                              T.C. Memo. 2015-116



                        UNITED STATES TAX COURT



               DON WARNER REINHARD, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 4589-12.                         Filed June 24, 2015.



      Don Warner Reinhard, pro se.

      Miriam C. Dillard, A. Gary Begun, and Caroline R. Krivacka, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: By notice of deficiency dated November 15, 2011,

respondent determined a deficiency in petitioner’s Federal income tax for 2001 of
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[*2] $216,498 and a penalty for fraud under section 6663 of $162,374.1 Apart

from computational matters, the issues for decision are (1) whether petitioner

improperly claimed a loss deduction of $554,622 from his wholly owned

subchapter S corporation for 2001 and (2) whether the underpayment attributable

to the claimed loss deduction was due to fraud, justifying the penalty and negating

the bar of the statute of limitations. We answer both questions in the affirmative.

                               FINDINGS OF FACT

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

facts and the attached exhibits are incorporated herein by this reference. Petitioner

resided in Georgia when the petition was filed.

      Petitioner was an experienced and successful investment adviser. He holds

a bachelor’s degree in finance and a master’s degree in business administration.

During 2001 petitioner owned Magnolia Capital Management, Inc. (MCM), a

subchapter S corporation. MCM was the sole owner of a limited partnership

called Magnolia Capital Management, LP (MCM LP). MCM LP was a general

partner of several hedge funds that managed investments for petitioner’s clients.




      1
       All section references are to the Internal Revenue Code as in effect for the
tax year at issue. All Rule references are to the Tax Court Rules of Practice and
Procedure. All dollar amounts are rounded to the nearest dollar.
                                         -3-

[*3] For 2001 both MCM and MCM LP reported the same $38,013 as their only

income.

      On April 2, 2003, petitioner filed his 2001 Federal income tax return. The

return was prepared by a certified public accountant (C.P.A.). On Schedule E,

Supplemental Income and Loss, petitioner claimed a flowthrough loss of $516,609

from MCM. Although MCM did not report a loss on its Form 1120S, U.S. Income

Tax Return for an S Corporation, petitioner claimed a loss deduction of $554,622

on his own tax return and applied it against the $38,013 of passthrough income he

reported from MCM. The deduction was characterized in a statement attached to

petitioner’s 2001 return as “General Partner Expenses paid to reimburse”.

      Petitioner claimed the deduction for payments he allegedly made to his

clients to reimburse them for their losses in the hedge funds. Petitioner did not

provide any detailed information or documentation about these payments to the

C.P.A. who prepared his return. He simply told the C.P.A. to use the $554,622

expense on his 2001 income tax return.

      Ten days after petitioner filed his 2001 return, he submitted a different

version of the return to a bank while applying for a loan. This version omitted the

$554,622 deduction petitioner claimed on his filed tax return.
                                        -4-

[*4] From December 2002 through June 2003 petitioner engaged in a fraudulent

scheme to retain his hedge fund clients during a tumultuous year. During this

time, petitioner provided his clients with false quarterly account statements

showing materially inflated account values. When margin calls on these accounts

were issued in August 2003, his clients’ accounts were dissolved in a single day.

Some of the clients sued petitioner to recover their lost funds.

      On November 3, 2006, as litigation with these clients was pending,

petitioner voluntarily filed a petition with the U.S. Bankruptcy Court for the

Northern District of Florida under 11 U.S.C. chapter 7, No. 06-50298-KKS.

During the bankruptcy proceedings petitioner failed to report numerous assets on

his bankruptcy schedules, including two boats, a Harley Davidson motorcycle,

investment accounts, and $40,000 of artwork.

      On October 21, 2008, petitioner was indicted in the U.S. District Court for

the Northern District of Florida on 23 counts of criminal misconduct. United

States v. Reinhard, No. 4:08-Cr-00049-RH-CAS (N.D. Fla. filed Oct. 21, 2008).

On May 13, 2009, petitioner pleaded guilty to seven counts of the indictment,

including: (1) making false statements on his 2001 and 2002 income tax returns,

in violation of section 7206(1); (2) making false statements on a loan application,
                                           -5-

[*5] in violation of 18 U.S.C. sec. 1014; and (3) transferring assets and concealing

them from the bankruptcy trustee, in violation of 18 U.S.C. sec. 152(7).

      In the stipulated factual basis for plea, petitioner admitted that he included a

$554,622 fraudulent Schedule E expense as part of his 2001 individual income tax

return. He admitted that he underpaid his tax by $216,498 and that his 2001 tax

return was materially false as a result of his underreported Schedule E income.

The factual basis for plea also showed that petitioner’s criminal activity occurred

over several years and involved numerous false filings and statements, including

filing a fraudulent tax return for 2002.

      On April 30, 2012, petitioner submitted a Form 1040X, Amended U.S.

Individual Income Tax Return, for 2001. The amended return removed the

$554,622 Schedule E deduction and claimed a net operating loss carryback from a

subsequent year.2 Petitioner now argues that the Schedule E deduction should

have been claimed for 2002 and 2003.

      On January 5, 2011, petitioner submitted documents to respondent in an

effort to substantiate the disallowed $554,622 deduction. The documents show

      2
        Petitioner’s amended tax return is unclear as to whether he reported a net
operating loss carryback from his 2002 tax return or his 2003 tax return. On his
petition, petitioner reported only a net operating loss carryback from his 2002 tax
return. Respondent’s filings with the Court suggest, and we will assume, that
petitioner reported net operating loss carrybacks for both years.
                                         -6-

[*6] that petitioner made cash transfers from his personal bank account to

accounts for the hedge funds. In one instance, a cash transfer was made to a

client’s bank account in 2002. According to the documents, all of the transfers

took place in either 2002 or 2003 and pertain only to $318,906 of petitioner’s

claimed deductions. Petitioner did not attempt to substantiate the remaining

$235,716 on his 2001 return. Petitioner claims that these transfers show that he

reimbursed several clients for their investment losses and that he refunded the

clients’ previously charged management fees. Petitioner claims that instead of

distributing cash to the clients, he reimbursed them by increasing their capital

accounts in one particular hedge fund managed by MCM LP.

       In claiming the deduction, petitioner relies on a letter submitted by a C.P.A.

to petitioner’s public defender in his criminal case. In the letter, the C.P.A. states

that, on the basis of petitioner’s representations, he believed petitioner incurred

expenses related to these transactions in 2002 and 2003. The C.P.A. did not

testify at trial.

                                      OPINION

I.     Petitioner’s Claimed Schedule E Deduction

       The Commissioner’s determinations set forth in a notice of deficiency are

generally presumed correct, and the taxpayer bears the burden of proving them
                                        -7-

[*7] erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner does not contend that the burden of proof as to any factual issue should

shift to respondent under section 7491(a).

      Section 162(a) allows a taxpayer to deduct “all the ordinary and necessary

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

business”. A necessary expense is one that is “appropriate and helpful” to the

taxpayer’s business, while an ordinary expense is one that is common or frequent

in the type of business in which the taxpayer is engaged. Deputy v. du Pont, 308

U.S. 488, 495 (1940); Welch v. Helvering, 290 U.S. at 113. The taxpayer bears

the burden of proving that reported expenses are ordinary and necessary. See Rule

142(a). The taxpayer also bears the burden of substantiating expenses underlying

claimed deductions. See sec. 6001; Hradesky v. Commissioner, 65 T.C. 87, 89

(1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).

      Respondent determined that petitioner improperly claimed a passthrough

loss deduction of $516,609 from MCM for 2001. The loss resulted from a

deduction of $554,622 against $38,013 of income that MCM reported for that

year. Petitioner concedes that the deduction should not have been claimed for

2001. Instead, on his amended return petitioner claims his income for 2001 was

fully offset by a net operating loss carryback from 2002 and 2003.
                                        -8-

[*8] Petitioner has not provided any evidence of a net operating loss for 2002 or

2003, and we have no way of determining from the record whether a net operating

loss was available for these years. See sec. 1.172-1(c), Income Tax Regs. (“Every

taxpayer claiming a net operating loss deduction for any taxable year shall file

with his return * * * a concise statement setting forth the amount of the net

operating loss deduction claimed and all material and pertinent facts relative

thereto, including a detailed schedule showing the computation of the net

operating loss deduction.”); see also Ames-Mechelke v. Commissioner, T.C.

Memo. 2013-176; Philpott v. Commissioner, T.C. Memo. 2012-307. Regardless

of whether petitioner had verifiable expenses in 2002 when he transferred money

from his personal bank account to the bank account of a client, we cannot

determine that he had an aggregate net operating loss for that year.

      Accordingly, we sustain respondent’s deficiency determination for the 2001

tax year.

II.   Fraud Penalty

      If any part of any underpayment of tax required to be shown on a return is

due to fraud, section 6663(a) imposes a penalty of 75% of the portion of the

underpayment due to fraud. Fraud is an intentional wrongdoing on the part of the

taxpayer with the specific purpose of evading a tax believed to be owing. Edelson
                                        -9-

[*9] v. Commissioner, 829 F.2d 828, 833 (9th Cir. 1987), aff’g T.C. Memo. 1986-

223; DiLeo v. Commissioner, 96 T.C. 858, 874 (1991), aff’d, 959 F.2d 16 (2d Cir.

1992). The Commissioner has the burden of proving fraud, and he must prove it

by clear and convincing evidence. Sec. 7454(a); Rule 142(b); Langille v.

Commissioner, T.C. Memo. 2010-49, aff’d, 447 Fed. Appx. 130, 134 (11th Cir.

2011). To sustain his burden, the Commissioner must establish two elements:

(1) that there was some underpayment of tax for the taxable year at issue and

(2) that at least some portion of the underpayment was due to fraud. Hebrank v.

Commissioner, 81 T.C. 640, 642 (1983). If the Commissioner proves that any

portion of an underpayment is attributable to fraud, then the entire underpayment

shall be treated as attributable to fraud unless the taxpayer shows by a

preponderance of the evidence that some portion was not so attributable. Sec.

6663(b).

      A.     Underpayment of Tax

      Petitioner’s conviction pursuant to section 7206(1) for filing a false return

for 2001 estops him from contesting that an underpayment exists for that year.

See Considine v. United States, 683 F.2d 1285, 1287 (9th Cir. 1982); Wright v.

Commissioner, 84 T.C. 636, 643-644 (1985); McGowan v. Commissioner, T.C.

Memo. 2004-146, aff’d, 187 Fed. Appx. 915 (11th Cir. 2006).
                                       - 10 -

[*10] B.     Fraudulent Intent

      Under usual circumstances, fraud is rarely admitted and direct evidence of

the taxpayer’s intent is rarely available. In these instances fraud may be proved by

circumstantial evidence and reasonable inferences drawn from the facts. Bradford

v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601;

Petzoldt v. Commissioner, 92 T.C. 661, 699 (1989).

      Petitioner admitted as part of his plea agreement that he “included as part of

his return a fraudulent Schedule E expense of $554,622”. Therefore, petitioner

had admitted to fraud and is liable for the civil fraud penalty under section 6663(a)

for the 2001 tax year. See Abdallah v. Commissioner, T.C. Memo. 2013-279

(holding that taxpayer’s admissions of fraud in plea agreement established

fraudulent intent); Price v. Commissioner, T.C. Memo. 1996-204. Nevertheless,

for the sake of thoroughness, we will examine whether petitioner meets the

circumstantial test for fraud. We hold that he does.

      Circumstances that may indicate fraudulent intent, commonly referred to as

“badges of fraud”, include but are not limited to: (1) understating income; (2)

maintaining inadequate records; (3) giving implausible or inconsistent

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

activities; (6) providing incomplete or misleading information to one’s tax
                                        - 11 -

[*11] preparer; (7) the lack of credibility of the taxpayer’s testimony; and (8) filing

false documents, including false income tax returns. Spies v. United States, 317

U.S. 492, 499 (1943); Morse v. Commissioner, T.C. Memo. 2003-332, aff’d, 419

F.3d 829 (8th Cir. 2005). No single factor is dispositive; however, the existence

of several factors is persuasive circumstantial evidence of fraud. Vanover v.

Commissioner, T.C. Memo. 2012-79.

      Numerous badges of fraud demonstrate that petitioner intentionally evaded

the payment of tax he knew to be owed. He substantially understated his income

for the year at issue and other years by claiming deductions he was not entitled to.

See Hatling v. Commissioner, T.C. Memo. 2012-293. He maintained inadequate

records, and the records he produced lacked credibility and did not substantiate his

claims. See Sowards v. Commissioner, T.C. Memo. 2003-180. His behavior was

inconsistent and implausible when he reported substantially higher income on his

loan application than on his Federal income tax return and offered no logical

explanation for this behavior. See Powerstein v. Commissioner, T.C. Memo.

2011-271. He attempted to conceal assets during his bankruptcy proceeding. See

Bussell v. Commissioner, T.C. Memo. 2005-77, aff’d, 262 Fed. Appx. 770 (9th

Cir. 2007). And he was convicted of willfully filing a false income tax return for

2001. See Wright v. Commissioner, 84 T.C. at 643-644.
                                        - 12 -

[*12] Nevertheless, petitioner argues that he lacked the requisite intent for fraud

because the deduction was appropriate and should have been claimed for 2002 and

2003. Petitioner claims that he incurred expenses in 2002 and 2003 to reimburse

his clients for their investment losses. To bolster his argument, petitioner points to

an opinion letter submitted by a C.P.A. to petitioner’s public defender in his

criminal case. In the letter the C.P.A. acknowledges that petitioner withdrew

money from his personal bank account and transferred it to other accounts, but the

C.P.A. does not make an objective determination of the purpose of the transfers.

The C.P.A. merely relies on petitioner’s representations. Furthermore, the C.P.A.

acknowledges that determining whether petitioner’s reimbursements to clients

were ordinary and necessary business expenses under section 162 was outside the

scope of his opinion letter.

      When he filed his original 2001 tax return in 2003, petitioner was aware that

the payments he reported would have been made in 2002 or 2003, not in 2001.

Yet he directed his C.P.A. to claim a deduction for the payments for 2001 without

any explanation. Petitioner is an intelligent and well-educated businessman, and

we find that he knew that a cash method taxpayer can claim a deduction for an

expense only for the year in which it is paid. See Black v. Commissioner, T.C.

Memo. 2007-364.
                                        - 13 -

[*13] We find that the facts, taken as a whole, clearly and convincingly establish

that petitioner acted with fraudulent intent and that the underpayment attributable

to his claimed loss deduction of $554,622 from his wholly owned subchapter S

corporation was due to fraud.

III.   Statute of Limitations

       Generally, the Commissioner must assess tax within three years after a

return is filed. Sec. 6501(a). There is an exception to this general rule: “In the

case of a false or fraudulent return with the intent to evade tax, the tax may be

assessed * * * at any time.” Sec. 6501(c)(1). We have held that petitioner’s

claimed loss deduction was due to fraud. Therefore, respondent is not time barred

from assessing petitioner’s 2001 tax liability. See Romer v. Commissioner, T.C.

Memo. 2001-168.

       We accordingly sustain respondent’s deficiency determination and

imposition of the civil fraud penalty under section 6663(a) for the 2001 tax year.

       To reflect the foregoing,


                                                 Decision will be entered

                                       for respondent.
