                          T.C. Summary Opinion 2012-25



                         UNITED STATES TAX COURT



             WILLIAM PORCH AND LISA PORCH, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 9036-10S.                          Filed March 21, 2012.



      James G. Meimaris, for petitioners.

      Nancy P. Klingshirn, for respondent.



                              SUMMARY OPINION


      DEAN, Special Trial Judge: This case was heard pursuant to the provisions

of section 7463 of the Internal Revenue Code in effect when the petition was filed.
                                           -2-

Pursuant to section 7463(b), the decision to be entered is not reviewable by any

other court, and this opinion shall not be treated as precedent for any other case.

Unless otherwise indicated, subsequent section references are to the Internal

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

Court Rules of Practice and Procedure.

      Respondent issued a notice of deficiency to petitioners in which he

determined deficiencies of $8,392 and $4,4711 for 2005 and 2006, respectively, as

well as section 6663 fraud penalties of $5,964 and $3,239 against William Porch

(petitioner) for 2005 and 2006, respectively. Alternatively, respondent determined

section 6662(a) accuracy-related penalties of $1,678 and $894 against petitioners

for 2005 and 2006, respectively. The issues for decision are whether: (1)

petitioners received unreported income for 2005 and 2006; (2) petitioners are

entitled to deductions claimed for expenses on Schedules C, Profit or Loss From

Business; and (3) petitioner is liable for section 6663 fraud penalties for 2005 and

2006, or alternatively that petitioners are liable for section 6662(a) accuracy-related

penalties for 2005 and 2006.2


      1
          All amounts are rounded to the nearest dollar.
      2
        Other adjustments made to petitioners’ Federal income tax returns for the
years in issue are computational and will not be discussed.
                                          -3-

                                       Background

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

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

resided in Ohio when they filed their petition.

      Petitioner owned and operated Best for Less Carpets Sales and Installation,

Inc. (Best for Less), during the years in issue. Petitioner also sold and installed

carpet as an independent contractor for the Sherwin-Williams Co. (Sherwin-

Williams) during the years in issue.

      Petitioner used unnumbered invoices for payments from Best for Less

customers. The funds generated from petitioner’s operation of Best for Less were

deposited into an account ending in 0501 at Fifth Third Bank (account 0501). The

name on the account is Best for Less Carpets, L.L.C.3

      Petitioners received gross receipts from Best for Less of $111,048 for 2005.

They reported gross receipts of only $75,000 from Best for Less on Schedule C for

2005. They reported supplies expenses4 of $12,650 and other expenses of $5,685

      3
       Petitioner’s business’ name includes the term “Inc.” Petitioner, however,
reported his income from Best for Less on Schedule C, and there is no evidence in
the record that Best for Less elected to not be disregarded as an entity separate from
its owner. See sec. 301.7701-3(b)(1)(ii), Proced. & Admin. Regs.
      4
          The supplies expenses should have been properly reported as cost of goods
                                                                        (continued...)
                                         -4-

on Schedule C. Petitioner deposited checks made out to Best for Less totaling

$48,990 and cash totaling $7,640 into account 0501. He also received nonemployee

compensation of $54,418 from Sherwin-Williams and was issued a Form 1099-

MISC, Miscellaneous Income, for the compensation. Petitioner deposited the

Sherwin-Williams compensation into an account ending in 4438 at Huntington

National Bank (account 4438).

      Petitioner purchased a house from June Lomax for $31,7075 in December

2004. He sold the same property to Gary Cooper for $93,000 in February 2005.

Thirty seven thousand dollars of the proceeds from the sale of the property was paid

to Maxlo Construction, Inc., for renovations. Petitioner received proceeds of

$40,000 from the real estate transaction. Those proceeds were deposited into

account 0501 in 2005. Petitioners did not report any short-term capital gain income

on their 2005 joint Federal income tax return from the real estate

transaction.


      4
       (...continued)
sold on Schedule C. The supplies included carpet, tack strips, and the like sold to
customers for the installation of carpet. This is also true for the supplies expense
deduction claimed on the 2006 Schedule C.
      5
        The purchase price in the stipulation of facts is $31,500. This amount does
not reflect the settlement charges and county taxes petitioner paid in addition to the
contract price of $31,500.
                                         -5-

      Petitioner also received a Form 1099-B, Proceeds From Broker and Barter

Exchange Transactions, reporting $3,033 of capital gain income from

Computershare Shareholder Services for 2005. Petitioners did not report the $3,033

on their 2005 return.

      Petitioners received gross receipts from Best for Less of $123,664 for 2006.

They reported gross receipts of only $75,000 on Schedule C from Best for Less for

2006. They reported the following expenses: mortgage interest of $5,864, supplies

of $10,575, and other expenses of $8,755. Petitioner deposited checks made out to

Best for Less totaling $56,407 and cash totaling $13,360 into account 0501. He

also received nonemployee compensation of $53,898 from Sherwin-Williams and

was issued a Form 1099-MISC for the compensation. Petitioner deposited the

Sherwin-Williams compensation into account 4438.

      Petitioners’ 2005 return was chosen for audit, and the audit was later

expanded to include the couple’s 2006 joint Federal income tax return. The auditor

(Mr. Montgomery) attempted to verify petitioners’ 2005 return using a “Cash T”

analysis. He recorded all of the income that came in per the return and all of the

income that went our per the return. He also included a figure for personal living

expenses.
                                          -6-

      The combination of this information is used to determine whether there is an

imbalance in the taxpayer's account. The imbalance can be either positive or

negative. If the imbalance is negative, an understatement is indicated. To determine

whether the understatement is due to unreported income, an auditor should question

the taxpayer in depth about his or her income. After Mr. Montgomery performed a

Cash T analysis for 2005, he determined that petitioners had an understatement of

over $49,000.

      At the initial meeting with Mr. Montgomery petitioner provided the 2005

Form 1099-MISC from Sherwin-Williams and 13 unnumbered Best for Less

invoices6 that roughly matched the amount of gross receipts reported on the 2005

return. Petitioner did not provide bank statements or any other documents requested

by Mr. Montgomery during the initial meeting, nor did he mention the 2005 real

estate transaction. Mr. Montgomery informed petitioner that a second meeting was

necessary. At this point in the process, petitioner retained counsel.

      Petitioner provided some but not all of the requested bank statements at his

second meeting with Mr. Montgomery. Mr. Montgomery summonsed the remaining

bank statements and all deposit items from petitioners’ banks.



      6
          One of the invoices is dated 2004.
                                         -7-

      Respondent issued petitioners a notice of deficiency for 2005 and 2006 that:

included unreported Schedule C income of $36,048 and $48,664 for 2005 and 2006,

respectively; included unreported capital gain income of $27,326 for 2005;

disallowed a deduction for Schedule C other expenses of $5,371 for 2005 and all

Schedule C other expenses for 2006; and disallowed a deduction for Schedule C

mortgage interest of $2,386 for 2006.7 Respondent also determined that petitioner

was liable for section 6663 fraud penalties for both years in issue. Alternatively,

respondent determined that petitioners were liable for section 6662(a) accuracy-

related penalties for both years in issue if the underpayments of Federal income tax

were not due to fraud.

                                     Discussion

      Generally, the Commissioner’s determinations are presumed correct, and the

taxpayer bears the burden of proving that those determinations are erroneous. Rule

142(a); see INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Welch v.

Helvering, 290 U.S. 111, 115 (1933). In some cases the burden of proof with

respect to relevant factual issues may shift to the Commissioner under section

7491(a). Petitioners did not argue or present evidence that they satisfied the


      7
       Petitioners were allowed additional Schedule C supplies expense deductions
during the audit.
                                         -8-

requirements of section 7491(a). Therefore, petitioners bear the burden of proof

with respect to the adjustments to income in the notice of deficiency.

I.    Unreported Income

      Gross income is defined as including all income from whatever source

derived. Sec. 61(a). Compensation for services, gross income derived from

business, and gains derived from dealings in property are specifically included in

that definition. Sec. 61(a)(1), (2), and (3). Through their counsel’s signature on the

stipulation of facts, petitioners are bound by the statements therein. See Rule 91(e).

      The parties agree that petitioners had gross receipts from Best for Less of

$111,048 and $123,664 for 2005 and 2006, respectively, and that they reported

gross receipts from Best for Less of only $75,000 for each year. The parties also

agree that petitioners failed to report short-term capital gain income from

petitioner’s 2005 real estate transaction. Additionally, petitioners concede that they

failed to report Form 1099B capital gain income for 2005.

      A.     Petitioners’ Use of a Tax Return Preparer

      Petitioner testified that a return preparer prepared the couple’s 2005 and 2006

returns but did not sign them. Petitioners’ only argument for why income for 2005

and 2006 was unreported is that their return preparer was elderly and failed
                                          -9-

to include it on the returns. A bare allegation against their return preparer does not

relieve petitioners of their duty to know what their returns report.8 See Metra

Chem. Corp. v. Commissioner, 88 T.C. 654, 662 (1987); Bailey v. Commissioner,

21 T.C. 678, 687 (1954). Generally, absent reasonable reliance, in good faith and

after full disclosure, the duty to file accurate returns cannot be avoided by placing

responsibility on a return preparer or agent. Zfass v. Commissioner, 118 F.3d 184,

188 (4th Cir. 1997), aff’g T.C. Memo. 1996-167; Freytag v. Commissioner, 89 T.C.

849, 888 (1987), aff’d, 904 F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868 (1991).

      B.     Short-Term Capital Gain Income From the Real Estate Transaction

      During the audit petitioner claimed that he sold a house for Mr. Lomax so that

Mrs. Lomax would not receive any share of the house when the couple divorced.

Petitioner explained that Mr. Lomax gave him a quitclaim deed for the house and he

gave Mr. Lomax the proceeds from the sale of the house. When Mr. Montgomery

requested copies of the quitclaim deed, the settlement statements for the sale of the

property, and the check that petitioner wrote to Mr. Lomax for the sale proceeds,

petitioner’s story changed.




      8
        Petitioners’ return preparer was not called as a witness at trial. Petitioner
testified that she died before the date of trial.
                                         - 10 -

      At trial petitioner testified that he had received $2,500 for some work that he

performed on the house but that he wrote a check to Mr. Lomax for the remainder of

the proceeds from the sale of the property. Petitioner also testified that the deed to

the property was in Mrs. Lomax’s name and that she is the individual that sold him

the house.

      Petitioner’s testimony that he was merely acting as a conduit for Mr. Lomax

is not supported by the record. Petitioner provided no documents to support his

testimony. The settlement statements entered into evidence show a sale of real

property from June Lomax to petitioner in December 2004 and the sale of the same

real property by petitioner to a third party in February 2005.

      Respondent’s determination to include $36,048 and $48,664 of unreported

gross receipts from Best for Less for 2005 and 2006, respectively, and to include

$27,326 of unreported capital gain income in petitioners’ gross income for 2005 is

sustained.

II.   Deductions

      Deductions and credits are a matter of legislative grace, and the taxpayer

bears the burden of proving that he or she is entitled to any deduction or credit

claimed. Rule 142(a); Deputy v. du Pont, 308 U.S. 488, 493 (1940); New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Additionally, a taxpayer
                                            - 11 -

must substantiate all expenses for which deductions are claimed. Sec. 6001;

Hradesky v. Commissioner, 65 T.C. 87, 89 (1975), aff’d per curiam, 540 F.2d 821

(5th Cir. 1976). Section 162 generally allows a deduction for ordinary and

necessary expenses paid or incurred during the taxable year in carrying on a trade or

business.

       Petitioners stipulated they paid Schedule C other expenses of $624 and $533

for 2005 and 2006, respectively. Petitioners also stipulated that they paid Schedule

C mortgage interest of $3,478, the amount respondent allowed, for 2006.

       Petitioners made no arguments nor did they produce evidence to show that

they are entitled to deductions in any amounts greater than respondent allowed.

Therefore, respondent’s determination to disallow petitioners’ deductions for

amounts in excess of what was allowed is sustained.

III.   Section 6663 Fraud Penalty

       Respondent determined that petitioner was liable for a section 6663 fraud

penalty for each of the years in issue.9 The Commissioner has the burden of

proving fraud by clear and convincing evidence. Sec. 7454; Rule 142(b); Parks v.

Commissioner, 94 T.C. 654 (1990).



       9
           Petitioner wife is not liable for the fraud penalty. See sec. 6663(c).
                                        - 12 -

      As part of his burden of proof in the trial of a fraud case, the Commissioner

must first prove an underpayment of some amount of tax. Sec. 6663(a); Hebrank v.

Commissioner, 81 T.C. 640, 642 (1983). To do this the Commissioner may not

merely rely on the taxpayer’s failure to disprove the deficiency determination. Parks

v. Commissioner, 94 T.C. 654. Petitioners, however, stipulated that they had tens

of thousands of dollars of unreported income for 2005 and 2006 that created

underpayments of Federal income tax.

      Second, the Commissioner must show that at least some part of the

underpayment of tax was due to fraud. Sec. 6663(a); Rule 142(b); DiLeo v.

Commissioner, 96 T.C. 858, 873 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); Parks v.

Commissioner, 94 T.C. at 664; Hebrank v. Commissioner, 81 T.C. 640. If the

Commissioner establishes that some portion of the underpayment is attributable to

fraud, the entire underpayment shall be treated as attributable to fraud, except with

respect to any portion of the underpayment that the taxpayer establishes is not

attributable to fraud. Sec. 6663(b).

      The existence of fraud is a question of fact to be resolved upon

consideration of the entire record. DiLeo v. Commissioner, 96 T.C. at 874.

Because direct evidence of fraud is rarely available, fraud may be proved by

circumstantial evidence and reasonable inference from the facts. Petzoldt v.
                                          - 13 -

Commissioner, 92 T.C. 661, 699 (1989). The taxpayer’s entire course of conduct

may establish the requisite fraudulent intent. Rowlee v. Commissioner, 80 T.C.

1111, 1123 (1983).

         Courts have developed a nonexclusive list of factors or “badges of fraud” that

demonstrate fraudulent intent. Niedringhaus v. Commissioner, 99 T.C. 202, 211

(1992). No single factor is necessarily sufficient to establish fraud; however, a

combination of several of the factors may constitute persuasive evidence of fraud.

Id. For the years in issue, several badges of fraud relate to petitioner’s unreported

Schedule C and capital gain income.

         A.    Understatement of Income

         Petitioner reported gross receipts from Best for Less of $75,000 for each of

the years in issue. Petitioner stipulated that he had gross receipts from Best for Less

of $111,048 and $123,664 for 2005 and 2006, respectively. Petitioner also

stipulated that he had unreported short-term capital gain income from the sale of real

estate for 2005 and unreported capital gain income of $3,033 from the sale of

securities for 2005. Petitioner had understatements of income for both years in

issue.
                                        - 14 -

      B.     Inadequate Records

      Section 6001 requires a taxpayer to maintain sufficient records to allow for

the determination of the taxpayer’s correct tax liability. Petzoldt v. Commissioner,

92 T.C. at 686. If a taxpayer fails to maintain or does not produce adequate books

and records, the Commissioner is authorized to reconstruct the taxpayer’s income.

Sec. 446(b); Petzoldt v. Commissioner, 92 T.C. at 686. Indirect methods may be

used for this purpose. Holland v. United States, 348 U.S. 121 (1954). The

Commissioner’s reconstruction need only be reasonable in light of all the

surrounding facts and circumstances. Petzoldt v. Commissioner, 92 T.C. at 687;

Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). Bank deposits constitute

prima facie evidence of income. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

      Mr. Montgomery performed a Cash T analysis for petitioners’ 2005 return

and found an understatement of more than $49,000. After performing the Cash T

analysis, Mr. Montgomery requested petitioners’ bank records.

      At the initial meeting with Mr. Montgomery, petitioner provided 13 invoices

and a Form 1099-MISC totaling $75,987 to substantiate his 2005 income. He,

therefore, produced documentation showing gross receipts approximating the

amount reported on his Schedule C. Petitioner’s invoices are unnumbered and

incomplete and fail to account for an additional $35,061 in unreported gross receipts
                                         - 15 -

from Best for Less that Mr. Montgomery determined was includible in income after

reviewing petitioner’s bank deposits. Petitioner subsequently agreed that the

unreported amount was income. Petitioner provided no records to substantiate his

2006 income. Petitioner’s records for 2005 and 2006 were inadequate.

      C.     Implausible or Inconsistent Explanations of Behavior

      As discussed supra pp. 9-10, petitioner provided inconsistent explanations for

his 2005 real estate transaction. His explanation for how he provided financially for

his family was implausible.

      Petitioner answered in the affirmative when he was asked whether he was the

“primary breadwinner in his family”. The 2005 return reports the couple’s adjusted

gross income as $11,537, and petitioner testified that he experienced a business loss

for 2005. He also testified that he paid taxes and mortgage interest of $11,705 for

2005. When asked: “[W]hat did you live on in 2005?”, petitioner testified: “I

mean, it was rough. My wife, my friends, Lomax. You know, people helped me

out. I mean, when I couldn’t make ends meet, you know, I prayed about it.”

      Petitioner’s testimony is self-serving and improbable, and the Court does not

have to accept it as the truth. See Tokarski v. Commissioner, 87 T.C. at 77. His

explanation for the real estate transaction is inconsistent, and his explanation for

how he paid living expenses for 2005 is implausible.
                                         - 16 -

      D.     Failure To Cooperate With Tax Authorities

      Mr. Montgomery testified that he mailed a Letter 2202 (letter) to petitioners

that explained the audit process and what records they were required to bring to the

audit. A copy of the letter was entered into evidence. Petitioners did not deny

receiving the letter. The letter informed petitioners that they would need to provide

records to substantiate items reported on Schedule C for the following: petitioner’s

income, expenses, and deductions; workpapers used in preparing his return; bank

statements, canceled checks, and duplicate deposit slips covering the period form

December 21, 2004, through January 1, 2006; and information on loans,

repayments, and other nontaxable sources of income.

      After multiple unavailing attempts to obtain petitioner’s bank statements from

him and his counsel, respondent had to summons petitioner’s bank records to obtain

the necessary information. Respondent’s finding it necessary to issue summonses to

obtain petitioner’s records is evidence of petitioner’s failure to cooperate with tax

authorities. See Zadan v. Commissioner, T.C. Memo. 1993-85.

      E.     Dealing in Cash

      When Mr. Montgomery reviewed petitioner’s bank statements and deposits,

he found thousands of dollars of cash deposits that petitioner did not include in his

income or show to be nontaxable. Mr. Montgomery testified that the cash deposits
                                         - 17 -

were included in petitioner’s business income because “I could not find another

explanation for the cash.” Petitioner did not deny that the cash payments were

business income. He testified that when he was paid in cash he used the money to

buy supplies for his business. Although this may be what petitioner did when a

customer paid cash, it does not relieve him of his obligation to report the cash

received as income. See sec. 61(a)(2).

      F.     Engaging in a Pattern of Behavior That Indicates an Intent To
             Mislead

      Intent to mislead or conceal may be inferred from a pattern of conduct. Spies

v. United States, 317 U.S. 492, 499 (1943). A pattern of consistent underreporting

of income, especially when accompanied by other circumstances showing intent to

conceal, is strong evidence of fraud. Holland, 348 U.S. 121; Parks v.

Commissioner, 94 T.C. at 664.

      Petitioner reported gross receipts from Best for Less of $75,000 for 2005 and

2006. He provided records to substantiate approximately that amount of gross

receipts for 2005 at the initial audit meeting. Petitioner stipulated that he had gross

receipts from Best for Less of over $100,000 for each of the years in issue. The

Court concludes that petitioner engaged in a pattern of behavior with the intent to

mislead respondent.
                                         - 18 -

IV.   Conclusion

      Respondent’s determinations concerning petitioners’ unreported income and

improperly claimed deductions are sustained.

      After a review of all of the facts and circumstances, the Court finds several

badges of fraud. Taken together, petitioner’s understatements of income,

inadequate records, implausible or inconsistent explanations for his behavior, failure

to cooperate with tax authorities, dealings in cash, and intent to mislead are clear

and convincing evidence of fraud. Petitioner did not establish that any amounts of

the underpayments for 2005 and 2006 were not due to fraud. Therefore, the entire

amount of the underpayment for each of the years in issue is due to fraud.10

      We have considered all of petitioners’ arguments, and, to the extent not

addressed herein, we conclude that they are moot, irrelevant, or without merit.




      10
         Because the Court finds that petitioner is liable for sec. 6663 fraud penalties
for both of the years in issue, sec. 6662(a) accuracy-related penalties do not apply
for the years in issue. See sec. 6662(b) (flush language).
                            - 19 -

To reflect the foregoing,


                                         Decision will be entered

                                     under Rule 155.
