                        T.C. Memo. 2011-45



                      UNITED STATES TAX COURT



       ENERGY RESEARCH AND GENERATION, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 4936-02, 1561-04.    Filed February 24, 2011.



     John M. Youngquist, for petitioner.

     Daniel J. Parent and Kaelyn J. Romey, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:   In these consolidated cases, respondent

determined deficiencies in petitioner’s Federal income taxes,
                                    - 2 -

additions to tax pursuant to section 6651(a)(1),1 and fraud

penalties2 pursuant to sections 6653(b) and 6663 as follows:3

                             Docket No. 4936-02

                                             Fraud Penalty
         Year          Deficiency             Sec. 6653(b)

           1988        $187,030               $140,272.50

                                 Addition to Tax      Fraud Penalty
    Year          Deficiency     Sec. 6651(a)(1)      Sec. 6663(a)

    1989          $355,725          $89,162.00         $266,793.75
    1990           400,041          100,250.50          300,030.75
    1991           870,725          217,681.25          653,043.75
    1992           534,706          133,676.50          401,029.50

                                             Fraud Penalty
         Year          Deficiency             Sec. 6663(a)

           1993        $382,865               $287,148.75
           1994         178,506                133,879.50

                             Docket No. 1561-04

                                             Fraud Penalty
         Year          Deficiency            Sec. 6663(a)

           1995        $457,143               $342,857.25




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
     2
      We use the term “fraud penalty(ies)” to include the
addition to tax under sec. 6653(b) for 1988.
     3
      As set forth in an amendment to answer, respondent seeks to
increase the amounts of disallowed rent expenses for tax years
1990-94. On brief respondent states that, because of
concessions, the deficiencies and penalties will not exceed the
amounts in the notices of deficiency.
                              - 3 -

     The parties agree that the period of limitations for

assessment has expired for each of the years 1988 through 1995

(years at issue) unless the Court finds that petitioner’s returns

were false or fraudulent with the intent to evade tax.    See sec.

6501(c)(1).

     If we find that petitioner’s returns were fraudulent, most

of the adjustments to petitioner’s income are now agreed.

Pursuant to the parties’ stipulations and posttrial concessions

in their briefs, all but two of the adjustments to income,

deductions, and credits have been agreed.   The following

schedules show the agreed adjustments:

                              1988

  Adjustments to Taxable Income               Agreed Adjustment

  Gross receipts                                  ($22,270)
  Disallowed deductions:
    Legal & professional fees                       23,598
    Research & development                          24,601
    Employee relations                                 467
    Auto expenses                                    9,645
    Life insurance expenses                          2,425
    Tax and license expense                            311
    Rents                                           29,400
    Salaries & cost of goods sold labor            264,134
    Pension plan expense                            15,348
    Director’s fees                                 24,000
    Other payments                                    -0-
    Accounting method for customer deposits         86,000
    Employee benefits                               (1,170)
  Increased taxable income                         456,489
                            - 4 -

                            1989

Adjustments to Taxable Income              Agreed Adjustment

Gross receipts                                 $318,507
Disallowed deductions:
  Legal & professional fees                     138,484
  Research & development                        102,222
  Royalty                                       248,098
  Employee relations                              1,347
  Auto expenses                                  10,624
  Life insurance expenses                         2,404
  Tax and license expense                         7,909
  Rents                                          29,400
  Salaries & cost of goods sold labor           118,686
  Bad debts                                      31,675
  Pension plan expense1                            --
  Director’s fees                                24,000
  Other payments                                   -0-
  Janitorial expense                              5,980
  Contributions                                    -0-
Increased taxable income                      1,039,336

Disallowed research & development credit         $5,515
   1
    A $100,000 adjustment for pension plan expense is in
   dispute.

                            1990

Adjustments to Taxable Income              Agreed Adjustment

Gross receipts                                ($173,872)
Cost of goods sold (purchases & materials)       26,387
Disallowed deductions:
  Legal & professional fees                      49,652
  Research & development                        132,687
  Royalty                                       193,508
  Employee relations                              7,139
  Auto expenses                                  23,676
  Life insurance expenses                         2,480
  Tax and license expense                        34,147
  Rents                                          61,308
  Salaries & cost of goods sold labor           404,435
  Interest expense                                  938
  Bad debts                                      19,255
  Pension plan expense                           50,000
  Director’s fees                                24,000
                             - 5 -

  Compensation of officers                          -0-
  Other payments                                    -0-
  Materials & supplies                            (4,698)
  Employee benefits                               10,930
  Janitorial expense                               7,239
  Repairs & maintenance                            3,567
  Contributions                                   (6,000)
  Dues & subscriptions                              (683)
Increased taxable income                         866,095

Disallowed research & development credit             $5,693

                             1991

Adjustments to Taxable Income               Agreed Adjustment

Gross receipts                                  $459,833
Cost of goods sold (purchases & materials)        (1,220)
Disallowed deductions:
  Legal & professional fees                       55,046
  Research & development                         169,137
  Royalty                                      1,764,049
  Employee relations                               8,418
  Auto expenses                                   12,706
  Life insurance expenses                          2,458
  Tax and license expense                          1,799
  Rents                                           61,308
  Interest expense                                 8,128
  Bad debts                                       36,053
  Director’s fees                                 24,000
  Compensation of officers                          -0-
  Materials & supplies                             9,254
  Janitorial expense                               6,730
  Depreciation                                       (11)
  Contributions                                  (13,200)
  Dues & subscriptions                            (2,027)
  NOL carryback from 1993                           --
Increased taxable income                       2,602,461

Disallowed research & development credit             $7,256

                             1992

Adjustments to Taxable Income               Agreed Adjustment
                                                 1
Gross receipts                                   $51,017
Cost of goods sold (purchase & materials)        (11,212)
Disallowed deductions:
                              - 6 -

  Legal & professional fees                       64,880
  Research & development                         136,045
  Royalty                                        907,443
  Employee relations                              23,429
  Paid to Kent Greene                              7,634
  Auto expenses                                   20,636
  Life insurance expenses                          2,590
  Tax and license expense                         21,057
  Rents                                           80,400
  Interest expense                                 9,051
  Bad debts                                       84,455
  Pension plan expense                            (2,792)
  Director’s fees                                 36,000
  Compensation of officers                          -0-
  Other payments                                    -0-
  Materials & supplies                             4,800
  Employee benefits                               25,446
  Janitorial expense                               6,760
  Repairs & maintenance                           15,280
  Depreciation                                      (303)
  Contributions                                  (14,400)
  Salaries & wages                               (13,782)
Increased taxable income                       1,454,434

Disallowed research & development credit          $5,836
   1
    Respondent’s adjustment is $145,418 and petitioner has
   conceded $51,017; therefore, $94,401 is in dispute.

                              1993

Adjustments to Taxable Income               Agreed Adjustment

Gross receipts                                   $52,597
Cost of goods sold (purchase & materials)         (3,959)
Disallowed deductions:
  Legal & professional fees                       85,560
  Research & development                         118,989
  Royalty                                        220,000
  Employee relations                               4,255
  Paid to Kent Greene                              7,032
  Auto expenses                                   28,303
  Life insurance expenses                          2,646
  Employee education expenses                      2,599
  Computer purchase                                 -0-
  Tax and license expense                         24,546
  Rents                                          105,086
  Salaries & cost of goods sold labor            164,039
                            - 7 -

  Interest expense                                 9,436
  Bad debts                                        3,377
  Pension plan expense                            28,027
  Director’s fees                                 36,000
  Mark Benson’s medical expense                     -0-
  Compensation of officers                          -0-
  Employee benefits                                  628
  Depreciation                                    (1,435)
  Contributions                                     -0-
  Dues & subscriptions                               (76)
Increased taxable income                         887,650

                            1994

Adjustments to Taxable Income               Agreed Adjustment

Gross receipts                                    $1,559
Disallowed deductions:
  Legal & professional fees                      167,237
  Research & development                         106,694
  Royalty                                        160,063
  Employee relations                              10,630
  Auto expenses                                   14,723
  Life insurance expenses                          4,779
  Employee education expenses                      7,269
  Tax and license expense                         14,960
  Rents                                          102,360
  Salaries & cost of goods sold labor             35,561
  Bad debts                                        9,906
  Pension plan expense                           (56,083)
  Director’s fees                                 36,000
  Compensation of officers                          -0-
  Materials & supplies                             3,274
  Employee benefits                               (3,310)
  Maintenance & repair                              (359)
  Travel                                           7,955
  Depreciation                                    (8,327)
  Dues & subscriptions                             4,119
  Other deductions                                 4,106
  Contributions                                  (20,000)
Increased taxable income                         603,116

                            1995

Adjustments to Taxable Income               Agreed Adjustment

Gross receipts                                  ($58,507)
Cost of goods sold (purchase & materials)        114,568
                                - 8 -

  Disallowed deductions:
    Legal fees                                   133,703
    Professional fees                              5,263
    Royalty                                      260,160
    Engineering studies                          108,714
    Employee relations                             2,332
    Auto expenses                                  8,455
    Life insurance expenses                        6,011
    Employee education expenses                   13,088
    Tax and license expense                        2,075
    Rents                                        135,518
    Salaries                                     145,620
    Bad debts                                     11,343
    Director’s fees                               36,857
    Compensation of officers                        -0-
    Supplies (including R & D)                    40,543
    Employee benefits                             30,199
    Janitorial expense                               584
    Depreciation                                 (10,677)
    NOL deduction                                131,975
    Telephone expense                              2,149
    Business meetings                                666
    Contributions                                (19,800)
  Increased taxable income                     1,100,839

     The issues we must decide are:

     (1) Whether petitioner’s returns for the years at issue were

false or fraudulent with the intent to evade tax.   If so, the

periods of limitations for assessing tax remain open and

petitioner is liable for fraud penalties pursuant to section

6653(b) for 1988 and section 6663(a) for 1989 through 1995;4

     (2) whether petitioner is entitled to deduct $100,000 as a

pension plan expense in 1989;




     4
      Respondent alternatively asserts that petitioner is liable
for an addition to tax under sec. 6651(f) for 1994 should we not
find petitioner liable under sec. 6663(a).
                                 - 9 -

     (3) whether petitioner understated its gross receipts by

$94,401 in 1992; and

     (4) whether petitioner is liable for an addition to tax

pursuant to section 6651(a)(1) for 1989 through 1992.

                         FINDINGS OF FACT

     Even though most of the adjustments to petitioner’s taxable

income have been agreed, it is necessary to make fact findings

regarding many of those adjustments because the factual basis for

those adjustments is also the factual basis for respondent’s

allegations of fraud.   Some of the facts have been stipulated and

are so found.   The stipulation of facts, the first and second

supplemental stipulations of facts, and the stipulation of

settled issues are incorporated herein by this reference.5    At

the time the petitions were filed, petitioner’s principal place

of business was in California.

Background

     Petitioner is a corporation incorporated in California in

1967 by Glendon M. Benson (Glendon), his wife, Janet Benson




     5
      In Benson v. Commissioner, T.C. Memo. 2004-272,
supplemented by T.C. Memo. 2006-55, affd. 560 F.3d 1133 (9th Cir.
2009), in which Burton O. Benson (Burton) was a petitioner, we
made certain findings that the parties agree apply in this case.
                              - 10 -

(Janet), and Burton O. Benson (Burton),6 Glendon’s younger

brother.

     Petitioner is the only company in the world that

manufactures various forms of foam metal and foam metal baffles.7

Duane Walz and Glendon invented the process known as foam metal,

which Glendon then developed into a product.   Mr. Walz was given

sole credit as the inventor of the patent and, on March 23, 1976,

he assigned his patent rights to petitioner.

     In the mid-1980s a dispute arose between Burton and Glendon

over the operation and ownership of petitioner.   On April 4,

1985, Burton and his wife, Elizabeth, filed suit against Glendon,

Janet, and petitioner.   In October 1985 Burton and Glendon

executed an agreement delineating their respective

responsibilities concerning contracts with two of petitioner’s

major clients, Hercules Aerospace Co., Inc. (Hercules),8 and Gas

Research Institute (GRI).   Under the agreement, Burton was



     6
      Burton has a degree in mechanical engineering from the
University of Minnesota. He and his wife, Elizabeth Benson
(Elizabeth), have three sons: Eric, Mark, and Brad. Esther V.
Benson (Esther) was the mother of Burton and Glendon. Burton
served 9 years as an officer in the U.S. Navy and 23 years as an
officer in the U.S. Naval Reserve, retiring with the rank of Rear
Admiral.
     7
      Foam metal baffles are used in the U.S. Navy’s fleet of
ballistic missiles.
     8
      Hercules Aerospace Co., Inc., and all predecessors and
successors in interest will be referred to throughout this
opinion as Hercules.
                               - 11 -

granted all rights to and responsibility for contracts with

Hercules,9 and Glendon was granted all rights to and

responsibility for contracts with GRI.

     In May 1986 Burton and Glendon initiated binding

arbitration.   On July 9, 1986, the arbitration panel issued an

interim decision.    In October 1986 Burton and Glendon entered

into an agreement to adjourn the arbitration proceedings,

choosing to mediate the dispute with the aid of Winston E. Miller

(WEM) as mediator.    On June 28, 1987, during the course of

mediation, Burton and Glendon entered into an agreement entitled

“Memorandum Re:    Unbundling of ERG (June 24, 1987)”.   The

unbundling agreement provided terms for petitioner to purchase

Glendon’s interest (stock) in petitioner with the result that

Burton becomes the sole owner of petitioner.    Burton and Glendon

subsequently executed a document entitled “Supplemental

Memorandum Re:    Unbundling of ERG (December 4, 1987)”.   On

December 5, 1987, Burton and Glendon executed a document entitled

“Memorandum Re:    Other Commitments made to WEM”.10

     In July 1987 Glendon started Aker Industries (Aker) in

Oakland, California.    Aker performs research and development


     9
      During the years at issue petitioner produced for Hercules
the First Stage Baffle for the Trident II D-5 U.S. Navy Fleet
Ballistic Missile Program.
     10
      Except as noted to the contrary, we refer to the documents
executed by Burton and Glendon during mediation collectively as
the unbundling agreement.
                                - 12 -

contracts.   During the years at issue neither Glendon nor Aker

performed research or development for petitioner.    Burton is not,

and never has been, an owner, shareholder, employee, director, or

officer of Aker.

     Neither petitioner nor Burton paid Glendon for his interest

in petitioner, and the brothers continued to fight over what, if

anything, was due to Glendon.    On March 23, 1993, Glendon and

Janet filed a motion asking a California court to enforce the

unbundling agreement as a settlement agreement.    In response to a

1994 petition filed by Burton, the court ordered the parties to

recommence arbitration.   In 1994 arbitration proceedings

recommenced.   On June 7, 1995, a second interim arbitration

decision was issued and, on November 8, 1996, a third interim

arbitration decision was issued.

     On March 5, 1999, a final arbitration decision was issued.

The final arbitration decision comprehensively decided the issues

between Burton and Glendon.   The arbitrators held that Burton

became the 100-percent owner of petitioner on July 1, 1987, and

found, inter alia, that

          During the period from and after July 1, 1987,
     * * * [Burton]/* * * [petitioner]/* * * [New Process
     Industries, Inc.,] was extremely successful * * *. As
     a result, in the period from 1988 through 1996, * * *
     [Burton] and his family obtained in excess of
     $6,500,000 in salaries, director’s fees and cash
     distributions from * * * [petitioner]/* * * [New
     Process Industries, Inc.].
                                 - 13 -

          * * * from and after July 1, 1987, * * * [Burton]
     had total control over both * * * [petitioner] and
     * * * [New Process Industries, Inc.] * * *.

The arbitrators also found that Burton owed Glendon a gross

amount of $3,119,475 for Glendon’s interest in petitioner.            The

arbitrators awarded property (the Lowell plant) at 952 57th

Street, Oakland, California, to Glendon/Aker, for which Burton

received a credit of $185,500.     Additionally, the arbitrators

found that Glendon/Aker should have paid New Process Industries,

Inc. (NPI),11 rent for the Lowell plant at $2,000 per month from

July 1, 1987, to December 31, 1994, and $2,500 thereafter.

Accordingly, Burton was credited with $420,650 for the rent

payments plus interest.   The final arbitration decision awarded

Glendon a net $2,412,172 after credits and deductions.




     11
      New Process Industries, Inc. (NPI), was a family-owned S
corporation, incorporated in Minnesota. On its respective 1988
through 1995 tax returns, the Benson family’s percentage of
ownership of NPI was reported as follows:

                          Year and Percentage Ownership
Individual         1988   1989 1990 1991 1992 1993 1994                1995

  Burton           66.7   66.7    66.7    66.7   50.0   66.7   50.0   50.0
  Esther           33.3   33.3    33.3    33.3   50.0    –-     –-     –-
  Eric              –-     –-      –-      –-     –-    11.1   16.7   16.7
  Mark              –-     –-      –-      –-     –-    11.1   16.7   16.7
  Brad              –-     –-      –-      –-     –-    11.1   16.7   16.7

Burton exercised almost sole control over management and
operations of NPI.
                                - 14 -

     During the years at issue Burton was petitioner’s president

and director.12    Burton alone exercised almost sole control over

petitioner’s management and operations.    On each of petitioner’s

1988 through 1994 Forms 1120, U.S. Corporation Income Tax Return

(tax returns), Burton is listed on Schedule E, Compensation of

Officers, as owning 100 percent of petitioner’s common stock.    On

petitioner’s 1995 Schedule E, Burton is listed as owning 28

percent of petitioner’s common stock and Elizabeth, Eric B.

Benson (Eric), and Mark D. Benson (Mark), Burton and Elizabeth’s

sons, are listed as each owning 24 percent.

Tax Return Preparation

     Tax Return Preparers

     G.A. “Al” Piepho (Mr. Piepho) performed all of petitioner’s

bookkeeping and accounting up until his death on October 1, 1989.

Mr. Piepho prepared petitioner’s 1987 tax return, which was filed

on May 23, 1989.    Burton worked directly with Mr. Piepho and

provided him the records from which he was to prepare

petitioner’s tax returns.

     Edward J. Bradac, C.P.A. (Mr. Bradac), purchased Mr.

Piepho’s accounting business.    For tax years 1988 through 1993,

Mr. Bradac prepared petitioner’s tax returns.    In 1995 Mr. Bradac


     12
      Burton joined petitioner in 1969 in the capacity of vice
president. Before working for petitioner, Burton was an
assistant program manager at Westinghouse, where it was his
responsibility to check and ensure that the accounting was being
done correctly.
                                - 15 -

became associated with Armstrong, Gilmour & Associates

(Armstrong) and prepared petitioner’s 1994 tax return.

Petitioner’s 1995 tax return was prepared by Jill Toibin, C.P.A.

(Ms. Toibin), who was Mr. Bradac’s manager at Armstrong.

     Books and Records

     Burton supervised petitioner’s general bookkeeping, accounts

receivable, accounts payable, sales, and purchases.    Petitioner

kept sales, invoice, and check registers.    The sales, invoice,

and check registers were not provided to Mr. Bradac or Ms. Toibin

for the preparation of petitioner’s 1988 through 1995 tax

returns.    Instead, Burton prepared summary/data sheets from the

information in the registers and provided the summary/data sheets

to the return preparer.

     Burton understood income taxes, and he frequently asked

petitioner’s accountants tax questions or discussed tax planning

or tax return preparation.    Burton responded to any questions the

return preparers had about any of the entries on the summary/data

sheets.    However, Burton’s responses generally did not include

providing the return preparers with any of the underlying

documentation used in preparing the summary/data sheets.

     Filing the Tax Returns

     Most of petitioner’s tax returns for the years at issue were

not timely prepared or filed.    The dates on which Burton first

provided the summary/data sheets to petitioner’s return preparers
                               - 16 -

and the dates on which petitioner’s returns were filed are as

follows:

                     Summary Provided
       Year            to Preparer            Return Filed

       1988                  7/94                8/1/94
       1989                8/1/94                8/8/94
       1990               8/27/94              11/20/94
       1991               1/26/95               7/16/95
       1992                2/9/95               7/16/95
       1993               9/13/94               9/18/94
       1994               9/15/95               9/15/95
       1995                9/4/96               9/16/96

Respondent’s Initial Examination

     Respondent sent to petitioner a letter dated June 9, 1991,

inquiring as to petitioner’s unfiled 1988 tax return.     On August

23, 1995, respondent’s revenue agent contacted petitioner’s

president, Burton, by telephone regarding petitioner’s 1993 tax

return.    On January 8, 1996, petitioner’s case was assigned to

respondent’s revenue agent Theresa Martin (Revenue Agent Martin).

The initial appointment was rescheduled several times.

     On May 8, 1996, Revenue Agent Martin met with Burton and Mr.

Bradac at Mr. Bradac’s office and reviewed information and

documents.    At this meeting Revenue Agent Martin was provided

schedules of expenses for 1993 and copies of invoices for

“royalties”, “research and development”, and “engineering

services”.    The examination was subsequently expanded to include

the other years at issue.    During the examination petitioner did

not provide respondent with copies of its invoice or check
                                - 17 -

registers for 1988 through 1995.    Petitioner first provided the

invoice and check registers for 1988 through 1995 to respondent

in February and March 2008.

     During the examination Revenue Agent Martin requested the

corporate minutes and was told that there were no corporate

minutes.   At trial petitioner offered into evidence documents

which petitioner’s president testified were contemporaneously

kept corporate minutes.

     Gross Receipts

     Respondent conducted a bank deposits analysis to determine

whether petitioner correctly reported its gross receipts.     The

parties agree to the bank deposits analysis, except for the

inclusion of a $94,401 deposit on March 27, 1992, into

petitioner’s Merrill Lynch account #XXX-X7888.    For tax years

1989, 1991, 1993, and 1994 petitioner understated its gross

receipts by $318,507, $459,833, $52,606, and $1,559,

respectively.   Petitioner also understated its gross receipts by

at least $51,017 in 1992.   Petitioner overstated its gross

receipts or sales by $22,270, $173,872, and $58,507 in 1988,

1990, and 1995, respectively.    Thus, for the 8 consecutive years

at issue in this case, petitioner understated its gross receipts

or sales by at least $628,873 ($883,522 in understatements less

$254,649 in overstatements).    Gross receipts reported on
                               - 18 -

petitioner’s tax returns were based on the summary/data sheets

prepared by Burton and given to the return preparers.

     Rent

     During the years at issue NPI owned the Lowell plant and

property at 900-960-962-964 Stanford Avenue, Oakland, California

(the Stanford plant).    Petitioner deducted the rent payments it

made to NPI for both the Lowell plant and the Stanford plant on

its tax returns as follows:    $91,308 in 1988; $91,308 in 1989;

$127,308 in 1990; $127,308 in 1991; $146,400 in 1992; $171,086 in

1993; $168,360 in 1994; and $201,518 in 1995.    Petitioner

conducted its foam metal and manufacturing operations from the

Stanford plant before and after July 1, 1987.    For years 1988 and

1989, petitioner paid $5,159 per month to NPI for the use of the

Stanford plant.    The monthly rent expense remained unchanged

until August 15, 1990, when petitioner paid $26,159 to NPI.      For

the remaining 4 months of 1990, petitioner made rent payments of

$8,159, $8,159, $14,159, and $8,159, respectively.    In 1993 and

1994 petitioner paid to NPI $9,380 and $10,787 per month,

respectively.    Petitioner made 1 monthly payment of $10,787 and

11 monthly payments of $12,405 to NPI for tax year 1995.

     The 1989 unbundling agreement provided that the Stanford

plant would be leased for a term of 8 years at “$5,000 (or $5,500

per month)”.    The maximum monthly lease amount listed in the

unbundling agreement reflected the product of an arm’s-length
                              - 19 -

negotiation.   The rent petitioner paid for the Stanford plant in

excess of $5,500 per month was a constructive dividend to Burton

that petitioner was not entitled to deduct.

     The Lowell plant was used by Glendon and Aker.   In the

unbundling agreement Glendon and Burton agreed to enter into an

8-year lease with respect to the Lowell plant, which was to

provide that Glendon would pay $2,000 per month to NPI.   In 1988

a confirming commercial lease was prepared but not executed.

This lease agreement was for a term of 8 years to commence in

March 1988 and provided that Aker pay rent of $2,000 per month.

During the years at issue neither Glendon nor Aker paid rent to

NPI for the use of the Lowell plant.   Instead, petitioner paid

rent to NPI on behalf of Glendon/Aker.

     Petitioner had no contractual obligation to pay rent to NPI

for Glendon’s/Aker’s use of the Lowell plant.   It was Aker’s

responsibility to pay NPI for the use of the Lowell plant, which

Glendon ultimately paid by virtue of the final arbitration

decision.   The rent petitioner paid to NPI was a constructive

dividend to Burton that petitioner was not entitled to deduct.

     Legal and Professional Fees

     During the years at issue petitioner deducted legal and

professional fees that were properly disallowed as deductions.

     Among these deductions was a $96,749 legal fee paid to

Michael B. Carroll (Mr. Carroll) for advice and services as an
                                - 20 -

advocate for Burton concerning ownership and control of

petitioner and NPI.   Mr. Carroll’s representation involved a

personal and noncorporate matter between Glendon and Burton.       On

May 19, 1989, petitioner issued a $96,749 check to Burton, and

Burton deposited the check.     On or about May 23, 1989, Burton

purchased a $97,467.21 cashier’s check made payable to Mr.

Carroll.   On its 1989 tax return, petitioner claimed a $96,749

deduction for legal fees paid to Mr. Carroll.     Burton also

claimed the $96,749 as a deduction in computing his 1989 Federal

income tax liability.   The $96,749 petitioner paid was a

constructive dividend to Burton that petitioner was not entitled

to deduct.

     Royalties and Engineering Services

     During the years 1988, 1993, and 1994 petitioner transferred

significant amounts of money to NPI as follows:

             Date Transferred                Amount

                 12/30/88                   $180,000
                  4/15/93                    750,000
                  4/15/93                    190,000
                  4/20/93                  2,060,000
                 12/30/93                    600,000
                  4/15/94                    129,414
                  6/17/94                     30,649
                    Total                  3,940,063

     Burton’s goal was to limit petitioner’s reported profits.

The plan to achieve this goal was put in place in 1993 and Burton

caused petitioner to transfer most of the money in 1993.
                                   - 21 -

Burton’s goal was to have petitioner show a paper profit of

approximately $75,000 per year.

     On its 1989 through 1995 tax returns, petitioner claimed

deductions for royalties expense and engineering services as

follows:

     Year                 Amount               Classification
                      1
     1989             $252,679               Royalty expense
     1990              193,508               Royalty expense
     1991            1,764,049               Royalty expense
     1992              907,443               Royalty expense
     1993              220,000               Royalty expense
     1994              160,063               Royalty expense
     1995              260,160               Royalty expense
     1995              108,714               Engineering services
       Total         3,866,616
            1
           In the notice of deficiency for 1989, respondent
     disallowed $248,098 of the claimed $252,679 as a
     royalty expense. As previously noted the parties now
     agree to respondent’s adjustment.

     Since most of petitioner’s payments to NPI were made after

the claimed royalties were supposedly earned the deductions on

petitioner’s tax returns have little, if any, correlation to when

the funds were transferred to NPI.

     The royalty deductions were based on a purported licensing

agreement between petitioner and NPI.       The purported licensing

agreement to pay royalties to NPI was merely a tax planning tool,

completely lacking in economic substance.       Burton, however, told

Mr. Bradac that the purported licensing agreement was legally

enforceable.
                               - 22 -

     During the years at issue there was no written agreement

between petitioner and NPI relating to engineering, design, or

management services, and NPI did not perform any engineering work

for petitioner or provide any services to petitioner.   NPI did

not treat anyone as an employee, did not issue any Forms 1099,

and did not file any Forms 941, Employer’s Quarterly Federal Tax

Return.    The label “engineering services” was created to achieve

Burton’s goal of having petitioner show profits of approximately

$75,000.

     At a May 8, 1996, meeting, petitioner provided Revenue Agent

Martin with royalty invoices and engineering services invoices in

support of its claim that during 1993 it paid $224,023 to NPI as

royalties and $220,000 as engineering services.   These invoices

were on NPI letterhead, addressed to petitioner, showed amount

“due”, and were dated and stamped as “RECEIVED” in 1993.    The NPI

letterhead shows NPI’s address in Minneapolis, Minnesota.   Burton

created and backdated these royalty and engineering services

invoices shortly before the May 8, 1996, meeting.   Burton did not

inform Revenue Agent Martin that he created the royalty and

engineering invoices in preparation for his meeting with her.

Mr. Bradac first saw the royalty and engineering services

invoices on May 8, 1996, shortly before they were provided to

Revenue Agent Martin.    Burton did not inform Mr. Bradac that he
                              - 23 -

had just created the invoices for the meeting with Revenue Agent

Martin.

     In February 1998 Burton told respondent’s agents that he

always computed the royalties each month and he always made the

invoice each month for royalties and then gave it to his

secretary.   However, the only year for which petitioner provided

the examining agent invoices for royalties or engineering

services was 1993.   In late 1999 or early 2000 Burton finally

acknowledged to respondent’s agents that the NPI invoices that he

had provided were created in 1996 and backdated to 1993.

     The purported royalty and engineering services payments that

petitioner transferred to NPI were used for Burton’s and his

family’s economic benefit and constituted constructive dividends

to Burton in the year of transfer.     Petitioner was not entitled

to any of the claimed deductions for royalty and engineering

services purportedly provided by NPI.

     Payments to Cox Construction and to Kent Greene

     In 1992 Burton and Cox Construction entered into a contract

to remodel a recreation room in Burton’s residence.    The contract

provided, inter alia, that “Mr. Benson may furnish a maintenance

man from his plant to help with the framing.”    Burton provided

petitioner’s maintenance man, Kent Greene (Mr. Greene), to assist

in the remodel of his residence.   On its 1992 tax return

petitioner improperly deducted a $15,280 “repair and maintenance
                              - 24 -

expense” that it paid to Cox Construction.     On its 1992 and 1993

tax returns petitioner improperly deducted salaries and labor

expenses of $7,634 and $7,032, respectively, which it paid to Mr.

Greene.

     Employee Education Expense

     On its 1993 and 1994 tax returns, petitioner improperly

deducted employee education expenses of $2,599 and $7,269,

respectively, for payments made to Oregon State University,

Corvallis, Oregon (OSU).   On its 1995 tax return, petitioner

deducted employee education expenses of $13,334.    Petitioner’s

1995 ledger reflects payments made as follows:

    Date Paid     Check           Payee                 Amount

      1/9/95      25588    OSU                         $3,129
     3/25/95      25840    Linn-Benton College            128
                             Albany, Oregon
     4/24/95      25886    OSU                              200
     4/25/95      25921    OSU                            2,812
     10/1/95      26345    OSU                            3,422
     10/4/95      26349    OSU                            3,397
       Subtotal                                        13,088
                           Burt Hutchinson                   73
                           Drexel University                135
                           Don Holleran                      38
                                                       1
          Total                                          13,334
             1
           Of the amount claimed in 1995, respondent allowed
     $246 of employee education expense for the payments to
     Burt Hutchinson, Drexel University, and Don Holleran.

     The payments made to OSU were for college tuition, fees, and

books for Burton’s son Eric during 1993, 1994, and for Burton’s

sons Eric and Mark in 1995.
                              - 25 -

     Petitioner produced letters dated June 12, 1993, and June

12, 1995, indicating that Eric and Mark, respectively, were

selected from a vast field of applicants for the “ERG Management

Training Program”; however, neither Eric nor Mark was selected

from a “vast field” of applicants for the scholarship.   In fact,

petitioner’s awarding of “scholarships” coincided with Burton’s

three sons’ turning 18 or 19 years old and starting college.

Neither Eric nor Mark received a salary from petitioner before

receiving the purported scholarship from petitioner.

     Automobile and Truck Deductions

     During the years at issue petitioner improperly deducted

automobile and truck expenses, including Department of Motor

Vehicle fees, insurance, gasoline, and repairs for automobiles

used by Burton’s family (the Bensons).   The Bensons were

authorized signators on a First Interstate checking account,

which was used exclusively to pay for gasoline purchases through

Interlink bank debit card(s) linked to that account.   Petitioner

paid and deducted $1,853 in 1990, $3,327.85 in 1991, $3,995.08 in

1992, $4,194.09 in 1993, $4,383.16 in 1994, and $3,875.32 in 1995

for gasoline purchases.   On its respective 1990 and 1993 tax

returns, petitioner improperly deducted the purchase of a $15,000

Jeep for Eric, and a $13,500 Ford Bronco for Mark.

     Burton provided Mr. Bradac with the amounts of petitioner’s

automobile expenses for 1988 through 1993.   When Mr. Bradac
                                     - 26 -

questioned Burton as to how the automobile expenses were

calculated and what they represented, Burton responded:                 “LEAVE

AS IS.”     When Mr. Bradac prepared petitioner’s 1988 through 1993

tax returns, he did not know that petitioner had purchased the

vehicles for Eric and Mark.

     Director’s Fees

     During 1988 through 1995 petitioner improperly deducted

payments it made to Elizabeth, Esther, Eric, and Mark as

director’s fees.        Petitioner did not file a Form 1099 (or other

information return) with respondent reporting that it paid

director’s fees to Elizabeth, Esther, Eric, or Mark.              During the

years at issue, petitioner made the following payments, which it

deducted as director’s fees:

Individual        1988    1989   1990    1991    1992    1993    1994      1995

Elizabeth         -0-    $3,000 $12,000 $12,000 $12,000 $12,000 $12,000 $16,260
Esther            -0-     3,000 12,000 12,000 12,000 12,000       9,000    --
Eric               --      --      --      --     6,000 12,000 12,000 12,000
Mark               --      --      --      --      --      --     5,000 12,000

     Petitioner concedes that it is not entitled to deduct the

director’s fees claimed on its 1988 through 1995 tax returns.

This is another instance where Burton had petitioner pay and

improperly deduct personal expenditures.

     Life Insurance

     In 1969 Burton applied for a $100,000 life insurance policy

with Massachusetts Mutual Life Insurance Co. (MassMutual).

MassMutual issued policy number XXX6416 to Burton, the insured
                              - 27 -

and owner of the policy, and during the years at issue his wife

Elizabeth was the primary beneficiary.   For each of the years at

issue, petitioner paid and claimed a deduction for payments made

to MassMutual for a policy on Burton’s life.    In a memorandum

sent to Burton, dated September 14, 1995, Mr. Bradac asked:

“What is included in insurance.   Life insurance is not

deductible.”   In a handwritten note Burton responded that there

was “NO LIFE”.

     In May 1996 Revenue Agent Martin asked Burton who the

beneficiary of the life insurance policy was.    On October 7,

1996, petitioner’s representative provided Revenue Agent Martin

with a letter dated October 2, 1996, on petitioner’s letterhead

addressed to MassMutual, which indicated that in a telephone

conversation between Burton and a customer service representative

it had been confirmed that petitioner was the beneficiary of the

life insurance policy.   On December 16, 1996, respondent’s

examining agent was given a letter dated December 2, 1996, from

MassMutual indicating that petitioner was the current beneficiary

of the life insurance policy; the letter did not indicate who the

beneficiary was during the years at issue.   On February 18, 1997,

Revenue Agent Martin issued a summons to MassMutual and on March

11, 1997, MassMutual produced numerous documents including a copy

of a “Change of Beneficiary with Proceeds Paid in One Sum” dated

October 25, 1996, wherein Burton had changed the beneficiary of
                                   - 28 -

the life insurance policy to petitioner effective November 1,

1996.     During the examination process, neither Burton nor any

other of petitioner’s representatives disclosed to respondent’s

agents that petitioner was not the primary beneficiary of the

MassMutual life insurance policy during the years at issue.

     1994 Travel Expenses

        Burton’s mother Esther passed away September 3, 1994, and

funeral services were held in Minnesota.        On or about October 4,

1994, petitioner paid $833.06 for travel expenses incurred on

behalf of Pastor Leroy M. Nelson, Burton’s cousin.        Pastor Nelson

presided over Esther’s funeral services.

        During 1994 Eric attended college at OSU, in Corvallis,

Oregon.        On or about February 9, 1994, Burton signed a travel

expense report indicating that he spent $286.95 on behalf of

petitioner for travel to Corvallis, Oregon.        In 1994 charges were

made to a credit card issued for petitioner’s BankAmericard

account as follows:

        Date                    Description               Amount

        2/5/94               Grand Manor Inn #35          $223.82
                               Corvallis, OR
   2/3-6/94                  Hertz/fuel/parking            105.70
    5/10/94                  Hertz Rent-A-Car,              91.61
                               St. Paul, MN
    5/10/94                  Radisson Hotels,              227.32
                               Minneapolis, MN
    5/13/94                  Ramada Inns                   342.17
                               Falls Church, VA
    5/13/94                  Hertz Rent-A-Car              137.46
                               Washington, D.C.
                              - 29 -

    9/10/94            Lowell Inn                    1,542.79
                         Lake Elmo, MN
    9/11/94            Super America 4454                9.23
                         Bloomington, MN
    9/11/94            Hertz Rent-A-Car                 89.90
                         St. Paul, MN
      Total                                          2,770.00

     On its 1994 tax return, petitioner improperly claimed

deductions for these travel expenses, which petitioner now agrees

are not deductible.

     Property Taxes

     In June 1990 petitioner purchased real property in Orinda,

California (Orinda property), for $335,000.13   Title to the

Orinda property was put in the name of “Burton O. Benson,

Trustee” of petitioner’s retirement trust.   Petitioner’s

retirement trust neither paid for the purchase nor reflected the

Orinda property as an asset on any tax return or financial

statement.

     Petitioner’s purchase of the Orinda property occurred at

approximately the same time that Burton and Elizabeth purchased

a vacant lot between their home and the Orinda property.     With

petitioner’s purchase of the Orinda property, Burton and

Elizabeth had effectively acquired a large, uninterrupted piece

of land behind and abutting their residence.    On October 28,

1997, Burton, acting as trustee of petitioner’s retirement trust,



     13
      The price paid inclusive of fees and taxes was
$336,410.72.
                               - 30 -

deeded the Orinda property to Burton and Elizabeth, as husband

and wife.   The deed shows no consideration for the transfer of

property and, in a handwritten note, describes the transfer as a

“Gift to spouse”.

     Petitioner’s payment in 1990 for the acquisition of the

Orinda property and petitioner’s payment of property taxes on the

Orinda property were constructive dividends to Burton.      On its

tax returns, petitioner improperly deducted property taxes paid

on the Orinda property as follows:      $4,363 in 1991; $3,796 in

1992; $3,879 in 1993; $8,196 in 1994; and $2,075 in 1995.

     Research and Development Expenses and Credits

     On or about March 9, 1989, petitioner opened Money Fund

account No. XXXXXXX9082 with Franklin Funds under the name of

“R & D Division, ERG Inc.” and used petitioner’s tax

identification number, 94-XXXX686.      From 1989 through 1995 Burton

was the only person who had signature authorization over the

account.

     From March 1989 through January 1995 Burton wrote checks

made payable to “R & D Division, ERG, Inc.”; “Aker Industries,

Inc.–-R & D Division”; “Aker Industries R & D Division”; or

“R & D Division, Aker Industries, Inc.”      These checks were

written on petitioner’s Bank of America account, and deposited

into petitioner’s Franklin Funds “R & D Division, ERG Inc.”

account.    Burton handwrote the endorsement “Aker Industries” on
                                - 31 -

the back of each check made payable to Aker Industries which was

deposited into the Franklin “R & D Division ERC Inc.” account.

Between 1989 and 1995 over $700,000 was accumulated in the

Franklin Funds “R & D Division, ERG Inc.” account in the above

described manner.

     During the years at issue neither Aker nor Glendon provided

any research and development services for petitioner and did not

issue invoices to petitioner.    Glendon had no knowledge of the

Franklin Funds account.

     On its tax returns for 1988 through 1994, petitioner

improperly deducted research and development expenses of $24,601

in 1988; $102,222 in 1989; $132,687 in 1990; $169,137 in 1991;

136,045 in 1992; 118,989 in 1993; and $106,694 in 1994.

Petitioner also deposited a $3,865 check made payable to “R & D

Division, Aker Industries Inc.” into the Franklin Funds “R & D

Division, ERG Inc.” account and improperly claimed a deduction

for it as part of a supplies expense on its 1995 tax return.

     In a confirmation letter dated July 11, 1995, sent to Burton

regarding the preparation of petitioner’s 1988 through 1993 tax

returns, Mr. Bradac wrote, in pertinent part:

     Research and Development expenses: The research and
     development expense shown on your summary is for
     qualified research costs. Qualified research is
     limited to scientific experimentation or engineering
     activities designed to aid in the development of a new
     or improved product, process, technique, formula,
     invention or computer software program held for sale,
                               - 32 -

     lease, or license, or used by you in a trade or
     business. All research was conducted in the state of
     California.

Mr. Bradac was not aware of the fact that neither Aker nor

Glendon had provided any services to petitioner and was unaware

of petitioner’s Franklin Funds “R & D Division ERG Inc.” account

until after the examination of petitioner’s 1993 tax year had

begun.

     At the May 8, 1996, meeting with Revenue Agent Martin,

Burton provided her with research and development invoices for

tax year 1993.   These research and development invoices are on

Aker letterhead and were provided to agent Martin to support that

the research and development deductions claimed on petitioner’s

1993 tax return were for expenses paid to Aker.   The research and

development invoices are dated and stamped as “RECEIVED” by

petitioner in 1993.   Burton created these research and

development invoices shortly before the May 8, 1996, meeting to

substantiate the improper deductions.   Mr. Bradac saw the

fabricated research and development invoices for the first time

approximately 5 minutes before the initial meeting with Revenue

Agent Martin on May 8, 1996.

     Petitioner also improperly claimed research and development

credits as follows:   $5,515 in 1989, $5,693 in 1990, $7,256 in

1991, and $5,836 in 1992.   While preparing petitioner’s tax

returns, Mr. Bradac informed Burton of the requirements to
                              - 33 -

qualify for the research and development credit.   Nevertheless,

Burton told Mr. Bradac that petitioner’s purported research and

development payments qualified for the research and development

credit.   On August 2 and November 11, 1994, Burton sent (via

facsimile) memorandums to Mr. Bradac to inform him not to forget

the research and development tax credit.

     Concealed Bank Accounts/Checks

     In an information document request (IDR) dated August 23,

1995, respondent requested “Bank statements, reconciliations and

cancelled checks for all corporate accounts for the period

beginning December 1, 1992 and ending January 31, 1994.”    On May

8, 1996, petitioner provided bank statements and canceled checks

for petitioner’s accounts at Bank of America and Merrill Lynch

but did not disclose or provide statements for its accounts with

Franklin Funds.

     In an IDR dated August 19, 1996, respondent requested “Bank

statements, reconciliations and cancelled checks for all

corporate accounts for the period beginning January 1994 and

ending January 1995.”   On October 7, 1996, petitioner provided

bank statements and most canceled checks for petitioner’s

accounts at Bank of America and Merrill Lynch but did not

disclose or provide statements for its accounts with Franklin

Funds.
                                - 34 -

     In an IDR dated October 10, 1996, respondent requested 18

missing checks as follows:    “Cancelled checks shown on bank

statements for Bank of America account XXX-X8267 but not included

with the statements on 10-07-96”.    On December 16, 1996,

petitioner provided respondent with 12 checks made payable to

“R & D Division, Aker Industries, Inc.”

     In December 1996 respondent requested bank statements and

canceled checks for the period 1988 through 1992.    On January 29,

1997, petitioner provided statements and most canceled checks for

petitioner’s accounts at Bank of America and Merrill Lynch but

did not disclose or provide statements for its accounts with

Franklin Funds.

     After comparing canceled checks to the Bank of America

statements, Revenue Agent Martin determined that 12 canceled

checks were missing for 1989.    Respondent issued summonses to

Bank of America and to Merrill Lynch requesting petitioner’s bank

records for the years at issue.    Bank of America and Merrill

Lynch complied with the summonses to the extent that records

existed.   Bank of America provided copies of the 12 missing

checks for 1989.    Eleven of the checks were made payable to Aker

and one $33,328 check was made payable to “cash”.

     On February 6, 1997, respondent issued two summonses to

Franklin Funds.    One summons was in the matter of “Energy

Research and Generation, Inc.”, and the other summons was in the
                               - 35 -

matter of “R & D Division E.R.G. Aker Industries, Inc. Trust”.

The Franklin Funds legal department received the summonses, and

they were forwarded to a loss prevention specialist who began

retrieving the documents.    On February 19, 1997, Burton called

Franklin Funds and indicated that he thought the accounts did not

fall within the scope of the summons.      On February 21, 1997,

Franklin Funds issued a “Certificate of No Records” which stated

that “no records exist pertaining to securities in the name of or

for the benefit of Energy Research and Generation, Inc. under tax

identification number 94-XXXX686.”      On February 27, 1997,

respondent issued a summons to Franklin Funds requesting the

signature card for the account in which the checks made payable

to “R & D Division Aker Industries” had been deposited.      On or

about March 10, 1997, Franklin Funds provided the account

application to respondent.    The account application was signed by

Burton as president of petitioner and the tax identification

number on the account was petitioner’s.

     On April 14, 1997, respondent issued additional summonses to

Franklin Funds, which, in turn, provided copies of account

statements and deposited items.    When Revenue Agent Martin

received the Franklin Funds account information she learned for

the first time that the account--where the checks payable to

“R & D Division, Aker Industries” were deposited--was owned by

petitioner, was under petitioner’s tax identification number, and
                                 - 36 -

Burton, as petitioner’s president, was the only individual with

signature authority over the account.

      Revenue Agent Martin also learned for the first time that

petitioner maintained a second account with Franklin Funds, the

ERG-Recreation Fund.     During the years at issue Burton was the

only person with signature authorization over the ERG-Recreation

Fund.

      During the years at issue $87,102 was deposited into the

ERG-Recreation Fund account.      Checks written on the ERG-

Recreation Fund account were often for the benefit of Burton and

his family and were constructive dividends to Burton.

                                 OPINION

A.   The Statute of Limitations

        The parties agree that the periods for assessing tax for the

years at issue have expired unless petitioner’s returns were

fraudulent.     Generally, the Commissioner must assess any tax

within 3 years after a return is filed.      See sec. 6501(a).   An

exception to the “3-year rule” is provided in section 6501(c).

Section 6501(c), in pertinent part, provides:

        SEC. 6501(c).   Exceptions.--

             (1) False return.--In the case of a false or
        fraudulent return with the intent to evade tax, the tax
        may be assessed, or a proceeding in court for
        collection of such tax may be begun without assessment,
        at any time.
                              - 37 -

     Fraud is defined as an intentional wrongdoing on the part of

the taxpayer designed to evade tax believed to be owing.     Neely

v. Commissioner, 116 T.C. 79, 86 (2001) (citing Edelson v.

Commissioner, 829 F.2d 828, 833 (9th Cir. 1987), affg. T.C. Memo.

1986-223, and McGee v. Commissioner, 61 T.C. 249, 256 (1973),

affd. 519 F.2d 1121 (5th Cir. 1975)).   The existence of fraud is

a question of fact to be resolved from the entire record.    DiLeo

v. Commissioner, 96 T.C. 858, 874 (1991), affd. 959 F.2d 16 (2d

Cir. 1992).

     A corporation acts through its officers, and corporate fraud

necessarily depends upon the fraudulent intent of a corporate

officer.   DiLeo v. Commissioner, supra at 875 (citing Auerbach

Shoe Co. v. Commissioner, 216 F.2d 693 (1st Cir. 1954), affg. 21

T.C. 191 (1953), Currier v. United States, 166 F.2d 346 (1st Cir.

1948), and Federbush v. Commissioner, 34 T.C. 740, 749 (1960),

affd. 325 F.2d 1 (2d Cir. 1963)).

     Respondent bears the burden of proving fraud by clear and

convincing evidence.   See sec. 7454(a); Rule 142(b); DiLeo v.

Commissioner, supra at 873.   Respondent must establish both that

(1) petitioner has underpaid its taxes for each year; and (2)

some part of the underpayment is due to fraud.   DiLeo v.

Commissioner, supra at 873 (citing Hebrank v. Commissioner, 81

T.C. 640, 642 (1983)).
                              - 38 -

     The undisputed facts show that petitioner substantially

underpaid its taxes for each of the years at issue, and we find

that respondent has met his burden of proof with respect to the

first prong of the fraud test.   We must now decide whether

petitioner filed its tax returns with the specific willful intent

to evade taxes.

     Any conduct, the likely effect of which would be to mislead,

conceal, or otherwise prevent the collection of taxes may

establish an affirmative act of evasion.   See DiLeo v.

Commissioner, supra at 874; see also Spies v. United States, 317

U.S. 492, 499 (1943).   The taxpayer’s entire course of conduct

can be indicative of fraud.   DiLeo v. Commissioner, supra at 874.

Because fraudulent intent is rarely established by direct

evidence, fraud may be inferred from various kinds of

circumstantial evidence.   Bradford v. Commissioner, 796 F.2d 303,

307 (9th Cir. 1986), affg. T.C. Memo. 1984-601.   Circumstantial

evidence tending to indicate that an underpayment of tax is due

to fraud has often been referred to as “indicia of fraud” and

generally includes:   (1) Understatement of income; (2) inadequate

records; (3) failure to file tax returns; (4) implausible or

inconsistent explanations of behavior; (5) concealing assets; and

(6) failure to cooperate with tax authorities.    Id.   Although no

single factor is necessarily sufficient to establish fraud, the

existence of several of these indicia is persuasive
                               - 39 -

circumstantial evidence of fraud.    Petzoldt v. Commissioner, 92

T.C. 661, 700 (1989).

     1.   Understatement of Income

     The evidence clearly establishes that petitioner

substantially understated its taxable income in each of the years

at issue.   The understatements of income are the result of both

understated gross receipts and overstated costs of goods sold and

expenses.

     Gross receipts reported on petitioner’s tax returns were

based on summary/data sheets prepared by Burton and given to the

return preparers.    The underlying corporate records were not

provided to the return preparers.    In the light of respondent’s

bank deposits analysis, petitioner now concedes that its gross

receipts were understated in tax years 1989, 1991, 1992, 1993,

and 1994, with the exception of a $94,401 deposit in 1992.      The

bank deposits method of reconstruction has long been sanctioned

by the courts.   Clayton v. Commissioner, 102 T.C. 632, 645

(1994); Estate of Mason v. Commissioner, 64 T.C. 651, 657 (1975),

affd. 566 F.2d 2 (6th Cir. 1977).    For the 8 years at issue

petitioner understated its gross receipts by at least $628,000.

Petitioner has offered no explanation for these understatements

of gross receipts.

     The evidence also shows that petitioner claimed substantial

improper deductions in each of the years at issue.    For the 8
                               - 40 -

years at issue petitioner has agreed to the disallowance of at

least $8.5 million in improperly deducted expenses.     The most

egregious of the improper deductions were for the fabricated

research and development expenses and the fabricated royalty and

engineering services expenses paid to NPI.

     The research and development expenses were allegedly paid to

Aker but were actually deposited into an undisclosed bank account

controlled by petitioner and its principal officer, who knew that

Aker never performed any research and development services for

petitioner during the years at issue.      These phony research and

development deductions exceed $790,000 during the years at issue.

     The fabricated royalty and engineering services expenses

were paid to NPI, which was a separate entity controlled by

Burton.    The purported royalties and engineering services were

fabrications intended to reduce petitioner’s reported income to a

range that was acceptable to petitioner’s principal officer, who

was also the personal beneficiary of the payments to NPI.      These

transfers and improper deductions were as follows:

    Year              Amount Transferred         Amount Deducted

    1989                   $180,000                 $248,098
    1990                       --                    193,508
    1991                       --                  1,764,049
    1992                       --                    907,443
    1993                  3,600,000                  220,000
    1994                    160,063                  160,063
    1995                       --                    368,874
      Total               3,940,063                3,862,035
                                - 41 -

     We will not repeat the previously stated facts regarding the

other improper deductions.    Suffice it to say that we find that

they represent a pattern demonstrating a consistent and

deliberate attempt to understate petitioner’s correct tax

liabilities.

     Consistent and substantial understatements of income over

several years are highly persuasive evidence of intent to defraud

the Government, particularly when combined with other indicia of

fraud.    See Baisden v. Commissioner, T.C. Memo. 2008-215.     To

this effect the Court of Appeals for the Ninth Circuit has

stated:    “repeated understatements in successive years when

coupled with other circumstances showing an intent to conceal or

misstate taxable income present a basis on which the Tax Court

may properly infer fraud.”     Furnish v. Commissioner, 262 F.2d

727, 728-729 (9th Cir. 1958), affg. in part and remanding in part

Funk v. Commissioner, 29 T.C. 279 (1957).     Accordingly, we find

petitioner’s consistent understatements of income to be clear and

convincing evidence of an intent to evade tax known to be owing.

     2.    Inadequate Records/Failure To Provide the Tax Return
           Preparers With Accurate Information

     Petitioner’s records consisted of sales, invoice, and check

registers.     However, petitioner did not provide these registers

to the return preparers for their use in the preparation of

petitioner’s tax returns.    Rather, Burton instructed Mr. Bradac

and Ms. Toibin to use the summary/data sheets he had prepared.
                              - 42 -

The total sales amounts Burton provided for 1988 through 1993 do

not match the sales amounts recorded in petitioner’s sales

registers.

     At the time petitioner’s 1988 through 1995 tax returns were

prepared, Mr. Bradac was unaware of the existence of the Franklin

Funds “R & D Division, ERG Inc.” account and that the alleged

research and development expenditures had been deposited into

that account.   Burton intentionally misled the tax return

preparer by insisting that petitioner’s payments to Aker

qualified as research and development expenditures even though

Mr. Bradac had told him the requirements for research and

development deductions and credits.

     Burton told the return preparer that the so-called royalty

payments to NPI were made pursuant to a legal obligation when in

fact the purported licensing agreement was nothing but a sham

whose purpose was to reduce petitioner’s taxable income.     Burton

also told Mr. Bradac that petitioner’s insurance expenses did not

include life insurance when Mr. Bradac asked whether the

insurance expense included any life insurance.   He also insisted

that Mr. Bradac “LEAVE AS IS” the automobile expenses on

petitioner’s 1990 and 1993 tax returns after Mr. Bradac had

inquired as to the substance of the expenses.

     Burton’s failure to keep and provide adequate records and

his obfuscatory behavior--when questioned by Mr. Bradac regarding
                                 - 43 -

claimed expenses--is evidence of petitioner’s intent to evade

taxes known to be owing by concealing corporate information and

records and failing to provide this information to its tax return

preparer.    See Federbush v. Commissioner, 34 T.C. at 749-750.

     3.     Failure To File Tax Returns

     Petitioner filed untimely tax returns for 1988, 1989, 1990,

1991, and 1992 indicating a disregard of its legal obligation to

pay tax.

     4.     Implausible or Inconsistent Explanations of Behavior

             a.   Royalty and Engineering Services Invoices

     At the meeting with the Internal Revenue Service (IRS) on

May 8, 1996, Burton provided Revenue Agent Martin with recently

fabricated royalty and engineering services invoices to support

hundreds of thousands of dollars in alleged deductible expenses.

The invoices were written on NPI letterhead and were respectively

dated at the end of each calendar month in 1993.     Burton had

actually created and backdated the invoices shortly before the

May 8, 1996, meeting but did not inform either Mr. Bradac or

Revenue Agent Martin that these invoices had just been created.

Burton’s conduct was deceptive with the specific purpose of

misleading respondent with respect to the legitimacy of the

alleged royalty and engineering services expenses.
                                - 44 -

          b.   Research and Development Invoices

     At the May 8, 1996, meeting Burton also provided Revenue

Agent Martin with research and development invoices.    The

research and development invoices were written on Aker’s

letterhead and were provided to Revenue Agent Martin as support

for the research and development deductions claimed on

petitioner’s 1993 tax return.    Neither Aker nor Glendon had

performed any research and development for petitioner.    Burton

had created and backdated the research and development invoices

shortly before the May 8, 1996, meeting.    Again, Burton did not

disclose to Revenue Agent Martin that he had fabricated the

research and development invoices shortly before the meeting.

This was a deliberate attempt to mislead respondent.

     5.   Concealing Assets

     During the examination of petitioner’s tax returns

respondent’s agents issued several IDRs, requesting that

petitioner provide records of all of its bank accounts.    Although

petitioner provided information regarding accounts at Bank of

America and Merrill Lynch, no information was disclosed regarding

the Franklin Funds “R & D Division, ERG Inc.” account.    When

Revenue Agent Martin expanded the examination to include tax year

1994, she discovered that copies of several of the Bank of

America canceled checks were missing.    After inquiring further,

Revenue Agent Martin determined that most of the missing checks
                                  - 45 -

were payable to Aker and deposited into the Franklin Funds “R & D

Division, ERG Inc.” account.

     In order to acquire information regarding the ownership of

the Franklin Funds account, on February 6, 1997, respondent

issued two summonses to Franklin Funds.      When Burton learned of

the summonses, he contacted Franklin Funds in an attempt to

persuade it that the summonses did not pertain to petitioner’s

accounts.    As a result, Franklin Funds indicated to the IRS that

no records existed; but after issuing additional summonses to

Franklin Funds, Revenue Agent Martin was able to determine that

petitioner was the owner of the Franklin Funds “R & D Division,

ERG Inc.” account.       Between 1988 and 1995 petitioner accumulated

more than $700,000 in the Franklin Funds “R & D Division, ERG

Inc.” account.

     6.   Failure To Cooperate With Tax Authorities

     Petitioner consistently failed to provide complete and

accurate information to Revenue Agent Martin, and some of the

information was false with the intent to mislead her.

     7.     Conclusion

     Respondent has clearly and convincingly established that

petitioner filed its 1988 through 1995 tax returns intending to

conceal, mislead, or otherwise prevent the collection of tax.

Accordingly, we hold that the requirements for the exception in

section 6501(c)(1) to the 3-year period of limitations are met
                               - 46 -

and, therefore, each of the years at issue is open for

assessment.

       Before the trial in these cases petitioner moved for summary

judgment on the fraud issue on the basis of our finding in Benson

v. Commissioner, T.C. Memo. 2004-272 (Benson I), supplemented by

T.C. Memo. 2006-55, affd. 560 F.3d 1133 (9th Cir. 2009).    In

Benson I we found that, even though there was evidence that could

be considered indicia of fraud, respondent had failed to carry

his burden of proving by clear and convincing evidence that

Burton’s individual returns were fraudulent with intent to evade

tax.    In the instant proceedings we denied petitioner’s motion

for summary judgment on the obvious grounds that petitioner and

Burton are separate taxpayers and the issue of whether

petitioner’s tax returns were fraudulent was neither presented

nor decided in Benson I.    And while the parties agree that some

of the fact findings in Benson I should be followed in the

instant case, a separate trial was held in petitioner’s case

wherein additional evidence was presented to prove that

petitioner’s returns were fraudulent.    We also note that some of

the evidence of fraud regarding petitioner’s returns was excluded

from evidence in the Benson I trial pursuant to Burton’s

attorney’s objection.14


       14
      In Benson v. Commissioner, T.C. Memo. 2004-272 (Benson I),
we expressed some concern about whether the return preparers
                                                   (continued...)
                              - 47 -

B.   Fraud Penalties

      The determination of fraud for purposes of section

6501(c)(1) is the same as the determination of fraud for purposes

of the fraud penalty under section 6663.    Neely v. Commissioner,

116 T.C. at 85; Rhone-Poulenc Surfactants & Specialties, L.P. v.

Commissioner, 114 T.C. 533, 548 (2000).    Since we have already

found that petitioner filed a fraudulent return under section

6501(c) for each of the years at issue, it follows that

petitioner is also liable for the fraud penalty pursuant to

section 6653(b) for tax year 1988 and section 6663 for tax years

1989 through 1995.

      Common to both the old section 6653(b) and the newer section

6663 is the provision that when the Commissioner has established

that any portion of the underpayment is due to fraud, the entire



      14
      (...continued)
might have shared responsibility for some of the inaccuracies
regarding the improper reporting of transactions between
petitioner and NPI, even though Burton was also responsible for
misrepresenting the true nature of those transactions. The
records in the instant cases contain additional evidence, not
presented in Benson I, regarding other similar inaccuracies and
misrepresentations for which Burton is solely responsible. For
example, the improper deductions for research and development
expenses that were allegedly paid to Aker, but were in fact
deposited into petitioner’s Franklin Funds account, were the
result of misrepresentations that Burton made to the return
preparers. He falsely told them that research and development
had been done and failed to disclose the existence of the
Franklin Funds account. And, as he did with respect to NPI
invoices, Burton also fabricated invoices from Aker in another
attempt to mislead respondent’s agent regarding the validity of
the research and development expenditures.
                               - 48 -

underpayment is treated as attributable to fraud except for any

portion that the taxpayer establishes is not due to fraud.

     Petitioner bears the burden of showing by a preponderance of

the evidence what portion, if any, of the underpayment in each

year is not attributable to fraud.      See sec. 6663(b).   Petitioner

has failed to meet its burden.15

      We hold that the entire underpayment for each of the years

at issue is subject to the fraud penalty.      Accordingly, we

sustain respondent’s determinations regarding the fraud penalty

under section 6653(b) for 1988 and section 6663 for 1989 through

1995.

C.   $100,000 Retirement Plan Expense

      On December 22, 1989, a $100,000 check was written on

petitioner’s Merrill Lynch Ready Asset Trust account made payable

to “ERG-Retirement Trust”.    The memo section of the check shows

“BBC [sic] Muir Terrace”.    In the notice of deficiency for tax

year 1989, respondent allowed the $100,000 expense as a pension

plan deduction, even though petitioner did not claim a deduction

for it on its 1989 tax return.




      15
      On brief petitioner has not asserted that any specific
portion of the underpayment in each year was not attributable to
fraud; rather, petitioner’s argument was that no portion of any
underpayment was attributable to fraud because Burton lacked “the
specific intent” to evade income tax when he signed and filed
petitioner’s tax returns.
                               - 49 -

      Respondent has not offered any convincing evidence to

contradict the position originally taken in the notice of

deficiency.   Accordingly, we hold that petitioner is entitled to

deduct $100,000 as a pension plan payment on its 1989 tax return

under section 162.

D.   $94,401 Understatement of Gross Receipts

      Respondent reconstructed petitioner’s gross receipts using a

bank deposits analysis.   The parties agree to the bank deposits

analysis, except for the inclusion of a $94,401 deposit into

petitioner’s Merrill Lynch account on March 27, 1992.

      Muir Terrace was having financial problems which resulted in

a lawsuit’s being filed in Contra Costa Superior Court in 1989.

In March 1992 a settlement was effected and a $94,401 check was

paid to “Burton O. Benson, Tee, Research & Generation Ret.

Trust.”   At trial Burton testified that the check was “a return

on another investment that the ERG retirement trust had   * * *

made in something that was termed BBC (sic) Muir Terrace, which

was an investment of the ERG retirement trust.”   Burton also

acknowledged that the $94,401 check was deposited into

petitioner’s general operating account rather than its retirement

trust.    Petitioner asserts that knowledge of the mistaken deposit

was not discovered until pretrial preparation in spring 2008.

Petitioner, however, has not shown by any probative evidence that

the settlement funds were ever transferred into petitioner’s
                              - 50 -

retirement trust.   In fact, the only testimony Burton provided

regarding whether the $94,401 had been transferred to

petitioner’s retirement trust was that he did not know whether it

had been transferred.

      On brief respondent asserts that he believes the appropriate

adjustments are to allow the previously mentioned $100,000

deduction in 1989 and include the $94,401 in income in 1992.    We

agree with respondent.   Accordingly, we hold that petitioner must

include in its 1992 income the $94,401 it received and deposited

into its general operating bank account.

E.   Section 6651 Additions to Tax

      Respondent determined that petitioner was liable for an

addition to tax under section 6651(a)(1) for tax years 1989

through 1992.

      Section 6651(a)(1) provides for an addition to tax when a

taxpayer fails to file a timely return.    Section 6651(a)(1)

provides an exception to the addition to tax when the failure to

file a timely return “is due to reasonable cause and not due to

willful neglect”.

      The parties agree that petitioner’s 1989, 1990, 1991, and

1992 tax returns were received by respondent on August 28, 1994,

November 20, 1994, July 16, 1995, and July 16, 1995,

respectively.   On brief petitioner has not contested the addition

to tax under section 6651(a)(1) for any of the tax years 1989
                                - 51 -

through 1992.   Consequently, we treat petitioner’s failure to

argue or address this issue on brief as a concession by

petitioner.   See Rule 151(e)(4) and (5); Petzoldt v.

Commissioner, 92 T.C. at 683.    Accordingly, we sustain

respondent’s determinations regarding the addition to tax under

section 6651(a)(1) for tax years 1989 through 1992.

     We have considered all of petitioner’s contentions,

arguments, requests, and statements.     To the extent not discussed

herein, we conclude that they are meritless, moot, or irrelevant.

To reflect the foregoing, and because of the numerous concessions

by the parties,


                                           Decisions will be entered

                                     under Rule 155.
