                          T.C. Memo. 1997-455



                        UNITED STATES TAX COURT



                 BONITO RUIZ MOLINAR, Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 411-95.                         Filed October 8, 1997.



     Bonito Ruiz Molinar, pro se.

     Franklin Hise, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:     Respondent determined deficiencies in

petitioners' Federal income tax and additions to tax and

penalties as follows:

                                 Additions to tax and penalties
     Year       Deficiency       Sec. 6653(b)(1)     Sec. 6663
     1988        $15,843             $11,882
     1989         29,538                              $22,154
     1990         41,403                               31,052
                                - 2 -

     Respondent also determined that if petitioner was not liable

for fraud, he was liable for additions to tax and penalties for

negligence under section 6653(a)(1) for 1988, penalties for

negligence under section 6662 for 1989 and 1990, an addition to

tax for substantial understatement under section 6661 for 1988

and additions to tax for failure to timely file under section

6651(a)(1) for 1988 and 1990.

     After concessions, the issues for decision are:

     (1)    Whether, as respondent contends, petitioner had

unreported income of $55,100 in 1988, $114,385 in 1989, and

$23,966 in 1990.    We hold that he did.

     (2)    Whether petitioner is liable for fraud for 1988, 1989,

and 1990.    We hold that he is.1

     Section references are to the Internal Revenue Code in

effect in the years in issue.       Rule references are to the Tax

Court Rules of Practice and Procedure.

                          FINDINGS OF FACT

A.   Petitioner

     Petitioner is a single individual who lived in New Mexico

when he filed his petition.



     1
       We need not consider respondent's alternative
determinations.
                               - 3 -

     1.   1988

     Petitioner bought the El Rancho Motel (the motel) in Deming,

New Mexico, for $175,000 on October 1, 1988.   He owned and

operated it during the years in issue.   He paid $50,000 as a

downpayment and agreed to pay the balance at $1,385.88 per month.

He had gross receipts of $3,193 and expenses of $9,512 (including

$1,819 for depreciation) from the motel in 1988, for a net loss

of $6,319.

     Petitioner reported no other income or deductions for 1988,

1989, and 1990.   Petitioner spent $12,600 for personal living

expenses in each year in issue.

     2.   1989

     Petitioner had gross receipts of $10,500 and expenses of

$35,104 (including $11,806 for depreciation) from the motel in

1989, for a net loss of $24,604.

     On March 3, 1989, the Valencia County Sheriff's Department

arrested petitioner in Valencia County, New Mexico, for

possession of marijuana with intent to distribute.   He owned a

Ford pickup truck in which he was traveling that had a

compartment in the gas tank which concealed 70 pounds of

marijuana wrapped in cellophane.   The marijuana had a wholesale

value of $56,000.   He had $1,447.97 in U.S. currency and 365,670

Mexican pesos with him when he was arrested.   The Valencia County

Sheriff's Department seized the truck.   Petitioner was charged,

convicted, and placed on probation for 1 year for this offense.
                                - 4 -

       On March 20, 1989, petitioner paid $6,000 to the Sheriff's

Department to recover his Ford truck.    Later in 1989, the Drug

Enforcement Agency (DEA) seized the truck.    The gas tank was

still modified to conceal marijuana.     The DEA seized it because

it had been used to transport illegal narcotics.

       Petitioner bought a 1990 Chevrolet truck for $21,556 on

December 28, 1989.    Petitioner paid for the truck in full.

       3.   1990

       Petitioner had gross receipts of $8,767 and expenses of

$15,803 (including $9,099 for depreciation) from the motel in

1990, for a net loss of $7,036.    He also had $18,078 in rental

income for 1990.    He also received $5,000 as damages for an auto

accident in Belen, New Mexico, in July 1988.

       In 1990, petitioner was in the first of two pickup trucks

traveling together that were stopped by the border patrol of the

DEA.    There were no drugs in the first truck.   The second truck

had 115 pounds of marijuana with a wholesale value of $92,000

wrapped in cellophane and concealed in the gas tank.     The driver

of the second truck had petitioner's name and telephone number in

his possession.    The driver of the second truck was convicted of

a drug offense.    Petitioner was not.   Petitioner paid legal fees

of $5,000 for criminal defense work.

       Petitioner gave $15,000 to his brother in 1990.
                                 - 5 -

     4.      Petitioner's Income Tax Returns

     William D. Kennon, a certified public accountant in Deming,

New Mexico, prepared petitioner's Federal income tax returns for

the years in issue.

     Petitioner reported losses from the motel of $6,319 in 1988,

$24,604 in 1989, and $7,036 in 1990.     Those losses included

depreciation of $1,819 in 1988, $11,806 in 1989, and $9,099 in

1990.     He filed his 1989 return on or after October 10, 1990, and

his 1990 return on or after October 15, 1991.

B.   Respondent's Audit and Determination

     The U.S. Attorney's office told Kathleen Roberts (Roberts),

respondent's revenue agent, that petitioner may have unreported

income because he was a drug trafficker.       Roberts first audited

only petitioner's 1988 tax year, but later audited 1989 and 1990.

Roberts met once with petitioner and once at a different time

with his representative.     Roberts asked them to produce books and

records for the years in issue, but they never did.      Petitioner

first told Roberts that his records were in Mexico.      Later,

petitioner told Roberts that his records had been stolen.

     Roberts used the source and application of funds method to

calculate petitioner's income for the years in issue because

petitioner did not have records, petitioner engaged in illegal

drug activities, and he spent much more than he reported as

income on his tax returns.     Roberts' audit of petitioner revealed

the following:
                                 - 6 -

                              1988         1989         1990
Source
   Cash on hand           $12,000
   Insurance proceeds                                  $5,000
   Depreciation                1,819      $11,806       9,099
   Gross receipts                          10,500       8,767
   Sch. E income                                       30,000

     Total sources        $13,819         $22,306     $52,866

Application
   Sch. C expenses                        $35,104     $15,803
   Net loss, Sch. C        $6,319
   Purchase motel          50,000
   Personal living expense 12,600          12,600      12,600
   Purchase truck                          21,556
   Purchase truck                           6,000
   Equity motel                             5,431       6,457
   Marijuana                               56,000      92,000
   Gift to brother                                     15,000
   Legal fees                                           5,000
   Sch. E expenses                                     11,922
   Cash payment motel                                  10,050
     Total applications   $68,919        $136,691    $168,832

Excess of applications
     over sources             55,100      114,385     115,966

     Respondent determined the deficiencies at issue in this case

based on Roberts' analysis.

C.   Trial

     Petitioner did not appear at trial or request a continuance,

and no one appeared on his behalf.

     At trial, respondent conceded that the $92,000 of marijuana

seized by the DEA in 1990 from the second vehicle should not be

counted as an application of petitioner's funds.2


     2
       Respondent now contends that for 1990, petitioner is
liable for a deficiency of $7,851 and a penalty for fraud under
sec. 6663 of $5,888.
                                 - 7 -

                               OPINION

A.   Deficiencies

     Taxpayers must maintain sufficient records to determine

their correct tax liabilities.    Sec. 6001.   The Commissioner may

reconstruct income using any method that is reasonable in light

of all facts and circumstances if a taxpayer does not keep

sufficient records.   Sec 446; Petzoldt v. Commissioner, 92 T.C.

661, 686-687 (1989); Harbin v. Commissioner, 40 T.C. 373, 376

(1963).

     This Court has approved the Commissioner's use of the source

and application of funds method to reconstruct income.     Vassallo

v. Commissioner, 23 T.C. 656, 661-662 (1955).     This method is

based on the assumption that the amount by which the taxpayer's

application of funds exceeds his or her known sources of income

is taxable income, unless the taxpayer shows that he or she had a

nontaxable source.    See Taglianetti v. United States, 398 F.2d

558, 562 (1st Cir. 1968).

     Petitioner did not have adequate records.    Respondent used

the source and application of funds method to reconstruct

petitioner's income for the years in issue and to determine the

deficiencies and additions to tax in this case.    At trial,

respondent's agent explained the basis for each source and

application that she used to reconstruct petitioner's income in

this case.   Respondent's agent interviewed petitioner and his

representative and obtained documents from third parties to
                               - 8 -

reconstruct petitioner's income.   By applying the source and

application of funds method, respondent's agent concluded that

petitioner had income of $55,100 in 1988, $114,385 in 1989, and

$23,966 (as adjusted for respondent's concession) in 1990.

     Respondent's determination is presumed to be correct, and

petitioner bears the burden of proving otherwise.   Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933).    Petitioner did not

do so.   He did not contact the Court to explain why he did not

appear for trial.   In his petition, petitioner contended that

respondent's method of reconstructing income was incorrect

because he had a cash hoard from Mexico before 1988.    However,

there is no evidence that he had a cash hoard.

     We sustain respondent’s determinations as to the

deficiencies for 1988, 1989, and 1990 (except as conceded by

respondent for 1990).

B.   Fraud

     Respondent determined that petitioner is liable for the

addition to tax for fraud under section 6653(b) for 1988 and the

fraud penalty under section 6663 for 1989 and 1990.    A taxpayer

is liable for an addition to tax or penalty for fraud equal to 75

percent of the part of the underpayment that is due to fraud.

Secs. 6653(b), 6663(a).   If the Commissioner shows that any part

of an underpayment is due to fraud, the entire underpayment is

treated as due to fraud unless the taxpayer proves that part of

the underpayment is not due to fraud.   Secs. 6653(b)(2), 6663(b).
                                   - 9 -

     Respondent has the burden of proving fraud by clear and

convincing evidence.    Sec. 7454(a); Rule 142(b); Parks v.

Commissioner, 94 T.C. 654, 660 (1990).      First, respondent must

prove that there is an underpayment.       Parks v. Commissioner,

supra.    Respondent may not rely on the taxpayer's failure to

carry the burden of proving the underlying deficiency.       Parks v.

Commissioner, supra at 660-661.       Second, respondent must show

that the taxpayer intended to evade taxes by conduct intended to

conceal, mislead, or otherwise prevent tax collection.       Stoltzfus

v. United States, 398 F.2d 1002, 1004 (3d Cir. 1968); Parks v.

Commissioner, supra at 661; Rowlee v. Commissioner, 80 T.C. 1111,

1123 (1983).

     1.     Underpayment

     Respondent may prove that the taxpayer underpaid tax by

proving that the taxpayer had a likely source of the unreported

income, Holland v. United States, 348 U.S. 121 (1954); Parks v.

Commissioner, supra; Nicholas v. Commissioner, 70 T.C. 1057

(1978), or, where the taxpayer alleges a nontaxable source, by

disproving the alleged nontaxable source; United States v.

Massei, 355 U.S. 595 (1958); Kramer v. Commissioner, 389 F.2d

236, 239 (7th Cir. 1968), affg. T.C. Memo. 1966-234; Parks v.

Commissioner, supra.       Petitioner does not allege that he had

nontaxable sources of income.      His only known source of legal

income was the motel.      Petitioner's illegal drug trafficking

activities were a likely source of his unreported income.
                               - 10 -

Petitioner underpaid his tax each year for which Roberts applied

the source and application of funds method.

     2.    Fraudulent Intent

     Respondent must prove by clear and convincing evidence that

petitioner had fraudulent intent.    Parks v. Commissioner, supra

at 664.    Fraud is defined as actual, intentional wrongdoing,

Mitchell v. Commissioner, 118 F.2d 308, 310 (5th Cir. 1941),

revg. 40 B.T.A. 424 (1939), or intentionally committing an act

for the specific purpose of evading a tax believed to be owing.

Webb v. Commissioner, 394 F.2d 366, 377 (5th Cir. 1968), affg.

T.C. Memo. 1966-81.

     The Commissioner may prove fraud by circumstantial evidence

because direct evidence of the taxpayer's intent is rarely

available.    Stephenson v. Commissioner, 79 T.C. 995, 1005-1006

(1982), affd. 748 F.2d 331 (6th Cir. 1984).    The courts have

developed a number of objective indicators or "badges" of fraud,

such as:    (a) A pattern of understatement of income, (b)

inadequate books and records, (c) implausible or inconsistent

explanations of behavior, (d) engaging in illegal activities, and

(e) failure to cooperate with tax authorities.    Bradford v.

Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C.

Memo. 1984-601.    We consider all of the facts and circumstances

of each case to decide if fraudulent intent is present.      King's

Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 516

(1992); Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).
                               - 11 -

            a.   A Pattern of Substantially Understating Income

     A pattern of substantially underreporting income over

several years is evidence of fraud.     Holland v. United States,

supra at 137-139; Estate of Mazzoni v. Commissioner, 451 F.2d

197, 202 (3d Cir. 1971), affg. T.C. Memo. 1970-37 and T.C. Memo.

1970-144.    Petitioner underreported his income by $55,100 in

1988, $114,385 in 1989, and $23,966 in 1990.    A pattern of

consistent underreporting of income for several years, especially

when accompanied by other circumstances showing intent to conceal

such as dealing in illegal drugs, is strong evidence of fraud.

Holland v. United States, supra; Patton v. Commissioner, 799 F.2d

166, 171 (5th Cir. 1986), affg. T.C. Memo. 1985-148; Estate of

Mazzoni v. Commissioner, supra; Anderson v. Commissioner, 250

F.2d 242, 250 (5th Cir. 1957), affg. on this issue T.C. Memo.

1956-178.

            b.   Failing to Maintain Adequate Records

     A taxpayer's failure to keep adequate records is a badge of

fraud.   Bradford v. Commissioner, supra; Lollis v. Commissioner,

595 F.2d 1189, 1192 (9th Cir. 1979), affg. T.C. Memo. 1976-15.

Petitioner did not keep adequate records.

            c.   Implausible or Inconsistent Explanations

     Implausible or inconsistent explanations of behavior by a

taxpayer to respondent's agents can show that he or she had

fraudulent intent.    Bradford v. Commissioner, supra at 307;

Grosshandler v. Commissioner, 75 T.C. 1, 20 (1980).     Petitioner
                               - 12 -

told Roberts that his books and records were in Mexico.      Later,

he told Roberts that his books and records had been stolen.

            d.   Engaging in Illegal Activities

     Engaging in illegal activities is evidence that the taxpayer

intends to evade tax.    Bradford v. Commissioner, supra at 308;

see Patton v. Commissioner, supra (income from illegal activities

is a badge of fraud).    Petitioner engaged in illegal drug

activities during the years in issue.

            e.   Failure to Cooperate With Tax Authorities

     A taxpayer's failure to cooperate with the Commissioner's

examining agents is a badge of fraud.    Bradford v. Commissioner,

supra.    Petitioner did not cooperate with Roberts.

     3.     Conclusion

     Respondent has proven by clear and convincing evidence that

petitioner is liable for the addition to tax and penalty for

fraud.    We sustain respondent's determination except for the

concession for 1990, and hold that petitioner is liable for the

addition to tax for fraud under section 6653(b) for 1988 and the

penalty for fraud under section 6663 for 1989 and 1990 and that

all of the underpayments are due to fraud.

     To reflect the foregoing and respondent's concession,


                                                  Decision will be

                                     entered under Rule 155.
