                        T.C. Memo. 2010-282



                      UNITED STATES TAX COURT



             EDWARD AND ODETTE DAOUD, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12070-04.                Filed December 22, 2010.



     Joseph E. Mudd, for petitioners.

     Laura A. McKenna, for respondent.



                        MEMORANDUM OPINION


     HOLMES, Judge:   The Daouds owned two Wienerschnitzel

franchises in Southern California, both of which gobbled up

unusually large amounts of money.   These expenses grabbed the

Commissioner’s attention and during his audit of the Daouds’ 2000

and 2001 returns, he found that they had reported a large loss on

kitchen equipment they never owned, and lacked substantiation for
                                - 2 -

many of the other deductions that they claimed.      The Commissioner

determined a large deficiency for each year, and wants to add

fraud or at least accuracy-related penalties.      We make our way

through the resulting menu of possibilities to determine the

correct taxes and penalties.

                              Background

     Edward and Odette Daoud are both highly educated.      Mr. Daoud

has a Ph.D. in engineering and an M.B.A., and he worked as the

director of engineering for Ameritech (the telecommunications

company) in 2000 and part of 2001.      By his own account he was

business savvy.   He claimed to have anticipated the downturn in

the telecommunication market, causing him to look for a new job

even before he was laid off in April 2001.      Mrs. Daoud has a

bachelor’s degree in physical science and has taken classes

toward a master’s degree in psychology.      She also managed the

day-to-day operations of the couple’s two Wienerschnitzel

franchises in Southern California:      one in Cypress and the other

in Irvine.

     In addition to wage and business income, the couple earned

rent on a house they owned in Austin, Texas.      Yet despite their

many sources of income, the Daouds reported zero taxable income

in both 2000 and 2001 after claiming a combination of losses and

deductions.   The largest of all were business expenses from their

Wienerschnitzel operations.    These claimed expenses reduced the
                                - 3 -

more than $1 million in combined yearly sales the restaurants

produced to $22,000 of income in 2000 and a $7,000 loss in 2001.

The Commissioner sent the Daouds a notice of deficiency.      We

tried the case in Los Angeles, where the Daouds lived when they

filed their petition.

I.   The Deficiency and the Amounts at Issue

     Our first task was to determine what expenses are at issue

and in what amounts.    This was complicated by the way the

Commissioner made adjustments to the Daouds’ returns, and by how

Mr. Daoud prepared the returns in the first place.

     According to Mr. Daoud’s testimony, his wife kept the

Wienerschnitzels’ books on handwritten daily logs.    He would then

take these daily logs and transfer the information onto his

Quicken software program.    Once all the information was entered,

he was able to use the program to generate reports.    He claims

that it was from his Quicken reports that he prepared the

couple’s tax returns.

     The curious thing about this claim is that many of the

amounts on the Quicken reports do not match the amounts listed on

the Daouds’ returns.    The revenue agent nevertheless allowed the

Daouds to substantiate their expenses with these Quicken reports.

She made a few exceptions, but if an expense was documented on

the Quicken reports, she generally allowed it--even if the amount
                                - 4 -

was greater than the Daouds reported on their returns.1      A

consequence of allowing the Daouds amounts for certain expenses

greater than those which they reported on their returns is that

if they can substantiate all the expenses still in dispute, their

net income would be even less than what they originally reported.

     We also had difficulty determining the amounts in dispute

because the revenue agent inadvertently increased the Daouds’

Schedule C income by sometimes disallowing the same expense

twice.    She first disallowed the expenses under an adjustment

labeled “Other Expenses,” which included her changes to the

stores’ 2000 and 2001 Schedule Cs.      She then disallowed some of

the same expenses in other parts of the notice of deficiency.      We

have corrected her mistakes in making our calculations and

constructing our tables.

     A.     Schedule C Income and Deductions

     The following tables summarize the adjustments made to the

Daouds’ Schedule C income:




     1
       From the “Explanation of Items” prepared by the revenue
agent it appears that she used this examination method for both
2000 and 2001, but neither party introduced the 2001 Quicken
reports into evidence.
                                   - 5 -

           Summary of Cypress’s Schedule C Adjustments
                                     2000                      2001
                                                           Per
                             Per Return     Per IRS                   Per IRS
                                                         Return
Net gross receipts            $648,071     $647,462     $664,827   $664,820
COGS                           336,998      316,090      320,996    320,996
Advertising                     38,885       38,885       39,890     39,890
Car & truck                     14,719        -0-          5,317     -0-
Commissions/fees                32,404       32,404       33,241     33,241
Depreciation                     9,018        -0-          6,482      -0-
Insurance                        4,633        2,314        4,994      1,875
Mortgage interest               10,029        -0-          5,324      -0-
Other interest                   -0-           2,0671      ---        ---
Legal & professional fees        3,965        -0-          5,880      -0-
Pension/profit sharing           ---          ---          2,250      -0-
Office expenses                 14,309        -0-         17,692      -0-
Rent or lease: Auto,
                                11,075       -0-         21,075        -0-
  machine & equipment
Rent or lease: Other
                                71,308       73,957      88,640        72,000
  business property
Repairs & maintenance            6,706        3,072      16,451           975
Supplies                         7,692       15,736       2,307           833
Taxes & licenses                25,829        5,088      27,581             25
Travel                           6,710        -0-         3,238         -0-
Meals & entertainment            1,752        -0-         1,383         -0-
Utilities                       24,019       18,9802     24,201        24,201
Charitable contributions         3,189        -0-         3,890         -0-
Contracted services              2,360        2,701       2,418         2,433
Laundry                            490        -0-           583         -0-
Pest control                       480        -0-           600           504
Trash                            2,194        2,045       2,183         2,320
Uniforms                         1,604          727       2,116         1,310
  Total net income              17,703      133,396      26,095       164,217
     1
        The Daouds incorrectly categorized “Other interest” as “Mortgage
interest.” The Commissioner disallowed this entire amount--it wasn't interest
on a mortgage--but then allowed the amount the Daouds could substantiate as
“Other interest.”
      2
        The Commissioner at first gave the Daouds an increased deduction for
utilities of $27,252 but then reduced it by $8,372.
                                         - 6 -

                Summary of Irvine’s Schedule C Adjustments
                                         2000                         2001
                                Per Return    Per IRS       Per Return     Per IRS
 Net gross receipts              $464,856    $463,401        $431,320     $431,320
 COGS                             260,352     258,1021        250,825      250,825
 Advertising                       27,892      27,905          26,047       26,047
 Car & truck                       12,951       1,201          15,586        -0-
 Commissions/fees                  23,243        23,251        21,566        21,566
 Depreciation                          1,882     -0-           1,466         -0-
 Insurance                             1,222     2,614         1,222         1,222
 Mortgage interest                     4,465     -0-           3,220         -0-
 Other interest                        ---       ---           ---           ---
 Legal & professional fees             2,760     -0-           2,988         -0-
 Office expenses                       5,614     4,918         3,938         -0-
 Rent or lease: Auto,
                                       9,744      1,980         2,794        -0-
   machine & equipment
 Rent or lease: Other
                                   46,879        50,532        72,000        72,000
   business property
 Repairs & maintenance              4,286           990         5,065         1,000
 Supplies                          ---            ---           1,625         -0-
 Taxes & licenses                  30,483         2,497        26,915         -0-
 Travel                             2,072         -0-           1,989         -0-
 Meals & entertainment              ---           ---           1,172         -0-
 Utilities                         19,681        20,362        19,782        19,782
 Charitable contributions           1,960         -0-             788         -0-
 Contracted services                  931         -0-           1,932         -0-
 Laundry                              490         -0-             490         -0-
 Pest control                         438         -0-             458           458
 Trash                              1,492         1,260         1,512         1,408
 Uniforms                           1,524         -0-           1,689             88
 Misc. materials                    -0-          10,053         -0-             827
   Total net income                 4,495        57,736       (33,749)       36,097
      1
        The Commissioner at first increased Irvine’s COGS by $304, but then
adjusted it downward by $2,590. The net amount is listed.

                            Total Schedule C Adjustments
                  Cypress                                     Irvine
       2000                   2001                 2000                   2001
     $115,693               $138,122              $53,241                $69,846
                                     - 7 -

     The parties compromised or conceded some of these

adjustments.    What’s left for us to decide are the following

amounts (in each instance the difference between the parties’

final positions):

                 Schedule C Expenses Still at Issue
                                            Cypress              Irvine
                                        2000       2001    2000        2001
Cost of goods sold                    $20,908      ---    $2,250       ---
Car & truck                            14,719    $5,317   11,750     $15,586
Depreciation                            9,018     6,482    1,882       1,466
Insurance                               2,319     3,119    ---         ---
Mortgage interest & other interest      7,962     5,324    4,465       3,220
Legal & professional services           3,965     5,880    2,760       2,988
Pension/profit sharing                   ---      2,250      ---        ---
Office expenses                        14,309    17,692      696       3,938
Rent or lease: Auto, machine &         11,075    21,075    7,764       2,794
  equipment
Rent or lease: Other business           ---     16,640      ---        ---
  property
Repairs & maintenance                   3,634    15,476    3,296      4,065
Supplies                                 ---      1,474     ---       1,625
Taxes/licenses                         20,741    27,556   27,986     26,915
Travel                                  6,710     3,238    2,072      1,989
Meals & entertainment                   1,752     1,383     ---       1,172
Utilities                               5,039     ---       ---        ---
Contracted services                      ---      ---        931      1,932
Laundry                                   490       583      490        490
Pest control                              480        96      438       ---
Trash collection                          149      ---       232        104
Uniforms                                  877       806    1,524      1,601
 Total                                124,147   134,391   68,536     69,885

The parties did stipulate that the Daouds are not entitled to any

of the deductions claimed for charitable contributions.

     B.    Schedule A Deductions

     The Commissioner challenged two of the Daouds’ Schedule A

deductions from 2000: $3,640 in claimed gift/jewelry expenses and

$10,183 for mileage.      The Daouds conceded after trial that they

aren’t entitled to any Schedule A deductions beyond those already
                                 - 8 -

allowed by the Commissioner, but they are still relevant for our

determination of penalties.     The Daouds also concede that they

failed to report a $2,565 state-income-tax refund received in

2000.     The Daouds were required to include this amount because

their 1999 Schedule A claimed a deduction for all of the state

income taxes paid, including the amount that they overpaid.

     C.      Gain on the Sale of the Irvine Wienerschnitzel

     In the notice of deficiency, the Commissioner adopted the

calculations of the revenue agent and determined that there was

unreported gain realized on the sale of the Irvine business in

2001.     The Daouds purchased the Irvine Wienerschnitzel in 1994

for approximately $200,000, and sold it for about $350,000.     The

IRS determined that the adjusted basis in the business was

$236,166.55, which included the cost of improvements made by the

Daouds in 2001.     In addition, it was determined that the Daouds

had an available net capital loss of $88,896 that could offset

some of the gain realized on the sale.

     Out of the $54,866 gain subject to tax, he also determined

that $38,848 was ordinary income under section 12502 and the rest

was capital gain.     He arrived at these numbers by starting with

the amount paid by the Daouds for the Irvine Wienerschnitzel in

1994, about $200,000, and divided it by 39 years--the recovery



     2
        Unless otherwise noted, all section references are to the
Internal Revenue Code; all Rule references are to the Tax Court
Rules of Practice and Procedure.
                                 - 9 -

period for nonresidential real property under section 168.    From

that calculation he concluded that the depreciation allowed per

year under a straight-line method was $5,128.    He then multiplied

$5,128 by the number of years the Daouds owned the Irvine

franchise, coming to $38,848.    Because $38,848 was found to be

“section 1250 income,”3 he presumed that the remaining $16,018

was capital gain.    Eventually the parties agreed that the Daouds

realized only a $12,325 capital gain, but the Commissioner’s

determination of section 1250 income is still at issue.

     D.     Penalties

     On their 2000 return, the Daouds reported a $110,015 loss on

the sale of kitchen equipment.    As a result, the revenue agent

requested documentation from the Daouds substantiating this loss;

and Mr. Daoud gave the agent a document titled “CONTRACT” that

was written on SILVA/MBA II Restaurant Equipment letterhead.     The

document was a bid from SILVA listing new equipment and equipment

upgrades that the Daouds would have to buy before they could sell

the Irvine Wienerschnitzel.   The total amount of SILVA’s bid was

$110,015.

     When the revenue agent received the bid she noticed a couple

of odd things about it.   The document was signed by Edward Daoud

but the line for Michael Freed, one of the contractor’s partners,



     3
        The terms “section 1250 gain,” “section 1250 recapture,”
and “section 1250 income” refer to the amount of ordinary income
required to be recognized under section 1250.
                               - 10 -

was blank.   It also appeared as though the date on the document

had been altered to read March 1, 2000.    Her suspicions prompted

her to issue a summons to SILVA.    SILVA quickly sent her a list

of bids it had made for the Daouds’ Irvine Wienerschnitzel, and

three canceled checks totaling $31,241 written by the Daouds.

One of the bids on the list was for $110,015 and was made on

March 1, 2001.    From this the revenue agent determined that the

document provided by Mr. Daoud had been altered, causing her to

disallow the kitchen-equipment loss and apply a civil-fraud

penalty under section 6663 for the amount of the deficiency

attributable to the kitchen equipment loss, and accuracy-related

penalties under section 6662 for the rest.

      At the end of trial, however, the Commissioner orally moved

under Rule 41(b) to conform the pleadings to the evidence

presented.   He now wants us to attach the civil-fraud penalty to

the full amount of the underpayment for both tax years.    And, as

an alternative, he asks us at least to apply the accuracy-related

penalty under section 6662 to whatever amount we determine is not

subject to the civil-fraud penalty.     The Daouds did not object to

the Commissioner’s motion, and both parties have specifically

addressed the merits of the issue in their briefs.

II.   The Trial

      The Daouds were unable to substantiate many of their

deductions at trial, and Mr. Daoud’s testimony did not help their

case.   Mr. Daoud conceded that he and his wife were not entitled
                              - 11 -

to the loss on the sale of kitchen equipment, but he tried to

explain why he reported a loss for equipment he had neither

bought nor sold.   He testified that he was unsure how the

$110,015 loss got on his return, but he speculated that the bid

was mixed up with all the other paperwork on his desk, which

caused him to enter it into Turbo Tax by mistake.    He also

testified that the date he recorded on the Form 4797, Sales of

Business Property, as the date that he sold the equipment was

simply one that he chose at random after Turbo Tax prompted him

to enter a date.   He went on to explain that he gave the altered

document to the revenue agent “out of panic.”

     During the remainder of Mr. Daoud’s direct examination, he

proffered numerous bits of evidence and explained how each piece

substantiated the Daouds’ deductions and expenses.    One of these

exhibits included two mileage logs and various receipts from

airline, hotel, and car rental companies.   Mr. Daoud offered this

exhibit to substantiate the travel-expense deductions he claimed

for his job search and for the Wienerschnitzel restaurants.

     The two mileage logs--especially the dates on them--are

particularly interesting.   On the first entry of the first log,

Mr. Daoud filled in 1/7/00 for the date, wrote his destination,

the business purpose, and the miles driven.   The log continues

sequentially until 12/18 when just the day and month are noted.

On the second log the dates start over with 1/5/00 and the log

again continues sequentially with just the day and month written
                                  - 12 -

from 1/9 until 11/27.      Some of the dates appear twice and others

do not.   The Commissioner’s counsel wondered why Mr. Daoud had

two logs for the same year, and during the cross-examination she

asked him:

     Q      Are they all for 2000, or could you explain that
            to us?

     A      It looks like both of them are for 2000.

                 *     *      *     *      *       *     *

     Q       And you don’t have one for 2001?

     A       I may. I don’t really know.

     During the next part of her cross-examination, the

Commissioner’s counsel asked Mr. Daoud about his other travel

expenses.     She questioned him about the dates of specific trips

and the corresponding business purpose.        For each trip, Mr. Daoud

explained who interviewed him or described a Wienerschnitzel

function that he and his wife attended.        One of the receipts Mr.

Daoud was questioned about came from a hotel in Lake Tahoe.        The

receipt showed that two adults checked into a hotel on December

22, 2001, and checked out on the 26th.         Mr. Daoud explained that

this trip was for a Wienerschnitzel conference.        The

Commissioner’s counsel found it odd and asked:

     Q       Would you characterize this as a Christmas
             conference?

     A       It is not really up to us when they hold it.
             It is when they hold it and we go to it.

     Q       Do they typically hold Wienerschnitzel
             conferences over the Christmas holidays?
                              - 13 -

     A    Occasionally, yes, they do.   This is on the request
          of the franchisees.

     The Commissioner’s counsel continued asking Mr. Daoud

questions about specific receipts but soon returned to the

mileage logs to ask about specific dates listed.    For example:

     Q    And on 2/7, you went to Mission [Viejo]?

     A    Yes.

     Q    And who did you interview with there?

     A    Another employer. I don’t really remember the
          name.

                 *   *    *     *       *      *     *

     Q    On 2/16, you went to Santa Monica?

     A    It looks like Santa Monica.

     Q    Okay. And on 2/19 you went to Riverside?

     A    Yes.

     Q    And who did you interview with in Santa Monica?

     A    I don’t really remember.

     Q    Okay. But you had an interview?

     A    Yes, all these are interview related.

     Q    Okay. And who did you interview with in
          Riverside?

     A    Give me a second, please. I believe it was--I
          believe they are a subsidiary, and I don’t
          remember exactly their name.

     Having gotten what she wanted from Mr. Daoud, the

Commissioner’s counsel asked him to compare the dates on the

receipts with those on the mileage logs:
                                  - 14 -

     Q    All right. Mr. Daoud, we have now just gone over
          some of your travel, and I am just curious. Isn’t
          it true that you just testified that on February 7,
          2000, you were on an interview in Mission [Viejo]?
          Yet, you have also testified that * * * on 2/7
          * * * you were in Portland? * * *.

     A    It can be. Something in the morning and something
          in the afternoon.

     Q    And so you went to both of them?

     A    Possibly.

     Q    Okay. Now what about how you just testified that
          on 2/14 that you were in Long Beach, and on 2/16,
          * * * were in Santa Monica, and on 2/19, you were
          in Riverside for interviews. Yet at the same time,
          you were in Korea between 2/13 and 2/19? How can
          that be? That’s quite a far distance.

              *       *   *         *      *    *     *

     A    The Korea trip * * * was 2001.

                 *    *      *       *     *     *     *

     Q    This is your ticket to Korea, correct?

     A    Yes.

     Q    And if you look at the date of issue, February 9,
          2000 and not 2001, correct?

     A    It looks like it.

     Through further cross-examination, the Commissioner’s

counsel showed that the mileage logs placed Mr. Daoud in Oxnard

on the same day he was in Toronto, in California when he was in

Illinois, at interviews in several California cities when he was

apparently in London, and in San Jose and Santa Monica when he

was shown to be in Hawaii.       Mr. Daoud then conceded that it was

possible that the mileage logs reflected two separate years, one
                                - 15 -

for 2000 and one for 2001.   But even if we assume that the

mileage logs cover both years, it would not explain the

inconsistences between the logs and Mr. Daoud’s other travel

receipts.   This extraordinarily effective cross-examination

substantially undermined Mr. Daoud’s credibility and the value of

any of the evidence that he himself created.

                             Discussion

I.   The Commissioner’s Motion To Amend the Pleadings

     We must first decide whether to grant the Commissioner’s

motion to conform the pleadings to the evidence presented at

trial, to let him assert a fraud penalty for both 2000 and 2001.

See sec. 6214(a); Rule 41(b).    Rule 41(b)(1) treats an issue as

if raised in the pleadings if it was tried with the express or

implied consent of the parties.    See, e.g., LeFever v.

Commissioner, 103 T.C. 525, 538-39 and n.16 (1994), affd. 100

F.3d 778 (10th Cir. 1996).   That’s what happened here.    The

Daouds failed to object to the Commissioner’s motion at trial.

The facts giving rise to the Commissioner’s motion were raised

during trial, and without objection.      And both parties addressed

the substance of whether the civil-fraud penalty should be

applied to the entire 2000 and 2001 deficiency in their briefs.

There’s also no surprise here--the evidence on which the

Commissioner bases his motion comes from Mr. Daoud’s own

testimony and the facts stipulated by the parties.     We will
                                  - 16 -

therefore grant the Commissioner’s motion and allow him to assert

the additional civil-fraud penalties.4

II.   Substantiation of the Disputed Schedule C Items

      The parties dispute $192,683 of Schedule C expenses for 2000

and $204,276 for 2001.     The Daouds deducted expenses in multiple

categories, but we divide them into two:      (1) expense categories

for which the Daouds have offered no evidence, and (2) expense

categories that the Daouds actually tried to substantiate.       We

quickly deal with those items that fall into the first category.

Because the Commissioner’s determination is presumed correct,

without further evidence the Daouds have not met their burden of

proof.     See Rule 142(a).   The Daouds therefore have failed to

substantiate the disputed portions of the following categories of

expenses:     car and truck, depreciation, pensions and profit

sharing plans, utilities, legal and professional fees, and

laundry.

      We next consider whether the Daouds have substantiated any

of the remaining expenses.

      A.     Cost of Goods Sold

      The Commissioner says that the Daouds aren't entitled to

$23,158 of their cost-of-goods-sold adjustment--the difference

between the total cost of goods sold reported on the Daouds’ 2000



      4
       He of course bears the burden of proving that the penalty
is warranted by clear and convincing evidence. See sec. 7454(a);
Rule 142(b).
                              - 17 -

return and the corresponding amount listed on the Quicken

reports.   The Daouds don't attempt to reconcile this discrepancy.

Instead they argue that the amounts they claimed were reasonable,

and thus should be allowed in full.    But we don't believe that

the Commissioner acted unreasonably in denying less than four

percent of the Daouds’ claimed cost of goods sold in 2000.    This

is especially true given the fact that the revenue agent relied

on the Daouds’ own Quicken reports in reaching her conclusion.

     The Daouds also tried to substantiate the disputed portion

of the cost of goods sold with an exhibit containing page after

page of photocopied receipts from grocery stores and wholesale

clubs.   These receipts are of little value.   Without an

explanation from the Daouds, it is impossible for us to

distinguish items used at their Wienerschnitzels from those used

by them personally.   Many of the items on the receipts are

household or personal care products, or food and drink (e.g.,

liquor) that we find were probably not served or used at their

restaurants.   We therefore sustain the Commissioner’s cost-of-

goods-sold adjustment for 2000.5




     5
       The Daouds entered into evidence a number of checks
written to their payroll-service company. The Commissioner
allowed the funds paid on these checks as part of cost of goods
sold. These checks do not, therefore, substantiate any of the
expenses still in dispute.
                               - 18 -

     B.    Insurance

     The parties dispute only the Cypress restaurant’s insurance

expenses for 2000 and 2001.    The Commissioner did allow $2,314 of

the $4,633 amount claimed for 2000, and $1,875 of the $4,994

amount claimed for 2001.    But the Daouds argue that they are

entitled to the full amount and offer invoices from their

insurance agent, and a policy summary from their insurance

carrier.   According to these documents, the insurance premium for

the Cypress Wienerschnitzel in 2001 was about $2,000.    (The

Daouds introduced no evidence on their 2000 insurance expense.)

Although the $1,875 the Commissioner allowed is less than the

premiums shown on the documents, the Daouds have not proven that

they paid those premiums.    We therefore find in favor of the

Commissioner.

     C.    Mortgage and Other Interest

     The parties dispute $13,286 of the mortgage-interest expense

claimed for 2000 and $7,685 for 2001.    The Commissioner

disallowed these expenses because the Daouds were renters, not

owners, of their Wienerschnitzels’ real estate.    Mr. Daoud

conceded that the mortgage label wasn't proper, but said that he

had just mistakenly reported as mortgage interest the interest

they paid to finance their purchase of restaurant equipment.     As

proof, he offered canceled checks totaling $15,807 written to a

credit union in 2001.   These checks and Mr. Daoud’s testimony

don’t prove that the payments were being made on a business, and
                              - 19 -

not a personal, loan; therefore, we find that they failed to

substantiate the disputed interest expenses.

     D.   Equipment Lease

     The Commissioner disputes equipment-lease deductions

totaling $18,839 for 2000 and $23,869 for 2001.   The Daouds claim

that part of the 2000 equipment-lease expense was for an ice

machine at their Irvine restaurant that cost $165 per month.    To

substantiate this expense, they introduced a leasing contract for

years other than 2000 and canceled checks showing that they made

their payments.   These are the types of records we like to see,

but the Commissioner is also correct that on this point they were

superfluous--he had already allowed the ice-machine expense.6

     The only evidence the Daouds provide to substantiate the

rest of their equipment-lease expenses is a stack of canceled

checks written to three different banks.   As with the mortgage-

interest expense, they did not provide any additional

documentation to show the purpose for those checks.   And our

examination of the 2000 Quicken reports showed checks written to

the same banks for the same amounts also showing up as “Mortgage

interest expense,” “Other interest expense,” and “Misc.

materials” and “Supplies.”   Such double-duty doesn’t work: the




     6
       The Daouds originally claimed $9,744 and the Commissioner
allowed $1,980 ($165 x 12 months), leaving the disputed balance
of $7,764.
                                - 20 -

Daouds aren’t entitled to claim any of the disputed equipment-

lease expenses.

     E.     Lease Expense:   Other Business Property

     The parties’ only dispute in this category is over the

expense of leasing the building and land used by the Cypress

Wienerschnitzel in 2001.     The Commissioner allowed $72,000 of the

$88,640 claimed.

     The Daouds argue that they are entitled to a deduction for

the money they paid the franchisor under a common-area

maintenance contract, about $395 a month.     But the invoices

offered are for the Irvine, not the Cypress, store and from 2000,

not 2001.    The Daouds did not provide us with Cypress’s lease or

any other evidence showing Cypress’s obligation to pay this

amount.

     We nevertheless found, buried deep within one of the

Commissioner’s exhibits, copies of eight checks drawn on

Cypress’s bank account and deposited by the building’s lessor.

Five checks are for $6,129.69 and three are for $6,341.73.       We

find these checks substantiate eight rent payments made for eight

different months in 2001.

     Although the Daouds cannot fully substantiate their rental

expense for the entire year, under Cohan we can approximate the

allowable amount if we have a reasonable basis to do so.     Cohan

v. Commissioner, 39 F.2d 540, 543-44 (2d Cir. 1930); Vanicek v.

Commissioner, 85 T.C. 731, 742-43 (1985).     Therefore, we will
                                 - 21 -

allow the Daouds to claim $6,129.69--the lesser of the two

amounts listed on the checks--for each of the four months not

proven directly.      This is a small victory for the Daouds:    We

find substantiation of $74,192.40 of their lease expenses for

2001, which comes out to be $2,192.49 more than the Commissioner

allowed.

     F.     Repairs

     The Daouds offered copies of checks to prove the disputed

repair expenses of $6,930 for 2000 and $19,541 for 2001.        Three

of the checks were written from the Irvine Wienerschnitzel’s bank

account in 2000, and their total is less than the amount already

allowed by the Commissioner for this category.        The fourth check

was written from the Daouds’ personal account in 2001, and the

only evidence offered to explain its purpose is Mr. Daoud’s

testimony that it was for repairs.        We are not persuaded, and

find that the Daouds have not substantiated the disputed repair

expenses.

     G.     Supplies

     Included with the receipts previously discussed are ones

from Home Depot and Restaurant Depot, which the Daouds argue

substantiate their deductions for supplies.        During his

testimony, Mr. Daoud claimed that these receipts were for

restaurant supplies.      We do find Mr. Daoud’s claims more likely

than not true for the items that he bought at Restaurant Depot,

but the things he bought at Home Depot could just as likely have
                                - 22 -

been used by the Daouds at home.    The Daouds’ inability to prove

that these items were bought for a business purpose is not the

only problem here--the total amount the Commissioner allowed the

Daouds for supplies is greater than the total amount they claimed

on their returns.7   And while $3,099 is still in dispute for 2001

($1,474 for Cypress and $1,625 for Irvine), the Daouds have not

provided any specific proof that these receipts correspond to

that amount.   We again find for the Commissioner.

     H.   Taxes & Licenses

     The Commissioner and the Daouds continue to argue over

property taxes and licensing fees.       For the Cypress store, the

Commissioner allowed only $5,088 for 2000 and $25 for 2001; for

the Irvine store, he allowed $2,497 for 2000 and nothing for

2001.

     Even though the Daouds did not own the property their

Wienerschnitzels sat on, they claim that both franchise

agreements required them to pay property taxes.       If true, this

would be a proper business deduction, though properly reportable

as part of their rental/lease expense.       See sec. 162(a); sec.

1.162-11(a), Income Tax Regs.    But here again they produce no


     7
       On Cypress’s Schedule C for 2000, the Commissioner allowed
a $15,736 deduction for “Supplies” even though the Daouds claimed
only $7,692. Nothing was claimed or allowed for Irvine in 2000.
And for 2001, the Commissioner allowed $833 of Cypress’s $2,307
supply expense, and zero of Irvine’s $1,625 supply expense.
Thus, the total deduction allowed by the Commissioner for
supplies, $16,569, is $4,945 more than the total deductions taken
by the Daouds on their returns.
                              - 23 -

records for the Cypress store, and so we find for the

Commissioner on this issue.

     The Daouds did produce invoices for real-property taxes on

the Irvine store for two fiscal years: 1999-2000 and 2000-2001.

The tax liabilities shown were for $4,816 and $4,894.82,

respectively.   They also provided records showing that their

landlord billed them for the Irvine property’s taxes (plus a copy

of a $424 bill from the City of Orange for health-service fees).

     Invoices by themselves don’t prove payment.   But the Closing

Statement generated by Heritage Escrow Company, documenting the

sale of their Irvine business in November 2001, confirms that

they were current on their real-property taxes and health-service

fees through the closing date.   Though the documentation is

sparse, we do find it more likely than not that the Daouds paid

real property taxes totaling $4,856 in 2000 and $4,283 in 2001.8

We also find it more likely than not that the Daouds paid $424 in

health-service fees in 2000 and $347 in 2001.   After subtracting

what the Commissioner previously allowed, the Daouds are entitled

to claim an additional $2,783 for 2000 and $4,630 for 2001.

     I.   Travel, Meals, and Entertainment

     The Daouds argue that they are entitled to deduct $10,534 in

expenses for travel to Lake Tahoe in 2000, and $7,782 for travel

to Hawaii for a Wienerschnitzel conference in 2001.   They showed


     8
       Because the Daouds sold their business in November 2001,
the expenses for “Taxes & Licenses” are less in 2001.
                                - 24 -

receipts from these trips and Mr. Daoud testified about the

trips’ business purpose.     While we believe that the

Wienerschnitzel organization has conferences, we do not believe

Mr. Daoud’s testimony that these trips were for those

conferences.     We need corroboration, especially given Mr. Daoud’s

claim that he and Mrs. Daoud were in Lake Tahoe on Christmas Day

for a conference.    Even if we credited his testimony on this

point, section 274(d) requires enhanced substantiation for travel

expenses which neither Daoud supplied.     We therefore find that

they are not entitled to deduct these travel expenses.

     The Daouds also claim that the numerous restaurant receipts

introduced into evidence were for meals with suppliers and other

people related to the Wienerschnitzel business.     Mr. Daoud cannot

remember the specifics of the meals, but he assured us in his

testimony that they were for business.     This testimony also lacks

the specificity that section 274(d) requires.     We find that the

Daouds can’t deduct these meals.

     J.     Other Expenses

            1.   Contracted Services

     To substantiate the deductions for contracted services, the

Daouds offer copies of checks written to various individuals.

The Daouds, however, failed to explain what the individuals did

for them.    The only explanation they gave is that one of the

individuals was a labor contractor who helped out at their Irvine

store.    With only the checks and Mr. Daoud’s testimony, we are
                                 - 25 -

not convinced that the money was spent for a business purpose.

Therefore, we will allow neither the disputed $931 for 2000 nor

the disputed $1,932 for 2001.

            2.    Pest Control

     The Commissioner allowed the Daouds almost $1,000 for pest-

control expenses in 2001, but the parties still fight over $918

in 2000 and an extra $96 in 2001.      To support their claim, the

Daouds offer invoices from Lloyd Pest Control for $692 billed and

dated 2001.      But they don’t argue that these invoices

substantiate expenses disallowed by the Commissioner, nor do they

offer any evidence to substantiate any 2000 expense for this

category.    We find for the Commissioner on this issue as well.

            3.    Trash Collection

     The Commissioner allowed the Daouds most of their claimed

expenses for trash collection, including an amount greater than

what they claimed on their 2001 returns for their Cypress store.

But the Daouds say they should still be able to deduct an extra

$381 in 2000 ($149 for the Cypress store and $232 for Irvine

store) and $104 in 2001 (for the Irvine store).      The Daouds

produced a few invoices billed to the Cypress location, but the

Commissioner already allowed an amount greater than the total of

the invoices.      The Daouds’ failure to show how the invoices prove

any disputed amount forces us to toss this argument.        We find

that the Daouds failed to substantiate the disputed trash-

collection expense.
                               - 26 -

            4.   Uniforms

     The disputed uniform expenses are $2,401 for 2000 and $2,407

for 2001.    To substantiate these expenses, the Daouds offer only

invoices sent to their Cypress Wienerschnitzel in 2001.   The

invoices total $1,310, which is the exact amount the Commissioner

allowed their Cypress store for that year.   Because no other

evidence was provided, we find that the Daouds have not

substantiated the disputed portions of the uniform expense.

III. Depreciation Recapture

     The parties agree that the Daouds realized at least $12,325

of capital gain on the sale of their Irvine Wienerschnitzel in

2001, so we need to decide only if the Daouds are liable for the

$38,848 of section 1250 gain.9

     As we’ve already briefly noted, in calculating the Daouds’

section 1250 income the Commissioner started out with the

purchase price of the Irvine Wienerschnitzel in 1994


     9
       The only argument the Daouds make to dispute their
liability for section 1250 gain is that the parties agreed in the
stipulation that $12,325 was the amount of gain that should have
been recognized in 2001; therefore, the Commissioner is estopped
from asserting any additional gain under section 1250. But the
stipulation states only that the Daouds “received capital gain in
2001 from the sale of their Irvine Wienerschnitzel in the amount
of $12,325 * * *.” It does not stipulate to the overall gain
realized on the sale. Given that this Court applies general
contract principles when interpreting tax-settlement agreements,
the Daouds’ position is without merit. See, e.g., Dutton v.
Commissioner, 122 T.C. 133, 138 (2004). Parties “are bound to
the terms agreed upon and not to the premises underlying their
agreement[.]” Pack v. United States, 992 F.2d 955, 959-60 (9th
Cir. 1993) (citing Zaentz v. Commissioner, 90 T.C. 753, 761
(1988)).
                              - 27 -

(approximately $200,000) and divided it over 39 years--the

recovery period for nonresidential real property.    See sec.

168(c).   He then calculated that the annual allowable

depreciation under a straight-line method was $5,128 which, when

multiplied by the years that the Daouds owned the Irvine

franchise equaled $38,848.

      The math works, but the reasoning is wobbly.   Section 1250

applies to real property depreciable under section 167 (i.e.,

used in a trade or business) other than section 1245 property.

See secs. 167(a), 1250(c); sec. 1.1250-1(e)(3), Income Tax Regs.

When section 1250 property is disposed of (e.g., sold or

exchanged), a taxpayer generally has to recognize as ordinary

income the lesser of (1) the “additional depreciation,” or (2)

the taxpayer’s gain on the disposition of the property.    See sec.

1250(a)(1); sec. 1.1250-1(a), Income Tax Regs.   Additional

depreciation--for property acquired after 1975 and held for more

than one year--is usually the amount of depreciation (or

amortization) claimed by the taxpayer in excess of the amount

allowed under a straight-line method.10   Sec. 1250(b)(1); sec.

1.1250-2(a), Income Tax Regs.; see, e.g., Universal Mktg., Inc.




     10
       The straight-line method requires taxpayers to take
depreciation deductions evenly over an asset’s useful life or
recovery period--roughly, the asset’s cost divided by the number
of years required by the Code. See sec. 1.167(b)-1, Income Tax
Regs.
                                - 28 -

v. Commissioner, T.C. Memo. 2007-305; Murry v. Commissioner, T.C.

Memo. 1993-471.

     “[S]ection 1250 property” is usually a building, including

its structural components, owned by the taxpayer and used in his

trade or business.    See secs. 1245(a)(3), 1250(c); Hosp. Corp. of

Am. v. Commissioner, 109 T.C. 21, 56 (1997).     A leasehold

interest in land or a building, which is what the Daouds held in

their Irvine Wienerschnitzel, may also qualify as section 1250

property.     Sec. 1250(c); sec. 1.1250-1(e)(3), Income Tax Regs.;

see also Kingsbury v. Commissioner, 65 T.C. 1068, 1090 (1976).

But tangible and intangible personal property used in the

taxpayer’s trade or business does not--it’s governed by section

1245.11    See sec. 1245(a)(3); Hosp. Corp., 109 T.C. at 56-92

(discussing the differences between section 1250 and section 1245

property).

     Under section 1245, all deductions for depreciation are

recouped as ordinary income to the extent a taxpayer realizes a

corresponding gain on the disposition of his section 1245

property.12    See e.g., sec. 1245(a); Buffalo Tool & Die Mfg. Co.

v. Commissioner, 74 T.C. 441, 445 (1980).     Like section 1250,

section 1245 only applies when a gain is realized.    The key



     11
       Section 1245 also includes some real property used in
mining, manufacturing, and certain service industries. See sec.
1245(a)(3)(B)-(C).
     12
          See section 1245(b) for the exceptions and limitations.
                                - 29 -

distinction between the two sections is that section 1245

recaptures all depreciation deductions affecting the adjusted

basis of the property, and section 1250 only recovers “additional

depreciation.”

     Because the Code treats section 1250 and section 1245

property differently, the regulations require gain to be computed

separately for each type of property.    See secs. 1.1245-1(a)(5),

1.1250-1(a)(6), Income Tax Regs.; Kingsbury, 65 T.C. at 1090.

Section 1.1245-1(a)(5), Income Tax Regs., states:

     In case of a sale, exchange, or involuntary conversion
     of section 1245 and nonsection 1245 property in one
     transaction, the total amount realized upon the
     disposition shall be allocated between the section 1245
     property and the nonsection 1245 property in proportion
     to their respective fair market values. * * *

The recapture rules for section 1245 are also usually applied on

an asset-by-asset basis.   See sec. 1.1245-1(a)(4), Income Tax

Regs.; Buffalo Tool & Die, 74 T.C. at 445-52; cf. sec. 1.1250-5

(d)(2)(iii), Income Tax Regs.

     In this case, the Commissioner incorrectly assumed that the

Irvine Wienerschnitzel was composed of only section 1250

property.   This is evident from the fact that his agent took the

aggregate value of the business property in 1994 (i.e., the

purchase price), and divided it by a recovery period used only

for section 1250 property.   But the restaurant was already there

in 1994, leading us to find that the Daouds had bought both

section 1250 and section 1245 property.   Certainly by 2001, much
                                - 30 -

of the Irvine franchise’s property fell under section 1245 (e.g.,

franchise rights, machines, equipment, and purchased goodwill).

     The Commissioner also confused the application of section

1250 with section 1245.    The Commissioner added to the Daouds’

ordinary income the sum of all the depreciation that was

calculated under a straight-line method, for the period in which

they owned the business.     This is not right:   Section 1250 gain

is realized only if the Daouds took more than a straight-line-

depreciation deduction.    See sec. 1250; sec. 1.1250-1, Income Tax

Regs.

     There is no evidence in the record that suggests the Daouds

used anything other than a straight-line method when depreciating

and amortizing their business’s 1250 property.     The Daouds paid

rent in equal, monthly installments for the use of the land and

building, and it appears that they claimed depreciation

deductions on their Schedule Cs only for section 1245 property.13

We therefore find that the Daouds are not required to recognize

any recapture income under section 1250.

        The question of recapture under section 1245 is a bit more

complicated.     We have consistently held that we will not consider

“issues” which have not been pleaded, see, e.g., Markwardt v.

Commissioner, 64 T.C. 989, 997 (1975); Troutman v. Commissioner,


        13
       The Daouds never depreciated their 2001 improvements,
which may or may not qualify as 1250 property. See sec. 1250(c);
sec. 1.48-1(e), Income Tax Regs.; Walgreen Co. v. Commissioner,
68 F.3d 1006, 1007 (7th Cir. 1995), revg. 103 T.C. 582 (1994).
                               - 31 -

T.C. Memo. 2004-32, affd. 137 Fed. Appx. 70 (9th Cir. 2005), but

we can sustain the Commissioner’s determination for “reasons”

other than those given in the notice of deficiency, e.g., Estate

of Finder v. Commissioner, 37 T.C. 411, 423 (1961).   What

distinguishes “issues” from “reasons” is that a new issue would

alter the evidence presented, but a new reason is just a new

argument about the existing evidence.   See, e.g., Hurst v.

Commissioner, 124 T.C. 16, 30 (2005).

     The Commissioner neither argued nor determined that a part

of the Daouds’ deficiency stemmed from section 1245 recapture,

and this is not a case where the Commissioner used the right

rules but labeled it with the wrong section number.   Under

section 1245, the Commissioner’s determination would still be

amiss.14   We therefore find that Daouds were not put on notice of

the section 1245 argument, and did not know to present evidence

or arguments addressing it.




     14
       The Daouds did in fact sell some section 1250 property as
part of the sale of their business--for example, their leasehold
interest in the land and building, and possibly some of the
leasehold improvements that they had made. This means that some
of their adjusted basis and sale proceeds would still need to be
allocated between section 1245 and section 1250 property. This
the revenue agent did not do. Even then, the 39-year recovery
period would not apply. Intangibles such as purchased goodwill
and the right to operate a franchise all have a 15-year deprecia-
tion recovery period. Sec. 197. And the Daouds’ equipment and
other section 1245 property that they sold would likely be recov-
erable over 5 and 15 years. See sec. 168. Thus, we can’t consi-
der the $38,848 amount merely wearing the wrong label to be a
reasonable estimate of the section 1245 gain.
                               - 32 -

      Neither party litigated the issue of section 1245 gain.

Neither party tried to value the business’s section 1245

property, and neither offered any valuation of the Daouds’

section 1245 property.   We therefore find in the Daouds’ favor on

any issue of section 1245 income.

IV.   Penalties

      A.   Fraud Penalties

      Section 6663(a) imposes a penalty of “an amount equal to 75

percent of the portion of the underpayment which is attributable

to fraud.”   A taxpayer commits fraud when he “evade[s] taxes

known to be owing by conduct intended to conceal, mislead, or

otherwise prevent the collection of taxes.”      Parks v.

Commissioner, 94 T.C. 654, 661 (1990).      The Commissioner has

conceded that Mrs. Daoud is not liable for the fraud penalty and

we must determine only Mr. Daoud’s liability.

      To impose a penalty for fraud we must find that the

Commissioner has proven by clear and convincing evidence that (1)

an underpayment of taxes occurred, and (2) that some portion of

the underpayment was due to fraud.      See sec. 6663(a); Rule

142(b).    It is the second element that is often difficult for the

Commissioner to prove because he likely does not have direct

proof of the taxpayer’s intent.     This is why we allow the

Commissioner to prove fraud with “circumstantial evidence and

reasonable inferences drawn from the facts * * *.”      Meier v.

Commissioner, 91 T.C. 273, 297 (1988).      We have identified
                                 - 33 -

various indicia of fraudulent intent.     Id. at 297-98.     These

include:

     •     understatement of income;

     •     inadequate records;

     •     failure to file tax returns;

     •     implausible or inconsistent explanations of behavior;

     •     concealment of assets;

     •     failure to cooperate with tax authorities;

     •     engaging in illegal activities;

     •     attempting to conceal illegal activities;

     •     dealing in cash; and

     •     failing to make estimated tax payments.

Id. (citing Bradford v. Commissioner, 796 F.2d 303, 307-08 (9th

Cir. 1986), affg. T.C. Memo. 1984-601).    The Commissioner must

also prove fraud for each year in issue.     See Niedringhaus v.

Commissioner, 99 T.C. 202, 210 (1992).

     If the Commissioner meets his burden as to any portion of

the underpayment, then we have to treat the entire underpayment

as attributable to fraud except to the extent the taxpayer

establishes, by a preponderance of the evidence, that a portion

of the underpayment is not due to fraud.     Sec. 6663(b).

           1.   Fraud for 2000

     The Commissioner has met his burden with respect to the

first element of fraud--he has shown that the Daouds underpaid

their 2000 taxes.   Mr. Daoud even concedes that he wasn't
                               - 34 -

entitled to the loss reported on the sale of kitchen equipment.

The second element, requiring the Commissioner to show fraudulent

intent at the time the Daouds reported the loss, is a bit

trickier.

     This case is a good example of why we allow the Commissioner

to prove fraudulent intent using circumstantial evidence and the

taxpayer’s entire course of conduct.    Mr. Daoud claims that he

reported the loss by mistake, and he asks us to believe that he

first learned about it when the revenue agent brought it to his

attention.    We do not believe him--Mr. Daoud’s credibility

suffered during trial.    His testimony was often suspect, and the

records he provided have proven not to be what he said they were

on many subjects.

     The first indicium of fraud, understatement of income, can

be shown by an overstatement of deductions.    E.g., Hicks Co. v.

Commissioner, 56 T.C. 982, 1019 (1971), affd. 470 F.2d 87 (1st

Cir. 1972).    For 2000, Mr. Daoud reduced the Daouds’ income by

the $110,015 kitchen equipment loss, more than $200,000 in

unsubstantiated Schedule C expenses, and more than $10,000 in

unsubstantiated Schedule A deductions.    These deduction

overstatements are significant.

     Mr. Daoud was also unable to substantiate expenses and

deductions because the Daouds kept inadequate records--another

indicium of fraud.    He tried to disguise this shortcoming by

throwing piles of documents at the revenue agent and counsel for
                               - 35 -

the IRS.    These documents are spotty and disorganized.   They

include what appear to be falsified mileage logs and numerous

receipts for personal items.    And almost all of Mr. Daoud’s

records proved inadequate to substantiate the deductions and

expenses he disputes.

     Attempting to conceal fraudulent activity is another

indicium of fraud present in this case.    When asked to

substantiate the $110,015 loss, Mr. Daoud gave the revenue agent

the altered bid that he was trying to pass off as a contract for

the purchase of equipment.    He claims that he gave the document

to the revenue agent because he panicked after finding out about

his mistake.    This story does not help his cause.   Whatever his

reasoning, he was trying to conceal his true income from the

Commissioner and that shows fraud.

     Further evidence of fraud, and perhaps the most damaging, is

Mr. Daoud’s implausible explanation of how the $110,015 loss got

onto his return.    He asks us to believe that while preparing his

2000 return he found a bid among his tax papers and he mistakenly

entered it into Turbo Tax in a way that reduced his income by

$110,015.    Then months later, upon realizing his mistake, he

found the bid again, altered it, and gave it to the revenue agent

to substantiate the loss because he panicked.    This is an

implausible story:    Mr. Daoud was actively negotiating for other

bids from SILVA when the alleged mistake took place, so he was

familiar with the document.    The Daouds didn’t sell any equipment
                                  - 36 -

in 2000.   And why wouldn’t he recognize his mistake when he

completed the return and discovered that all they owed in taxes

was $2,621 in self-employment tax?

     The final indicium of fraud present in this case is the

Daouds’ failure to make estimated tax payments.         In 2000, the

only tax payments they made were those that Ameritech withheld.

With so many of the indicia of fraud present, we find that the

Commissioner has met his burden and proved by clear and

convincing evidence that a portion of the Daouds’ 2000

underpayment was due to fraud.

     We will therefore treat the Daouds’ entire 2000 underpayment

as fraudulent.    See sec. 6663(b).    This shifts the burden to Mr.

Daoud to prove that some portion of that underpayment was not

attributable to his fraud.    He argues, and we agree, that the

deduction he reported for the jewelry he gave to his wife was not

a result of fraud.    He identified the jewelry on the 2000 return

as “gift to spouse.”    This deduction shows disregard for the tax

rules, but not fraudulent conduct.         As for the rest of the

underpayment, Mr. Daoud hasn’t tried to show that any other

portion of it was not attributable to fraud beyond arguing that

his records substantiate his deductions and expenses.

           2.    Fraud for 2001

     In his brief, the Commissioner attempts to conflate the

penalty issue for 2000 and 2001, arguing the evidence of fraud

without referring to the particular tax year he is addressing.
                                - 37 -

But we can’t impute or presume fraud--it must be established by

independent evidence for each tax year.      See, e.g., Niedringhaus,

99 T.C. at 210; Petzoldt v. Commissioner, 92 T.C. 661, 699

(1989).     Thus, we next look to see if there is clear and

convincing evidence of an underpayment attributable to fraud for

2001.

     The Commissioner did establish the first element:      There

clearly was an underpayment in 2001.      The parties have even

stipulated the fact that the Daouds should have reported the

capital gain realized on the sale of their Irvine franchise.        And

as previously determined, the Daouds did take Schedule C

deductions in 2001 to which they were not entitled.

     As to the issue of fraudulent intent, we look at the various

badges of fraud.     The first one, an understatement of income, is

shown by Mr. Daoud’s unsubstantiated job search and Schedule C

expenses, and his failure to report the gain realized when the

Daouds sold their Irvine business.       Mr. Daoud also failed to make

estimated tax payments in 2001, another indicium of fraud.        But

these transgressions could also reflect mere negligence or a

disregard of the Code and regulations.

        The Commissioner argues that Mr. Daoud’s education and

experience elevate these omissions to fraud.      The Commissioner,

however, does not allege, and the record does not suggest, that

Mr. Daoud had any expertise or specialized knowledge in tax law.

We are not persuaded by the Commissioner’s argument that Mr.
                                  - 38 -

Daoud’s general intelligence and prior experience of being

audited are enough to prove an intent to evade taxes.

         The Commissioner also alleges that Mr. Daoud tried to

conceal his income in 2001 by “[burying] the sale of the Irvine

franchise as a loss on Schedule D-1, following the list of stock

sales.”     We are unpersuaded.   Mr. Daoud, although incorrectly,

did disclose the sale of the Irvine business on the returns.

Moreover, the way he reported the sale shows an attempt to

disclose information, not conceal it.

     The Commissioner also points to Mr. Daoud’s testimony

regarding the mileage logs as proof of fraudulent intent.     Mr.

Daoud, however, did not use the mileage logs to substantiate any

of his 2001 deductions.     He testified that the mileage logs were

exclusively for 2000, and only after the Commissioner’s effective

cross-examination did Mr. Daoud suggest that it was possible that

some of the notations on the mileage logs were for 2001.     This

does not show an intent to evade his 2001 taxes, and in fact his

not relying on it to shrink his 2001 tax bill shows the opposite.

And the Commissioner does not allege any other misleading

statements were made by Mr. Daoud about his 2001 return.

     We can’t help but find that Mr. Daoud kept inadequate

records and was not always cooperative with the IRS for both

years.     But poor bookkeeping and frostiness toward IRS agents do

not necessarily prove fraudulent intent.     See Terrell Equip. Co.

v. Commissioner, T.C. Memo. 2002-58; Piekos v. Commissioner, T.C.
                              - 39 -

Memo. 1982-602.   The IRS does argue that Mr. Daoud had a pattern

of underreporting his income and overstating his deductions.    But

a “pattern” of two years is thin soup, and not enough to let us

find clear and convincing evidence of fraud for 2001.    See Loftin

& Woodard, Inc. v. U.S., 577 F.2d 1206, 1239 (5th Cir. 1978)

(finding that even a “consistent and substantial understatement

of income is * * * [insufficient], by itself, to support a

finding of fraud”).

     The Commissioner does not allege, and the evidence does not

suggest, that Mr. Daoud fabricated, destroyed, or concealed

documents related to his 2001 return.     Given the weight of the

evidence, we conclude that the Commissioner has failed to carry

his burden of proving, by clear and convincing evidence, that any

part of the 2001 underpayment was a result of fraud.

     B.   Section 6662 Accuracy-Related Penalty

     On the portion of the Daouds’ deficiency not subject to

section 6663, the Commissioner seeks a 20-percent

accuracy-related penalty under section 6662 because of: (1)

negligence, (2) disregard of the rules or regulations, or (3) a

substantial understatement of income tax.

     The Commissioner also wants Mrs. Daoud to be liable for an

accuracy-related penalty on the portion of the underpayment

already subject to Mr. Daoud’s civil-fraud penalty.    An accuracy-

related penalty, however, cannot be imposed on one spouse where

the other one is liable for fraud.     See, e.g., Zaban v.
                                - 40 -

Commissioner, T.C. Memo. 1997-479.       Unlike the fraud penalty,

which is imposed on each spouse separately, the accuracy-related

penalty applies jointly and severally.      See Talmage v.

Commissioner, T.C. Memo. 2008-34, affd. without published opinion

106 AFTR 2d 2010-5706, 2010-2 USTC par. 50,550 (9th Cir. 2010);

Aflalo v. Commissioner, T.C. Memo. 1994-596.      Thus, to impose an

accuracy-related penalty on Mrs. Daoud when her husband is liable

for fraud is “impermissible stacking.”      See, e.g., Zaban, T.C.

Memo. 1997-479.     Therefore, we need to decide only whether the

jewelry deduction and the Daouds’ 2001 underpayment will be

penalized under section 6662.

        Once the Commissioner provides some evidence of negligence,

disregard of the Code and regulations, or a substantial

understatement, the burden of proving that the Commissioner got

his penalty determination wrong shifts to the taxpayer.      See Rule

142(a); Higbee v. Commissioner, 116 T.C. 438, 446-47 (2001).         A

taxpayer can shoulder this burden by showing that, under all the

facts and circumstances, he acted with reasonable cause and in

good faith.    Sec. 6664(c)(1); sec. 1.6664-4(b)(1), Income Tax

Regs.

     Negligence, as the regulations define it, is the failure to

make a reasonable attempt to prepare one’s tax returns, keep

adequate books and records, substantiate items properly, or

otherwise comply with the Code.    Sec. 1.6662-3(b)(1), Income Tax

Regs.    Disregard of the rules includes careless, reckless, or
                              - 41 -

intentional disregard of the Code provisions or regulations.

Section 1.6662-3(b)(2), Income Tax Regs.    And an understatement

is substantial if it is more than $5,000 or 10 percent of the tax

required to be shown on the return, whichever is greater.    Sec.

6662(d)(1)(A).

     We find that Mr. Daoud clearly disregarded the rules when he

deducted the cost of jewelry given to his wife in 2000 as a

business expense.   The Daouds don't argue otherwise.   The Daouds

also claimed excessive Schedule C expenses on their 2001 return

which they were unable to substantiate, disregarding the

requirements of sections 162 and 274.

     The fact that the Quicken reports do not match the amounts

claimed on their returns buttresses our finding that these

taxpayers were negligent in keeping their records and preparing

their 2001 returns.   See Lysek v. Commissioner, 583 F.2d 1088,

1094 (9th Cir. 1978), affg. T.C. Memo. 1975-293.    The Daouds also

ignored the depreciation deducted in prior years when calculating

the adjusted basis of their Irvine business.    See Bissey v.

Commissioner, T.C. Memo. 1994-540.     We therefore find them liable

for a negligence penalty on their 2001 underpayment.

     We also believe that we can sustain the section 6662 penalty

on the distinct ground that the Daouds substantially understated

their 2001 income tax.   If, as appears likely, their

understatement of income tax as calculated under Rule 155 exceeds

the greater of $5,000 or 10 percent of the tax required to be
                             - 42 -

shown on their 2001 return, the Commissioner has succeeded in

defending the section 6662 penalty on this alternative ground.

     The accuracy-related penalty does not apply if the taxpayer

had reasonable cause and acted in good faith, sec. 6664(c)(1),

but the Daouds failed to present any evidence or make any

arguments addressing this defense.    We therefore find that the

accuracy-related penalty applies to the jewelry deduction they

took in 2000 and to the full amount of their 2001 underpayment.


                                          An order granting

                                     respondent’s oral motion to

                                     conform the pleadings to the

                                     proof will be issued, and

                                     decision will be entered under

                                     Rule 155.
