioner, 114 T.C. 333, 342 (2000); Rowe v.

Commissioner, T.C. Memo. 2001-325.       The allocation, however, is

not permitted if the Secretary shows by a preponderance of the
                                 - 39 -

evidence that the electing individual had “actual knowledge, at

the time such individual signed the return, of any item giving

rise to a deficiency (or portion thereof) which is not allocable

to such individual”.    Sec. 6015(c)(3)(C); Culver v. Commissioner,

116 T.C. 189, 195 (2001); Cheshire v. Commissioner, 115 T.C. 183

(2000), affd. 282 F.3d 326 (5th Cir. 2002).

       Here, respondent does not contest that petitioners were not

members of the same household during the 12-month period before

electing relief and that the omitted income and disallowed

deductions are allocable to Mr. Sowards to the extent that Ms.

Sowards did not have actual knowledge.    Our inquiry then focuses

on whether respondent has shown that Ms. Sowards had actual

knowledge, at the time she signed the joint returns, of “any item

giving rise to a deficiency (or portion thereof)”.36   Sec.

6015(c)(3)(C).

            (a) Omitted Income

       Respondent argues that Ms. Sowards had actual knowledge of

the omitted income since she received WPA checks from her husband

and knew that her husband made payments out of the WPA bank

account for personal expenses, like tuition, mortgage payments,

etc.    We articulated the “actual knowledge” standard in omitted



       36
      Sec. 6015(c)(3)(C) places the burden of proof on
respondent with regard to whether the electing spouse had actual
knowledge of the items in question. Culver v. Commissioner, 116
T.C. 189, 195 (2001).
                                - 40 -

income cases as “an actual and clear awareness (as opposed to

reason to know) of the existence of an item which gives rise to

the deficiency (or portion thereof).”    Cheshire v. Commissioner,

supra at 195.

     No evidence was presented that Ms. Sowards had actual

knowledge of the amounts that STL paid to WPA or that her husband

failed to report those items.    Ms. Sowards testified that her

husband told her and she believed that the WPA bank account was

his law firm’s account, that her husband never discussed the

family’s finances, and that she did not even know of the

existence of her purported beneficial interest in WPA.      We find

her testimony credible and persuasive.

     In Culver v. Commissioner, supra, we held that the taxpayer

was entitled to relief because the Commissioner failed to prove

that the electing taxpayer had actual knowledge of the funds

embezzled by his wife.   The Court found that despite the fact

that the embezzled funds were deposited into the couple’s joint

bank account and family expenses were paid therefrom, the

Commissioner had failed to demonstrate that the electing spouse

had actual knowledge of the embezzled funds.    The Court

emphasized that the standard under section 6015(c) “is not that

of a hypothetical, reasonable person, but only that of * * * [the

electing spouse’s] actual subjective knowledge.”    Id. at 197.
                              - 41 -

     In Rowe v. Commissioner, supra, we found that the electing

taxpayer did not have actual knowledge of omitted income

distributed from an IRA opened in her name.    The Commissioner

attempted to establish the requisite knowledge by citing the fact

that the IRA statements were mailed to the taxpayer’s home

address and bore the electing spouse’s name.    Finding the

electing taxpayer credible, we determined that the Commissioner

failed to prove that she had an actual awareness of the omitted

income.

     On the basis of the record, we hold that respondent failed

to prove that Ms. Sowards had an actual and clear awareness of

the omitted income.   Ms. Sowards credibly testified that she did

not know of the nature and amounts of the payments made by STL to

WPA, which was confirmed by Mr. Sowards’s testimony.

Accordingly, we hold that petitioner is entitled to relief from

liability under section 6015(c) for the omitted income.

          (b) Erroneous Deductions

     In King v. Commissioner, 116 T.C. 198, 204 (2001), we held

that “the proper application of the actual knowledge standard in

section 6015(c)(3)(C), in the context of a disallowed deduction,

requires respondent to prove that petitioner had actual knowledge

of the factual circumstances which made the item unallowable as a

deduction.”   In that case, the Commissioner disallowed a

deduction because the electing taxpayer’s former spouse lacked
                               - 42 -

the necessary profit motive.    Id. at 203.    We narrowed the

question to whether the electing spouse knew or believed that her

former husband was not engaged in the activity for the primary

purpose of making a profit.    Id. at 205.    We found that the

Commissioner failed to carry his burden.      A similar result is

appropriate on this record.

      Here, Ms. Sowards had no involvement in her husband’s law

practice.   All the records, bills, correspondence, bank

statements, etc., were delivered to the law firm’s address.       Mr.

Sowards did not discuss his business affairs with her.

Furthermore, as the record demonstrates, Ms. Sowards knew nothing

of the organizational consulting business fabricated by her

husband.    Respondent presented no evidence which would convince

us that Ms. Sowards’s testimony should be questioned.

Accordingly, respondent has failed to prove that Ms. Sowards had

actual knowledge of the factual circumstances which made the

items “unallowable as deductions”.

G.   Conclusion

      On this record, we hold that Mr. Sowards omitted significant

income from petitioners’ 1995, 1996, and 1997 returns and that

the resulting underpayments for 1996 and 1997, as determined in

the notice of deficiency, were due to fraud.      We also hold that

petitioners are not entitled to deductions that respondent

disallowed and that the negligence penalties determined by
                              - 43 -

respondent are correct.   Finally, we hold that Ms. Sowards is

entitled to relief from liability pursuant to section 6015(c) for

the deficiencies and penalties in issue.



                                           Decisions will be

                                    entered under Rule 155.
