                         T.C. Memo. 1997-30



                      UNITED STATES TAX COURT



                     HENRY HARDY, Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13458-93.                   Filed January 16, 1997.



     Henry Hardy, pro se.

     Linette B. Angelastro and Michelle Or, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Chief Judge:      Respondent determined deficiencies in,

an addition to, and a penalty on, petitioner's Federal income

taxes as follows:

                                     Addition to Tax and Penalty
     Year        Deficiency          Sec. 6653(b)      Sec. 6663

     1988         $16,590              $11,387            ---
     1989          37,184                ---            $26,523
                                - 2 -

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.

     After concessions, the issues for decision are:    (1) Whether

petitioner had unreported income in 1988 and 1989; (2) whether

petitioner is liable for the addition to tax and penalty for

fraud in 1988 and 1989, respectively, or, in the alternative,

liable for the addition to tax and penalty for negligence; and

(3) whether the period of limitations for assessment is open for

1988 under section 6501(c)(1) or, in the alternative, open under

section 6501(e)(1)(A).

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Included among the stipulated exhibits is the transcript of

petitioner's criminal trial.   At the time the petition was filed,

petitioner was incarcerated at the California Correctional

Institution in Tehachipi, California.

     Petitioner started a business known as the Stardust Modeling

Agency (Stardust) in 1987.   Petitioner opened a bank account for

Stardust, purchased furniture for Stardust, and signed the lease

for Stardust.    Petitioner operated Stardust from the end of 1987

into mid-1991.   The hours of operation of Stardust were Monday

through Saturday, 10 a.m. to 10 p.m.    During 1988 and 1989,
                                 - 3 -

Stardust employed approximately 10 women (the models).      The

business of Stardust was conducted out of an office and

"studios".   When the business began, there was one studio.

Petitioner eventually added two studios for a total of three

studios where the models could perform at Stardust.

     The business of Stardust consisted of customers paying for

the models to engage in various acts.    The customers either

called Stardust and scheduled an appointment or walked in off the

street.   The models' acts included dancing seminude to nude,

modeling for pictures, and engaging in various sexual acts,

including intercourse.   During 1988 and until approximately

August 1989, petitioner charged $80 for a model to spend a

half-hour session at a Stardust studio with a customer.      In

August 1989, the half-hour rate increased to $100 per session.

The models received $30 of the fee paid to Stardust and any tip

made at the discretion of the customer.    The models often gave to

petitioner a percentage of their tips.    Stardust offered 1-hour

sessions at Stardust for $180.    Stardust also offered "outcalls"

for $200, where the models were taken to a different location,

such as a hotel, for a session with a customer.

     Stardust kept records of the models' sessions on log sheets.

The original log sheets were filled out contemporaneously as

customers arrived at Stardust.    The models would record

information about the session on the log sheet.    The information

included the date, time in/out, and type of session (modeling or
                                - 4 -

outcall), along with the price, the model's name, and comments.

The comments consisted of the customer's first name and

occupation, although this information was based on conversations

with the customers and was not verified.    Additionally, the

amount of tip a model received was recorded next to her name with

a circle around the amount.    The original log sheets were written

in different color inks, with different penmanship, and the times

of the sessions varied throughout the day.

     The models received the cash fee for the session prior to

the start of the session.    Stardust did not take checks or credit

cards.    The cash was placed inside of a book in the office and

was later removed by petitioner.    Sometimes the models would be

paid their percentage with the money in the book right after a

session ended.

     Petitioner was not at Stardust during all of its hours of

operation.    He was concerned about the models' performing

sessions without his knowledge and keeping the fees.    To prevent

a loss of fees, petitioner installed video cameras in strategic

locations at Stardust.    He told the models that the cameras

recorded every customer that came into Stardust and that he

reviewed the videotapes.    In actuality, the video cameras worked

as surveillance cameras but were not connected to a recording

device.

     Petitioner was also concerned about privacy.    He instructed

the models not to talk to anyone outside the business about the
                                 - 5 -

business and, particularly, not to mention his name in

association with the business.

     Okema Wells (Wells) assisted petitioner with the management

of Stardust from its inception.    Wells was a friend of

petitioner.   In 1989, she also began modeling for Stardust.

Petitioner instructed Wells to recreate the Stardust daily logs

by hand for 1988 and 1989.    The 1988 logs were recreated in 1989,

and the 1989 logs were recreated in 1990.    The log recreated for

1988 listed the time that every session occurred during the year

as "9:00-9:30", "3:00-3:30", or "6:00-6:30".    All of the sessions

were listed as half-hour sessions, and there were no outcalls.

The log recreated for 1989 listed various times for the sessions

but omitted the comments.    For 1989, all of the sessions were

recorded as half-hour sessions with the exception of two 1-hour

sessions in June.    Neither the log recreated for 1988 nor the log

recreated for 1989 contained any record of a tip next to the

models' names.

     Petitioner timely filed Forms 1040, U.S. Individual Income

Tax Returns, for the taxable years ended December 31, 1988, and

December 31, 1989.    Petitioner claimed married filing separate as

his filing status on the 1988 and 1989 returns.    He reported his

adjusted gross income as $1,193 and $9,123 for 1988 and 1989,

respectively.    Petitioner received $7,920 in April 1988 as a

settlement on an insurance claim.    Petitioner filed his Form 1040

for 1990 in October 1991.    Petitioner claimed married filing
                                - 6 -

separate as his filing status on his 1990 return and reported his

adjusted gross income as $77,814.    Petitioner's 1988 and 1989

returns were prepared by H&R Block.     Petitioner provided the

preparer with amounts to be used on the returns for income and

expense, but he did not supply any supporting documentation.

     Petitioner's 1988, 1989, and 1990 returns each included a

Schedule C, Profit or Loss From Business, that listed the

business as Stardust.    Petitioner claimed income and expense

items for Stardust on the Schedules C.     For 1988, petitioner

claimed an expense of $6,540 for commissions.     Petitioner issued

Forms 1099-MISC to three models in 1988 for total commissions of

$6,030.    For 1989, petitioner claimed an expense of $17,830 for

wages.    Petitioner issued Forms 1099-MISC to six models in 1989

for total wages of $16,530.

     During the years in issue, petitioner's wife, Kathy Hardy

(Mrs. Hardy), worked at Clairol.    She filed her Forms 1040 for

1988 and 1989 and claimed as her filing status married filing

separate.    Her adjusted gross income for 1988 and 1989 was

$17,996 and $19,890, respectively.

     Petitioner, Mrs. Hardy, and Mrs. Hardy's daughter resided at

petitioner's parents' home in Oxnard, California, from September

1986 through July 1988.    On July 9, 1988, petitioner and

Mrs. Hardy executed a residential rental agreement to rent a home

in Oxnard for $930 per month.    As part of the rental agreement,

petitioner paid the new landlord $3,143 for the first and last
                                - 7 -

months' rent and a security deposit.     In 1990, petitioner and

Mrs. Hardy purchased, as joint tenants, a home on Eastridge Loop

in Oxnard for $265,000.    They made a downpayment of $53,000

towards the purchase price.

     In approximately September 1990, the Oxnard Police

Department began an investigation of Stardust for "in-call,

out-call prostitution service".    Police officer Michael

Williamson was involved in the surveillance, execution of the

search warrants, interviews of suspects, and completion of

reports.    The Criminal Investigations Division of the Internal

Revenue Service (IRS) was also involved in the investigation.       A

search warrant was executed at petitioner's parents' home.       The

police seized paperwork, a briefcase, and other items relating to

Stardust showing the name Henry Hardy.     The briefcase contained

paperwork, bills, receipts, and calendars.     The calendars were

for 1987 through 1989.    The police also executed a search warrant

at petitioner's home on Eastridge Loop.     The police seized a 1990

calendar from the Eastridge Loop location.

     Beginning with December 1987 and throughout the years in

issue, the calendars contained "X" marks.     The X marks were

placed on Mondays through Saturdays.     There were no X marks on a

Sunday.    There were numerical notations at the end of various

weeks and months on the calendars.      The notations often consisted

of a total of the number of X's for the week or month and of

another number that equaled the number of X's multiplied by
                                - 8 -

petitioner's percentage of the fees that Stardust charged for a

session.    The X's were often in different color inks on the same

day.

       In September 1991, in a criminal trial in the Superior Court

of California, County of Ventura, petitioner was convicted of

nine counts of pandering and two counts of pimping in connection

with his operation of Stardust.    In March 1993, the Court of

Appeals of the State of California, Second Appellate District,

Division Six, conditionally reversed and remanded petitioner's

State court conviction for further action on petitioner's

discriminatory prosecution claim.    Petitioner subsequently

pleaded guilty to nine counts of pandering and two counts of

pimping by a Felony Disposition Statement filed July 21, 1993.

       In October 1992, the IRS began an audit of petitioner's 1988

and 1989 Federal income tax returns.    Revenue Agent James Deguchi

(Deguchi) received the 1988 return, transcripts, and information

obtained from the Criminal Investigations Division of the IRS.

Deguchi made copies of numerous documents, including the

calendars that were obtained through use of the search warrants.

Deguchi counted the number of X's on the calendars for 1988 and

1989 and multiplied the number by $50 to establish petitioner's

gross income from Stardust.    Deguchi was aware that many of the

sessions were 1-hour sessions and outcalls for which petitioner

received a higher fee, but Deguchi used only the half-hour fee in

his computations.    Deguchi used the same method to determine
                               - 9 -

petitioner's 1990 gross income.   Because the reconstructed income

was sufficiently similar to the income that petitioner had

reported on his 1990 Schedule C, the IRS decided not to pursue an

audit of petitioner's 1990 Federal tax return.   As a result of

the audit, respondent sent a statutory notice of deficiency to

petitioner for 1988 and 1989 on April 9, 1993.




                              OPINION

     Respondent argues that petitioner understated his income

from Stardust in 1988 and 1989.   Respondent contends that

petitioner maintained inadequate books and records and that the

calendars are the most accurate reflection of petitioner's

income.   Respondent also argues that petitioner underpaid his

taxes for both years due to fraud and, accordingly, that section

6501(c)(1) permits assessment at any time.

     Petitioner asserts that his records accurately reflect

income.   On brief, petitioner states that he placed the X marks

on the calendars not to count income but to "tell if the dancers

were stealing customers, determine how effective telephones were

being handled, and gauge the potential profits to be made if the

business were being handled correctly".   Petitioner further

asserts that respondent has not satisfied her burden of proving

fraud either for penalty purposes or for statute of limitations

purposes.
                               - 10 -

     The addition to tax and penalty in the case of fraud are

civil sanctions provided primarily as a safeguard for the

protection of the revenue and to reimburse the Government for the

heavy expense of investigation and for the loss resulting from

the taxpayer's fraud.    Helvering v. Mitchell, 303 U.S. 391, 401

(1938).   Respondent has the burden of proving, by clear and

convincing evidence, an underpayment for each year and that some

part of an underpayment for each year was due to fraud.   Sec.

7454(a); Rule 142(b).    If respondent establishes that any portion

of the underpayment is treated as attributable to fraud, the

entire underpayment is treated as attributable to fraud and

subject to the 75-percent addition to tax or penalty unless the

taxpayer establishes that some part of the underpayment is not

attributable to fraud.   Secs. 6653(b), 6663(b).   This burden is

met if it is shown that the taxpayer intended to conceal,

mislead, or otherwise prevent the collection of such taxes.

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

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

T.C. Memo. 1966-81.

     The existence of fraud is a question of fact to be resolved

upon consideration of the entire record.    Gajewski v.

Commissioner, 67 T.C. 181, 199 (1976), affd. without published

opinion 578 F.2d 1383 (8th Cir. 1978).   Fraud will never be

presumed.   Beaver v. Commissioner, 55 T.C. 85, 92 (1970).     Fraud

may, however, be proved by circumstantial evidence because direct
                                - 11 -

proof of the taxpayer's intent is rarely available.    The

taxpayer's entire course of conduct may establish the requisite

fraudulent intent.     Stone v. Commissioner, 56 T.C. 213, 223-224

(1971); Otsuki v. Commissioner, 53 T.C. 96, 105-106 (1969).      A

pattern of consistent underreporting of income for a number of

years, when accompanied by other circumstances showing an intent

to conceal, justifies the inference of fraud as to each of the

years.    Holland v. Commissioner, 348 U.S. 121, 137 (1954); Otsuki

v. Commissioner, supra.

     Under section 61, gross income includes "all income from

whatever source derived."    Gross income includes funds derived

from legal and illegal sources.     Rutkin v. United States, 343

U.S. 130 (1952).     Where a taxpayer keeps no books and records, or

the taxpayer fails to file a return from which his income tax

liability can be assessed, the IRS may reconstruct the taxpayer's

income.    Sec. 446(b); Moore v. Commissioner, 722 F.2d 193 (5th

Cir. 1984), affg. T.C. Memo. 1983-20.    The IRS has great latitude

in reconstruction methods.     Giddio v. Commissioner, 54 T.C. 1530,

1532-1534 (1970).    As a general rule, the computation of taxable

income is made under the method of accounting regularly employed

by the taxpayer or, if no method of accounting has been used by

the taxpayer, made under such method as, in the opinion of

respondent, clearly reflects income.     Sec. 446(b); Moore v.

Commissioner, supra; Giddio v. Commissioner, supra.     This Court

has approved the use of "trick sheets" to reconstruct a
                                - 12 -

taxpayer's income from prostitution.     Cooper v. Commissioner,

T.C. Memo. 1987-303.

       In cases of unreported illegal income, respondent must

establish that the deficiency determination is supported by a

proper foundation of substantive evidence.     Weimerskirch v.

Commissioner, 596 F.2d 358, 362 (9th Cir. 1979), revg. 67 T.C.

672 (1977).    In this case, petitioner admits that the source of

his income was from Stardust.    Only the amount of income is in

dispute.

       Respondent substantiates her assertion of unreported income

with the calendars, the purported business records of Stardust,

the evidence of petitioner's expenditures not explained by

reported income, and testimony of petitioner and several of the

models.    Respondent maintains that petitioner's business records

are inaccurate representations of the number of models' sessions.

       Petitioner argues that the transcribed business records are

accurate and that they bear resemblance to the originals

sufficiently to show that petitioner is not liable for additional

tax.    Petitioner argues that he had the originals copied because

they were stained with coffee or cola and that the originals

"turned up missing" after the police executed a search warrant at

Stardust.

       At the criminal trial and at trial of this case, various

models testified consistently about walk-in customers, length of

sessions, triangle sessions, and outcalls.    Their testimony was
                               - 13 -

corroborated and credible.    Petitioner's purported business

records do not reflect the income produced from the sessions

described by the models.    We conclude, therefore, that the

records are not complete or accurate.

      Respondent's agent examined the calendars and the notations

on the calendars.    Respondent's calculation of the number of X's

on the calendars multiplied by petitioner's fee corresponded with

the notations that petitioner made on the calendars.

Petitioner's explanation is that the X's represent telephone

calls to Stardust.   Petitioner testified that, after midnight, he

would call his answering machine from his home.    He would listen

to the messages and record an X for every five calls that came

in.   He stated that he had a goal of getting one customer for

every five calls and that listening to the messages helped him to

determine if he was reaching his goal.

      Petitioner's explanation is contradicted by the evidence.

The X marks on the calendars were in different colors of ink on

the same day.   No X marks were shown on Sundays, which would

imply that there were no calls on a Sunday from the inception of

the business until the termination of the business.    Petitioner's

wife testified that she never saw petitioner use the calendars at

home.   Many of the dates on the calendars contain 10 or more X's,

which would mean that petitioner would have had to have listened

to 50 telephone messages at home, after midnight, while marking

X's on the calendars.
                               - 14 -

     From the entire record, we are convinced that the calendars

reflect petitioner's business receipts, as respondent has argued,

and we reject petitioner's improbable explanation.

     Respondent's determination is corroborated by evidence of

petitioner's expenditures in excess of reported income.

Petitioner has not offered a credible explanation for many of his

expenditures described in the testimony and exhibits, such as the

$53,000 downpayment on the Eastridge Loop home.

     The evidence is clear and convincing that petitioner

received income from Stardust and the models and that petitioner

did not report all of the income.    Thus, respondent has proven an

understatement of income.    Even in criminal cases, where the

Government bears the burden of proof beyond a reasonable doubt,

proof of unreported income is sufficient to establish an

underpayment of tax absent proof by the taxpayer of offsetting

expenses.   See, e.g., Elwert v. United States, 231 F.2d 928, 933-

936 (9th Cir. 1956).    A fortiori, that proof is sufficient in

this civil case.    Although respondent has conceded that

petitioner is entitled to additional expenses for costs of labor,

those expenses are less than the unreported income.    Petitioner's

testimony that he did not underreport his income is implausible

and not credible.    Respondent has proven an understatement by

clear and convincing evidence.

     Respondent must also prove fraudulent intent.    Fraudulent

intent may be inferred from various kinds of circumstantial
                                - 15 -

evidence, or "badges of fraud", including an understatement of

income, inadequate records, implausible or inconsistent

explanations of behavior, engaging in illegal activities,

attempting to conceal the illegal activities, and dealing in

cash.     Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir.

1986), affg. T.C. Memo. 1984-601; Meier v. Commissioner, 91 T.C.

273, 297-298 (1988).

        The facts in this case include many "badges of fraud".

Petitioner kept inadequate books and records for Stardust and

created false records.     Petitioner's explanations for the X marks

on the calendars are implausible and not credible.       Petitioner

engaged in illegal activities.     Stardust operated as a "cash

only" business.

        Respondent has proven by clear and convincing evidence an

underpayment of tax due to fraud for each year.      Petitioner has

not proven that any part of the underpayment is not attributable

to fraud.     See secs. 6653(b)(2), 6663(b).

        Section 6501(c)(1) provides:   "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."      Assessment for 1988

is not barred.

                                            Decision will be entered

                                       under Rule 155.
