                          T.C. Memo. 2010-49



                     UNITED STATES TAX COURT



      DEANNA LANGILLE f.k.a. DEANNA BIRDSONG, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 17227-08.                 Filed March 18, 2010.



     Deanna Langille, pro se.

     Miriam C. Dillard, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GUSTAFSON, Judge:    Petitioner Deanna Langille practiced law

in the years in issue (1993, 1994, and 1995), and she also owned

and leased real estate.    The Internal Revenue Service (IRS)

issued a statutory notice of deficiency to Ms. Langille on April
                                 -2-

14, 2008, pursuant to section 6212,1 determining the following

income tax deficiencies and fraud penalties:

                                                  Fraud penalty
             Year            Deficiency            Sec. 6663(a)

             1993              $44,324               $33,243
             1994               70,683                53,012
             1995               41,927                31,445

       After a concession,2 the issues for decision are:

       (1) Whether Ms. Langille received from Birdsong & Smith,

P.A., unreported passthrough income of $8,689 in 1993 and an

unreported passthrough loss of $15,851 in 1994.    We find that she

did.

       (2) Whether, in connection with Ms. Langille’s law practice,

she received unreported receipts and paid unreported law practice

expenses as follows:

                             Additional            Additional
             Year             receipts              expenses

             1993             $112,150                $4,643
             1994              193,817                 5,485
             1995              255,314               135,809

We find that she did.



       1
      Unless otherwise indicated, all citations of sections refer
to the Internal Revenue Code of 1986 (the Code, 26 U.S.C.), as
amended, all citations of Rules refer to the Tax Court Rules of
Practice and Procedure, and amounts are rounded to the nearest
dollar.
       2
      Respondent concedes that Ms. Langille did not receive
$2,587 in capital gain income in 1995.
                                  -3-

     (3) Whether Ms. Langille received interest income on seller-

financed mortgages as follows:

                                   Mortgage interest
                     Year                income

                     1993               $11,511
                     1994                 9,601
                     1995                 5,977

We find that she did.

     (4) Whether Ms. Langille realized from her rental

activities:    $1,935 less income than she reported in 1993, $4,444

more income than she reported in 1994, and $2,019 more income

than she reported in 1995.     We find that she did.

     (5) Whether Ms. Langille is liable for the fraud penalty

under section 6663(a) for the years in issue.     We hold that she

is liable for the fraud penalty for each year but in amounts less

than the IRS determined in the notice of deficiency.

                            FINDINGS OF FACT

     This case was tried in Jacksonville, Florida, on May 6,

2009.   We incorporate by this reference the parties’ stipulation

of facts.

Law Practice

     Ms. Langille earned her law degree in 1974 and was a lawyer

in private practice during the years in issue.      Ms. Langille and

Elinor Smith incorporated Birdsong & Smith, P.A. (the firm), as

an S corporation under section 1361(a) in 1990.     They each owned
                                -4-

half its stock, and they practiced law under the name of the firm

until they dissolved it (for reasons the record does not show) on

October 31, 1994.   Thereafter, Ms. Smith practiced law in the

same building as Ms. Langille until July 1995, and Ms. Langille

operated her own solo practice in that building until she stopped

practicing law in November 1996.

     Each lawyer had her own client trust account, and each knew

of the other’s client trust account.    Neither lawyer wrote checks

against the other’s trust account, and neither reviewed nor

balanced the other’s trust account.     Both lawyers disbursed funds

from their individual client trust accounts either directly to

themselves or to pay personal expenses, as follows:

                                 Personal expenditures
           Year            Ms. Langille           Ms. Smith

           1993               $47,670                 $1,080
           1994                 -0-                    2,731

Ms. Langille did not report the $47,670 as income in 1993.

     During the years in issue Ms. Langille had exclusive control

over the account named Birdsong & Smith P.A. General Account

(operating account).   Only she had access to the operating

account monthly statements, and only she wrote checks against

that account.   She deposited just enough receipts from clients

into the operating account to cover law practice expenses (and

she claimed those expenses as deductions for the firm).    She also

wrote checks for distributions to the shareholders from that
                                   -5-

account.    Under their agreement Ms. Langille was to provide

monthly distribution checks to Ms. Smith representing the net

income Ms. Smith earned, i.e., Ms. Smith’s income after deducting

common expenses.      She distributed $21,631 to Ms. Smith in 1993

and $26,000 in 1994.      She did not issue any distribution checks

to herself in 1993, but she distributed $5,000 from the operating

account to herself in 1994.

     Ms. Langille wrote monthly checks from the operating account

to her wholly owned subchapter S corporation Birdsong Management

Company (BMC) for the rental of the office building where she

practiced law.      She claimed rental expense deductions for the

firm for these payments, and she included the receipts in income,

as is discussed below.

     Ms. Langille diverted legal fees for her own use, bypassing

the firm’s bank accounts and depositing additional law practice

receipts into other accounts, from which she also paid some law

practice expenses, as follows:

                              Deanna McBride
                            Birdsong Attorney    DMB Development Co.
             Item             at Law account           accounts

     1993   fees                $111,425                -0-
     1993   expenses              (4,643)               -0-
     1994   fees                 192,651                -0-
     1994   expenses              (5,485)               -0-
     1995   fees                  12,897             $169,403
     1995   expenses                (631)             (31,728)

She did not report these receipts or expenses on her returns.
                                     -6-

     Ms. Langille kept the books for the firm.        She prepared and

filed the firm’s tax returns for 1993 and 1994, reporting the

following:

                           Item                     1993       1994

         Gross receipts                          $241,926    $223,228
         Deductions                              (185,451)   (158,254)
                                                              1
         Net income                                56,475       65,034

         Each 50-percent shareholder’s share       28,238      32,517
            of income
     1
      The 1994 tax return Ms. Langille filed for the firm
contains a subtraction error: The difference between the firm’s
receipts and deductions (i.e., the firm’s net income) is $64,974,
not $65,034; and, thus, each shareholder’s share of that income
is $32,487.

     As is noted above, Ms. Langille did not report on the firm’s

return the law practice income she deposited into the Deanna

McBride Birdsong Attorney at Law account in 1993 or 1994, and she

did not claim the expenses she paid from that account.        She also

did not report as income any of the money that she and Ms. Smith

expended from their client trust accounts for personal purposes.

     Ms. Langille worked long hours in her law practice

throughout the years at issue.        Her real estate activities

consumed somewhat less of her time.

Real Estate Activities

     Between 1990 and 1992 Ms. Langille sold certain residential

real property with seller financing, i.e., she extended mortgages

to the purchasers.        During the years in issue, she received
                                 -7-

payments of principal and interest on two of these mortgages; and

on the third, she received payments until she repurchased the

property in August 1994.    She did not report any interest or

other income from the receipt of these payments during the years

in issue, even though she received mortgage interest payments of

the following amounts:

                                  Mortgage interest
                    Year          payments received

                    1993               $11,511
                    1994                 9,601
                    1995                 5,977
                       Total            27,089

     Ms. Langille rented her office building and certain

residential rental properties through BMC.       Ms. Langille’s law

practice paid rent of $1,500 each month throughout 1993 and 1994

(i.e., $18,000 per year) and $1,600 each month in 1995 (i.e.,

$19,200 for the year).3    These amounts were paid to Ms. Langille

through BMC.   For the first two of those three years she reported

the following income and expenses on BMC’s Forms 1120S, U.S.

Income Tax Return for an S Corporation:




     3
      Until it dissolved on October 31, 1994, the firm paid rent
on the office building. After the dissolution of the firm,
Ms. Langille paid rent from her unincorporated law practice. She
reported $18,000 rent paid on the firm’s tax returns for each of
1993 and 1994. Ms. Langille wrote rent checks for the first
seven months of 1995, and the IRS imputed rent for the remaining
five months.
                               -8-

                                              Amounts reported
                       Item                    1993        1994

     Gross receipts                           $18,000      $1,212
     Repairs and maintenance                   (2,465)       -0-
     Taxes and licenses                          (150)       -0-
     Interest                                 (10,440)       -0-
       Total deductions                       (13,055)       -0-
     Net income                                 4,945       1,212

     That is, for 1993 Ms. Langille entered $18,000 in gross

receipts and amounts for certain expenses for BMC on its

Form 1120S and used those expenses to calculate total deductions

and net income from renting the office building; but for 1994 she

entered not $18,000 but only $1,212 as gross receipts or sales,

drew an arrow to carry that figure down the page to the total

income line, and drew another arrow to carry that figure to the

ordinary income line; she included no other income or expense

information on that return.

     Although her practice paid $1,600 per month to rent the

office building in 1995, Ms. Langille did not file a return for

BMC for 1995.

     Ms. Langille earned a profit for each year in issue renting

the commercial building to her law practice as follows:

                Item                  1993       1994         1995

  Office rental net income           $3,010     $5,656       $4,574

     In addition to her own home and the office building she

rented to her law practice, Ms. Langille owned five houses and
                                -9-

nine condominiums, and she rented those residential properties to

third parties.4   She owned outright one of those houses and five

of those condominiums, and she had mortgages on the remaining

four houses and four condominiums.

     Ms. Langille’s residential rental activities lost money

during each year in issue, and for the years in issue she did not

report income or expenses from renting the residential

properties.   Because of the losses from the residential rentals,

her rental activities overall lost money during each year in

issue.   Adjusting for depreciation, the cash flow from her rental

activity was negative for two of three years in issue, as

follows:




     4
      Ms. Langille held the residential rental properties and her
personal residence in the name of the David Justin Birdsong
Family Trust (the trust). However, in a year not disclosed by
the record, a U.S. bankruptcy court held that all of the real
estate Ms. Langille ostensibly held in the name of the trust was
actually owned by Ms. Langille individually. The record does not
reflect any bank accounts in the name of the trust or that the
trust had any existence aside from being the putative owner of
Ms. Langille’s real estate. Ms. Langille did not file any tax
returns for the trust during the years in issue, and she does not
challenge the IRS’s decision to disregard the trust or its
conclusion that any income from her rental activities is taxable
to her individually.
                                -10-

                Item                     1993       1994       1995

  Rental income                        $36,488    $58,747    $61,017
  Total expenses                       (60,460)   (65,489)   (76,100)
  Net rental income (loss)             (23,972)    (6,742)   (15,083)

  Depreciation expense                  (9,280)   (11,970)   (14,288)

  Cash expenses                        (51,180)   (53,519)   (61,812)
  Cash flow from rental activities     (14,692)     5,228       (795)

Individual Income Tax Returns

     Ms. Langille prepared and timely filed income tax returns

for herself, the firm, and BMC.   On her Form 1040, U.S.

Individual Income Tax Return, for each year in issue, she claimed

head of household filing status and one dependent, her son, and

she reported the following:
                                  -11-

                        Item              1993        1994         1995

         Schedule K-1 real estate        $4,945        -0-         -0-
         Schedule K-1 lawfirm            28,238        -0-         -0-
         Schedule E
                                                  1            2
           Rents received                 ---      $33,729      $19,200
           Total expenses                 ---         -0-        16,645
             Net income                             33,729        2,555
         Schedule C
           Law office gross receipts       ---          ---     130,054
           Law office total expenses       ---          ---    (87,454)
             Net law office profit         ---          ---      42,600
               Total income              33,183       33,729     45,155
     1
       Ms. Langille appears to have added her share of the income
from the firm, $32,517, to the net income she reported for BMC,
$1,212, and entered that sum, $33,729, as “Rents received” on her
1994 Schedule E, Supplemental Income and Loss (From rental real
estate, royalties, partnerships, S corporations, estates, trusts,
REMICs, etc.).
     2
       The practice paid BMC rent of $1,600 per month in 1995, but
Ms. Langille reported her commercial rental income and expenses
on Schedule E, and she did not file a Form 1120S for BMC for
1995.

     Ms. Smith and Ms. Langille dissolved the firm on October 31,

1994, and Ms. Langille continued practicing law throughout 1994;

but she did not file a Schedule C, Profit or Loss From Business,

for 1994 to report her law practice income and expenses for

November and December 1994.     As indicated, she did not report the

law practice income she deposited into the Deanna McBride

Birdsong Attorney at Law account on the firm’s return for 1993 or

1994.     She also did not report that income on her individual

return for 1993 or 1994.
                                 -12-

     As is shown above, Ms. Langille reported $130,054 in 1995

law practice receipts on Schedule C.    However, she earned

$385,368 from her law practice in 1995, and she deposited those

law practice receipts in various accounts, as follows:

                                                          Amount
                     Account                            deposited

Operating account                                       $183,723
DMB Development Co. operating account                    153,616
DMB Development Co. investment account                    15,788
Deanna McBride Birdsong Attorney at Law account           12,897
BMC account                                               19,344
  Total law practice deposits                            385,368

Ethics Controversies and Resignation

     The Florida Bar reviewed the firm’s client trust accounts

for 1993 and determined that Ms. Langille had misappropriated

funds from her client trust account.    On January 27, 1994, the

Florida Supreme Court publicly reprimanded Ms. Langille for

professional misconduct.    Fla. Bar v. Birdsong, 634 So. 2d 628

(Fla. 1994).   On October 26, 1995, the Florida Supreme Court

suspended Ms. Langille from practicing law for 30 days, imposed 1

year of probation, and required her to complete professional

education courses, because the court found that she had continued

to assist a client with a lawsuit after a Florida court had

issued an order disqualifying her from further representing that

client in that matter.     Fla. Bar v. Birdsong, 661 So. 2d 1199

(Fla. 1995).
                                 -13-

        Ms. Langille stopped practicing law in November 1996.   In

1997 she resigned in lieu of disciplinary proceedings.     Fla. Bar

v. Birdsong, 690 So. 2d 1301 (Fla. 1997).

Efforts To Sell The Law Practice

     In July 1996 Ms. Langille put her law practice up for sale.

She advertised that its gross receipts were $350,000 per year.

Ms. Langille met with a prospective buyer on August 26, 1996, and

again on September 5, 1996.     This buyer chose not to purchase the

law practice.     Instead he reported to the IRS that Ms. Langille

had indicated that she was keeping two sets of book for the law

practice--one set with reduced income for preparing tax returns

and another set with greater income to show potential buyers.

IRS Criminal Investigation

     An undercover agent from the IRS’s Criminal Investigation

Division (CID) posed as a representative of a different

prospective buyer of the law practice and met with Ms. Langille

on November 5, 1996.     On the basis of the undercover agent’s

observations and the report from the earlier prospective buyer,

the IRS requested and obtained a search warrant.

     The IRS searched Ms. Langille’s law office on November 15,

1996.     An IRS special agent interviewed Ms. Langille during the

search.     She admitted that she prepared her individual tax

returns and the firm’s corporate tax returns.     She acknowledged
                               -14-

that some of her income might have been unreported, and she

asserted that “everyone has unreported income”.

     When asked to identify entities and bank accounts in which

she had an interest, Ms. Langille told the IRS about the firm,

the trust, and BMC; and she told the IRS about the firm’s

operating account, her client trust account, and the BMC account.

She did not inform the IRS of any interest in DMB Development

Company, nor did she identify the two DMB Development Company

accounts (which were at a different bank from the accounts she

did identify).   She also did not disclose her Deanna McBride

Birdsong Attorney at Law account.

     The undercover agent had reported that certain financial

records were in plastic trash bags and that Ms. Langille had

offered those records for inspection and stated that those

records would not be sold with the practice but would be

destroyed.   Following the search of Ms. Langille’s office, the

IRS departed with 10 or more boxes of records and five 39-gallon

plastic bags seized from Ms. Langille’s office.   The bags

contained both garbage and financial records, including income

ledgers that closely reconciled to the bank accounts petitioner

disclosed.

     When the IRS agents sorted through the documents in the

plastic bags after the search, they found records for the two DMB
                               -15-

Development Company accounts, including bank statements, canceled

checks, and the envelopes the bank used to mail the statements.

     The special agent interviewed Ms. Langille on November 19,

1996, when he returned certain records.5    He asked her about the

DMB Development Company accounts.     She stated that she thought

she had disclosed those accounts to him and that she deposited

only rental receipts into those accounts.     The agent then

specifically asked her about a $47,000 deposit into the DMB

Development Company investment account, as that seemed too large

an amount for a residential rental receipt.     Ms. Langille

identified the deposit as a settlement check related to one of

the clients of her law practice, and she then admitted to

depositing law practice receipts into the DMB Development Company

accounts.   Total deposits during 1995 into the DMB Development

Company accounts were $175,081.6

     In addition to the special agent who supervised the search

of Ms. Langille’s office and interviewed her, the CID team

included a revenue agent who analyzed the documents seized and


     5
      The special agent returned records relating to the then-
current year, 1996, which is not one of the years in issue.
     6
      It appears that DMB Development Company’s only existence
was in the name Ms. Langille used on the DMB Development Company
Investment Account and the DMB Development Company operating
account. Ms. Langille provided no evidence that DMB Development
Company was a legitimate business, and the record contains no
indication that she filed a tax return for any such entity during
any year in issue.
                                 -16-

performed bank deposits analyses and check spreads to identify

income and expenses.     In the bags and boxes seized from

Ms. Langille’s office, the revenue agent discovered a single

check drawn on the Deanna McBride Birdsong Attorney at Law

account--an account Ms. Langille had not disclosed but into which

she had deposited law practice receipts.     The IRS had been

unaware of this account before the revenue agent found this

check.   The IRS summoned the bank records for this account and

found total deposits of the following amounts:

                                           Amount
                Year                      deposited

               1993                        $136,593
               1994                         210,968
               1995                          13,359
                 Total                      360,920

IRS Examinations

     The IRS summoned the bank records and examined both BMC’s

and the firm’s corporate Federal income tax returns for 1993 and

1994; and it summoned the bank records and examined

Ms. Langille’s individual returns for 1993, 1994, and 1995.

Examination of the S Corporation’s Returns

     To determine the income and expenses of the S corporation

law firm, the IRS used both the client trust accounts and the

operating account.     Each shareholder knew about the other’s

client trust account, and both knew about the firm’s operating
                              -17-

account, so the IRS treated deposits to and expenditures from

these accounts as income and expenses of the S corporation.7

However, Ms. Smith had not been aware of the other bank accounts

that Ms. Langille used, so the IRS determined the firm’s income

and expenses without reference to these other accounts, which

instead were attributed to Ms. Langille personally.

     As for the trust accounts, the IRS did not include in firm

income the deposits to the client trust accounts, because that

money generally did not belong to the lawyers until they had

earned their fees and paid themselves.   However, the IRS did

include in the firm’s income both fees withdrawn from the client

trust accounts that were paid directly to the lawyers and any of

the lawyers’ personal expenses that they paid directly from their


     7
      Ms. Langille has challenged the IRS’s treating, as firm
income (half of which is taxable to Ms. Langille), amounts that
Ms. Smith took from her client trust account for her own use.
However, while Ms. Smith did not know that Ms. Langille was
diverting law practice income to her other accounts, each lawyer
knew about the operating account and the other’s trust account,
and the IRS consistently characterized trust expenditures for
either lawyer’s personal benefit from either trust account as
income to the firm, with each lawyer taxable for half of the
total. Since Ms. Langille actually took more than half of the
total, she arguably received more income than the IRS
determined--i.e., income in the full amount of what she took.
See James v. United States, 366 U.S. 213, 219-220 (1961)
(“wrongful appropriations [are] within the broad sweep of ‘gross
income’”); Webb v. IRS, 15 F.3d 203, 205 (1st Cir. 1994) (funds
misappropriated from a trust by a trustee are includable in his
gross income). However, this position would result in a greater
deficiency than was determined in the notice of deficiency or
pleaded in the answer, so we do not consider an approach more
aggressive than respondent has proposed.
                               -18-

trust accounts.   For business-related expenses paid from the

client trust accounts, the IRS neither included the payment of

those expenses in corporate income nor allowed deductions

therefor, because such income and expenses would net to zero.       We

find this treatment reasonable.   As for the operating account,

all expenditures from the account were allowed as law firm

expenses, with the reasonable exception that deductions were not

allowed for distributions paid to Ms. Langille and Ms. Smith.

     The books that Ms. Langille had kept for the firm did not

match the income and expenses that the revenue agent found.       When

filing the firm’s tax returns, Ms. Langille had understated firm

receipts in 1993 and overstated receipts in 1994, and she

understated deductible firm expenses in both years.     The IRS

determined the following for the firm:

                      Item                     1993         1994

     Adjustments to gross receipts           $33,429      ($21,574)
     Adjustments to deductions               (16,051)      (10,127)
       Total adjustments to firm income       17,378       (31,701)
     Corporate income as reported             56,475        65,034
       Corrected taxable income               73,853        33,333

     Adjustment for each shareholder           8,689       (15,851)

Thus, the IRS determined, as to the S Corporation law firm,

adjustments that in one year were favorable to Ms. Langille.

However, as we show below, the adjustments related to
                                -19-

Ms. Langille’s solo practice outside the firm overwhelmed those

favorable adjustments.

Examination of BMC’s Returns

     For 1993 and 1994 the IRS examined the rental activity that

Ms. Langille had undertaken in the name of BMC; and for each year

in issue the IRS analyzed Ms. Langille’s rental receipts, rent

book, and bank account records to determine the rental income and

rental expenses for all of Ms. Langille’s properties.    The

revenue agent calculated depreciation schedules for

Ms. Langille’s rental properties and included depreciation

allowances in rental expenses for each year in issue.    The IRS

concluded that Ms. Langille did not qualify as a real estate

professional during the years at issue (because she spent most of

her time working in her law practice) and that her passive rental

losses are deductible only against passive income.    The IRS

determined that any income generated by Ms. Langille’s renting

the office building to her own law practice was not passive

income and could not be offset by any passive losses from her

other real estate activities.   The IRS therefore segregated

Ms. Langille’s office building rental activity from her

residential property rental activity.   The IRS determined the

following amounts of rental income and expense:
                              -20-

               Item                     1993       1994         1995

  Rental income                      $36,488      $58,747    $61,017
  Rental expenses                    (60,460)     (65,489)   (76,100)
    Net income (loss)                (23,972)      (6,742)   (15,083)
  Character of net income (loss)
    Non-passive (office rental)        3,010        5,656      4,574
    Passive (residential rentals)    (26,982)     (12,398)   (19,657)

  Non-passive income                     3,010     5,656          4,574
  Less rental income reported            4,945     1,212         2,555
                                                                1
    Adjustment to rental income         (1,935)    4,444          2,019
     1
      In the notice of deficiency for 1995 the IRS determined a
negative adjustment of $4,189 to Ms. Langille’s rental income and
a positive adjustment of $2,587 to her capital gain. At trial
respondent conceded the capital gain adjustment, and on brief he
contends that the correct rental income adjustment is $2,019, as
indicated. However, he also stated that he is not seeking any
greater deficiency than he determined in the notice of deficiency
(which determined a $4,189 reduction rather than a $2,019
increase in rental income). The record does not clearly reflect
how the IRS determined the $4,189 reduction in rental income in
the notice of deficiency, but given that the reduction is in
Ms. Langille’s favor and considering respondent’s concession that
he is not seeking any greater deficiency, we need not address
this issue further.

     Because Ms. Langille did not have any passive income during

the years in issue--the capital gain in 1995 from the sale of

real property having been conceded--the IRS contends (and we

hold, for the reasons explained below) that no deduction should

be allowed for any residential rental real estate losses incurred

in the years in issue.

Examination of Ms. Langille’s Returns

     Ms. Langille not only failed to report the rental income

discussed above but also failed to report the $27,089 of interest
                              -21-

income that (as we have found) she received from seller-financed

mortgages that she had taken back from purchasers of property.

The IRS identified the amounts she received during the years in

issue as payments for her prior real estate sales, examined the

sales documents and the terms of the mortgages, and calculated

the amount of interest paid each month.8   Ms. Langille did not

report any of the interest payments she received on her

individual return, on BMC’s corporate return, or on any other

return for any of the years in issue.

     The IRS also performed a bank deposits and check spread

analysis of the DMB Development Company accounts and of the

Deanna McBride Birdsong Attorney at Law account, confirming that

Ms. Langille had deposited legal fees into those bank accounts

and that those receipts were not reflected on the books she kept

for her law practice activities, nor were they reported on her

individual returns (including the Schedule C for her

unincorporated law practice) or on the Forms 1120S for the firm.

The IRS also identified legal fees Ms. Langille deposited (along

with rental receipts) into the BMC account.9   The revenue agent’s

check spread analysis also determined that Ms. Langille had paid




     8
      Ms. Langille sold each of the properties before the years
in issue, so any gain or loss on the sales themselves is not at
issue.
     9
      Legal fees deposits into the BMC account were $725 in 1993,
$1,167 in 1994, and $19,344 in 1995, totaling $21,236.
                                 -22-

additional law practice expenses from those accounts and had not

deducted them on any return.

     The IRS treated the legal fees that Ms. Langille diverted

from the firm and into her other accounts as Schedule C income

from her running an unincorporated solo law practice on the side

and allowed as deductions from that Schedule C income the

previously unreported expenses.10   The shareholders dissolved the

firm on October 31, 1994, and Ms. Langille included her 1995 law

practice income on Schedule C.    The IRS adjusted the income and

expenses on that Schedule C to include all amounts related to the

law practice that Ms. Langille deposited to or paid from any of

her accounts.

     The IRS’s analysis produced the following adjustments to

Ms. Langille’s individual income tax reporting:




     10
      If the diverted proceeds were attributed to the
S corporation, then each shareholder’s share of the net income
would be increased, and Ms. Smith would be taxable on income that
Ms. Langille had diverted for her own use. Ms. Langille has not
challenged the IRS’s characterization of diverted legal fees as
Schedule C income to her rather than as income to the firm.
                                -23-

             Item                      1993       1994           1995

                                                             1
Capital gain or (loss)                   ---        ---          $2,587

Interest income                    $11,511        $9,601         5,977

Schedule C
  Gross receipts                   112,150       193,817     255,314
  Expenses                          (4,643)       (5,485)   (135,809)
Sch. K-1 income from the firm        8,689       (15,851)        n/a
  Net law practice income          116,196       172,481     119,505

                                                             2
Sch. E rental income/expense           (1,935)     4,444      (4,189)

Self employment AGI adjust.         (5,011)       (6,279)    (2,956)
Personal exemptions                    752         2,940        800
Itemized deductions                (10,354)         -0-      (8,950)
Standard deduction                   5,450          -0-       5,750
  Total adjustments                116,609       183,187    118,525

Self employment tax                    10,022     12,588      11,930
     1
       Respondent conceded the capital gain adjustment at trial,
as is discussed above on page 20.
     2
       At trial respondent asserted that the correct Schedule E
income adjustment for 1995 is a $2,019 increase, but he also
stated that he is not seeking any greater deficiency than
determined in the notice of deficiency, which determined a $4,189
decrease in rental income, as is discussed above on page 20.

     The phaseout of personal exemptions, the self-employment

taxes, and the self-employment tax adjustments are computational

in nature and flow from the resolution of the other issues.         The

IRS determined that the sum of the real estate taxes and the

mortgage interest Ms. Langille paid on her personal residence in

1993 and 1995 exceeded the standard deduction she claimed on her
                                -24-

returns.   Thus, the IRS allowed the larger itemized deduction

for those years.   The IRS determined that the standard deduction

was more beneficial for Ms. Langille in 1994.      She has not

challenged these adjustments.

Fraud Determination

     The IRS determined that Ms. Langille, a lawyer, was aware of

the requirement that she report her law practice receipts, rental

receipts, and mortgage interest receipts as income, and that she

deliberately omitted this income for the purpose of evading

Federal income tax.    The IRS compared the sum of the deposits

into Ms. Langille’s accounts and the amounts withdrawn from the

client trust accounts for personal expenses to the amount of

income Ms. Langille reported for each year for the firm, BMC, and

herself, as follows:

                                         1993       1994         1995

   Total deposits & client trust
     account income                    $449,596   $451,355   $442,193
   Total income reported                259,926    224,500    149,254
     Total unreported income            189,670    226,855    292,939

The IRS determined therefrom that Ms. Langille had significantly

understated her income for the years in issue.      The IRS concluded

that Ms. Langille intentionally concealed and omitted income with

the intent to evade tax she knew she owed.
                                 -25-

Criminal Prosecution

     The U.S. Attorney’s Office for the Middle District of

Florida obtained an indictment11 against Ms. Langille, and she

pleaded guilty to one count of the indictment:    violating section

7206(1) by willfully filing a false tax return for 1994.    The

Government had the remaining count of the indictment (a charge as

to 1995) dismissed pursuant to the plea agreement.    In that plea

agreement Ms. Langille admitted that she did not report all of

her income for 1994 and 1995.    The court sentenced her to time

served and 12 months of supervised release and ordered her to pay

$144,360 in restitution to the IRS and a $50 special assessment.

United States v. Birdsong, No. 8:01CR126T17 (M.D. Fla. Sept. 10,

2004).

Notice of Deficiency and Petition

     The IRS issued the notice of deficiency on April 14, 2008.

The IRS derived the adjustments in the notice of deficiency from

the criminal investigation conducted by the special agent and the

analysis performed by the revenue agent.    The IRS determined that

Ms. Langille is liable for the civil fraud penalty under section

6663 for each year in issue.12


     11
      The record before us includes the plea agreement but does
not include the indictment.
     12
      The IRS did not determine an accuracy-related penalty
under section 6662 as an alternative to the fraud penalty.
Accordingly, we are not asked to decide whether the 20-percent
                                                   (continued...)
                                -26-

     Ms. Langille filed a timely petition in this Court for

redetermination of the deficiency, asserting that she provided a

list of business deductions to the IRS but that the IRS did not

allow her those deductions.    Her petition includes a summary of

income and expenses and a summary of further adjustments that she

asserts result in her having no aggregate deficiency for the

years in issue.    When she filed her petition, Ms. Langille

resided in Florida.

Trial

     Ms. Langille testified at trial, and she did not call any

other witnesses.    Respondent called the lawyer who answered the

advertisement to purchase Ms. Langille’s practice.13   He also

called the IRS special agent who searched the office and

interviewed Ms. Langille; the revenue agent who analyzed the

records and summoned documents, performed the bank deposits




     12
      (...continued)
penalty for negligence or disregard of rules or regulations
should apply, pursuant to section 6662(a) and (b)(1), to any
portion of the underpayment not attributable to fraud.
     13
      This lawyer applied for a monetary award pursuant to
section 7623(b) when he reported his concerns to the IRS, and his
reporting triggered the investigation into Ms. Langille’s tax
returns and led to the criminal prosecution and the notice of
deficiency. As indicated, Ms. Langille pleaded guilty to
willfully filing an inaccurate tax return. The record developed
by the IRS following this lawyer’s tip is sufficient for us to
decide this case without reciting or relying upon details of his
testimony.
                                 -27-

analyses, and calculated the deficiencies determined by the IRS;

and a lawyer who was a former employee of the firm.

Summary of Findings

     We find that the IRS’s bank deposits analyses of the firm’s

accounts, the BMC account, and the accounts Ms. Langille held in

various names were reasonable, as was its reconstruction of her

real estate income and expenses; and we find that Ms. Langille

had unreported income and expenses as determined in the notice of

deficiency (except as conceded; see supra note 2).

     We find further that Ms. Langille was aware of her

obligations to maintain books and records of her business

activities, that she did not keep records that accurately

reflected her income, that she maintained bank accounts under

different names, that she diverted law practice receipts away

from the firm and into her own accounts, that she failed to

disclose all her bank accounts to the IRS, that she did not

report any income from her residential rental activities (but

that she also did not have any profit on those activities during

the years in issue), that she failed to report interest income on

mortgage payments she received, and that she intentionally failed

to report law practice income.    We find that she knew of her

obligations to accurately report her income on her tax returns,

that her actions were willful, and that she had the fraudulent
                                 -28-

intent to evade tax on her unreported law practice income for

each year in issue.

     However, we do not find that she had the fraudulent intent

to evade tax with respect to her unreported mortgage interest

income or her commercial rental income.

                               OPINION

I.   Statute of Limitations

     As a threshold matter, we must determine whether the IRS

timely issued the notice of deficiency from which Ms. Langille

timely filed a petition for redetermination.    The IRS issued the

notice of deficiency more than 12 years after Ms. Langille filed

her tax return for the last year in issue.

     Ms. Langille timely filed her individual income tax returns

for the years in issue.   A return is considered filed on the last

day prescribed for filing if it is filed before that day.    Sec.

6501(b).   Thus the latest-filed return at issue (for 1995) was

deemed filed April 15, 1996.   Generally, the IRS must assess a

deficiency within 3 years of the date of filing of the tax

return.    Three years from the filing date for the latest year in

issue would be April 15, 1999.    The IRS issued the notice of

deficiency with respect to all three years on April 14, 2008.

Clearly more than 3 years elapsed (in fact almost 12 years

elapsed) between the deemed filing date for Ms. Langille’s latest

tax return in issue and the date the IRS issued the notice of
                               -29-

deficiency, which is the first step in the process of assessing a

deficiency.   If the general rule of section 6501(a) applied, then

the IRS would have failed to assess the deficiency within the

period of limitations and would be barred from assessing and

collecting any of the deficiencies or penalties for the 3 years

in issue.

     However, section 6501(c) provides exceptions to the general

rule, including:

          (1) False return.--In the case of a false or
     fraudulent return with the intent to evade tax, the tax
     may be assessed, or a proceeding in court for
     collection of such tax may be begun without assessment,
     at any time.

     The period for assessing Ms. Langille’s liability for a

deficiency determined in this case remains open if she filed “a

false or fraudulent return with the intent to evade tax” for the

year of the deficiency; if she did, then the exception provided

in section 6501(c)(1) permits the IRS to assess the tax for that

year “at any time.”

     As is discussed below in parts IV and V.B, Ms. Langille

fraudulently failed to report income in each year in issue, and

her intent was to evade tax.   Accordingly, the statute of

limitations does not bar assessment; rather, the exception

provided in section 6501(c)(1) applies, and the IRS may assess at

any time.
                                 -30-

II.   Burden of Proof

      A.    Generally

      The Commissioner’s determinations set forth in a notice of

deficiency are presumed correct, and generally speaking the

taxpayer bears the burden of showing the determinations are in

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

(1933).    (The different burden of proof for fraud is discussed

below in part II.B.)    Deductions and credits are a matter of

legislative grace, and the taxpayer bears the burden of proving

that she is entitled to any deduction or credit claimed.    Rule

142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934).    This includes the burden of substantiation.   Hradesky v.

Commissioner, 65 T.C. 87 (1975), affd. per curiam 540 F.2d 821

(5th Cir. 1976).

      The unreported income that the IRS determined Ms. Langille

earned during the years in issue is predicated on bank deposits--

prima facie evidence sufficient to relieve the IRS of any

threshold burden of proving the source of that income.    See

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

      Under certain circumstances, the burden of proof as to

factual matters may shift pursuant to section 7491(a) from the

taxpayer to the Commissioner, but only if the taxpayer introduces

credible evidence regarding a factual matter affecting her

liability and only if she has complied with substantiation
                               -31-

requirements, has maintained all required records, and has

cooperated with the IRS’s reasonable requests.   Sec. 7491(a)(1)

and (2).   Ms. Langille has not introduced credible evidence

raising factual questions about her liabilities (rather, she has

made conclusory arguments based on her own summaries of income

and expenses, without supporting those summaries with references

to exhibits in the record); she has not complied with

substantiation or record-keeping requirements; and she did not

cooperate with the IRS, specifically with the special agent’s

request for banking information (rather, the special agent

discovered the DMB Development Company accounts and the revenue

agent discovered the Deanna McBride Birdsong Attorney at Law

account without deliberate help from Ms. Langille).   Accordingly,

section 7491(a) does not shift the burden to respondent, and

Ms. Langille therefore retains the burden of proof with respect

to the deficiencies.   See Rule 142(a)(1).

     B.    Fraud

     Conversely, the Commissioner has the burden of proof with

respect to the issue of fraud with intent to evade tax, and that

burden of proof must be carried by clear and convincing evidence.

Sec. 7454(a); Rule 142(b); see Rowlee v. Commissioner, 80 T.C.

1111, 1123 (1983).   He must establish each element of fraud by

clear and convincing evidence for each of the years at issue.

See sec. 7454(a); Rule 142(b); Smith v. Commissioner, 926 F.2d
                                 -32-

1470, 1475 (6th Cir. 1991), affg. T.C. Memo. 1989-171.       Section

6663(b) provides that a determination that any portion of an

underpayment is attributable to fraud results in the entire

underpayment’s being treated as attributable to fraud, except any

portion the taxpayer proves is not so attributable.       Thus

respondent must show not only that Ms. Langille has underpaid her

taxes for each year but also that some part of her underpayment

for each year is due to fraud.    See DiLeo v. Commissioner, 96

T.C. 858, 873 (1991), affd. 959 F.2d 16 (2d Cir. 1992).

     Section 6664(a) defines an underpayment as

     the amount by which any tax imposed by this title
     exceeds the excess of--

          (1) the sum of--

               (A) the amount shown as the tax by the
          taxpayer on his return, plus

               (B) amounts not so shown previously
          assessed (or collected without assessment),
          over

          (2) the amount of rebates made.

     Section 6211(a) defines a “deficiency” as the “amount by

which the tax imposed * * * exceeds * * * the amount shown as tax

by the taxpayer upon his return”.       The record does not indicate

any previous assessments or collections without assessments nor

any rebates made to Ms. Langille for the years in issue.         Thus,

in this case the underpayment asserted and the deficiency

determined by the IRS are the same.
                               -33-

     Therefore, if respondent proves that any of Ms. Langille’s

deficiency for a particular year is due to fraud, then

Ms. Langille will owe the fraud penalty on the entire deficiency,

except to the extent that Ms. Langille shows that a given

component was not due to fraud.14

     Thus the burden is initially on respondent to show fraud as

to some of the underpayment for each year; and if he satisfies

that burden as to even part of the underpayment, then the burden

will shift to Ms. Langille to demonstrate that any part of the

underpayment is not due to fraud.

III. Passive Activity Limitations

     A.   General Rules

     Congress designed section 469 to prevent taxpayers from

reducing taxable income by losses attributable to passive

activities.   Section 469 operates by generally prohibiting the

deduction of passive activity losses from unrelated income, thus

permitting passive losses to offset only passive income.

Schwalbach v. Commissioner, 111 T.C. 215 (1998).      Disallowed

passive activity losses are not lost; rather, they are deferred

or suspended and are available as a deduction against income from

that activity in the next year.     Sec. 469(b).   Suspended passive


     14
      In addition, as is stated in part I above, if respondent
proves that Ms. Langille filed a fraudulent return with the
intent to evade tax for a year in issue, then pursuant to
section 6501(c) the IRS may assess the entire deficiency for that
year at any time.
                                -34-

activity losses may be carried forward indefinitely.     Ziegler v.

Commissioner, T.C. Memo. 2007-166, affd. 282 Fed. Appx. 869

(2d Cir. 2008).    Finally, upon the taxable disposition of a

passive activity, a taxpayer may generally use any remaining

suspended passive activity loss from that activity first against

passive income from that activity, then against net passive

income from other passive activities, and then as a non-passive

loss against other income.    Sec. 469(g)(1).

       A passive activity is one in which the taxpayer does not

materially participate.    Sec. 469(c)(1).   Material participation

is defined as involvement in the operations of the activity that

is regular, continuous, and substantial.     Sec. 469(h)(1).

       Rental activity is treated as a per se passive activity

regardless of whether the taxpayer materially participates.

Sec. 469(c)(2), (4).    However, professional real estate lessors

argued that non-passive classification would be more beneficial

to them, and they convinced Congress to amended section 469 in

1993.    Fransen v. United States, 191 F.3d 599, 601 (5th Cir.

1999).    Congress carved out an exception for rental activities of

real estate professionals by adding paragraph (7) to subsection

(c).    Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66,

sec. 13143, 107 Stat. 440, effective for tax years beginning
                               -35-

after December 31, 1993;15 see Estate of Quick v. Commissioner,

110 T.C. 172, 184 (1998).   Under section 469(c)(7)(B), the rental

activities of a taxpayer in the real property business (a real

estate professional) are not per se passive activities under

section 469(c)(2) but rather are treated as trade or business

activities and are subject to the material participation

requirements of section 469(c)(1).    See Sec. 1.469-9(e)(1),

Income Tax Regs. (26 C.F.R.), effective for tax years beginning

after January 1, 1995.   Under section 469(c)(7)(B), a taxpayer

qualifies as a real estate professional and is not engaged in a

passive activity under section 469(c)(2) if:

          (i) more than one-half of the personal services
     performed in trades or businesses by the taxpayer
     during such taxable year are performed in real property
     trades or businesses in which the taxpayer materially
     participates, and

          (ii) such taxpayer performs more than 750 hours of
     services during the taxable year in real property
     trades or businesses in which the taxpayer materially
     participates.

     B.   Residential Rental Activities

     Ms. Langille did not provide any estimate of the number of

hours she worked on her rental activities, and she did not allege

that she spent more time on her rental activities than she



     15
      Because of the effective date--tax years beginning after
December 31, 1993--this exception would not provide any
opportunity for non-passive treatment of rental activities for
Ms. Langille’s 1993 tax year, even if she could show that she
satisfied the requirements of section 469(c)(7).
                                   -36-

devoted to her law practice.      The record reflects that

Ms. Langille worked long hours in her law office, and there is no

evidence that she worked most of those hours on real estate

rental activities and not on legal matters.      Ms. Langille has not

demonstrated either that she met the 50-percent requirement of

section 469(c)(7)(B)(i) or that she satisfied the 750-hour

requirement of section 469(c)(7)(B)(ii).      We conclude that she

was not a real estate professional for purposes of section

469(c)(7) for 1994 or 1995.       Accordingly, her residential rental

real estate activities are per se passive activities for each

year in issue.       See supra note 15.

     C.   Office Rental Activity

     Section 1.469-2(f)(6), Income Tax Regs., is effective for

taxable years ending after May 10, 1992, sec. 1.469-11(a)(1),

Income Tax Regs., and provides in relevant part:

     § 1.469-2.      Passive activity loss.--* * *

                 *       *    *     *     *     *     *

          (f)(6) Property rented to a nonpassive activity.
     An amount of the taxpayer’s gross rental activity
     income for the taxable year from an item of property
     equal to the net rental activity income for the year
     from that item of property is treated as not from a
     passive activity if the property--

          (i) Is rented for use in a trade or business
     activity * * * in which the taxpayer materially
     participates * * * for the taxable year * * *.

     “In essence, the regulation provides that when a taxpayer

rents property to his own business, the income is not passive
                                 -37-

activity income.”     Fransen v. United States, supra at 600.   The

IRS identified self-rental of property as presenting an

opportunity to shelter income (e.g., by having the passive rental

activity charge exorbitant rent to the trade or business, and

then using passive activity losses to offset trade or business

income) and promulgated this regulation to foreclose that

practice.   The regulation has been upheld as a valid

interpretation of section 469.     Id. at 601.

     Ms. Langille owned the building where her law practice

operated, and she rented the office to her law practice (i.e., to

the firm until it dissolved, and to her unincorporated law

practice thereafter).    As is discussed above in part III.B, she

also rented residential real property during the years in issue.

The IRS determined that the office rental was self-rental,

concluded that any income from that rental activity was not

passive income, and thus denied any offset of losses from

Ms. Langille’s residential real estate rental activities (per se

passive activities) against any income from the office building

rental (not a passive activity).

     It is undisputed that Ms. Langille rented the office

building to her law practice for use in its trade or business,

and it is clear that Ms. Langille’s involvement in the law

practice’s activities was regular, continuous, and substantial.

See sec. 469(h)(1).    Accordingly, Ms. Langille materially
                               -38-

participated in the law practice to which she rented the office

building, and we sustain the determination that Ms. Langille’s

income from renting the office to her law practice is nonpassive

under section 1.469-2(f)(6), Income Tax Regs.   Thus Ms. Langille

may not offset office rental income with losses from her passive

residential rental activities; rather, those losses are suspended

until she either has passive income from those activities or

disposes of her interest in those activities.   See sec. 469(b)

and (g).

IV.   Unreported Income

      A.   Income Reconstruction Generally

      Taxpayers bear the responsibility to maintain books and

records that are sufficient to establish their income.     See sec.

6001; DiLeo v. Commissioner, 96 T.C. at 867; sec. 1.446-1(a)(4),

Income Tax Regs.   Ms. Langille failed to fulfill that

responsibility as to both her law practice and her real estate

activities.

      The Commissioner may use any of several methods to

reconstruct a taxpayer’s taxable income; and when a taxpayer

fails to keep adequate books and records, the Commissioner is

authorized by section 446 to determine the existence and amount

of the taxpayer’s income by any method that clearly reflects

income.    See Holland v. United States, 348 U.S. 121, 130-132

(1954) (“To protect the revenue from those who do not render true
                                -39-

accounts, the Government must be free to use all legal evidence

available to it in determining whether the story told by the

taxpayer’s books accurately reflects his financial history”

(internal quotation marks omitted)); Mallette Bros. Constr. Co.

v. United States, 695 F.2d 145, 148 (5th Cir. 1983).     The

Commissioner has latitude in selecting a method for

reconstructing a taxpayer’s income, and the method need only be

reasonable in light of all surrounding facts and circumstances.

Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).

      A bank deposit is prima facie evidence of income, and bank

deposits analysis is a method of income reconstruction that this

Court has long accepted.    Tokarski v. Commissioner, 87 T.C. at

77.   When a taxpayer keeps inadequate or incomplete books or

records and has large bank deposits, the IRS is not acting

arbitrarily or capriciously by resorting to the bank deposits

method.   See DiLeo v. Commissioner, supra at 867-868.    The bank

deposits method of reconstruction assumes that all of the money

deposited into a taxpayer’s account is taxable income unless the

taxpayer can show that the deposits are not taxable.     See id. at

868; see also Price v. United States, 335 F.2d 671, 677 (5th Cir.

1964).    The IRS need not show a likely source of the income when

using the bank deposits method, but the IRS must take into

account any nontaxable items or deductible expenses of which the

IRS has knowledge.   See Price v. United States, supra at 677.
                               -40-

     B.   Reconstruction of Income and Expenses From
          Ms. Langille’s Activities

     In the instant case, the IRS chose to apply the bank

deposits method.   The special agent identified the DMB

Development Company bank accounts, and the revenue agent

discovered the Deanna McBride Birdsong Attorney at Law account.

Because Ms. Langille’s records appeared incomplete, the IRS

summoned the bank records for the firm’s operating account, the

client trust accounts, the BMC account, and the other accounts

discovered during the investigation.    The revenue agent performed

a detailed check spread analysis to identify legal expenses paid

from all these accounts (which expenses the IRS allowed as

deductions), rental expenses paid from these accounts (which

expenses the IRS allocated to Ms. Langille’s rental activities),

and personal expenses paid from these accounts (which expenses

the IRS did not allow as deductions).   The agent performed a bank

deposits analysis to compute gross income; and the record shows

that she did not include in income deposits to the client trust

accounts, but she did identify personal expenses paid from those

accounts and included those payments in income.

     The bank deposits analysis was thoroughly documented in the

exhibits submitted at trial, which included the revenue agent’s

work papers and copies of canceled checks, bank statements, rent

receipts, law firm fee receipts, and other substantiating

documents.   The revenue agent thoroughly supported her analysis,
                                   -41-

and we accept her reconstruction of Ms. Langille’s income and

expenses as reasonable and accurate.

        C.     Mortgage Interest Analysis

     The revenue agent obtained the loan documents for the

mortgages Ms. Langille took back from selling properties, and she

calculated the (non-taxable) principal and (taxable) interest

portions of the mortgage payments that Ms. Langille received each

year.     The revenue agent also obtained the loan documents for the

mortgages (on Ms. Langille’s rental properties) on which

Ms. Langille made payments during the years in issue, in order to

differentiate deductible mortgage interest payments from non-

deductible principal payments and to ensure that the IRS’s

determination properly accounted for the mortgage interest

expenses.       The revenue agent prepared depreciation schedules for

Ms. Langille’s properties and calculated the amounts of suspended

passive losses that Ms. Langille incurred during each year in

issue.       We find the IRS’s reconstruction of Ms. Langille’s

mortgage income and expenses to be reasonable.

     D.        Ms. Langille’s Contentions

     Ms. Langille has not identified any specific errors or

omissions in the bank deposits analysis; rather, she has argued

generally and summarily that the total of her income and expenses

shows that her net unreported income for the three years is less

than the IRS determined.       Although the Court invited Ms. Langille
                               -42-

to provide a detailed post-trial brief, clearly delineating

errors in the IRS’s analysis and supporting any such assertions

with specific references to the record evidence, she failed to do

so.

      Ms. Langille argues on brief that the IRS failed to allow

deductions for certain “necessary business expenses such as

mortgage interest expense, property taxes, HOA fees, [insurance

and] utilities”.   Ms. Langille has not demonstrated that the

revenue agent failed to account for any particular rental

business expenses; and her argument for a greater amount of

expenses for her rental activity is based in part on her

including the total monthly payment amounts for her mortgages on

each of her rental properties--ignoring the facts that only the

interest portion of mortgage payments is currently deductible and

that the revenue agent computed the mortgage interest payments

she made and included those amounts in the IRS’s analysis.

Furthermore, to the extent that she complains of the IRS’s

determination that the passive activity loss limitations prohibit

her from deducting residential rental activity losses from office

rental income, interest income, or law practice income, her

argument does not survive the section 469 analysis, set out above

in part III.

      Ms. Langille does allege on brief that the calculations the

revenue agent performed at trial to quickly calculate
                                 -43-

Ms. Langille’s total deposits for the years in issue include

“$13,000 which was a transfer from Sun Bank to Barnett [Bank] to

open a new account and $16,000 for an account that belonged to a

good friend of Petitioner who had a small business for a very

short while.”    Ms. Langille argues that these amounts are not

income and were erroneously included by the revenue agent.       She

provides no documentary support for this assertion, and her

unsupported allegations are not proof.     See ASAT, Inc. v.

Commissioner, 108 T.C. 147, 177 (1997).

     Ms. Langille acknowledged the Court’s admonition that she be

specific on brief, and she apologized for her lack of

specificity.    She explained:   “The point of analyzing these

expenses however is not to arrive at an exact amount but rather

to show how far off and totally unreasonable the Commissioner’s

assessment of a tax deficiency is”.     Ms. Langille clearly missed

the point, which was that she had an opportunity on brief to

argue her case (and carry her burden) by citing specific exhibits

in evidence and providing precise rebuttals to the IRS’s income

and expense analysis.    Instead, she complained vaguely but failed

to prove at trial and to support on brief her assertions that she

repaid amounts she took from her client trust account (by not

taking future fees and expense reimbursements from the trust

account), that Ms. Smith’s personal expenditures from her client

trust account are not income to her (ignoring the implications of
                               -44-

their decision to practice law as equal shareholders in an S

corporation),16 that the IRS did not allow rental expenses, that

the IRS limited certain personal deductions due to income

limitations, that various deductible business expenses were not

credited, and that certain deposits are not income.

     She included no record references and no particularized

answer to the IRS’s very detailed income and expense analysis of

her activities.   Rather, she argues that her generalized

adjustments show that the summary exhibit she introduced “in

which she totaled all deposits in all business and personal bank

accounts and all withdrawals is fairly accurate.”   She argues

that the amount of her unreported taxable income is much smaller

than the amount determined by the IRS, but without showing, with

specific reference to evidence admitted in the record, precisely

how she reaches that conclusion.17




     16
      Ms. Langille also ignores the fact that her trust account
misappropriations dwarfed Ms. Smith’s ($47,670 vs. $3,811), yet
the IRS held Ms. Langille liable for only 50 percent of that
income.
     17
      In her summary exhibit Ms. Langille asserted that the sum
of her net taxable income for the 3 years in issue was $147,799,
while on brief she asserted the correct figure was $188,934. She
then subtracted the $112,066 total income reported on Forms 1040,
arriving at unreported income of $35,733 (summary exhibit) or
$76,868 (brief). She argues that both figures are “a long, long
way from the amount, $418,320, alleged by the Commissioner.” The
IRS’s analysis is well supported while Ms. Langille’s sums are
unreconciled, and Ms. Langille has identified neither errors in
nor any necessary adjustments to the IRS’s determinations.
                                 -45-

     E.    Unreported Income Conclusion

     Ms. Langille has not identified any specific errors in the

IRS’s analysis, and her challenges on brief to respondent’s

proposed findings of fact are unsupported by evidentiary

references.   Ms. Langille has not demonstrated that her

unreported income for the years in issue differs from the IRS’s

determinations.     As noted, a taxpayer bears the burden of showing

that the IRS’s determination is in error, and Ms. Langille has

failed to carry that burden.

     The IRS’s deficiency determinations are sustained, with the

exception of the portion due to the capital gain item conceded.

See supra note 2.

V.   Fraud Penalties

     A.    Legal Principles

     As indicated above in part II.B, respondent has the burden

of proving fraud by clear and convincing evidence, and he must

prove (1) that Ms. Langille underpaid her taxes in each year and

(2) that she intended to evade taxes by conduct intended to

conceal, mislead, or otherwise prevent tax collection.     See Parks

v. Commissioner, 94 T.C. 654, 661 (1990).    Fraud is an actual

wrongdoing committed with the intent to evade a tax believed to

be owed.   Marshall v. Commissioner, 85 T.C. 267, 272 (1985).

Fraud is never presumed, and the Commissioner must produce

independent evidence of fraudulent intent to establish fraud.
                                 -46-

Petzoldt v. Commissioner, 92 T.C. at 699.    Whether fraud exists

is a question of fact, and before finding fraud a court must

consider the entire record and the taxpayer’s entire course of

conduct.   Id.   “Fraud ‘does not include negligence, carelessness,

misunderstanding or unintentional understatement of income.’”

Zhadanov v. Commissioner, T.C. Memo. 2002-104 (quoting United

States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956)).    As

indicated above in part II.B, if the Commissioner demonstrates

fraud as to any portion of an underpayment, then the entire

underpayment is deemed due to fraud unless the taxpayer shows by

a preponderance of the evidence that some or all of the

underpayment is not due to fraud.

     Courts have developed a nonexclusive list of factors that

demonstrate fraudulent intent.    These “badges of fraud” include:

(1) understating income; (2) maintaining inadequate records;

(3) implausible or inconsistent explanations of behavior;

(4) concealing income or assets; (5) failing to cooperate with

tax authorities; (6) engaging in illegal activities; (7) an

intent to mislead, which may be inferred from a pattern of

conduct; (8) lack of credibility of the taxpayer’s testimony;

(9) filing false documents; (10) failing to file tax returns; and

(11) dealing in cash.    Spies v. United States, 317 U.S. 492, 499

(1943); Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).

Although no single factor is necessarily sufficient to establish
                               -47-

fraud, the combination of a number of factors constitutes

persuasive evidence.   Solomon v. Commissioner, 732 F.2d 1459,

1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603.

     B.    Ms. Langille’s Underpayments Due to Fraud

     The IRS asserted the presence of the following indicia of

fraud in this case, in that Ms. Langille--

     1.    Substantially understated her law practice income.
     2.    Maintained records for her reported income.
           However, during the search warrant the bank
           records for the unreported law practice income
           were in the garbage. Still, the records for the
           corporation are incomplete and do not tie to the
           amounts reported.
     3.    Opened bank accounts in a fictitious name, DMB
           Development Company [Operating Account] and DMB
           Development Company, Investment Account.
     4.    Opened bank accounts in her name only, which she
           used to divert law practice income from her
           partner.
     5.    Failed to disclose the unreported law practice
           accounts to the Special Agent [who searched her
           office and interviewed her and her staff].
     6.    When confronted about the accounts stated,
           incorrectly, that they contained rental income vs.
           law practice income.
     7.    Stated to the Special Agent that “Probably,
           everyone has unreported income.”
     8.    Incorrectly told the special agent that all of her
           rental receipts were deposited when an analysis
           showed that a significant portion was not
           deposited.
     9.    Credit card payments on personal cards were higher
           each year than [the amount of income] the taxpayer
           reported on her return.
     10.   The taxpayer left off an entire source of income--
           interest income from seller-financed mortgages.
     11.   The taxpayer diverted law practice trust monies
           for personal use.

     Respondent thus contends that the following badges of fraud

are present:   (1) understating income; (2) maintaining inadequate
                               -48-

records; (3) implausible or inconsistent explanations of

behavior; (4) concealing income or assets; (5) engaging in

illegal activities; (6) failing to cooperate with tax

authorities; (7) an intent to mislead; and (8) filing false

documents.18

     We find many of those badges of fraud to be present.    First,

Ms. Langille understated her law practice income for every year

in issue.   Second, she maintained inadequate records:   Those she

kept reflected only the income she intended to report and not the

law practice income she intentionally diverted into other

accounts; the special agent found some of her records in garbage

bags--hardly a credible storage or filing system; and she told

prospective purchasers that not all of the records documenting

the law practice income would be permanently available.    Third,

her explanations are implausible:     She claimed to have diverted

trust account deposits into her personal account for the

convenience of a client, and she claimed that she repaid trust

account amounts used for personal expenses and that she

intentionally refrained from taking fees or reimbursements later

from her client trust account as a means to replace the funds.


     18
      Respondent’s counsel has implied that Ms. Langille engaged
in illegal activities when she diverted funds from the firm into
her own accounts and when she used client trust account funds for
personal purposes. The record before us is far from clear on the
details of Ms. Langille’s ethical and disciplinary proceedings
and in any event does not show that she has been indicted or
convicted of any crimes related to these activities.
                               -49-

The convenience argument is not credible, the alleged repayment

is not supported by the bank records analyzed by the IRS, and her

choosing not to take reimbursements or fees in the future did not

change the character of the money she took from the trust account

when she took it.   It was income when taken, regardless of

whether she considered it repaid when she allegedly forwent

payments later.   Fourth, Ms. Langille concealed income by

diverting payments to the firm into the DMB Development Company

accounts and the Deanna McBride Birdsong Attorney at Law account.

Fifth, she engaged in illegal activities (i.e., willfully filed

tax returns she did not believe to be true and correct as to

every material matter, the crime to which she pleaded guilty).

Sixth, she failed to cooperate with IRS investigators by not

identifying all the entities she was involved with when the

special agent interviewed her (i.e., omitting the apparently

fictitious business called DMB Development Company) and by

failing to identify every bank account she used (i.e., omitting

the DMB Development Company accounts and the Deanna McBride

Birdsong Attorney at Law account).    Seventh, her conduct supports

a reasonable inference (and we do infer) that she intended to

mislead:   (i) by diverting law practice funds into other

accounts; (ii) by paying personal expenses directly from her

client trust account; (iii) by keeping books reflecting only the

income she intended to report; and (iv) by omitting law practice
                                 -50-

income from her returns and not offering any explanation for her

failure to report that income.    Eighth, she filed false tax

returns, as she admitted in her plea agreement for 1994 and 1995,

and as we find she did for 1993.    Accordingly, we find

Ms. Langille’s actions were intended to prevent tax collection by

concealing her income and misleading the IRS.19

     We find fraudulent Ms. Langille’s failure to report the

following income items:

              Item                      1993        1994       1995

Schedule C gross receipts           $112,150       $193,817   $255,314
Sch. K-1 income from the firm          8,689          ---        ---

Ms. Langille has offered no explanation for failing to include

these items of income in her tax returns, and she has not shown

that her omission resulted from mere negligence or carelessness

and not from fraud.   On the basis of our finding that she

intentionally omitted this income, we find that respondent has

shown that at least some of Ms. Langille’s underpayment in each

of the years in issue was due to fraud.20      Unless Ms. Langille


     19
      In her plea agreement, Ms. Langille admitted telling a
prospective purchaser of her law practice “that she did not
report all her income and was able to do so because she was
smarter than the IRS.”
     20
      A necessary consequence of our finding fraud for at least
some of the underpayment for each year is that the exception in
section 6501(c)(1) applies to (i) trigger the exception to the
statute of limitations provided in section 6501(a) and
(ii) authorize the IRS to assess at any time (and hence to issue
                                                   (continued...)
                               -51-

demonstrates by a preponderance of the evidence that part of the

underpayment is not due to fraud, the entire underpayment for

each year is treated as due to fraud.    See sec. 6663(b).

     Ms. Langille testified that she became overwhelmed each

year, after preparing the firm’s Form 1120S, when she realized

that she had a net loss from her rental activities.    She asserts

that she was uncertain how to report a rental loss and that since

no tax is due on a loss, she felt she was doing nothing wrong in

not reporting all of her real estate income--i.e., omitting her

residential rental income and mortgage interest income.

     Although her subjective perceptions ignored some of the

applicable legal principles, those perceptions were plausible.

Combining Ms. Langille’s mortgage interest income with her net

rental income (without separating nonpassive and passive rental

activities) shows:

             Item             1993       1994       1995      Total

Mortgage interest income     $11,511     $9,601    $5,977    $27,089
Net rental income (loss)    (23,972)    (6,742)   (15,083)   (45,797)
  Net real estate income    (12,461)      2,859    (9,106)   (18,708)

Thus, Ms. Langille’s belief was correct for 1993 and 1995--i.e.,

her real estate transactions did result in net losses for those

two years.   For 1994 the result is a slight profit, but for the



     20
       (...continued)
the notice of deficiency at any time), as is discussed above in
pt. I.
                               -52-

three years combined the record shows that the real estate

activities (netting mortgage interest income against rental

losses) produced an economic loss over the years in issue.

     As is discussed above in part III, the self-rental passive

activity rule of section 1.469-2(f)(6), Income Tax Regs.,

prohibits Ms. Langille from offsetting her residential rental

real estate losses against the deemed non-passive self-rental

income earned from renting the office building to her law

practice.   However, as is also discussed above, fraud is an

actual wrongdoing committed with the intent to evade a tax

believed to be owed.   Marshall v. Commissioner, 85 T.C. at 272.

The Code’s “passive activity” rules are hardly intuitive, and we

cannot say that it was fraudulent for Ms. Langille, suffering net

negative cash flow of $10,259 from her rental activity over the

years in issue, to fail to realize that the passive activity

rules required her to report positive income.21   While

Ms. Langille’s reporting of her rental income and expenses was

negligent (and her entering an arbitrary income amount in 1994

and omitting her actual expenses was willful, see sec. 7206(1)),

we are satisfied that she did not omit her rental activity income

with the requisite intent to evade a tax she believed she owed;


     21
      Ms. Langille may also have thought she could avoid
reporting her mortgage interest income because it was offset by
mortgage interest she paid on loans encumbering the properties
she rented. This, too, is wrong, but the error was negligent and
not fraudulent.
                                 -53-

and we do not find that she intended to conceal, mislead, or

otherwise prevent tax collection with respect to her rental

activities.   She believed she could net all her rental activities

and that the net was negative for each year in issue.      Her belief

was based on ignorance and was incorrect, but her action as to

this income was negligent rather than fraudulent.

     Ms. Langille seems to argue that she should be able to

deduct the entirety of her mortgage payments (both principal and

interest) because from a cashflow perspective that is the amount

she paid each month.   But that contention is clearly wrong; only

the interest portion of such payments is currently deductible.

     Ms. Langille has not shown that any of the underpayment

resulting from her unreported law practice income for any year in

issue resulted from anything other than fraud.      The only portions

of the underpayment Ms. Langille has demonstrated did not result

from fraud are those arising from her rental income and her

mortgage interest income.   Accordingly, we do not sustain the

section 6663(a) fraud penalty as determined in the notice of

deficiency as it applies to these items, but we sustain the fraud

penalty as to her unreported law practice income.

     To reflect the foregoing,


                                             Decision will be entered

                                        under Rule 155.
