                        T.C. Memo. 2007-238



                      UNITED STATES TAX COURT



    LEE F. HANEY, SR. AND JEAN C. HANEY, a.k.a. JEANIE HANEY,
                          Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9459-06.               Filed August 20, 2007.



     Kevin D. Watley and B. David Sisson, for petitioners.

     Ann L. Darnold, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined deficiencies and

penalties with regard to petitioners’ Federal income tax as

follows:
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                                                 Penalty
        Year           Deficiency           I.R.C. Sec. 6663

        2000            $106,074              $79,555.50
        2001              74,841               56,130.75
        2002              74,156               55,617.00

     Unless otherwise indicated, all 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.     After concessions, the issues for decision are:

     (1) Whether petitioner’s solely owned S corporation received

and failed to report taxable income for taxable years 2000, 2001,

and 2002;

     (2) whether petitioners are entitled to reductions in their

Federal taxable income for 2000 attributable to additional

Employee Embezzlement Account deductions that were not claimed on

their return;

     (3) whether various deductions claimed as business expenses

of petitioner’s solely owned corporation should be disallowed as

personal expenses of petitioners or for failure to substantiate;

     (4) whether petitioners are entitled to disallowed

deductions relating to their racing activities; and

     (5) whether petitioners are liable for the fraud penalty

pursuant to section 6663 for the years in issue or, in the

alternative, whether petitioners are liable for the accuracy-

related penalty pursuant to section 6662.
                               - 3 -

                        FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated into our findings by this reference.

Petitioners are married and resided in Oklahoma at the time that

they filed their petition.

     Petitioner Lee F. Haney, Sr. (petitioner), is the sole

shareholder of Flair Enterprises, Inc. (Flair Enterprises or the

company), an S corporation.   Flair Enterprises operates three

full-service automobile paint and body shops doing business as

Flair Body Works in the Oklahoma City metropolitan area.    The

Flair Body Works shops are managed by petitioners’ sons, Phillip

Haney and Alan Haney.

     During the years in issue, it was the business practice of

Flair Enterprises to keep complete and accurate records of work

performed by Flair Body Works for their insurance customers.

Flair Body Works is a preferred provider for several major

automobile insurance companies, which requires strict records to

be maintained by service providers seeking payment on claims.

During the years in issue, Flair Enterprises maintained two

separate sets of books for Flair Body Works.   One set of books

recorded transactions that were covered by the automobile

insurance companies; the other recorded transactions with

noninsurance customers and other regular payors.
                               - 4 -

     Checks from customers with insurance were deposited and

recorded through a computerized accounting system; checks from

noninsurance customers and other payors were simply recorded and

totaled on a legal pad bearing the title “Do Not Touch” and on

bank deposit slips and then cashed, not deposited, by petitioner

Jean C. Haney (Mrs. Haney).   During the years in issue,

Mrs. Haney regularly endorsed and cashed checks for Flair

Enterprises, d.b.a. Flair Body Works.   Mrs. Haney continued to

cash company checks until approximately late 2001, when

petitioners’ bank no longer permitted her to cash company checks.

     In addition to checks from noninsurance customers, many

checks received by Flair Enterprises and cashed by Mrs. Haney in

2000 and 2001 were from COPART Salvage Auto Auctions (COPART),

which is in the business of purchasing wrecked vehicles from body

shops for sale to junk dealers.   COPART has been picking up

vehicles from Flair Body Works for more than 20 years.

     Many of the checks cashed by Mrs. Haney were received by

Flair Enterprises from Hudiburg Chevrolet.   Flair Enterprises

leased pickup trucks from Hudiburg Chevrolet during the years in

issue.   The lease payments were deducted as business expenses of

the company.   Flair Enterprises also purchased approximately

$300,000 in auto parts annually from Hudiburg Chevrolet in the

years in issue.   In appreciation for the volume of business that

Flair Enterprises did with it, Hudiburg Chevrolet reimbursed the
                               - 5 -

company for lease expenses in monthly checks ranging from

approximately $1,200 to $1,700.   Most of the Hudiburg Chevrolet

checks were cashed by Mrs. Haney, and the income from them was

not reported by Flair Enterprises.

     Many of the checks cashed by Mrs. Haney were received from

B&H Supply Co. (B&H), Flair Body Works’ paint vendor.    The B&H

checks will be described in detail below.

     When Mrs. Haney returned from cashing the checks at the

bank, she delivered the cash received from the Hudiburg Chevrolet

lease reimbursements and certain B&H payments to petitioner.    She

then divided the remainder of the cash among herself and

petitioners’ two sons.

     On March 28, 2000, a check in the amount of $580.62 was

deposited in petitioners’ personal checking account.    The deposit

slip for this deposit included the notation “Flair” next to the

amount of the check.   During 2002, $39,000 in cash was also

deposited into petitioners’ personal checking account.

     With a couple of minor adjustments, Flair Enterprises’s bank

deposits for the years in issue roughly totaled its reported

income for those years.   Any checks that were cashed instead of

deposited were not included in the income of Flair Enterprises.

Agreement With B&H

     Prior to and during the years in issue, B&H sold paint to

Flair Enterprises for use at its Flair Body Works body shop
                               - 6 -

locations.   Flair Enterprises is one of B&H’s largest customers.

In 1999, Flair Enterprises was purchasing PPG paint products for

use in its body shops.   PPG canceled its business with B&H, and

Flair Enterprises was asked by B&H to switch to Dupont paint

products.

     Flair Enterprises entered into an agreement (the supply

agreement) with B&H for the purchase of Dupont paint products

instead of PPG products for 5 years, for which change in supply

Flair Enterprises would be compensated $150,000.   Dupont financed

the supply agreement as an incentive for Flair Enterprises to

continue using B&H as its paint vendor and to switch to Dupont

paint products.   Half of the incentive payment was to be paid at

the time of the contract formation in 1999, and the remaining

half was to be paid in monthly installments of $1,250.

     Although the supply agreement does not address the issue,

B&H intended that Flair Enterprises would use the incentive

payment to purchase shop equipment, such as paint booths or

spraying machines, and referred to the supply agreement as a

“shop investment”.   Flair Enterprises received a payment of

$75,000 in 1999, which year is not before us, when the supply

agreement was executed, and received 60 monthly installments of

$1,250.   The monthly installments of $1,250 received throughout

2000 and until September 2001 were not invested in the business

of Flair Enterprises but were cashed by Mrs. Haney.
                               - 7 -

     In addition to the incentive payments, exhibit A to the

supply agreement between Flair Enterprises and B&H committed B&H

to provide Flair Enterprises with Dupont products at 25 percent

off the suggested shop price and 3M products at 35 percent off.

Although most of B&H’s customers receive their discounts as

reductions from their invoiced costs, Flair Enterprises requested

that it be issued monthly rebate checks instead.    The amounts

allocated to each Flair Body Works location were reflected on the

checks.

      At the direction of Phillip Haney, the rebate checks from

B&H were made payable to Flair Racing, Inc. (Flair Racing),

another operation solely owned by petitioner discussed infra,

instead of to Flair Enterprises.   The rebate checks were then

deposited into Flair Racing’s bank account.   There is no

reference to Flair Racing in the supply agreement between B&H and

Flair Enterprises.   Flair Racing does not purchase any paint

products from B&H.   The amounts paid pursuant to the supply

agreement were unrelated to any racing activities in which

petitioners or their family engaged and would have been paid

regardless of petitioners’ involvement in racing.    The supply

agreement was not a racing sponsorship by B&H or Dupont.
                                 - 8 -

Embezzlement by Karen Steelman

     Karen Steelman (Steelman) began her employment with Flair

Enterprises as bookkeeper and accountant in 1996 and was trained

in office procedures by Phillip Haney and Mrs. Haney.    The

practice of separating noninsurance checks and cashing them

instead of depositing them was established before Steelman joined

the company, although no records were kept of such transactions

at the time she began her employment.    Steelman was fired in

November 2000 when it was discovered that she was embezzling

substantial funds from Flair Enterprises during the course of her

employment.   Phillip Haney’s wife, Regina Haney (Gina Haney), had

been assisting Steelman with the bookkeeping for Flair

Enterprises from May 1999 through November 2000.    When Steelman’s

employment was terminated in November 2000, Gina Haney became the

primary bookkeeper.

     Respondent allowed petitioners a deduction of $86,950 in

calculating their taxable income for 2000 for money embezzled by

Steelman in that year.   The embezzlement deduction was labeled as

Employee Embezzlement Account in the “other deductions” section

of the Form 1120-S, U.S. Income Tax Return for an S Corporation,

filed by Flair Enterprises for the year 2000.

     In November 2000, petitioner employed attorney/certified

public accountant Jeffrey C. Trent (Trent) to investigate

misappropriation and embezzlement of corporate funds.    Trent
                               - 9 -

identified specifics of the suspected wrongdoing, and Steelman

was fired after Trent’s report to petitioner.   Trent was then

engaged to perform records reconstruction and to assist

petitioners in preparation of their income tax returns for the

years in issue.   Trent also assisted law enforcement, including

the Federal Bureau of Investigation, with the criminal

investigation of Steelman.

     During an audit interview, Trent, representing petitioners,

told the examining agent that Steelman embezzled funds three

ways:   Additional weekly payroll checks that Steelman tricked

Mrs. Haney into signing by showing her a check stub payable to

one entity and then making the check itself payable to a

different person, credits posted to Steelman’s personal credit

card account from Flair Enterprises’ credit card machine, and a

pension and profit sharing plan benefiting Steelman that she

created without authorization and enhanced using company assets

for her own benefit.   Trent also represented to the examining

agent that Flair Enterprises kept no cash on hand and that there

was no petty cash fund set up at the company.

     Steelman utilized several means to embezzle funds from Flair

Enterprises, including writing additional unauthorized payroll

checks to herself and depositing unauthorized funds from the

company into a section 401(k) account in her name.   However,

Steelman did not embezzle cash funds from the company.
                             - 10 -

Representations Made During Audit

     During audit, the examining agent conducted several

interviews of petitioners, Trent, and other related parties.

Regarding the practice of cashing checks, Trent, informed by

petitioners, represented in several interviews that all income of

Flair Enterprises was deposited during the years in issue.

Mrs. Haney represented that she did not cash any checks after

Steelman left in November 2000.   Regarding the existence of a

petty cash fund at Flair Enterprises, Trent represented that the

company had no petty cash fund and that none was reflected on the

company’s books.

     Regarding the B&H supply agreement, Gina Haney, through

Trent, told the examining agent that there was no written

agreement between Flair Enterprises and B&H.    One of B&H’s

representatives stated that B&H does not sponsor racers and that

the monthly payments from B&H to Flair Enterprises did not amount

to a racing sponsorship, although petitioners may have wanted to

characterize them in that manner.

Flair Racing, Inc.

     Petitioner formed Flair Racing in order to limit the

liability of petitioners and Flair Enterprises related to certain

Legends race cars owned by petitioner.   Legends race cars are

5/8-scale replicas of 1930s and 1940s sedans.
                              - 11 -

     Racing is a hobby for petitioner and his sons, and they have

been involved with cars and racing for more than 30 years.       They

have enjoyed participating in races and attending races as

spectators.   They have enjoyed their association with celebrities

and race car drivers, and photographs of petitioners’ family

members with several celebrity athletes and entertainers are

displayed at the Flair Body Works locations.     Petitioners’

grandchildren enjoy riding in the Legends race cars.

     Petitioner took his Legends race cars to a celebrity Legends

car race at the Texas Motor Speedway in 1997 or 1998, but he did

not participate in any races during the years in issue.     In 1997

or 1998, petitioner and his sons raced 50 of 52 weekends.       The

races petitioner entered took place all over the State of

Oklahoma and in several other States.     A good purse for winning a

race ranges between $300 and $500.     It cost petitioner

approximately $5,000 to enter his four cars in the Texas Motor

Speedway race.   Petitioner never made a profit from his racing

activities, nor did he intend to.

     Flair Enterprises advertises and promotes its Flair Body

Works business through the use of the Legends race cars

displaying the name and quality of paint jobs provided to

customers of Flair Body Works.   Examples of the promotional use

include celebrity associations and demonstrations of the Legends

race cars; however, the only promotional use of the Legends race
                                - 12 -

cars during the years in issue was their display at the Flair

Body Works locations.

     Most of Flair Body Works’ customers come from insurance

agents who send their clients to the shops.     Most of the

customers live in the Oklahoma City area and were not present in

large numbers at car races outside of the Oklahoma City area.

Petitioner has worked on race cars for other people occasionally,

but he typically does not charge to perform that work.

     Petitioner maintained a race shop originally located at

Flair Body Works’ Moore, Oklahoma, location.     The race shop and

the Legends race cars were used in Flair Body Works’ business to

demonstrate for customers how various car parts worked.       In

October 2000, petitioners acquired 80 acres of land in their

names personally.   A $20,000 escrow deposit, a $60,000

downpayment, and another $20,000 payment made at closing were all

paid by Flair Racing in cash.    Petitioners built their personal

residence on the acquired land, as well as a new race shop, which

was not completed as late as July 2003.     In October 2001,

petitioners gave to each of their two sons 5 acres of the 80-acre

parcel.

     The new race shop was not open to the public, and there were

signs saying “Stay Out” by the gates at the entrances to

petitioners’ property.   Petitioner did not want people around the

Legends race cars or the race shop.      The race shop was not air-
                              - 13 -

conditioned during the years in issue, and there was no bathroom

in the shop because it was near petitioners’ residence.

Following completion of the race shop, it housed the Legends race

cars owned by Flair Racing, trailers used to haul the Legends

race cars, petitioners’ personal motor home used by petitioners’

family when they traveled to races, an old pickup truck owned by

one of petitioner’s friends, as well as petitioners’ personal

lawnmower.   In 2002, petitioners acquired an additional parcel of

land adjacent to the 80-acre tract for the purpose of building a

test track for his Legends race cars.   The test track was

completed shortly before trial of this case in January 2007.

     Flair Racing did not have any employees during the years in

issue and did not pay petitioner a salary.   Petitioner made all

decisions about what expenses were paid from the Flair Racing

bank account, and only petitioners had signature authority on

that bank account.   The mortgage payments on petitioners’ 80-acre

tract, which included improvements such as petitioners’ personal

residence and the race shop, were paid automatically from Flair

Racing’s bank account monthly.   The mortgage payments were posted

on Flair Racing’s books as “notes payable”, except one payment in

November 2000 that was posted to a “loan from shareholder”

account.   The purchase of the 80-acre tract was entered on Flair

Racing’s depreciation schedules in the amount of $80,000.    In

September 2000, $13,625 was paid from Flair Racing’s bank account
                              - 14 -

to purchase pipe for fencing that surrounded the entire 80-acre

parcel.   The cost of the fencing pipe was capitalized and placed

on Flair Racing’s depreciation schedules.   Various other

deductions were claimed by Flair Racing for repair work performed

on the Legends race cars, insurance premiums on each of the

Legends race cars, and other expenses during the years in issue.

Depreciation and Other Expenses Claimed by Flair Enterprises

     During the years in issue, petitioners made substantial

improvements to their land, including cleaning and repairing

erosion from the preexisting pond located on the tract, preparing

the land for construction of three homes for petitioners and

their two sons, installing driveways on the land, and

constructing the race shop.   In 2000, Flair Enterprises purchased

heavy construction equipment totaling approximately $142,420 and

including bulldozers, dump trucks, track hoes, road graders, and

brush hog mowers.   All of these items were depreciated by Flair

Enterprises.   Flair Enterprises also claimed a $20,000 section

179 deduction for the taxable year 2000 related to the

acquisition of a tractor and loader.   The construction equipment

acquired in 2000 was purchased in anticipation of petitioners’

purchase of the 80-acre tract and was used almost exclusively on

the tract, where it was also stored.   Prior to 2000, the only

heavy equipment used at Flair Body Works locations included a
                              - 15 -

dump truck, a flatbed, and an old wrecker.     This equipment was

primarily used to move vehicles and to haul scrap items.

     In 2001, Flair Enterprises spent approximately $180,000 for

additional equipment, shop buildings, and improvements to the

80-acre tract.   Expenses were also incurred and paid by Flair

Enterprises for house plans and preliminary plumbing and

inspection work for the sites where the race shop and homes of

petitioners and their two sons were to be built.     The assets

acquired by Flair Enterprises in 2001 included two entryway signs

for the 80-acre tract, a second brush hog mower, a lawnmower, and

various other pieces of equipment.     For a total cost of

$81,315.74, two buildings were also purchased by Flair

Enterprises that year and placed on the tract for use as

petitioner’s race shop.   Flair Enterprises also made substantial

expenditures in 2001 for cleanup of a preexisting oil well site

on the 80-acre tract, fencing, drainage, construction of entry

signs and of the race shop building, and other improvements to

the land.

     In 2002, the year that petitioners moved into their new

house on the 80-acre tract, Flair Enterprises deducted on its tax

return $226,477.10 of costs classified as improvements, the

majority of which relate to improvements to the 80-acre parcel of

land and construction of the personal residences of petitioners

and their two sons.   The substantiation information provided for
                              - 16 -

these expenses consistently references the personal residences of

petitioners and their two sons.    Also included in the list of

Flair Enterprises’ expenditures for 2002 are numerous checks

payable to petitioners’ sons to reimburse them for expenses

related to their homes.   Additional expenses in 2002 related to

the improvement of the 80-acre tract and the construction of the

personal residences of petitioners’ family were deducted as

repair expenses by Flair Enterprises.    The utility costs for

petitioners’ home were deducted by the company as well.    Flair

Enterprises purchased a Harley Davidson motorcycle at a cost of

$19,000 in 2002 and added the motorcycle to its depreciation

schedule.   Repairs to the motorcycle that year were deducted by

Flair Enterprises as business promotion expenses.

     During the years in issue, Flair Body Works had an American

Express charge account that was used by several members of

petitioners’ family, and the statements were broken down by the

family member making the respective charges.    The American

Express card was used for personal travel and meals, including

several trips to Las Vegas, Nevada.    The use of the American

Express card increased about the time that the check cashing

practice of petitioners stopped.    Although substantiation for

these expenses was requested by the Internal Revenue Service

(IRS) during the audit of Flair Enterprises, no documentation was

provided by petitioners for most of the expenditures.
                              - 17 -

     In 2001, Flair Enterprises purchased gocarts costing

$2,160.70 and deducted the cost under miscellaneous expenses.

The gocarts were bought with company funds by petitioner as toys

for his grandchildren.   Also in 2001, a storm shelter was

purchased for $5,670 by Flair Enterprises and deducted as an

office supplies expense of the company.   The storm shelter is

located at petitioners’ personal residence inside their garage;

nothing related to the Flair Body Works business is stored in the

shelter.   During the years in issue, numerous dry cleaning bills

were paid by Flair Enterprises for petitioners and their family

members.   Department store and gift shop purchases were also

reimbursed as business expenses of the company, for which no

substantiation of business purpose has been provided.

     No substantiation of deductibility has been provided for

numerous company checks made payable to petitioners’ sons.    For

example, no explanation has been provided for reimbursements to

Phillip Haney by Flair Enterprises for dog food and a tee ball

glove, which were deducted as shop supply expenses.   During the

years in issue, Flair Enterprises deducted loan payments made on

Mrs. Haney’s Mercedes and Gina Haney’s Suburban vehicles.    One

$3,325.32 check to Mercedes Benz of OKC was categorized on the

company’s books as a “Materials” expense.   Flair Enterprises

deducted numerous payments related to petitioners’

grandchildren’s school and extracurricular activities.   In 2000,
                              - 18 -

three company checks were labeled as “grandkid cheer team”.     Many

similar expenses were recorded in the company’s records as

advertising expenses.

     During the years in issue, petitioners owned a Winnebago

that was used by their family when they traveled to car races.

The insurance on the Winnebago was paid by Flair Enterprises and

deducted as a business expense.

     Petitioners owned land on Lake Texoma in Marshall County,

Texas, during the years in issue.   The land and mobile home

located on the land are titled in the names of petitioners

personally.   Utility records for the Lake Texoma property reflect

petitioner as the property owner of record.   During the years in

issue, Flair Enterprises deducted utilities, taxes, and insurance

expenses related to petitioners’ Lake Texoma property.

Petitioners originally made payments on the trailer from their

personal account, but at some point started making payments out

of the Flair Enterprises account so that they could be written

off as business expenses.   Petitioners also personally owned a

boat and trailer that were kept on the Lake Texoma property.    The

insurance on the boat and trailer was in petitioner’s name but

was paid by Flair Enterprises and deducted as a business expense

of the company.   Insurance on petitioners’ personal water craft

was also paid and deducted by Flair Enterprises for the years in

issue.
                              - 19 -

                              OPINION

     As a general rule, with respect to the amount of the

deficiency in issue, the taxpayer bears the burden of proof.

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

(1992); Rockwell v. Commissioner, 512 F.2d 882, 886 (9th Cir.

1975), affg. T.C. Memo. 1972-133.   That burden may shift to

respondent if the taxpayer introduces credible evidence with

respect to any factual issue relevant to ascertaining the

taxpayer’s tax liability.   Sec. 7491(a)(1).    However, section

7491(a)(1) applies with respect to an issue only if the taxpayer

has complied with the requirements under the Code to substantiate

any item, has maintained all records required by the Code, and

has cooperated with reasonable requests by the Commissioner for

witnesses, information, documents, meetings, and interviews.

Sec. 7491(a)(2)(A) and (B).   For the reasons discussed below,

petitioners’ evidence is unreliable, and their claims are

unsubstantiated.   They have not satisfied the conditions for

shifting the burden of proof to respondent.     As discussed below,

however, respondent has the burden of proving fraud by clear and

convincing evidence.

Unreported Taxable Income

     Gross income is defined in section 61 as all income from

whatever source derived, including, but not limited to, income

derived from business.   Sec. 61(a).    Generally, in determining
                              - 20 -

the tax of a shareholder of an S corporation for the

shareholder’s taxable year, the shareholder’s pro rata share of

the corporation’s items of income, loss, deduction, or credit

must be taken into account.   Sec. 1366.   As the sole shareholder

of Flair Enterprises, the adjustments to the company’s ordinary

income would flow through to petitioner and be included on

petitioner’s individual income tax returns for the years in

issue.   The evidence establishes that petitioner’s solely owned S

corporation received and failed to report taxable income for the

years in issue.

     During the years in issue, Mrs. Haney regularly cashed

checks from noninsurance customers and checks received from

COPART, B&H, and Hudiburg Chevrolet.   Office procedures at Flair

Enterprises required that two sets of books be maintained.

Cashed checks were listed in a handwritten notebook, but not

posted to the company’s computer system.    Checks from insurance

customers were deposited in Flair Enterprises’ bank account, not

cashed, and were recorded in the company’s computer system.    Only

deposited checks were included as income on the tax returns of

Flair Enterprises for the years in issue.   Several of

petitioners’ family members participated in this dual record-

keeping process, by which petitioners were able to avoid

reporting substantial amounts of income received by the company.
                              - 21 -

     Included among those checks cashed by Mrs. Haney were checks

from COPART, which were reimbursements for towing, storage, and

expenses incurred with regard to vehicles that were eventually

declared totaled by insurance companies and hauled away from

Flair Body Works.   These costs reimbursed by COPART had already

been included in those deducted by Flair Enterprises on its Forms

1120-S for the years in issue.   Because Flair Enterprises failed

to take the COPART reimbursements into account either as

reductions in its claimed business expense deductions or as

taxable income, it underreported its net income in the years in

issue by the total amount of COPART checks cashed by Mrs. Haney

in those years.

     Also included in the checks cashed by Mrs. Haney during the

years in issue were lease reimbursement checks from Hudiburg

Chevrolet in appreciation for the high volume of business that

Flair Enterprises did with the car dealership.   The monthly lease

payments made by Flair Enterprises to Hudiburg Chevrolet were

deducted as business expenses of the company, but the lease

reimbursements from Hudiburg Chevrolet back to Flair Enterprises

were not included in the income of the company to offset the

previously taken lease expense deductions.   Rather than being

deposited into Flair Enterprises’ bank account and included in

income, the Hudiburg Chevrolet reimbursement checks were cashed

by Mrs. Haney and turned over to petitioner.
                               - 22 -

     Flair Enterprises also received two checks monthly from B&H

during the years in issue in accordance with a 1999 supply

contract between the company and B&H.   One monthly payment by B&H

to Flair Enterprises was an incentive payment of $1,250 in return

for a 5-year commitment of Flair Body Works to continue to

purchase paint products from B&H.   The B&H checks were cashed

throughout 2000 and through September 2001, when petitioners’

bank no longer allowed petitioners to cash checks.   Throughout

the remainder of 2001 and all of 2002, the incentive payments

from B&H were deposited into the bank account of Flair Racing and

were not recognized as income to Flair Enterprises, which was

contractually entitled to the payments.   None of the B&H

incentive payments that were cashed were recognized in the income

of any entity or individual.   The B&H incentive payments that

were deposited into the Flair Racing bank account were included

in the income of Flair Racing.

     The other monthly check from B&H to Flair Enterprises was a

rebate check for an agreed percentage of the invoiced cost of

Dupont and 3M products purchased from B&H.   The rebate checks

varied in amount each month and were based on the volume of

products purchased by Flair Body Works during the previous month.

Although the agreed percentage discount from B&H was guaranteed

to Flair Enterprises and the rebate was a remittance of that

discount to Flair Body Works, the B&H rebate checks were made
                              - 23 -

payable to Flair Racing, at the direction of petitioner’s son,

Phillip, and were deposited monthly into Flair Racing’s bank

account.   The B&H rebate checks are properly income to Flair

Enterprises, which was contractually entitled to the discount

rebates.

     Petitioners allege that Mrs. Haney gave all cash received

from the cashed checks to Steelman, who allegedly kept it as a

large petty cash fund.   Petitioners assert that new vendors

frequently would come by the Flair Body Works locations with very

expensive parts and needed to be paid immediately.   Because

Steelman was not authorized to sign checks for Flair Enterprises,

she allegedly needed the large petty cash fund to make these

purchases.   Petitioners rely on Steelman’s confessed embezzlement

activities to explain the missing cash from the cashed checks,

alleging that Steelman must have stolen the cash if it is

missing.

     Petitioners’ testimony is implausible.   Petitioners offered

no corroborating evidence that Steelman was engaged in buying

parts for the body shop business.   Petitioners have not presented

any records of cash purchases allegedly made by Steelman or any

other cash expenditures by the company.   Trent told the examining

agent that there was no petty cash fund, and Gina Haney testified

that none existed after Steelman was fired and that all cash from

checks cashed by Mrs. Haney after Steelman’s termination went to
                              - 24 -

petitioners.   Regarding the allegations that Steelman embezzled

the cash from the checks regularly cashed by Mrs. Haney, although

the embezzlement investigation and ensuing case against Steelman

was extensive, petitioners did not claim in any court proceeding

or police report prior to this case that Steelman stole cash from

Flair Body Works.   Steelman embezzled funds from Flair

Enterprises through misuse of checks payable to her and through

unauthorized contributions to a 401(k) plan, but we do not

believe that she embezzled cash from the company.

     Rather, the evidence establishes that substantial amounts of

cash received by Mrs. Haney from the checks cashed at

petitioners’ bank were retained by Mrs. Haney and distributed to

petitioner and their two sons.   Furthermore, petitioners admit

and the evidence establishes that substantial amounts of cash

were kept in petitioners’ personal safe at home and in a safe-

deposit box at their bank.

     In addition to determining that the cashed checks were

additional income to Flair Enterprises, and thus to petitioners,

respondent determined that cash deposits into petitioners’

personal checking account totaling $39,000 in 2002 constituted

additional unreported income to petitioners that year.

Petitioners argue that these cash deposits were taken from the

sum of cash received from cashing the above-mentioned checks and,

thus, that respondent is double counting this sum as income to
                                - 25 -

petitioners.     This argument is inconsistent with petitioners’

assertion that the cash received from the cashed checks was not

retained by petitioners but was entrusted to Steelman for an

alleged petty cash fund.     Because no records were maintained

regarding the amount, timing, or source of cash that petitioner

added to his personal safe, and because petitioners’ testimony

regarding the cash transactions was inconsistent and

unpersuasive, petitioners have not met their burden of proving

that respondent erred in including these cash deposits as

additional income to petitioners in the notice of deficiency for

2002.

Additional Employee Embezzlement Account Deduction

        Petitioners assert that they are entitled to an increased

deduction for cash funds allegedly embezzled by Steelman in 2000,

before her embezzlement scheme was discovered.     For the reasons

stated above, we do not believe that Steelman had access to the

cash that Mrs. Haney received upon cashing the checks received by

Flair Enterprises.     Petitioners are not entitled to a deduction

for their Employee Embezzlement Account beyond what respondent

has already allowed.

Claimed Deductions Disallowed

        Respondent disallowed many flowthrough deductions claimed by

petitioners because they related to personal expenses of
                              - 26 -

petitioners and their family or because petitioners failed to

provide the required substantiation.

     Petitioners argue that respondent has refused to recognize

the separate existence of Flair Racing as a business entity.

Petitioners point out that both Flair Enterprises and Flair

Racing are S corporations, and all income and deductions flow

through to petitioners.   However, respondent’s disallowance of

the disputed deductions is founded upon the determination that

Flair Racing was not actively conducting business operations

during the years in issue and upon general tax law principles

defining the limits of deductible business expenses.

     The parties agree that Flair Racing was incorporated to

shield petitioners and Flair Enterprises from liability

associated with the Legends race cars.   However, petitioners

presented no evidence of any business activities in which Flair

Racing engaged during the years in issue.   Petitioner testified

that the Legends race cars were an enjoyable hobby for himself

and his sons.   No racing activities occurred during the years in

issue, and the Legends race cars were not publicly displayed

anywhere outside of the Flair Body Works locations.    We are not

convinced that Flair Racing was carrying on business during the

years in issue.

     Funds deposited in Flair Racing’s bank account and included

as income on Flair Racing’s Federal income tax returns consisted
                               - 27 -

almost exclusively of rebate and incentive payments from B&H and

lease reimbursements from Hudiburg Chevrolet that properly

belonged to Flair Enterprises.    No payments were made from Flair

Enterprises to Flair Racing for advertising or marketing

services.    Flair Racing performed no services, engaged in no

sales during the years in issue, and earned no income in those

years.

     Petitioners argue that the B&H payments to Flair Racing,

which B&H owed to Flair Enterprises under the terms of their

supply contract, were racing sponsorships and were properly

allocated to Flair Racing.    Inconsistent testimony of petitioner

and B&H’s representatives regarding this issue was presented at

trial.    One of B&H’s representatives denied to the auditing agent

that the payments were for a sponsorship.    It appears that he

succumbed to pressure from his sales manager and his customer,

Flair Enterprises, because he later testified at trial that the

payments to Flair Racing did amount to a racing sponsorship.

Another B&H representative testified that B&H would not permit

petitioner to display B&H decals on their vehicles because B&H

could not afford to sponsor their many customers’ other race

cars.    Thus, B&H received no advertising or marketing benefits

from its alleged sponsorship of the Legends race cars, which

benefits are the essence of sponsorship.    See Gill v.

Commissioner, T.C. Memo. 1994-92, affd. without published opinion
                               - 28 -

76 F.3d 378 (6th Cir. 1996).   Furthermore, the evidence

establishes that B&H would have made the required monthly

payments regardless of petitioner’s racing activities.

     All expense deductions claimed by Flair Racing for the years

in issue were either nondeductible personal expenses of

petitioners and their family or business expenses of Flair

Enterprises.   Petitioners claimed deductions on Flair Racing’s

returns for improvements to land where petitioners and their two

sons built their personal residences, the purchase and repair of

a Harley Davidson motorcycle, and depreciation and repair

expenses incurred with respect to the Legends race cars and

trailer.   Additionally, petitioners deducted on Flair Racing’s

tax returns the interest paid on their residential mortgage

secured by the 80-acre tract of land.

     Because we have concluded that Flair Racing was not

conducting business during the years in issue, it is not entitled

to any business expense deductions related to any alleged racing

or advertising activities.   We are convinced that petitioners

reported income as paid to Flair Racing in order to disguise the

personal nature of expenses related to the Legends race cars and

the 80-acre tract of land on which the personal residences of

petitioners and their two sons sit.     Petitioners’ inclusion of

the mortgage interest deduction related to their personal

residence and surrounding land on Flair Racing’s tax returns is
                                - 29 -

further indication of petitioners’ attempts to portray falsely

Flair Racing as an active business operation.

     Petitioners claimed depreciation deductions for several

pieces of heavy construction equipment acquired during the years

in issue.   However, petitioners have not presented any evidence

of the business purpose of most of these items.    Petitioners have

presented some evidence with regard to a tractor and loader

purchase to substantiate a $20,000 section 179 deduction claimed

in 2000 by the company.   Respondent maintains that the tractor

was purchased as a personal asset for use on petitioners’ 80-acre

tract.    Petitioners maintain that the tractor and loader were

used to remove ice and snow from the Flair Body Works locations

and to move wrecked vehicles.    Petitioner testified, however,

that the equipment acquired in 2000 was purchased in anticipation

of buying the 80-acre tract, and it was stored at the tract, not

at the business locations.    He also testified that he thought the

equipment was being depreciated on the schedules for Flair

Racing.   We conclude that petitioners have failed to establish

that the tractor is a business asset, and Flair Enterprises is

not entitled to a section 179 deduction for the purchase of the

tractor in 2000.

     Petitioners have not contested, and have thus conceded,

respondent’s disallowance of deductions from Flair Enterprises’

income for various personal expenses of petitioners or for
                                - 30 -

unsubstantiated expenses.    We sustain the disallowance of these

claimed deductions as determined by respondent.

Fraud Penalty

     The penalty in the case of fraud is a civil sanction

provided primarily as a safeguard for the protection of the

revenue and to reimburse the Government for the heavy expense of

investigation and the loss resulting from the taxpayer’s fraud.

Helvering v. Mitchell, 303 U.S. 391, 401 (1938); Sadler v.

Commissioner, 113 T.C. 99, 102 (1999).     Respondent has the burden

of proving, by clear and convincing evidence, an underpayment for

the years in issue and that some part of the underpayment for

those years is due to fraud.    Sec. 7454(a); Rule 142(b).    If

respondent establishes that any portion of the underpayment is

attributable to fraud, the entire underpayment is treated as

attributable to fraud and subjected to a 75-percent penalty,

unless the taxpayer establishes that some part of the

underpayment is not attributable to fraud.    Sec. 6663(b).

Respondent must show that the taxpayer intended to conceal,

mislead, or otherwise prevent the collection of taxes.       Katz v.

Commissioner, 90 T.C. 1130, 1143 (1988).

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

upon consideration of the entire record.     King’s Court Mobile

Home Park, Inc. v. Commissioner, 98 T.C. 511, 516 (1992).      Fraud

will never be presumed.     Id.; Beaver v. Commissioner, 55 T.C. 85,
                               - 31 -

92 (1970).    Fraud may, however, be proved by circumstantial

evidence and inferences drawn from the facts because direct proof

of a taxpayer’s intent is rarely available.    Niedringhaus v.

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

course of conduct may establish the requisite fraudulent intent.

Stone v. Commissioner, 56 T.C. 213, 223-224 (1971).    Fraudulent

intent may be inferred from various kinds of circumstantial

evidence, or “badges of fraud”, including the consistent

understatement of income, inadequate records, implausible or

inconsistent explanations of behavior, concealing assets, and

failure to cooperate with tax authorities.    Bradford v.

Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo.

1984-601.    Dealing in cash is also considered a “badge of fraud”

by the courts because it is indicative of a taxpayer’s attempt to

avoid scrutiny of his finances.    See id. at 308.   Additional

“badges of fraud” include keeping a double set of books and

handling one’s affairs to avoid making the records usually made

in transactions of the kind.    Spies v. United States, 317 U.S.

492, 499 (1943).    Evidence of fraud also includes a taxpayer’s

use of a business entity to cloak the personal nature of

expenses.    See Romer v. Commissioner, T.C. Memo. 2001-168.

       For the reasons stated above, respondent’s burden regarding

the underpayment of tax in support of the fraud penalty has been

met.    Petitioners’ consistent failure to report taxable income
                                - 32 -

and their improper deductions of personal expenses on the

company’s accounts during the years in issue resulted in

substantial underpayments of tax for those years.

     The evidence in this case also establishes the existence of

several “badges of fraud” in petitioners’ personal and business

transactions.   Petitioners consistently failed to report taxable

income during the years in issue, most notably from checks that

were cashed by Mrs. Haney and never recorded in the company’s

official books.   Petitioner’s solely owned corporation

established and followed a policy of keeping complete and

accurate computerized records for insurance transactions that

would certainly be reported to the IRS by the insurance

companies, but kept only a handwritten list on a notepad of other

checks to the company and did not include the cashed checks as

income to the company during the years in issue.    The practice of

keeping a double set of books in this fashion indicates

petitioners’ fraudulent intent to evade tax liabilities with

regard to the income from checks that were cashed.

     Petitioners’ practice of consistently charging personal

items to business expense accounts of Flair Enterprises and Flair

Racing is additional evidence of fraudulent intent with regard to

their income tax liabilities.    Personal expenses of petitioners

that were charged as business expenses include the downpayment

and closing costs of petitioners’ purchase of the 80-acre tract
                              - 33 -

on which they built their personal residence and the homes of

their two sons.   Substantial expenses related to the improvement

of the 80-acre tract and the construction of the three residences

on site were charged to business accounts.   Petitioner testified

at trial that he paid all the costs of his home and related

improvements out of Flair Enterprises’ account.   Additional

personal expenses deducted from business accounts include dry

cleaning bills, lease payments for personal vehicles, insurance

premiums on a personal water craft and on a Winnebago, utilities

and taxes at petitioners’ lake house, and several personal family

vacations.

     Additional evidence of fraud in this case consists of

inconsistent and implausible explanations of behavior by

petitioners and members of their family that were involved with

their business.   For instance, Trent stated during the audit, as

informed by petitioner, that no checks were being cashed during

the years in issue and all income was deposited into the

company’s account.   Mrs. Haney stated during the audit that no

checks were cashed after Steelman was fired in November 2000.

These statements are contradicted by bank records.   The evidence

establishes and petitioners admit that Mrs. Haney regularly

cashed certain checks payable to Flair Enterprises through

September 2001, and handwritten records regarding such

transactions were maintained substantially by Gina Haney.
                               - 34 -

Furthermore, Mrs. Haney testified extensively at trial about her

regular practice of cashing checks for Flair Enterprises,

asserting that she was the only person who handled cashing

company checks.    Mrs. Haney testified that Steelman’s name was

not on the Flair Enterprises account, and thus Steelman could not

cash checks on the account, because petitioners were concerned

about the possibility of embezzlement in general.    Mrs. Haney

claimed, however, that Steelman required that she cash the checks

and turn over the currency obtained from the bank back to

Steelman on every occasion.    Her testimony is inconsistent,

implausible, and not credible.

     Gina Haney, who was the sole accountant and bookkeeper for

Flair Enterprises after Steelman was fired in November 2000,

represented during the audit that Flair Body Works did not

receive any money from COPART and that there was no written

agreement between Flair Enterprises and B&H.    The evidence

establishes that payments were received regularly from both

COPART and B&H and that the majority of those payments were

regularly converted to cash.

     During the extensive criminal investigation of Steelman’s

embezzlement, no allegation was made by petitioners that Steelman

embezzled cash from Flair Enterprises.    Trent, on behalf of

petitioners, represented during the audit that the company had no

petty cash fund.   Petitioners did not mention the existence of a
                              - 35 -

company petty cash fund during the embezzlement investigation,

but now allege, as discussed earlier, that Steelman maintained a

petty cash fund, into which all the cash from the cashed checks

was placed, and that Steelman took that money with her when she

left.   Petitioners developed this argument only when faced with

substantial income tax deficiencies related to the unreported

income represented by the cashed checks.   The belated,

inconsistent, and implausible representations made by petitioners

are evidence of petitioners’ fraudulent intent.

     Mrs. Haney regularly cashed checks from noninsurance

customers and business associates but deposited checks from

insurance customers.   We are convinced that this pattern was a

deliberate scheme to report only the income that was easily

traceable because of reporting requirements applicable to the

payors.   We conclude that petitioners’ statements and testimony

regarding the cash transactions and the cash kept on hand by them

personally were false.   Petitioners’ last-minute claims that all

cash received by Mrs. Haney at the bank was given to Steelman,

who then stole it, is particularly unconvincing.   To the

contrary, we believe that petitioners have fabricated this

argument as a defense to their own wrongdoing in underreporting

income and overstating deductions.

     The evidence in this case establishing the fraudulent intent

of each petitioner with regard to their understatements of
                             - 36 -

taxable income for the years in issue is clear and convincing.

Petitioners have not proven that any part of the underpayments in

dispute was not attributable to fraud.   See sec. 6663(b).   Upon

consideration of the entire record, we conclude that petitioners

are liable for the fraud penalty determined by respondent under

section 6663(a).

     We have considered the arguments of the parties that were

not specifically addressed in this opinion.   Those arguments are

either without merit or irrelevant to our decision.

     To reflect the foregoing,


                                         Decision will be entered

                                   under Rule 155.
