                         T.C. Memo. 2006-160



                       UNITED STATES TAX COURT



       PAUL BI-YANG CHEN AND CHIU-MEI CHEN, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15579-04.                Filed August 8, 2006.



     John Gigounas, Edward Simpson, and Gerald Holmes, for

petitioners.

     Huong T. Duong, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     HOLMES, Judge:    Paul Chen and his wife, Chui-Mei, were both

officers of a closely held business, PCTI.     PCTI was a successful

wholesaler of computer components for a few years, but it began

having a cashflow problem in 1998.   Mr. Chen tried to solve the

problem by committing insurance fraud.    The fraud unraveled, and
                               - 2 -

both Chens pleaded guilty to a variety of crimes.    Neither PCTI

nor the Chens reported the proceeds of the fraud as income.       The

Chens contest the resulting deficiency and fraud penalty.      Mrs.

Chen seeks innocent spouse relief.

                            Background

     The Chens came to the United States in 1985 from Taiwan,

where Mr. Chen had graduated from college and earned master’s

degrees in civil engineering and architecture.    He had taught

high school for 20 years in Taiwan, but after immigrating he

switched fields and worked for his brother’s computer business.

In 1991, he started up his own firm and began wholesaling

computer parts under the name PC Team.    Within two years, he

incorporated that business as PCTI.    He was PCTI’s sole

shareholder and its president, and he named Mrs. Chen vice

president and administrator.   She worked at PCTI full time,

managing the company’s inventory and running the business when

Mr. Chen was away.   She had full authority to sign checks and tax

returns on behalf of PCTI, though the parties stipulated that she

does not read, write, or speak English.

     PCTI made a valid S corporation election in 1995 and was

still an S corporation in 1998, the tax year at issue.      Its

accounting system was not complex--Mr. Chen simply dictated the

company’s financial transactions to Bo Hua He, PCTI’s in-house

accountant.   Ms. He also prepared many of the checks for the
                                - 3 -

Chens to sign.    These checks were drawn on accounts that PCTI

kept at several banks.    Mr. Chen kept signature authority over

them all, giving Mrs. Chen cosigning authority over only one.

     In September 1998, PCTI contracted with Beam Technology, a

Singapore company, to buy computer processor chips.    The chips

were shipped, but then lost in transit.    Mr. Chen spotted the

opportunity:    He submitted a claim to his carrier, Chubb

Insurance, stating that PCTI had paid $292,000 for the shipment.

This was a lie--PCTI had paid nothing at all.    Chubb, relying on

Mr. Chen’s representation, sent a $287,000 check to PCTI to cover

the alleged loss, less a $5,000 deductible.    Mr. Chen then

directed Mrs. Chen to open a new bank account in the name of Beam

Technology.    No one ever told Beam that the account existed, and

only the Chens had signature authority.    Once the account was

opened, Mr. Chen signed a check from PCTI labeled “refund

prepaid” for $287,000, which Mrs. Chen deposited.    We

specifically find that the Chens’ purpose in opening the account

was to make it seem that the insurance proceeds were being used

to pay off PCTI’s debt to Beam, while allowing them unfettered

access to the money.

     After the check cleared, Mr. Chen transferred $154,409.28

back to PCTI.    He directed Ms. He to record the money on PCTI’s

books as payment on an outstanding account receivable from

Citirom, one of PCTI’s customers--one that had several
                               - 4 -

outstanding invoices in 1998, and was having trouble making

payments to PCTI.   He then transferred another $130,000 from the

Beam account into Mrs. Chen’s personal account.   She in turn

signed checks totaling $80,000 from her account to PCTI, only to

receive the money back from PCTI a few days later.   She gave the

other $50,000 to Mr. Chen to cover some of his gambling losses.

(The Chens credibly testified that Mr. Chen had a severe gambling

compulsion.)

     The Chens used an accounting firm, Chang Accountancy Corp.,

to prepare both their own and PCTI’s 1998 tax returns.    Mr. Chen

did not disclose PCTI’s receipt of the Chubb insurance proceeds

to Chang, so the $287,000 in proceeds was not reported on PCTI’s

return and did not flow through to the Chens’ own joint return.

     Chubb grew suspicious and began an investigation, eventually

referring the matter to law enforcement.   In March 2001, Mr. Chen

pleaded guilty to money laundering and filing a false tax return;

likewise, Mrs. Chen pleaded guilty to wire fraud, aiding and

abetting Mr. Chen’s crime, and filing a false tax return.     In

their plea agreements, the Chens agreed to pay $287,000

restitution to Beam Technology, and they paid $40,000 of the

deficiency owed to the IRS.   The Commissioner determined a

deficiency based on the Chens’ failure to include the proceeds of
                               - 5 -

the fraud in their reported income.    He also determined a fraud

penalty under section 6663.1

     The Chens contest both the deficiency and the penalty.    Mrs.

Chen also asserts as a defense that she is an innocent spouse, on

the grounds that she could not communicate in English; had

nothing to do with the 1998 tax return other than signing the

return; wrote checks only at Mr. Chen’s direction; and did not

benefit from the additional income.    The Commissioner denied her

request as inconsistent with her signed plea agreement, in which

she had admitted participating in her husband’s fraudulent

scheme.   Mrs. Chen believes the Commissioner abused his

discretion in denying her request for innocent spouse relief.

     Both Chens also assert a statute-of-limitations defense.

The Commissioner admits that he sent the notice of deficiency

more than three years after they filed their 1998 tax return, but

argues that the Chens’ fraud makes the notice of deficiency

valid.

     The Chens also argue that even if they did commit fraud, the

amount of their understatement is exaggerated by the IRS.     They

argue that PCTI was already taxed on a portion of the proceeds,

and argue as well that if the fraudulently obtained proceeds are

no longer applied to the Citirom account receivable, that account



     1
       Section references are to the Internal Revenue Code; Rule
references are to the Tax Court Rules of Practice and Procedure.
                                 - 6 -

should be considered a bad debt and give rise to an offsetting

deduction from PCTI’s income.

     Trial was held in San Francisco, and the Chens were

California residents when they filed their petition.

                             Discussion

I.   Fraud

     We first consider whether the Commissioner has proven that

the Chens committed fraud, because this will resolve the

threshold question of the statute-of-limitations defense.      A

fraud penalty under section 6663(a) requires proof that there is

an underpayment of tax required to be shown on a return that the

underpayment is due to fraud.     Miller v. Commissioner, T.C. Memo.

1989-461.    The Commissioner has the burden of proving fraud by

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

     The Commissioner shoulders the first part of his burden with

a stipulation--the parties agree that the Chens underpaid their

1998 taxes:    “The $287,000 [of insurance proceeds] * * * was not

reported as income on Petitioners’ 1998 Form 1040.”    The second

part of the Commissioner’s burden is to show that the Chens’

underpayment was due to fraud.    We define fraud as the “willful

attempt to evade tax”, and look at the entire record of a case to

see if it exists.    Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

The indicia of fraud are numerous and varied, and can include
                               - 7 -

such circumstantial evidence as: (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.   Spies v. United States, 317 U.S. 492, 499 (1943);

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

affg. T.C. Memo. 1984-601.

     But we begin with what we think is the most important bit of

evidence in support of the Commissioner’s position:   In their

criminal plea agreements, Mr. Chen admitted that he conspired to

commit fraud and Mrs. Chen admitted to “act[ing] with a specific

intent to commit fraud.”   They also both pleaded guilty under

section 7206(1) to willfully filing their 1998 income tax return

knowing it was false because it did not include the proceeds of

their fraud.   (We specifically note, with regard to Mrs. Chen,

that the plea agreement has a certificate of accurate translation

and that Mrs. Chen did not attack her consent to the plea

agreement.)

     It is true that this is not enough for the Commissioner to

win on this issue through collateral estoppel--the fraud penalty

requires proof of an intent to evade taxes, and we held in Wright

v. Commissioner, 84 T.C. 636, 643 (1985), that a conviction under

section 7206(1) establishes as a matter of law only an intent to

falsify a tax return.   But a conviction for willful falsification
                                - 8 -

under section 7206(1) is certainly one of the facts to be

considered in deciding whether the Chens committed tax fraud.

See id. at 643-644; see also Welker v. Commissioner, T.C. Memo.

1997-472.    And the Chens’ specific acknowledgment of fraud in the

plea agreements certainly weighs against their claims of

innocence now.

     But even without the acknowledgment of fraud and the guilty

plea, the badges of fraud in this case are plain:

     !      Mr. Chen intentionally submitted a false claim of loss
            to Chubb Insurance;

     !      he concealed receipt of the resulting fraud proceeds
            from his tax preparer;

     !      the Chens’ testimony is replete with contradictory
            claims, ranging from Mr. Chen’s claim to know nothing
            about the financial aspect of the business--“I really
            [am] not too much concern[ed] about the finance[s], you
            know, I [am] just a super-sales[man] only”, while later
            claiming the opposite--“I am like a dictator in the
            company;” to saying that he “never touch[ed] the money
            flow and accounting issues * * * [or paid] too much
            attention in this issue”, only to testify in answer to
            the question “[D]id you tell the accountant what to
            do?”, “Yes”; to Mrs. Chen’s testimony both that she
            herself deposited the $287,000 into the fake Beam
            account and that Ms. He did;2

     !      implausible explanations--to take one example, Mr. Chen
            said he intended to split the insurance proceeds with
            Beam’s owner. Yet Mr. Chen never gave him any money,



     2
       Such inconsistency cannot be chalked up to bad memory or
simple misunderstanding, as the Chens argue. The flip-flops are
too numerous to discount, and the Court made sure that transla-
tors were available at trial to guarantee that the Chens under-
stood the questions being asked.
                                 - 9 -

           arguing at one point that he kept the whole $287,000 to
           cover a gambling loan of only $7,000; and

      !    concealment of assets--when Mr. Chen received the
           reimbursement check from Chubb, he directed his wife to
           open a fake account for Beam, into which he deposited
           the proceeds.

      The Chens’ counterargument is that despite these telltale

signs of fraud, they should be spared the penalty because they

cooperated with the IRS, kept company records, filed their tax

returns, etc.   However, these actions are not enough to overcome

the substantial evidence of fraudulent intent to evade tax on the

ill-gotten insurance proceeds.    Nor is the Court able to rely on

PCTI’s records in the face of credible evidence that those

records were created to cover up the Chens’ fraud by making it

seem to be a payment on an account receivable.    We conclude that

the Commissioner has met his burden of proving fraud by clear and

convincing evidence.

      There is no statute-of-limitations problem in this case.

See sec. 6501(c)(3).

II.   Innocent Spouse Relief

      The Chens eloquently argued at trial that Mr. Chen was the

more guilty party--and the Court does find that he was the

architect of the fraud at issue.    It was also his gambling

compulsion that motivated Mrs. Chen to help him move the stolen

money in and out of her account.    The Chens argue from this

lesser culpability that Mrs. Chen should be relieved from joint
                                - 10 -

liability for the deficiency.    Section 6015 allows relief from

joint and several liability on three grounds:    subsection (b)

lets a spouse seek relief if she can show that she neither knew,

nor had reason to know, of an understatement on the return;

subsection (c) lets divorced or separated spouses split their tax

liability; and subsection (f) allows relief where “it is

inequitable to hold the individual liable for any unpaid tax or

any deficiency (or any portion thereof).”

     Mrs. Chen’s first problem is section 1.6015-1(d), Income Tax

Regs., applicable to all these subsections.    It provides:

          If the Secretary establishes that a spouse
          transferred assets to the other spouse as
          part of a fraudulent scheme, relief is not
          available under section 6015 * * *. For
          purposes of this section, a fraudulent scheme
          includes a scheme to defraud the Service or
          another third party * * *

We hold that this section alone supports the Commissioner’s

refusal to grant Mrs. Chen innocent spouse relief under any

subsection of section 6015--Mrs. Chen admitted, after all, to

helping to defraud Chubb, “another third party.”

     As alternative grounds, however, we discuss each of the two

subsections that Mrs. Chen relies on.

     A.   Section 6015(b) Relief

     Section 6015(b) requires, among other elements, the spouse

asking for relief to prove that “in signing the return, * * *

[she] did not know, and had no reason to know, that there was
                               - 11 -

such an understatement.”    Sec. 6015(b)(1)(C).   Mrs. Chen’s claim

for relief under subsection (b) turns on whether she can prove

this.3    She argues that, despite her status as an officer of

PCTI, hers was only a clerical position giving her no

comprehension of what was happening when she signed corporate

checks and documents.    She says that she just signed whatever Mr.

Chen or Ms. He gave her without asking questions.    Mrs. Chen’s

limited English skill is a fact that would seem to support her

position.

     But the regulations interpreting subsection (b) direct us to

look at “all of the facts and circumstances.”     Sec. 1.6015-2(c),

Income Tax Regs.    And there are other facts weighing against

relief.    Perhaps most damning is Mrs. Chen’s admission of guilt

in committing wire fraud, filing a false tax return, and aiding

and abetting her husband to launder money.    Mrs. Chen’s plea

agreement, which she signed, specifically indicated that she

“acted with a specific intent to commit fraud.”    Even though Mrs.

Chen is not as well educated as her husband, she was too deeply

involved to be characterized as playing an unsuspecting dupe in

his fraud.    We also do not give much weight to Mrs. Chen’s

inability to communicate in English.    PCTI’s office was staffed



     3
       Petitioners have the burden of proof under section
6015(b), but need only persuade us by a preponderance of the
evidence rather than that the Commissioner abused his discretion.
See Haltom v. Commissioner, T.C. Memo. 2005-209.
                                - 12 -

with Chinese speakers, and we infer from the evidence and

observation during trial that the Chens simply worked together in

Chinese.    We find that Mrs. Chen knew exactly what she was doing

when she wrote Mr. Chen a $50,000 check to cover some of his

gambling debts.    The regulations direct us to look, not at

whether a spouse requesting relief knows specifically of the

understatement (as the Chens argue), but at whether “the

requesting spouse had actual knowledge of an erroneous item.”

Sec. 1.6015-3(c)(2)(i), Income Tax Regs., incorporated by sec.

1.6015-2(c), Income Tax Regs.    The regulation specifically

directs us to look at whether the spouses “jointly owned the

property that resulted in the erroneous item,” sec. 1.6015-

3(c)(2)(iv), Income Tax Regs., and the situation here is even

more egregious since Mrs. Chen had sole power and control of the

fake Beam account.

     We therefore conclude, after considering all these facts and

circumstances, that Mrs. Chen knew of Mr. Chen’s fraud when she

signed the joint tax return for 1998.    She is not entitled to

relief under subsection (b).

     B.     Section 6015(f) Relief

     Mrs. Chen also argues for relief under subsection (f),

arguing that it would be inequitable to hold her liable for the

unpaid tax.4   Rev. Proc. 2003-61, 2003-2 C.B. 296,5 sets out


     4
         Our jurisdiction to review Mrs. Chen’s claim for
                                                     (continued...)
                             - 13 -

general conditions a requesting spouse must meet in order to be

eligible for subsection (f) relief.    One of these is the absence

of fraudulent transfers of assets between the spouses.   As we

have already found, the Chens transferred assets back and forth

between Mrs. Chen, Mr. Chen, and PCTI in order to hide the trail

of fraud, and this enabled Mrs. Chen to give $50,000 to Mr. Chen

to cover some of his gambling losses.   Moreover, Mrs. Chen

admitted that she acted with fraudulent intent.   This means that

the Commissioner did not abuse his discretion in concluding that

she did not qualify for (f) relief.6

III. Amount of Deficiency

     The only remaining issue is the amount of the deficiency,

which the Chens argue should not reflect the full amount of the

     4
      (...continued)
subsection (f) relief stems from the existence of an assertion of
a deficiency in this case. Compare Commissioner v. Ewing, 439
F.3d 1009 (9th Cir. 2006) (no Tax Court jurisdiction when no
deficiency involved), revg. 122 T.C. 32 (2004) with Butler v.
Commissioner, 114 T.C. 276, 288 (2000) (Tax Court does have
jurisdiction when 6015(f) relief is sought as defense to
deficiency).
     5
       This new revenue procedure replaced Revenue Procedure
2000-15, 2000-1 C.B. 447, and became effective on November 1,
2003, for all pending or subsequently filed requests for relief.
The principal change in the new IRS guidance is revision of the
weight given to the knowledge factor. See Baumann v.
Commissioner, T.C. Memo. 2005-31.
     6
       The standard of review we apply differs between section
6015(b) and (f) cases. In section 6015(f) cases, we review the
Commissioner’s denial of relief for abuse of discretion. Butler
v. Commissioner, 114 T.C. 276, 292 (2000).
                              - 14 -

stolen insurance money.   The Chens are certainly right about part

of this.   Of the $287,000 deposited into the Beam account,

$154,409 was transferred to PCTI, with $140,372 applied to a

Citirom receivable.   The Commissioner concedes that $14,037 of

the proceeds was reported by PCTI, and thus flowed through to the

Chens in 1998, leaving $272,963 in unreported income.7    The Chens

argue, however, that the $154,409 that they transferred to PCTI

after a short detour through the fake Beam account should be

regarded as PCTI’s income, not their own.

     The problem with this argument is that PCTI was an S

corporation, and an S corporation’s income is generally taxable

to its owners, not to the corporation itself, sec. 1363(a); and

whether or not the income is distributed, sec. 1366(a).    In any

event, the Chens never identified any exception to the general

rules making PCTI’s income taxable to them.   The $140,372 is

therefore income to the Chens in 1998, and the IRS is right that

the total amount of unreported income is $272,963.

     The Chens also argue that if the insurance proceeds had not

been misapplied by PCTI’s accountant to wipe out one of Citirom’s

outstanding accounts receivable, PCTI would have been entitled to

a bad debt deduction for $140,372 on its 1998 return.    The

Citirom receivable was held by PCTI and so flowed through to the


     7
       The Commissioner’s concession is derived by subtracting
the total transferred back to PCTI from the amount applied to the
Citirom account ($154,409 - $140,372 = $14,037).
                                - 15 -

Chens; this meets the Code’s requirement of a debt relating to a

business activity.   Because the debt is a business one, the Chens

could deduct it if they proved the other elements of a bad debt

deduction:   (1) a valid debtor-creditor relationship; (2) the

amount of the debt; (3) its worthlessness; and (4) the year it

became worthless.    See Davis v. Commissioner, 88 T.C. 122, 142

(1987), affd. 866 F.2d 852 (6th Cir. 1989).

     We have no reason to doubt that Citirom and PCTI had a valid

debtor-creditor relationship.    The Chens also proved the amount

of the receivable through PCTI’s business records.    So far, so

good.   However, they stumble over the last two hurdles:

worthlessness, and worthlessness in 1998.    Mr. Chen did credibly

testify that PCTI had trouble collecting from Citirom in 1998,

but though Citirom was a slow payer, it did continue to make

payments throughout the year on a number of other outstanding

invoices.    A taxpayer’s “mere belief” that a debt is worthless

won’t support a deduction.    Fox v. Commissioner, 50 T.C. 813,

822-823 (1968), affd. per curiam 25 AFTR 2d 70-891, 70-1 USTC

par. 9373 (9th Cir. 1970); sec. 1.166-2, Income Tax Regs.    We

look instead for facts that establish reasonable grounds for

abandoning any hope of recovery--proof of the customer’s

insolvency, a description of action taken to recover the debt, or

an explanation of why no action was taken.    Fincher v.

Commissioner, 105 T.C. 126, 137-138 (1995); Crown v.
                              - 16 -

Commissioner, 77 T.C. 582, 598 (1981).     The Chens did not do this

and so cannot offset their 1998 gross income with a business bad

debt deduction.

                            Conclusion

     We reject each of the Chens’ arguments.    Because of the

fraud involved, the IRS has no time limit for assessing the

unpaid tax, so the statute of limitations had not passed.

Unreported income of $272,963 was omitted from the Chens’ 1998

return.   The Chens are liable for the fraud penalty due to their

intentional failure to report the insurance proceeds.    And

finally, Mrs. Chen does not qualify for innocent spouse relief.

To reflect the Commissioner’s concession, however,


                                    Decision will be entered under

                               Rule 155.
