                             T.C. Memo. 2015-179



                        UNITED STATES TAX COURT



              TRANSUPPORT, INCORPORATED, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 12152-13.                        Filed September 14, 2015.



      Michael S. Lewis and William F. J. Ardinger, for petitioner.

      Carina J. Campobasso and Kimberly A. Kazda, for respondent.



           MEMORANDUM FINDINGS OF FACT AND OPINION


      COHEN, Judge: Respondent determined deficiencies and penalties as

follows:
                                        -2-

                                                             Penalty
        [*2] Year                 Deficiency                sec. 6663
             1999                 $851,574                $638,680.50
             2000                1,402,030                1,051,522.50
             2001                1,078,565                  808,923.75
             2002                1,455,383                1,091,537.25
             2003                  977,921                  733,440.75
             2004                1,154,302                  865,726.50
             2005                1,042,719                  782,039.25
             2006                1,598,974                1,199,230.50
             2007                1,544,646                1,117,893.75
             2008                1,610,702                1,208,026.50

The deficiencies and penalties are attributable to adjustments of petitioner’s costs

of goods sold and officers’ compensation and arose from statements made by

petitioner and by its shareholder and president, Harold Foote (Foote), when

petitioner was offered for sale in 2007. The issue for decision in this opinion is

whether respondent has proven fraud by clear and convincing evidence for

purposes of the statute of limitations, section 6501(c)(1) and (2), and the section

6663 fraud penalties. Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all Rule references are

to the Tax Court Rules of Practice and Procedure.
                                          -3-

[*3]                                  Introduction

       Of the 10 years in issue in this case, assessments for 7 of those years are

barred by the statute of limitations absent proof of fraud; and it is this issue that is

the subject of this opinion. Twelve witnesses testified over five days, and

approximately 135 exhibits were marked, some for identification only. Due to

scheduling issues, trial was suspended after introduction of all factual evidence.

The only remaining evidence to be considered is expert testimony on the costs of

goods sold and reasonable compensation issues, based on previously submitted

reports, and cross-examination of experts. The factual findings in this opinion

include only those material to our conclusions regarding fraud, and further

findings will be necessary if other issues are the subject of a future opinion.

       At the conclusion of the factual evidence, the Court commented that

respondent had not established fraud by clear and convincing evidence, and the

fraud issue should be decided so that the evidence and arguments over costs of

goods sold and reasonable compensation would follow a determination of whether

10 years or 3 years remain in issue. Respondent’s counsel requested permission to

brief the fraud issue. The parties thereafter filed over 400 pages of briefs. The

Court’s views have not been altered by the posttrial briefs.
                                         -4-

[*4]                            FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulated facts are

incorporated in this opinion by this reference. Petitioner’s place of business was

in New Hampshire when the petition was filed.

       Petitioner is a supplier and surplus dealer of aircraft engines and engine

parts for use in military vehicles, including helicopters, airplanes, and tanks. It

primarily purchased surplus parts from the Government in bulk lots that contained

parts having little value as well as parts that petitioner wanted for its business.

Petitioner bought the lots to acquire items that it expected to sell but ended up

with items that would not be sold. The costs of particular items were not specified

as part of the purchase transactions.

       Petitioner was also a distributor of parts. The distributorship line of

business is referred to in the record as the Goodrich line. Distributorship

purchases were of specific parts, and the individual item costs were traceable. The

purchased distributorship items were susceptible of accurate inventory accounting,

and some computer records were kept in later years; but an accurate inventory was

never made part of petitioner’s financial and tax reporting.

       Foote, its president and chief executive officer, founded petitioner in 1972.

During the years in issue Foote and his four sons, William Foote (W. Foote),
                                          -5-

[*5] Kenneth Foote (K. Foote), Richard Foote (R. Foote), and Jeffrey Foote (J.

Foote) were petitioner’s only full-time employees and officers. None of

petitioner’s officers is an accountant.

      In 1999 Foote owned 98% of petitioner’s stock. The other 2% was

owned by Richard Smith, an unrelated person. As of December 31, 2004,

petitioner had issued, and had outstanding, 1,000 shares of class A voting common

stock and 9,000 shares of class B nonvoting common stock. On August 8, 2005,

Foote transferred 2,250 shares of class B nonvoting common stock to each of his

four sons. Accordingly, after this transfer, Foote owned 1,000 shares of class A

voting common stock and his four sons each owned 2,250 shares of class B

nonvoting common stock.

       Starting in the mid-to-late 1970s, petitioner retained Elaine Thompson as

its accountant, and she served as petitioner’s outside accountant until she died in

2010. Thompson was a certified public accountant (C.P.A.), was a name partner

in her firm, and was the first female president of the Connecticut Society of

Certified Public Accountants.

      Petitioner provided to Thompson handwritten summaries, usually prepared

by J. Foote. Thompson, through her accounting firm, prepared compiled financial

statements for petitioner for 1990 through 2008. The compiled financial
                                       -6-

[*6] statements were based upon the summaries and upon financial information

maintained by petitioner. The financial statements were not audited by Thompson

or her firm, and the information on the summaries was never verified by

Thompson or her firm. In a memorandum dated December 22, 2000, Thompson

advised Foote that “any inventory increase creates more income”.

      Petitioner filed Form 1120, U.S. Corporation Income Tax Return, for each

of the years in issue. Thompson prepared petitioner’s Forms 1120 using the same

financial information provided by petitioner in connection with preparation of

petitioner’s compiled financial statements.

      On petitioner’s returns the inventory and cost of goods sold amounts were

reported as follows:

                Inventory         Ending       Cost of      Cost of goods sold
      Year      purchases        inventory    goods sold     as a % of sales

      1990     $2,438,837        $349,036     $2,411,031           70.2%

      1991       2,411,063        504,265      2,293,132           69.0%

      1992       5,722,070        517,336      5,766,439           83.2%

      1993       2,992,018        575,808      2,989,565           71.5%

      1994       2,889,862        595,180      2,942,558           70.1%

      1995       5,735,674        698,584      5,715,005           79.6%

      1996       4,534,762        671,351      4,635,362           72.2%
                                        -7-

 [*7] 1997       8,442,613        700,851        8,466,177         80.5%

      1998       5,025,653        725,921        5,095,312         70.6%

      1999       4,582,833        731,783        4,619,035         68.0%

      2000       6,823,574        876,651        6,749,058         69.0%

      2001       5,653,767      1,488,289        5,086,870         63.5%

      2002       6,962,709      1,232,117        7,266,115         68.8%

      2003       5,523,832      1,553,889        5,264,284         64.4%

      2004       5,643,235      1,520,813        5,724,397         62.4%

      2005       5,401,471      1,389,847        5,603,004         68.1%

      2006       7,160,157      1,657,697        6,951,132         66.6%

      2007       6,510,873      1,867,257        6,365,543         60.7%

      2008       8,257,286      2,662,956        7,519,086         63.0%

Costs of goods sold reported as percentages of purchases ranged from 91% for

2008 to over 100% for 1999, 2002, 2004, and 2005.

      Petitioner’s Forms 1120 for 1982 and 1983 were audited by the Internal

Revenue Service (IRS) in 1984. Petitioner’s Forms 1120 for 1988, 1989, and

1990 were audited by the IRS in 1992. During each of the audits the examining

agent was aware that petitioner did not maintain a physical inventory of the unsold

parts in its warehouse and backed into the closing inventory, reported in its

returns, by using a percentage of sales as costs of goods sold. The examining
                                         -8-

[*8] agent conducting the audit for 1990 was advised that some surplus items had

been sold at amounts in excess of 100% gross profit, but he accepted petitioner’s

representation that, on the basis of Foote’s experience in selling the surplus items,

petitioner had averaged approximately a 30% gross profit margin. Although the

examining agents in each audit informed Foote or petitioner’s C.P.A. that

petitioner should maintain a physical inventory, the costs of goods sold were

adjusted only to reflect a minor change in the purchases that petitioner made in

1983.

        In 2000, 2002, 2004, and 2005, petitioner obtained appraisal reports that

presented a valuation analysis of the fair market value of petitioner’s stock as of

December 31, 1999, 2001, 2003, and 2004, respectively. The appraisal reports

were obtained in relation to Foote’s intent to make gifts of stock to his sons. After

the first appraisal Foote attempted to persuade the appraiser to reduce the

appraised value because the appraiser’s value would make it harder for Foote to

give petitioner’s stock to his sons. Foote later gave his sons stock valued at the

maximum allowed without gift tax liability and arranged for his sons to pay the

balance of the purchase price over a period of years. Foote and W. Foote were

familiar with the estate and gift tax consequences of such gifts. Foote was also

familiar with the marginal income tax rates applicable to him and to his sons.
                                                                 -9-

[*9] On its Forms 1120 for 1999 through 2008, petitioner deducted the following

amounts as compensation:

  O fficer       1999        2000        2001         2002        2003        2004        2005         2006         2007         2008


 Foote          478,528     593,587     538,213      538,269     428,291     513,152     213,194      353,211      478,993      599,858


 R . Foote      255,000     425,000     407,500      495,000     425,000     510,000     390,000      575,000      675,000      720,000


 K. Foote       255,000     425,000     407,500      495,000     425,000     510,000     390,000      575,000      675,000      720,000


 J. Foote       255,000     425,000     407,500      495,000     425,000     510,000     390,000      575,000      675,000      720,000


 W . Foote      255,000     425,000     407,500      495,000     425,000     510,000     390,000      575,000      675,000      720,000


 O thers           -0-         -0-         -0-         -0-          -0-         -0-         -0-          5,952        8,366        6,323


   Total       1,498,528   2,293,587   2,168,213    2,518,269   2,128,291   2,553,152   1,773,194    2,659,163    3,187,359    3,486,181


  G ross
  sales        6,796,928   9,781,839   8,004,622   10,563,463   8,174,258   9,174,563   8,227,003   10,439,336   10,483,854   11,943,576


    %           22.047%     23.447%     27.087%      23.839%     26.037%     27.829%     21.553%      25.473%      30.403%      29.189%




The closing inventory reported on petitioner’s Forms 1120 for 1999 through 2008

was: $731,783, $876,651, $1,488,289, $1,232,117, $1,553,889, $1,520,813,

$1,389,847, $1,657,697, $1,867,257, and $2,662,956, respectively.

             In 2007 Foote considered selling petitioner. On May 3, 2007, petitioner

entered into a nondisclosure agreement with Richard Lodigiani of BTS New

England, Inc. Foote provided Lodigiani with estimates of inventory and profit

margins on surplus parts. Lodigiani prepared several drafts of documents titled

“Confidential Offering Memorandum”. The drafts were based on information

provided by Foote, by J. Foote, and by Thompson. The drafts included a

document entitled “Recast Financial Summary”, in which the profits of
                                        - 10 -

[*10] petitioner’s operations as reported on its financial statements and tax returns

were substantially improved. Explanatory notes on the Recast Financial Summary

were as follows:

      Five shareholder salaries recast to market rate of $50,000 annually
      each.

      Management has elected to use an accounting method that writes off
      the majority of inventory as purchased. It is conservatively estimated
      that actual gross profit on sales exceeds 75% on general part sales and
      33% on distributor sales (approx. 20% of sales). Management
      believes that non-obsolete inventory on hand exceeds
      $100,000,000.00 at cost. The inventory adjustment shown above
      adjusts annual gross profit using the formula of 33% x distributor
      sales and 75% x general parts sales.

Documents prepared by Lodigiani also included an executive summary that

included the following statement:

             The company generates average gross profits exceeding 75%
      on the general parts sales and approximately 33% on the Goodrich
      distributorship sales. Project 07’ [sic] sales are approximately
      $12,000,000.00. The company operates with no formal marketing
      and very limited web presence. Growth throughout the world to the
      thousands of users of these turbine engines is unlimited. The
      company currently has inventory in excess of $100,000,000.00 at cost
      with a retail market value that exceeds $500,000,000.00.

      J. Foote provided to Lodigiani a document captioned “Honeywell 2007 T53

Price Book Effective: Jan 1, 2007” (Honeywell list), that listed parts, stock

quantities, and extended prices totaling $312,413,888.70, which J. Foote
                                        - 11 -

[*11] represented to be “reasonably accurate”. The Honeywell list was prepared

by W. Foote, whose duties for petitioner included inventory management. The

cost of a single type of nozzle listed on the Honeywell list in petitioner’s inventory

in 2007 was approximately $800,000. Another sample of items on the Honeywell

list in stock in 2007 had purchase prices totaling over $11 million. The lower of

cost or market value of the items on the Honeywell list alone far exceeded the total

inventory values reported on petitioner’s financial statements and tax returns.

      Foote also provided prospective purchasers with information about engines

in inventory in 2007. The estimated cost of a sample of the engines (identified by

Foote in his trial testimony) was approximately $2,440,000, and Foote estimated

the retail value at $60 million. By any measure, petitioner’s inventory at cost or

market value in 2007 far exceeded the inventory values reported on petitioner’s

correlating financial statements and tax return.

      Copies of the documents prepared by Lodigiani were provided to

prospective purchasers, including Beran Peter (B. Peter), Patrick Bromley, and

Peter LaHaise. Although B. Peter submitted a letter of intent expressing terms for

acquisition of 60% of petitioner, no agreements with respect to transfer of

petitioner were reached. During his conversations with prospective purchasers,

Foote never disavowed the information set forth in the Lodigiani documents.
                                       - 12 -

[*12] On February 12, 2008, LaHaise submitted an application for a

whistleblower award to the IRS Whistleblower Office. LaHaise and his lawyers

met with IRS personnel in relation to his application. LaHaise believes that he

could receive $13 million if respondent is successful in this matter.

      On January 20, 2009, the IRS commenced an audit of petitioner’s returns

for 2006 and 2007. The audit was conducted by Revenue Agent Robert Canale.

By early October 2009 the audit was expanded to include 1999 through 2005.

Petitioner provided invoices and purchase orders to Canale, and Canale toured

petitioner’s premises. Canale spoke by telephone with Thompson, who was ill and

had moved to Illinois, and interacted with one of the members of Thompson’s

firm. Canale interviewed and obtained documents from Lodigiani, B. Peter,

Bromley, and LaHaise.

      Frank J. Wojick, Jr., a senior appraiser and valuation specialist for the IRS,

was assigned to assist Canale in the audit. Petitioner gave Wojick complete and

unlimited access to all of petitioner’s business for his review and analysis and

welcomed Wojick to its facilities. Wojick toured petitioner’s facilities with J.

Foote on September 21, 2009. Wojick was permitted to take photographs of the

exterior and interior of petitioner’s warehouse. Neither Wojick nor Canale

attempted to conduct an inventory valuation of the parts in petitioner’s warehouse.
                                        - 13 -

[*13] In the notices of deficiency petitioner’s costs of goods sold were adjusted to

reflect a 25% cost and a 75% profit on petitioner’s sales of surplus parts.

Compensation to petitioner’s officers other than Foote was reduced to reflect a

reasonable allowance for their compensation. The notices also determined that all

or part of the underpayments of tax were due to fraud or, in the alternative, to the

extent that the fraud penalty did not apply, that an accuracy-related penalty under

section 6662(a) would apply. The determinations were made on the basis of the

admissions in the documents prepared by Lodigiani and statements made to

Canale by Foote.

                                     OPINION

       To sustain the 75% penalty provided by section 6663, the Commissioner

has the burden of proving by clear and convincing evidence (1) an underpayment

of tax and (2) that the underpayment was due to fraud. Sec. 7454(a); Rule 142(b);

see, e.g., May v. Commissioner, 137 T.C. 147 (2011), aff’d per order, 2013 WL

1352477 (6th Cir. Feb. 19, 2013); Sadler v. Commissioner, 113 T.C. 99, 102

(1999); Parks v. Commissioner, 94 T.C. 654, 660-661 (1990).

Underpayment of Tax

      The parties dispute whether petitioner’s costs of goods sold were overstated,

resulting in an underpayment of tax. Petitioner’s briefs rely in large part on
                                        - 14 -

[*14] petitioner’s expert’s opinions, which have not been received in evidence.

During the partial trial the Court indicated substantial problems with the reliability

of the expert’s reports, even without cross-examination of the experts.

Respondent made a motion in limine with respect to petitioner’s expert reports on

costs of goods sold. That expert did not attempt to conduct a physical inventory or

to address the value of parts in petitioner’s warehouse. Petitioner has ignored the

most compelling evidence in this case that its income and tax for the years in issue

were understated, relying instead on retrospective opinions and denials of prior

representations by Foote. Even if the expert reports are received in evidence, they

have no bearing on the state of mind of petitioner’s officers at the relevant times,

i.e., when the returns were filed. The experts’ opinions will be disregarded and

not addressed in this opinion.

      Petitioner also criticizes the testimony of respondent’s witnesses,

particularly LaHaise. Petitioner’s proposed findings of fact consist primarily of

arguments about the evidence and do not conform to Rule 151(e)(3). Our

conclusions are based on our observation of the witnesses and derived from the

contemporaneous records created on petitioner’s behalf.

      Petitioner argues that the consistency in reporting costs of goods sold over

the years is evidence of the correctness of its positions. We reject that argument.
                                        - 15 -

[*15] Petitioner argues, without admissible evidence, that the costs of goods sold

were consistent with industry averages and were consistent from 1990 through the

years in issue. However, the percentages used over the years varied without

explanation and, so far as the record reflects, were not based on industry averages

or reasoned analysis. Foote testified during trial that petitioner’s inventory at cost

was close to $100 million, the amount used in the promotional materials provided

to prospective buyers. He estimated that as much as 80% of the surplus parts

might be scrapped, but his estimates cannot be reconciled with petitioner’s tax

reporting.

      Foote’s sons did not provide any helpful testimony on the value of the

inventory. K. Foote worked closely with purchases and sales but had “no clue” as

to how much the inventory was worth and did not know how costs of goods sold

were determined. J. Foote, who acted as petitioner’s chief financial officer,

testified that he had “no idea” or “not a clue” about petitioner’s inventory at cost

in 2007. J. Foote provided to petitioner’s accountant the numbers used in

preparing petitioner’s tax returns, but he had no idea whether the amounts reported

on the returns were correct or not. W. Foote, whose duties included inventory

management, asserted that “nobody understands * * * our inventory” or that
                                        - 16 -

[*16] nobody can put a total valuation on it. As to a specific part in the inventory,

he had “no earthly clue” as to the purchase price.

      There is no reliable evidence that would enable us to quantify obsolescence

although there is credible evidence that many items purchased as part of

petitioner’s surplus parts operations would never be sold. The totality of the

evidence compels the conclusion that petitioner’s methodology consistently led to

incorrect results. Petitioner failed to keep accurate inventory records, and

respondent has proven that a fraction of the actual ending inventory for certain of

the years in issue was worth substantially more than was reported on petitioner’s

tax returns.

      If a taxpayer’s method of accounting does not clearly reflect income, the

computation of taxable income is made by a method that does clearly reflect

income. Sec. 446(b). Clear reflection of income is a basic principle of inventory

accounting. See secs. 471(a), 472(a); sec. 1.471-2(a)(2), Income Tax Regs.

Section 1.446-1(a)(4)(i), Income Tax Regs., provides:

            (i) In all cases in which the production, purchase, or sale of
      merchandise of any kind is an income-producing factor, merchandise
      on hand (including finished goods, work in process, raw materials,
      and supplies) at the beginning and end of the year shall be taken into
      account in computing the taxable income of the year. * * *
                                        - 17 -

[*17] In this case both parties back into inventory values by first determining costs

of goods sold as a percentage of sales. The evidence, however, refutes the result

of their method as clearly reflecting income.

      We are not persuaded that petitioner realized an average 75% gross profit

on all sales of surplus parts. That result is improbable given the nature of

petitioner’s business, the likelihood that many items will never be sold, and the

inherent obsolescence of some of the accumulated collection of parts. Thus we

discount the reliability of statements made during the attempts to sell petitioner in

2007, some of which Foote described as “bravado” and Lodigiani described as

“puffery”. Exaggerated or false representations to a prospective purchaser may

indicate lack of trustworthiness, but they are not proof of facts. The objective

evidence and the testimony of Foote, however, compel the conclusion that

petitioner’s methodology did not clearly reflect petitioner’s income. Moreover,

the proof that some of the ending inventory was consistently understated is clear

and convincing evidence that the costs of goods sold were consistently overstated

and that taxable income and tax were consistently understated. Respondent has

satisfied this element of the burden of proving fraud.
                                        - 18 -

[*18] Fraudulent Intent

      Respondent must also prove fraudulent intent by clear and convincing

evidence. See sec. 7454(a); Rule 142(b). Respondent must show that the taxpayer

intended to conceal, mislead, or otherwise prevent the collection of taxes. See

Katz v. Commissioner, 90 T.C. 1130, 1143 (1988). The existence of fraud is a

question of fact to be resolved upon consideration of the entire record. King’s

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

will never be presumed. Id.; Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

Fraud may, however, be proved by circumstantial evidence and inferences drawn

from the facts because direct proof of a taxpayer’s intent is rarely available.

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

      Respondent argues that fraud has been proven directly in this case and that,

therefore, the Court need not rely upon the badges of fraud typically used to

determine intent where direct proof of fraudulent intent is unavailable. See, e.g.,

Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986) (setting forth factors

or “badges” of fraud), aff’g T.C. Memo. 1984-601. Respondent’s argument,

however, rests on the assertion that petitioner realized a 75% gross profit on sales

of surplus parts, as claimed by Foote who knowingly represented to petitioner’s

tax preparer that the gross profit percentage was substantially less. Respondent
                                        - 19 -

[*19] relies heavily on the sales materials attributable to petitioner that boasted

about the favorable tax results from writing off “the majority of inventory as

purchased”. The Recast Financial Summary presented on petitioner’s behalf to

prospective purchasers assumed a 75% profit on “general part sales” and a

nonobsolete inventory on hand exceeding $100 million cost.

      We have found that petitioner failed to keep accurate inventory records or

records of costs of goods sold and that a fraction of the actual ending inventory for

certain of the years in issue was worth substantially more than the ending

inventory reported on petitioner’s tax returns. Petitioner’s failures of

recordkeeping preclude a correct determination of the actual costs of sales and net

taxable income, and those failures likely will result in detriment to petitioner.

      The statements made orally and in writing to prospective purchasers of

petitioner’s business by petitioner’s representatives are admissions of the taxpayer

that may be considered as evidence. Such admissions are not conclusive, and they

are not more likely to be truthful than any other uncorroborated statements of

interested persons. In the context in which they were made, those boastful

statements have no more guarantees of truthfulness than the tax return reporting.

The attitude of petitioner’s officers was best expressed by W. Foote during his

testimony about the Honeywell list: “Accuracy was not important. It’s a sales
                                         - 20 -

[*20] document. They can choose to accept it or not accept it, but it’s on them to

come and actually verify what they think we have versus what we actually have.”

      The attitude expressed in W. Foote’s testimony also characterizes

petitioner’s treatment of its tax reporting and its positions in this case. Petitioner’s

arguments are primarily directed--that is misdirected--at the adequacy of the IRS

audits and determinations. Petitioner argues, without admissible evidence, that the

costs of goods sold were consistent with industry averages and were consistent

from 1990 through the years in issue; but the percentages used over the years were

not the same and, so far as the record reflects, were not based on statistical

analysis. Petitioner’s admissions were to the effect that the deducted costs were

based on purchases. The amounts deducted were historically close to the

purchases reported during the tax years. Respondent’s reaction in pursuing the

fraud penalties is certainly understandable, but the objective evidence of

fraudulent intent is simply not clear and convincing.

      Throughout the testimony of petitioner’s officers are indications that a

physical inventory would be too difficult and “not worth the effort” involved.

Without specific and reliable proof that the underpayments that resulted from

flawed recordkeeping and accounting were intended to defraud, we do not agree

that the statements relied on by respondent constitute direct proof.
                                         - 21 -

[*21] We are persuaded that there was a pattern resulting in an underpayment of

tax for each year in issue resulting from petitioner’s failure to keep accurate

records and the undervaluation of ending inventory with consequent overstatement

of costs of goods sold. No other badge of fraud, however, is clearly and

convincingly established in this case.

      Although petitioner was required to and failed to keep inventory records,

the nature of its business of acquiring surplus parts through bulk purchases and

keeping them for years in the hope that many would ultimately be sold provides a

plausible nonfraudulent explanation of those failures. Petitioner’s employees did

not think that the effort to keep reliable inventories was worth the trouble. They

were wrong, and this case should convince them otherwise. However, so far as the

record reflects, neither the IRS agents conducting earlier exams nor petitioner’s

accountant made clear the consequences of failing to do what they should have

been doing. No adjustments were made or suggested during the early audits or the

annual review by the accountant. So far as the record reflects, petitioner was not

clearly advised to find a method to write off obsolete parts as a means of

legitimately reducing the inventory value.

       There is no convincing evidence that petitioner concealed anything from

the examining agents or failed to cooperate, as contended by respondent. The task
                                        - 22 -

[*22] of determining the correct numbers was apparently also too difficult for

Canale, who simply calculated the unreported income by using 75% of sales on

surplus parts as gross profit rather than pursuing more precise records or

reconstructions. Neither party purported to conduct tests of the 75% figure or the

reported figures until expert reports were prepared shortly before trial. Difficulty

does not excuse poor performance, but unreliable evidence undermines the party

having the burden of proof.

      Respondent also asserts “incredible and inconsistent explanations of

behavior and general lack of credibility” as a badge of fraud. Testimony presented

by petitioner’s owners, officers, and employees, particularly when led by counsel

on direct examination, was, not surprisingly, self-serving. To the extent that it

would support petitioner’s positions and satisfy its burden of proof, that testimony

may be unreliable. The Court is not convinced, however, that the testimony is

demonstrably false, which is what respondent argues. Petitioner’s officers’

descriptions of the nature of the business and the difficulties in tracing costs of

goods to sales were credible.

      The role played by petitioner’s accountant in the inaccurate reporting of

petitioner’s tax liabilities cannot be ignored. Because petitioner’s officers

provided the amounts incorporated into its tax returns, which were not audited or
                                        - 23 -

[*23] otherwise verified by the accountant, petitioner cannot sustain a claim of

good-faith reliance on the accountant sufficient to avoid the section 6662(a)

penalty resulting from a substantial understatement of tax or negligence, and that

is an appropriate penalty in this case. Acquiescence in petitioner’s methodology

by its well-credentialed C.P.A., which apparently satisfied successive IRS

examiners, may well have lulled petitioner’s principals into thinking that what

they were doing would pass muster for tax reporting purposes even if the

economics of the business were better than reported. In this context, their open

and puffing statements to prospective purchasers are reconcilable with their

current explanations. There is no clear and convincing evidence to the contrary.

      The admissions made in petitioner’s promotional materials establish that

petitioner’s officers and shareholders knew that the ending inventory was

substantially undervalued. Those materials openly asserted that the accounting

method used allowed current writeoffs of purchases during the year, and they

boasted of a gross profit percentage far in excess of that reported on petitioner’s

tax returns. Those claims, however, were not concealed. Respondent argues that

these same admissions were repeated to respondent’s agents during the

examination. Petitioner’s methodology had been used for years notwithstanding

two prior audits and petitioner’s use of a well-qualified accountant who knew or
                                         - 24 -

[*24] should have known that petitioner did not keep physical inventories.

Petitioner’s officers expected that they could continue with the practices that had

gone unchallenged for so long, and apparently they justified the practices in their

own minds by the difficulties of determining accurate inventories.

      Contrary to petitioner’s contentions, petitioner’s officers were not

unsophisticated about tax matters. They well understood, for example, estate

planning concepts. We do not believe that Foote did not know the difference

between profit margins and markups. We do not believe that petitioner’s officers

were unaware of the overly favorable tax results that they were claiming, and the

boasting to prospective purchasers demonstrates knowledge that petitioner’s

economic income exceeded petitioner’s reported taxable income. We are not

persuaded, however, that the clear and convincing evidence of underpayments also

establishes fraudulent intent.

      As stated in a frequently quoted opinion of this Court: “[T]his case

epitomizes the ultimate task of a trier of the facts--the distillation of truth from

falsehood which is the daily grist of judicial life.” Diaz v. Commissioner, 58 T.C.

560, 564 (1972). A judge has a prerogative and a duty to reach an opinion after

consideration of the facts. Interex, Inc. v. Commissioner, 321 F.3d 55, 60 (1st Cir.

2003), aff’g T.C. Memo. 2002-57. After carefully considering the testimony of
                                         - 25 -

[*25] the witnesses, the exhibits, and the arguments of the parties, the Court

concludes that the evidence falls short of clear and convincing as to fraudulent

intent. This conclusion is not a vindication of petitioner or its officers.

      The actions or inactions of petitioner’s accountants and the IRS auditors,

however, included no clear warnings to petitioner that its conduct was illegal or

fraudulent. To the extent that none of these professionals undertook the task of

determining petitioner’s correct income, they were complicit in the duration of the

improper reporting. This case is before the Court only because the IRS’

acquiescence in petitioner’s methodology ended when a whistleblower saw an

opportunity for an informant’s reward.

      Because fraud has not been established, assessments for 1999 through 2005

are barred by section 6501(a). To allow for the disposition of the costs of goods

sold and reasonable compensation issues for 2006, 2007, and 2008,


                                                  An appropriate order

                                            will be issued.
