                                 T.C. Memo. 2013-251



                           UNITED STATES TAX COURT



                 RODNEY ERIC MCCLELLAN, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 14300-11, 14314-11.1              Filed October 31, 2013.



      Cindy L. Ho, for petitioner.

      Kaelyn J. Romey, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      LARO, Judge: In a notice of deficiency, respondent determined

deficiencies in petitioner’s Federal income tax for 2006 and 2007 as well as fraud




      1
          These cases are consolidated for purposes of trial, briefing and opinion.
                                         -2-

[*2] penalties under section 6663(a) or alternatively negligence penalties under

section 6662 as follows:2

                                 Fraud penalty      Accuracy-related penalty
     Year      Deficiency         sec. 6663(a)             sec. 6662

     2006       $86,211           $39,279.75               $6,767.60
     2007        80,396             49,119.75               2,980.60

      Petitioner, while residing in California, petitioned this Court for

redetermination. After concessions, the only remaining issue for us to decide is

whether petitioner is liable for the fraud penalties under section 6663(a) for 2006

and 2007. We hold that he is.

                                FINDINGS OF FACT

      The parties’ stipulation of facts with accompanying exhibits, their

supplemental stipulation of facts with accompanying exhibits, and their second

supplemental stipulation of facts with accompanying exhibits are incorporated

herein by this reference. We find the facts accordingly.




      2
      Unless otherwise indicated, section references are to the Internal Revenue
Code in effect for the years at issue.
                                           -3-

[*3] I.         R.E. McClellan Enterprises

          R.E. McClellan Enterprises (REM) is a construction drywall business

owned and operated solely by petitioner. In his role as REM’s sole owner,

petitioner conducted all billing, invoicing, and customer deposits for REM.

Petitioner was also actively involved in the day-to-day management of the

business and timely paid monthly rent checks, insurance bills, utility bills and

other work expenses.

          Petitioner founded REM in 1994. By 2006 and 2007, the tax years at issue,

petitioner had grown REM into a successful drywall business. For both tax years,

REM brought in more than $1 million of gross receipts each year and, according to

petitioner, business was “busy”.

II.       Petitioner’s business and recordkeeping practices for 2006 and 2007

          Petitioner had sole control over REM’s assets and records for the tax years

at issue. In the 2006 and 2007 timeframe, REM had only one bank account, over

which petitioner had sole signatory authority and control. In addition, petitioner

alone prepared and maintained REM’s books and records for the years at issue.

As part of keeping REM’s financial records, petitioner maintained customer

invoices, tracked customer payments by making notations on the invoices, and

recorded income and expenses in a handwritten ledger.
                                         -4-

[*4] III.    Preparation of Petitioner’s 2006 and 2007 tax returns

       The Law Offices of Steven Moskowitz, LLP (Moskowitz) (formerly

Moskowitz & Cui, LLP and Moskowitz & Nixdorf), prepared petitioner’s tax

returns for taxable years 2001 through 2010.

       Moskowitz prepared petitioner’s 2006 and 2007 returns using only

information petitioner had provided in a tax organizer questionnaire. Petitioner

did not provide Moskowitz with his 2006 and 2007 ledgers. In addition,

Moskowitz did not perform an independent audit of REM’s books and records.

IV.    Petitioner’s history of noncompliance and prior audits

       Petitioner has a history of noncompliance with State and Federal tax laws

and has had several audits that resulted in tax deficiencies. These include the

audits of his 2002 Federal income tax return, his 2000 through 2003 California

employment tax returns, and his 2001 California income tax return.

       A.    Petitioner’s history of delinquent tax filings

       Petitioner has a long history of delinquent tax filings. With the exception of

the 2006 and 2007 tax years, petitioner filed his Federal income tax returns late

every year between 1999 and 2009. For many of those years, petitioner also failed

to pay the tax reported as due.
                                         -5-

[*5] B.      2002 Federal tax return audit

      In 2006 the IRS audited petitioner’s 2002 Federal income tax return, which

Moskowitz had prepared. In a memorandum dated August 21, 2003, Moskowitz

questioned petitioner’s ability to support himself in the light of the nearly $90,000

loss reported for 2002. Petitioner told Moskowitz that he had received monetary

support from family and friends. In addition, petitioner executed an economic

reality statement for 2002 stating that his personal living expenses were covered

by “low cost living expenses plus help from family and friends”, and a

supplemental economic reality statement stating that “I did not pay my material

bill in full each month. Also I factored invoices (Advance on invoice prior to

payment). Basically robbed Peter to pay Paul.”

      IRS Revenue Agent Ronalda Turner (Agent Turner) was assigned to

perform the 2002 audit. Agent Turner discovered that petitioner had failed to

report nearly $79,000 in deposits and had underreported his income by nearly

$234,000. Petitioner refused to meet with Agent Turner to offer an explanation

for the unreported income and also refused to provide documents. The only

explanation for the discrepancies petitioner provided Agent Turner was his

“acrimonious divorce”. Thus, Agent Turner had to obtain supporting documents

by third-party summonses. The 2002 audit resulted in a deficiency determination.
                                        -6-

[*6] C.      The California Employment Development Department audit

      The California Employment Development Department (EDD) audited

petitioner’s returns for 2000 through 2003. Petitioner retained Ms. Lori Schnall3

to assist him regarding the EDD Audit. In a letter to Ms. Schnall, petitioner stated

that he needed 30 to 60 days to go over his records because they were “atrocious”.

As a result of the audit, the EDD determined that petitioner owed an additional

$123,290.14 in State taxes. Following the EDD audit petitioner engaged

Independent Staffing Solutions (ISS) to help him pay his employees and prepare

employment tax returns.

      D.     California Franchise Tax Board audit

      The California Franchise Tax Board (FTB) audited petitioner’s State tax

return for 2001. The FTB audit also resulted in additional taxes due.

      Despite the multiple audits of petitioner’s State and Federal tax returns for

2000 to 2003, petitioner did not change his accounting practices. Petitioner admits

that for 2006 and 2007, he continued to use the same accounting methods that he

had used for 2002.




      3
        At the time petitioner sought Ms. Schnall’s assistance with regard to the
EDD audit, Ms. Schnall had the same address as Moskowitz’s Castro Valley
office.
                                        -7-

[*7] V.      2006 and 2007 IRS audits

      A.     History of the audits

      IRS Revenue Agent Laura Atherton (Agent Atherton) was assigned to audit

petitioner’s 2006 tax return. The 2006 audit eventually expanded to include

petitioner’s 2007 tax return.

      Throughout the audit petitioner routinely delayed in producing documents,

produced incomplete documents, and failed to produce documents altogether. In

petitioner’s first meeting with Agent Atherton, petitioner produced only a

handwritten ledger and a few bank statements for 2006. To obtain REM’s

complete 2006 bank statements and deposit items, Agent Atherton had to issue a

summons to Bank of America.

      In addition, petitioner did not provide Agent Atherton with REM’s 2006

invoices until his third interview. When asked how he kept track of his customers’

balances using those invoices, petitioner replied that he had a “magic memory”.

      After Agent Atherton discovered petitioner’s unreported income, petitioner

stopped complying with document requests altogether. All in all, Agent Atherton

issued a total of six information document requests and summoned petitioner’s

records twice in connection with the 2006 and 2007 audits. Agent Atherton also

had to summon additional records from petitioner’s customers, including Sutco
                                         -8-

[*8] Construction and Magallon Construction Co., as well as petitioner’s lender,

IndyMac Bank.

      B.       2006 audit findings

      Agent Atherton’s review of petitioner’s books and records revealed

numerous inconsistencies and substantial unreported income. For instance, Agent

Atherton’s initial review of petitioner’s 2006 ledger revealed that petitioner’s 2006

tax return reported approximately $90,000 more in gross receipts than the amount

recorded in petitioner’s ledger. Petitioner was unable to account for this

discrepancy.

      Agent Atherton’s analysis of REM’s monthly cashflow according to the

ledger also revealed payments significantly in excess of deposits. Upon further

analysis, Agent Atherton discovered that petitioner had underreported income by

withdrawing cash when depositing customer checks, by using the “joint check”

method, and by failing to record certain check deposits as receipts.

               1.    Unreported cash withdrawals

      Petitioner underreported his income by excluding cash withdrawals from

gross receipts, using that cash to pay labor expenses, and then deducting the labor

payments as business expenses.
                                         -9-

[*9] Petitioner routinely withdrew cash while depositing check payments from

REM’s customers. Whenever petitioner withdrew cash from a check deposit, he

made a notation on the customer invoice signifying the withdrawal. However,

REM’s ledger would often record only the deposit amount net of the cash

withdrawn as receipts.

      Initially, petitioner told Agent Atherton that he mostly received payments

from his customers by check and that he paid expenses also mostly by check.

Petitioner also denied paying expenses with cash. In addition, petitioner claimed

that he made deposits in full most of the time and only pulled cash out

occasionally.

      However, Agent Atherton’s audit revealed that throughout 2006, petitioner

withdrew a total of $163,000 in cash while making check deposits for REM,

$118,400 of which was not recorded in REM’s ledger as receipts. Petitioner never

withdrew $10,000 or more, though he frequently made cash withdrawals slightly

under $10,000. The following table summarizes the cash amounts petitioner

withheld from checks in 2006:

    Date                      Payer                     Check amount      Cash out
   2/23     Pacific State Bank Memo: Escolar              $10,075.00       $5,000
   3/2      Palomino & Sons, Inc.                          17,000.00        8,000
                                        -10-

   [*10]
   3/20     Mulder-Terpstra, LLC                            12,740.00        8,000
   4/13     Distinctive Remodel                             10,221.25        9,200
   4/17     Mulder-Terpstra, LLC                            15,400.00        8,400
   5/23     Palomino & Sons, Inc.                           11,933.93        9,000
   6/6      Distinctive Construction                        14,675.00        9,800
   6/19     Price Homes Neibauer Job                        21,970.00        9,800
   8/31     Pacific State Bank, memo: Postma                12,723.75        9,500
    9/16    MJK Builders, Inc.                              14,933.75        8,000
   9/29     GE Whitlock Construction                        17,123.75        6,000
   10/11    Sutco Construction, Inc.                        51,740.00        8,400
   10/12    GE Whitlock Construction                        14,677.50        9,600
   10/13    Calvin Andree and Nancy Andre/Andre Trust       18,042.50        9,600
   10/18    MJK Builders, Inc.                              10,250.00        9,800
   11/6     Calvin Andree and Nancy Andre/Andre Trust       16,215.00        9,800
   11/14    Paul & Sheila Van Konynenburg                   21,726.25        9,800
   11/18    GE Whitlock Construction                        17,123.75        9,900
   11/22    Paul & Sheila Van Konynenburg                   11,698.75        6,000
    Total                                                               $163,600

      Petitioner used these cash withdrawals to pay his laborers. These cash

payments were made in addition to the payroll amounts petitioner had reported

to ISS. For example, petitioner admits that he paid Juan Manual Lopez $55,825

in excess of what he reported to ISS. In addition, petitioner paid over 10
                                         -11-

[*11] independent contractors in cash. Petitioner then deducted these cash

payments as business expenses.

           2.       “Joint Check” system

      Petitioner also obfuscated income using the “joint check” system. Under

the joint check system, petitioner purchases materials from a materials supplier,

who then files a lien on the purchased materials. The supplier releases the lien

when REM’s customer issues a joint check payable to both REM and the supplier.

At that point, petitioner signs the check over to the supplier so that the supplier,

rather than petitioner, receives the funds from the check. Petitioner’s practice was

to have REM’s customers write two checks: one check to REM to cover only

nonmaterials costs and one check to REM and the materials supplier jointly for the

materials. For example, in 2006 petitioner paid Delta Materials Supply over

$100,000 in material costs using the joint check method. Petitioner did not report

the payment for materials as part of his gross receipts but deducted those materials

costs as business expenses.

           3.       Deposits not reported as income

      Finally, petitioner underreported income by sometimes failing to record

bank deposits. In 2006 petitioner deposited approximately $94,000 in REM’s
                                           -12-

[*12] bank account without recording it on REM’s ledger and without reporting it

on his return.

      C. 2007 audit findings

      Agent Atherton’s audit of petitioner’s 2007 tax return revealed that

petitioner continued many of the same practices in 2007. For instance, petitioner

continued to withdraw cash from check deposits. In 2007 petitioner made cash

withdrawals totaling $241,300, of which $155,350 was not recorded in REM’s

ledger as part of gross receipts. As before, none of petitioner’s cash withdrawals

equaled or exceeded $10,000, though on numerous occasions petitioner withdrew

amounts slightly less than $10,000.

      The following table summarizes the cash amounts petitioner withheld from

checks in 2007:

   Date                    Payer                      Check amount   Cash out
    1/30     Standard Pacific Homes--Central Valley     $26,272.00    $9,200
    2/15     William Mulder Construction                 16,355.00     9,300
    2/27     McRoy-Wilbur Communities, Inc.              15,933.75     9,900
    3/9      Standard Pacific Homes--Central Valley      41,185.00     9,800
    3/18     Michael J. Kinch                            11,553.75     9,800
    3/23     Standard Pacific Homes--Central Valley      41,892.25     9,800
    4/3      McRoy-Wilbur Communities, Inc.              18,210.00     9,800
                                       -13-

[*13]
4/2      Magallon Construction Co.                15,184.00      9,800
4/9      Craig Podesta                            27,500.00      9,800
5/2      McRoy-Wilbur Communities, Inc.           11,381.25      9,900
5/7      Gary Tschantz Construction, Inc.          5,750.00      4,450
5/7      Gary Tschantz Construction, Inc.          5,750.00      4,450
5/6      Craig Podesta                            12,815.00      7,000
5/7      Standard Pacific Homes--Central Valley   26,002.25      9,800
5/15     GK Commercial Properties                 21,385.00      9,800
5/20     Deann and Gary Autrey                    14,527.50      9,500
5/29     Terry Alkire                             14,900.00      9,100
5/15     Sutco Construction, Inc.                 14,240.00      9,200
6/19     Joel W. Geddes, Jr.                      29,400.00      2,300
6/26     Jorgensen Finance                        10,348.00      9,000
7/19     Terry Alkire                             12,325.00      9,800
7/20     The Grevemberg Co., Inc.                 11,800.00      9,800
9/20     Palomino & Sons, Inc.                    15,187.50      9,800
9/14     Standard Pacific Homes--Central Valley   46,659.75      9,800
10/8     Pac Northwest Development, LLC            5,000.00      2,400
10/19    Palomino & Sons, Inc.                     5,000.00      5,000
10/14    Palomino & Sons, Inc.                     4,000.00      3,000
11/7     Palomino & Sons, Inc.                    10,000.00      6,000
11/28    Roman Salazar                            10,147.50      8,000
12/22    The Grevemberg Co., Inc.                 10,500.00      6,000
 Total                                                        $241,300
                                               -14-

[*14] In addition, petitioner continued to make unreported bank deposits. In 2007

petitioner deposited nearly $84,000 into REM’s bank account without recording it

in REM’s ledger or reporting it on his 2007 return.

       D. 2006 and 2007 audit result summary

       All in all, Agent Atherton determined that petitioner had underreported

income by over $146,000 for 2006 and over $190,000 for 2007. The following

table summarizes Agent Atherton’s calculation of petitioner’s unreported income

for the years at issue:

                                                            2006               2007
    Book income                                           $928,658.43       $836,667.12
    Add:
     Income from customer deposits not reported             94,388.50         83,899.28
     in books
     Withheld cash omitted from receipts reported          118,400.00        155,350.00
     in books1
     Accounting errors                                         ---             2,470.00
    Subtract:
     Non-taxable income reported as taxable                 27,220.50         50,924.46
     Totals:
       Income per examination                             1,114,226.43     1,027,461.94


       Income per return                                   967,845.00        836,616.00


    Petitioner’s unreported income                         146,381.43        190,845.94

       1
        This figure includes sources of nontaxable income such as petitioner’s Bank of America
loans and travel funds.
                                          -15-

[*15] Petitioner concedes respondent’s determinations of the amounts of

underreported income.

VI.   Petitioner’s undisclosed assets and bank account

      Petitioner owned several assets which were omitted from his 2006 and 2007

returns. Petitioner waited until his third interview with Agent Atherton before

disclosing that he owned several investment properties in Washington on which he

was constructing homes to sell for a profit. Petitioner explained that some of the

properties were in his niece’s name in order to shield those assets from his divorce

proceedings. Petitioner further disclosed that he controlled another bank account

in his son’s name from which he paid the construction costs of the Washington

properties.

VII. Petitioner’s explanation for the 2006 and 2007 unreported income

      Petitioner asserts that his failure to report all his income was due to

circumstances in his personal life, including medical problems, a divorce, and the

ailing health of his father, rather than fraud.

      A. Petitioner’s medical problems

      Petitioner claims that he suffered from a variety of medical conditions

which impeded his ability to keep accurate books and records. These medical

conditions include stroke, transischemic attacks (TIAs), hydrocephalus (a.k.a.
                                       -16-

[*16] ventriculomegaly), and stress syndrome. Petitioner, however, never

mentioned these health issues nor any cognitive disability to Agent Atherton until

after the 2006 and 2007 audits were complete.

         1.        Stroke

      Petitioner suffered a stroke in 1999 and has not suffered another one since.

         2.        TIA

      Petitioner describes a TIA as essentially a ministroke with attendant

symptoms such as confusion, fatigue, headache, and dizziness. Such episodes

would last only several days. According to Dr. John Warwick, petitioner’s

primary care physician since 1994, petitioner suffered from TIA episodes in 2003

and 2004. However, office visit tests revealed “minimal neurologic or physical

findings”.

         3.        Hydrocephalus

      Hydrocephalus is an enlargement of the ventricles in the storage unit of the

brain. Dr. Warwick testified that petitioner experienced cognitive impairment

from hydrocephalus in early 2000 and that symptoms peaked in 2003-2004.

Because of his hydrocephalus, petitioner experienced short episodes of cognitive

impairment approximately once every two to three months. According to Dr.

Warwick, petitioner could drive a car, communicate, and generally take care of
                                         -17-

[*17] himself during such episodes. In 2003 petitioner received a ventriculogram

for his hydrocephalus following which he experienced rapid improvement in

symptoms.

          4.        Stress syndrome

       Dr. Warwick also diagnosed petitioner with stress syndrome, which is

characterized by excessive adrenaline caused by various life factors. Petitioner

experienced episodes of stress syndrome from 1994 through 2005, with each

episode lasting for a day or two. According to Dr. Warwick, any cognitive

impairment would be limited to blunted affect and temporary memory loss. Dr.

Warwick proscribed petitioner Wellbutrin, a mood stabilizer, to help him manage

his stress.

          5.        Petitioner’s office visits in 2006 and 2007

       Petitioner sought medical treatment from Dr. Warwick on at least four

occasions in 2006 and one occasion in 2007. Dr. Warwick’s medical records and

notes from 2006 and 2007 show no mention of petitioner’s 1999 stroke, TIA,

hydrocephalus, stress syndrome, or associated symptoms during those office visits.

       Dr. Warwick’s records also show that in 2007 petitioner made an office visit

to obtain a letter to the IRS verifying his medical condition. Dr. Warwick testified

that he drafted such a letter to the IRS for petitioner. Petitioner, on the other hand,
                                         -18-

[*18] claims that he did not have any letters from Dr. Warwick regarding his

health problems and their impact on his ability to conduct his business.

      B. Petitioner’s divorce

      Petitioner further attributes his inaccurate tax returns to his “messy

divorce”. Petitioner and his former wife legally separated in mid-2005, and their

divorce was finalized in December 2006. According to petitioner, the divorce was

devastating, left him “extremely depressed”, and made it difficult for him to

operate his business. Petitioner further claims that the financial implications of the

divorce extended into 2007, though he did not explain why or how.

      C. Health problems of Petitioner’s father

      Finally, petitioner attributes the inaccuracies in his tax returns to his father’s

poor health. According to petitioner, his father suffered from Alzheimer’s disease

in 2006 and required significant assistance from petitioner.

                                      OPINION

I.    Perception of witnesses

      During our trial we heard the testimony from Agent Atherton, Agent Turner,

Dr. Warwick, and petitioner. As the trier of fact, our charge is to review the

credibility of witnesses and evaluate the reliability of evidence for purposes of

finding disputed facts. In discharging that duty, we observe the truthfulness,
                                       -19-

[*19] candor, and demeanor of each witness to evaluate his or her testimony. HIE

Holdings, Inc. v. Commissioner, T.C. Memo. 2009-130, 97 T.C.M. (CCH) 1672,

1733 (2009), aff’d, 521 Fed. Appx. 602 (9th Cir. 2013). We weigh the evidence,

draw necessary inferences, and resolve disputed facts with a view toward

ascertaining the truth. Id.

      We found the testimony of Agent Turner, Agent Atherton, and Dr. Warwick

to be informed and credible. The testimony of Agent Turner and Agent Atherton

was supplemented by extensive audit documentation and helpful to understanding

petitioner’s exclusion of customer checks from his sales receipts, withdrawal of

cash from customer deposits, and understatement of gross receipts. Similarly, Dr.

Warwick’s testimony was corroborated by petitioner’s medical records. The

credible testimony of these witnesses clearly and convincingly establishes that

petitioner acted with fraudulent intent; the same testimony also shows that

petitioner lacked reasonable cause for underreporting his income.

      As to petitioner, we generally found his testimony to be self-serving,

improbable, internally inconsistent, and contradicted by documentary evidence

and stipulated facts. We illustrate these contradictions through the following

examples.
                                        -20-

[*20] First, petitioner made contradictory statements regarding his use of cash in

conducting REM’s business. Initially, petitioner represented to Agent Atherton

that he paid expenses mostly by check and only rarely withdrew cash from checks.

However, as REM’s records show, petitioner withdrew over $160,000 in cash

from checks in 2006 and over $240,000 in 2007. Petitioner later admitted to

making these cash withdrawals but stated that they were used to pay labor

expenses.

      Second, petitioner’s pattern of behavior belies his testimony regarding his

understanding of the IRS reporting requirement for cash withdrawals. Petitioner

testified at trial that his understanding was that cash withdrawals over $5,000 must

be reported to the IRS. However, petitioner’s books and records show that he

always withdrew less than $10,000 regardless of the check’s face amount. It could

not be a mere coincidence that petitioner withdrew between $9,000 and $9,900 in

over 10 instances in 2006 and in 20 instances in 2007. Petitioner’s pattern leads

us to conclude that petitioner was well aware of the $10,000 threshold that would

trigger the bank’s reporting requirement to the IRS. See, e.g., 31 C.F.R. sec.

1010.311 (2011).

      Third, the stipulated facts contradict petitioner’s testimony that he received

help in keeping REM’s books and records. Throughout the 2006 and 2007 audits
                                         -21-

[*21] and in stipulated facts, petitioner represented that he was the sole keeper of

records for REM at all times. At trial, however, petitioner testified that in 2006 he

hired a bookkeeper for three to four months to assist him in maintaining his books

and records. According to petitioner, he paid her in cash but had no record of her

employment and did not report his payments to her as a business expense. When

questioned about why he never mentioned this bookkeeper until trial, petitioner

claimed that he had “completely forgotten about her until over the weekend”.

      Fourth, petitioner’s testimony that Dr. Warwick never drafted any letters

concerning his medical condition is contradicted by Dr. Warwick’s testimony that

he had drafted a letter on petitioner’s behalf and by Dr. Warwick’s medical

records. We credit Dr. Warwick’s testimony. In the light of his testimony and

medical records, which show that petitioner’s medical problems had largely been

resolved by 2006 and 2007, we believe that Dr. Warwick’s letter was unfavorable

to petitioner.

II.   Section 6663 fraud penalty

      Section 6663(a) imposes a 75% penalty on the portion of any underpayment

of tax attributable to fraud. Section 6663(b) provides that where the

Commissioner establishes that any portion of an underpayment of tax is

attributable to fraud, the entire underpayment is treated as attributable to fraud
                                         -22-

[*22] except with respect to the portion of the underpayment that the taxpayer

establishes, by a preponderance of the evidence, is not attributable to fraud.

      The Commissioner bears the initial burden of establishing fraud by clear

and convincing evidence. Sec. 7454(a); Bradford v. Commissioner, 796 F.2d 303,

307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Scharringhausen v.

Commissioner, T.C. Memo. 2012-350 at *34. Clear and convincing evidence is:

      “that measure or degree of proof which will produce in the mind of
      the trier of facts a firm belief or conviction as to the allegations
      sought to be established. It is intermediate, being more than a mere
      preponderance, but not to the extent of such certainty as is required
      beyond a reasonable doubt as in criminal cases. It does not mean
      clear and unequivocal.”

Scharringhausen v. Commissioner, at *34 (quoting Ohio v. Akron Ctr. for Reprod.

Health, 497 U.S. 502, 516 (1990)). To carry his burden, the Commissioner must

prove for each year in which fraud is alleged that (1) an underpayment of tax

existed and (2) a portion of the underpayment was attributable to fraud. Petzoldt

v. Commissioner, 92 T.C. 661, 698 (1989); Scharringhausen v. Commissioner, at

*34. Because respondent has met his burden with clear and convincing evidence,

and because petitioner has failed to show any portion of the underpayment was not

attributable to fraud, we sustain the fraud penalty.
                                         -23-

[*23] A. Existence of underpayment for 2006 and 2007

      Respondent determined that petitioner had underreported his income by

$146,382 for 2006 and $190,846 for 2007. Petitioner concedes the resulting

underpayments.

      B. Underpayments attributable to fraud

      Fraud is defined as the intentional commission of an act or acts for the

specific purpose of evading tax believed to be owing. Petzoldt v. Commissioner,

92 T.C. at 698; Scharringhausen v. Commissioner, at *36-*37. Whether a portion

of the underpayment of tax is attributable to fraud is a question of fact to be

resolved on the basis of the record as a whole. Parks v. Commissioner, 94 T.C.

654, 660 (1990); Scharringhausen v. Commissioner, at *36. Fraudulent intent is

never imputed or presumed but must always be established by independent

evidence. Petzoldt v. Commissioner, 92 T.C. at 699.

      Because fraud is rarely admitted and the taxpayer's intent is rarely available,

fraud may be proven by circumstantial evidence and reasonable inferences drawn

from the facts. Id. The intent to conceal or mislead may be inferred from a pattern

of conduct. Id.

      There are several, nonexclusive “badges of fraud” from which the Court

may infer a taxpayer’s fraudulent intent, including: (1) understating income, (2)
                                          -24-

[*24] maintaining inadequate records, (3) failing to file tax returns, (4) giving

implausible or inconsistent explanations of behavior, (5) concealing assets, (6)

failing to cooperate with tax authorities, (7) engaging in illegal activities, (8)

attempting to conceal illegal activities, and (9) dealing extensively in cash.

Bradford v. Commissioner, 796 F.2d at 307-308; Scharringhausen v.

Commissioner, at *37. Although no single factor is necessarily sufficient to

establish fraud, the combination of a number of factors constitutes persuasive

evidence. Garavaglia v. Commissioner, T.C. Memo. 2011-228, 102 T.C.M.

(CCH) 286, 302 (2011), aff’d, 521 Fed. Appx. 476 (6th Cir. 2013). After

thoroughly examining the record, we found the presence of several indicia of fraud

such as: (1) understating income, (2) maintaining inadequate records, (3) giving

implausible explanations of behavior, (4) concealing assets, (5) failing to

cooperate with tax authorities, and (6) dealing extensively in cash. The presence

of six of the nine factors convinces us that petitioner harbored the requisite

fraudulent intent.

          1.         Understatement of income

      The understatement of income tends to indicate fraudulent intent. Bradford

v. Commissioner, 796 F.2d at 307-308. This is especially true where there is a

pattern of understating income over multiple years. Holland v. United States, 348
                                         -25-

[*25] U.S. 121, 139 (1954). Petitioner concedes that he understated his income by

$233,000 for 2002, $146,382 for 2006, and $190,846 for 2007. This factor weighs

against petitioner.

          2.          Maintaining inadequate records

      The failure to maintain adequate records is indicative of fraudulent intent.

Bradford v. Commissioner, 796 F.2d at 307-308. Petitioner did not maintain

accurate records of REM’s financial affairs. First, petitioner failed to record in his

ledger $118,400 of receipts for 2006 and $155,350 for 2007, which he withdrew

as cash from customer checks. Petitioner further failed to record in his ledger as

receipts bank deposits of $94,388.50 for 2006 and $83,899.28 for 2007. In

addition, petitioner admits that he paid his employees additional cash not reflected

in his payroll records with ISS.

      Petitioner’s culpability for maintaining inaccurate records is increased by

the results of his prior tax audits: the 2002 Federal audit, the EDD audit, and the

FTB audit. Despite the fact that all three audits resulted in tax deficiencies,

petitioner continued to use the same accounting and bookkeeping methods. The

results of these audits, coupled with petitioner’s failure to reform REM’s

accounting practices, make it simply impossible to find that petitioner acted in
                                         -26-

[*26] good faith. Petitioner’s practice of maintaining inadequate and inaccurate

records weighs against him.

           3.       Implausible explanations

        Giving implausible or inconsistent explanations of behavior is indicative of

fraud. Id. Petitioner’s explanations for his behavior are implausible and

inconsistent. Apart from petitioner’s self-serving testimony, nothing in the record

indicates that in 2006 and 2007 he suffered from medical conditions that impaired

his ability to maintain adequate business records. Petitioner’s primary care

physician, Dr. Warwick, testified that petitioner no longer experienced symptoms

from the 1999 stroke, TIAs, stress syndrome, or hydrocephalus as of 2006 and

2007.

        Agent Atherton testified that when questioned about his ability to keep track

of REM’s finances from the scant records, petitioner claimed that he had “magic

memory”. Moreover, petitioner did not claim to have had health problems until

after the audit was completed.

        Finally, petitioner actively and successfully managed REM’s business

affairs in 2006 and 2007, in which he brought in over $1 million of business per

year. Petitioner was intimately involved in REM’s activities, including bidding on
                                         -27-

[*27] new projects, maintaining REM’s books, preparing customer invoices, and

paying expenses.

      Petitioner’s claim that medical conditions prevented him from keeping

accurate business records is inconsistent with Dr. Warwick’s and Agent

Atherton’s testimony and highly implausible in the light of the fact that he single-

handedly and successfully managed every aspect of REM’s business operations

for the years at issue. This factor weighs against petitioner.

         4.        Concealing assets

      Concealing assets is further indicative of fraud. Bradford v. Commissioner,

796 F.2d at 307-308. Petitioner concealed the full extent of his income by keeping

it off REM’s books in several ways. First, petitioner kept income off his books by

not recording cash withdrawn from check deposits. Petitioner’s pattern of

withdrawing cash amounts just short of the $10,000 bank reporting threshold,

regardless of the check’s face amount, is emblematic of his intent to conceal

income. Next, petitioner kept significant income off the books using the joint

check system for material expenses yet deducted those amounts as business

expenses. Finally, petitioner also concealed several Washington investment

properties held in his niece’s name and a bank account in his son’s name which

contained the funds used to develop those properties. Taken together, these
                                        -28-

[*28] actions constitute a deliberate and methodical attempt to conceal income and

assets. This factor weighs against petitioner.

         5.        Failure to cooperate with tax authorities

      Failing to cooperate with tax authorities is indicative of fraud. Id.

Petitioner was uncooperative with Agent Atherton during the course of the 2006

and 2007 audits. Petitioner produced incomplete documents or simply ignored

Agent Atherton’s document requests. All in all, Agent Atherton issued a total of

six information document requests, summoned petitioner’s records twice, and

summoned additional records and information from multiple third parties.

Petitioner also made misrepresentations to Agent Atherton, including statements

that he rarely dealt in cash and that REM generally conducted its business using

only checks. This factor weighs against petitioner.

         6.        Extensive dealings in cash

      Extensive dealing in cash is indicative of fraud. Scharringhausen v.

Commissioner, at *37. Petitioner dealt extensively in cash by withholding cash

when depositing checks. In 2006 and 2007 petitioner routinely withdrew from

check deposits cash totaling over $160,000 in 2006 and over $240,000 in 2007;

he also used the cash to pay his employees on top of reported payroll expenses.

This factor also weighs against petitioner.
                                         -29-

[*29]      7.        Conclusion

        On the basis of our finding that six of the nine factors weigh against

petitioner, we conclude that respondent has proven by clear and convincing

evidence that petitioner acted with fraudulent intent.

        C. Section 6664 reasonable cause

        Under section 6664(c)(1), fraud penalties do not apply to any portions of the

underpayments of tax for which petitioner proves reasonable cause and good faith.

Section 1.6664-4(b)(1), Income Tax Regs., interprets “reasonable cause” as:

        The determination of whether a taxpayer acted with reasonable cause
        and in good faith is made on a case-by-case basis, taking into account
        all pertinent facts and circumstances * * * Generally, the most
        important factor is the extent of the taxpayer's effort to assess the
        taxpayer's proper tax liability. Circumstances that may indicate
        reasonable cause and good faith include an honest misunderstanding
        of fact or law that is reasonable in light of all of the facts and
        circumstances, including the experience, knowledge, and education of
        the taxpayer. * * *

Petitioner carries the burden to prove by a preponderance of the evidence that he

acted with reasonable cause and good faith. See sec. 6663(b).

        Petitioner argues that he meets the section 6664(c)(1) reasonable cause

defense because his diminished mental and physical capacity precludes a finding

of fraud. Petitioner has failed to meet his burden by a preponderance of the

evidence. The record contains no credible evidence that petitioner’s medical
                                          -30-

[*30] conditions interfered with his ability to conduct his business affairs in 2006

and 2007. During those years, petitioner single-handedly performed all of REM’s

core management and accounting functions, bid for new projects, and brought in

over $1 million of business per year. REM’s success demonstrated that petitioner

adequately and competently managed REM’s business affairs during the years at

issue.

         Furthermore, petitioner did not mention any medical impediments during

the 2006 and 2007 audits and even extolled his “magic memory” during interviews

with Agent Atherton. Dr. Warwick’s testimony and medical records show that any

diminished capacity resulting from petitioner’s 1999 stroke, TIA, stress syndrome,

or hydrocephalus had largely been resolved before 2006 and 2007. In 2006 and

2007 petitioner sought medical treatment from Dr. Warwick on at least five

separate occasions, yet on no occasion did petitioner mention that he suffered from

the medical conditions that he now argues impaired his cognitive abilities.

         Finally, petitioner argues that he was going through a difficult period

because of his divorce and the poor health of his father. While we credit this part

of his testimony, petitioner has failed to establish that these personal events caused

his understated income. First, we note that petitioner successfully ran REM’s

business affairs in those same years. Second, petitioner’s divorce, which was
                                          -31-

[*31] finalized by 2006, cannot account for his 2007 deficiency. Third,

petitioner’s prior audits established a long history of keeping inaccurate records

and underreporting his tax liabilities that predates his divorce and his father’s poor

health. For these reasons, we do not find credible petitioner’s argument that his

2006 and 2007 underpayments were due to these personal events.

      In the light of the foregoing discussion, we are convinced that petitioner’s

underreporting of income for the years at issue was attributable to fraud. The

record also fails to establish by a preponderance of the evidence that petitioner

acted reasonably and in good faith. Consequently, we sustain respondent’s

determinations of the fraud penalties.

              ____________________________________________

      Any arguments not discussed in this opinion are irrelevant, moot, or lacking

in merit.

      To reflect the foregoing,


                                                 Decisions will be entered for

                                         respondent.
