                            T.C. Memo. 2005-68



                         UNITED STATES TAX COURT



       ALBERT M. GRAHAM AND MARTHA A. GRAHAM, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 587-03.                Filed March 31, 2005.


       W. Rod Stern, for petitioners.

       Louis B. Jack and Kevin W. Coy, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


       COLVIN, Judge:    Respondent determined deficiencies in

petitioners' Federal income tax and penalties as follows:

                                       Penalties
Year        Deficiency          Sec. 6662   Sec. 6663

1995         $79,701                --      $58,241.25
1998          22,412            $2,187.80    48,376.50
1999          55,578               190.00     1,166.25
                                 - 2 -

     After trial, respondent filed a motion for leave to file

amendment to answer asserting increased deficiencies as a result

of petitioners’ failure to report $67,437 for 1995 and $87,942.76

for 1998 and additions to tax under section 6651(a)(1) and (2)

for failure to timely file their 1998 income tax return and to

timely pay the tax shown as due on that return.

     After concessions,1 the issues for decision are:

     1.     Whether petitioner2 had unreported income in 1995 of

$112,255.84 as respondent contends, or $70,587 as petitioners

contend, from the settlement of his claim for attorney’s fees.

Resolution of this issue depends on resolution of the following

issues:

            a.    Whether the statute of limitations bars assessment

of these amounts.     We hold that it does not.

            b.    Whether petitioners are taxable on $47,443.51

petitioners’ children received from the Anis Recovery Fund

partnership.     We hold that they are.

            c.    Whether the fair market value of petitioner’s

22.375 percent interest in two parcels of real property in which



     1
       Petitioners concede that, because they had a reasonable
prospect of recovery in 1999, the $393,954 embezzlement loss is
not deductible in 1999. Petitioners also concede that they are
not entitled to business expense deductions for 1998 and 1999.
Respondent concedes that Martha A. Graham is not liable for the
fraud penalty.
     2
         References to petitioner are to Albert M. Graham, Jr.
                                 - 3 -

the partnership owned fractional shares was $37,204, as

petitioners contend, or $64,812.33, as respondent contends.     We

hold that it had a fair market value of $59,629.38.

     2.   Whether petitioners had unreported income of $12,764 for

1998 and $2,735 for 1999.   We hold that they had unreported

income of $6,264 for 1998 and $2,735 for 1999.

     3.   Whether we will grant respondent’s motion to amend the

answer, and, if so, whether petitioners are liable for increased

deficiencies and additions to tax because of their failure to

report (a) business income of $67,437 for 1995 and $87,942.76 for

1998 and (b) distributions from the Anis Recovery Fund

partnership consisting of an ordinary loss of $2,240 for 1995, a

capital gain of $5,594 for 1998, and income of $9,127 for 1999.

We will grant respondent’s motion, and we conclude that

petitioners had unreported income of $67,437 for 1995 and

$87,942.76 for 1998, an ordinary loss of $2,240 for 1995, a

capital gain of $5,594 for 1998, and income of $9,127 for 1999.

     4.    Whether petitioner is liable for the fraud penalty

under section 66633 for 1995, 1998, and 1999.    We hold that he is

to the extent discussed below.

     5.   Whether petitioners are liable for the accuracy-related

penalty for negligence on a portion of the underpayment of their


     3
        Section references are to the Internal Revenue Code, and
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 4 -

tax for each of the years 1998 and 1999 that is not due to fraud.

We hold that they are to the extent discussed below.

     6.   Whether petitioners are liable for additions to tax

under section 6651(a)(1) and (2) for failure to timely file their

1998 income tax return and to pay the tax shown as due on that

return.   We hold that they are in the amounts of $3,277.35 and

$2,549.05, respectively.

                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

A.   Petitioners

     Petitioners lived in Newport Beach, California, when they

filed their petition.    Petitioner is an attorney and has

practiced law in California since 1969.       Mrs. Graham was a travel

agent during the years in issue.

     Petitioners have owned a cabin in Big Bear, California,

since the early 1970s.    During the years in issue, petitioner had

three personal bank accounts, one of which was at Security First

Bank in Big Bear (the Big Bear account).

     Donald Lewellen (Lewellen), a certified public accountant,

prepared petitioners' income tax returns for tax years 1972

through 1998.   He prepared their amended 1998 return in November

1999.
                               - 5 -

B.   The Redlands Mortgage and the Bogus Encumbrances

     In 1995, petitioners were general partners (with about a

one-third interest) in a California general partnership that

owned a 78-unit apartment building in Corona, California.   The

partnership had used the proceeds of a $3.4 million loan from

Redlands Federal Bank to buy the building.   By 1995, the value of

the building had declined substantially, and the partnership

stopped making payments on the Redlands mortgage.

     On April 29, 1995, Redlands instituted foreclosure

proceedings against petitioners and the other partners.   Attorney

Steven Smith (Smith) represented petitioner in that litigation,

which was settled in April 1996.   Petitioner owed Smith legal

fees of about $41,000 for his representation.

     During the Redlands litigation, petitioner became concerned

that he would become personally liable for the unpaid balance of

the Redlands mortgage.   Donald Sieveke (Sieveke), a California

attorney who specialized in bankruptcy law and who rented office

space from petitioner during some of the years in issue, advised

petitioner to encumber his assets to avoid having to divest

himself of assets if he had to file a petition in bankruptcy.

     In 1995, petitioners created bogus promissory notes and

deeds of trust to make it appear that their properties were

encumbered and to protect their assets from creditors such as

Redlands Federal.   Petitioners executed documents creating: (1) A
                                 - 6 -

lien relating to his 1956 Mercedes Benz in favor of his friend

Lee Cogan (Cogan), even though he did not owe Cogan money; (2) a

deed of trust secured by their residence in favor of petitioner’s

office manager, Charlene Edgar (Edgar), purportedly securing a

$164,465.06 debt, even though petitioners did not owe Edgar any

money; (3) a deed of trust secured by petitioner’s law office

building purportedly securing a $50,000 debt owed to petitioner’s

accountant, James O’Leary (O’Leary), when petitioner owed no

money to O’Leary; and (4) a deed of trust in favor of Lewellen

for $38,000, when petitioner owed Lewellen $8,000-$10,000 in

unpaid accounting fees.     Edgar prepared the deeds of trust, and

Sieveke notarized them.

C.   Petitioner’s Law Practice

     1.      Organization of Petitioner’s Law Office

     Petitioner was a deputy district attorney in Orange County,

California from 1969 to February 1972.      He has specialized in

family law since 1983.     Petitioner was a sole practitioner in

Santa Ana, California, during the years in issue.      Petitioner’s

law office is located in a one-story building that he owns.

     Edgar began working as petitioner’s office manager around

1982.     Edgar took over the bookkeeping and accounting for

petitioner's law practice in 1991.       From 1995 to early February

1999, Edgar was responsible for the day-to-day management of the

office.     She was primarily responsible for client billing and
                               - 7 -

banking, and she paid accounts payable, recorded cash receipts,

made bank deposits, paid office expenses, and prepared checks for

petitioner to sign.

     2.   Petitioner’s Business Bank Accounts

     Petitioner had two bank accounts for his law practice:      a

business checking account and a client trust account.    The

checking account was at Citizens Business Bank from January to

November 1998, Washington Mutual Bank from November 1998 to

September 1999, and Union Bank from September to December 1999.

     3.   Petitioner’s Client Files and Billing Records

     Edgar had eight filing cabinets in her office:    six for

ongoing cases; one for open billing files, and one for closed

billing files and receipts.   She kept two complete hard copy sets

of the billing records.   She filed one set alphabetically by

client name and the second set chronologically by month.

Petitioner knew that Edgar maintained the billing records in the

file cabinets.   Edgar and petitioner reviewed monthly billings.

     4.   Legal Fees From the Anis Litigation

     In 1991, Nick and Patricia Anis (the Anises) sued Allan

Stover (Stover) for wrongful termination of Mr. Anis (Anis).

Petitioner and Smith jointly represented the Anises.    Petitioner

and Smith had a contingent fee agreement with the Anises under

which petitioner and Smith would receive 50 percent of any

recovery obtained in their case against Stover.
                               - 8 -

     Petitioner and Smith agreed to split any fees received in

proportion to the hours they each spent on the case.    Petitioner

worked 44.75 percent of the hours on the case, and Smith worked

55.25 percent.   Thus, the Anises, Smith, and petitioner agreed to

split any amounts received from the case as follows:

     Nick and Patricia Anis    50 percent
     Smith                     27.625 percent (50% x 55.25%)
     Petitioner                22.375 percent (50% x 44.75%)

     The Stover case went to trial, and the jury awarded the

Anises damages of $1.2 million in May 1992.     Before the judgment

was filed, Stover and his wife filed a petition in bankruptcy.

Shortly thereafter, the parties agreed to reduce the Stovers’

liability to $600,000.

     In May 1992, Stover paid $60,000 to the Law Offices of

Steven C. Smith, which Smith deposited in his client trust

account.   On August 4, 1992, Smith paid petitioner $15,060, his

22.375-percent share of Stover's initial payment.

     Before making any other payments, the Stovers filed a second

petition in bankruptcy on August 30, 1993.    On January 21, 1994,

the Anises filed a proof of claim in the Stovers' bankruptcy.

Petitioner was listed as a secured creditor in some of the

bankruptcy pleadings.

     5.    The Anis Recovery Fund Partnership

     In April 1994, Smith, on behalf of himself, the Anises, and

petitioner (the Anis parties), began negotiating a settlement
                               - 9 -

with the Stovers’ counsel.   The Anis parties decided to form a

partnership to hold property they expected to receive from the

Stovers.

     The initial draft of the partnership agreement provided that

the partnership would be owned by Smith, the Anises, and

petitioner in proportion to their interests in the recovery;

i.e., the Anises 50 percent, Smith 27.625 percent, and petitioner

22.375 percent.   In an April 24, 1994 letter, Smith advised the

Anises and petitioner that any cash received from the Stovers

would be taxable upon receipt, and that they should get a legal

opinion as to the tax consequences of the transaction.

     In 1995, Smith formed the Anis Recovery Fund partnership

(the Anis partnership) to negotiate the bankruptcy court

settlement with the Stovers and to hold certain real property

that the Anis parties expected to receive under the settlement.

Smith was the tax matters partner for the partnership.

     On January 24, 1995, Smith wrote to petitioner, the Anises,

and Marc Tow, counsel for the Anis parties in the bankruptcy

court proceeding.   Smith enclosed the settlement agreement and a

proposed Anis partnership agreement for Anis and petitioner to

sign.

     Petitioner told Smith that he wanted his name removed from

the partnership agreement and his two children, Drew and Allison

Graham, named as partners.   Smith removed petitioner’s name from
                               - 10 -

the preamble and signature page of the partnership agreement and

listed petitioners’ two children as partners with a combined

interest in the partnership of 22.375 percent.

     Petitioner attended partnership meetings.   Smith contacted

petitioner, not his children, regarding partnership decisions and

other partnership matters.    Partnership distributions and

correspondence were sent to petitioner’s office.    Petitioner was

the only person who made cash contributions to the partnership

when there was a cash call.

     On February 24, 1995, the Anises signed a settlement

agreement on behalf of the partnership.    Under the settlement

agreement, on May 30, 1995, the Stovers transferred: (1) $229,538

to the Smith client trust account, (2) a 50-percent interest in

the Vivienda Ranch, a 160-acre orchard located in Riverside,

California (the Riverside property), to the Anis partnership, and

(3) a 25-percent interest in a 40-acre farm in Kansas to the Anis

partnership.

     On June 6, 1995, Smith wrote two checks from his client

trust account totaling $47,443.51; one check for $23,721.76

payable to Drew Graham, and the other check for $23,721.75

payable to Allison Graham.    The sum of these two checks equaled a

22.375-percent interest (less expenses) in the $229,538 from the

Stovers.   On June 23, 1995, petitioners’ children cashed the two

checks and had them reissued as cashier’s checks payable in the
                              - 11 -

same amounts and to the same payees.   Petitioners’ children gave

him the money they received from the Anis partnership.

     The Anis partnership filed Forms 1065, U.S. Partnership

Return of Income, for tax years 1995 through 1999.    The Anis

partnership issued Schedules K-1, Partner’s Share of Income,

Deductions, Credits, etc., for 1995 to Drew Graham and Allison

Graham.   The Schedules K-1 indicated that the partnership had

allocated an ordinary loss of $1,120 to each.

     In May 1996, the partnership sold its interest in the Kansas

farm and distributed the proceeds to the Anis partners.

Petitioner authorized Smith to apply his children’s 22.375-

percent share ($5,146.25) from the sale of the Kansas farm

against the attorney’s fees petitioner owed to Smith for

representing him in the Redlands litigation.    He told Smith the

partnership funds being distributed were petitioner’s funds.

     For 1998, on Schedules K-1 it issued to Drew and Allison

Graham, the partnership allocated to each of them income of

$2,461, consisting of an ordinary loss of $336 and a capital gain

of $2,797.

     Petitioner told Smith that he would fully pay his attorney’s

fees when the Anis partnership sold the Riverside property.      The

Anis partnership sold the Riverside property and received a

payment of $50,000 in December 1998.   In a letter dated December

28, 1998, Smith allocated the $50,000 as follows:    Nick Anis
                               - 12 -

$27,000, Al Graham $10,292.50, Tammy Smith $2,773.29, and Steve

Smith $9,934.21.    Smith applied petitioner’s $10,292.50 share of

the distribution against the attorney’s fees petitioner owed him.

Smith wrote a check to himself for that amount.     In January 1999,

petitioner told Smith not to apply any future partnership

distributions to petitioner’s debt to Smith.

     Escrow on the sale of the partnership’s interest in the

Riverside property closed on February 18, 1999.     Additional funds

were distributed to the partners, including checks dated March 1,

1999, in the amounts of $75,747.60 and $1,118.75, both jointly

payable to Drew and Allison Graham.     Drew and Allison Graham

endorsed both checks to O’Leary.    O’Leary deposited the two

checks in his investment account at A.G. Edwards and Sons Inc.

O’Leary then wrote a $55,615.64 check from his Merrill Lynch cash

management account to petitioner, and that check was deposited in

petitioner’s law firm’s business account and recorded on the

books as a loan to petitioner from his children.

     The Anis partnership allocated ordinary income of $4,564 to

Drew Graham and $4,563 to Allison Graham on Schedules K-1 issued

to them for 1999.

     6.   Petitioner’s Diversions of Business Income

          a.   Diversions of Income Through Edgar

     Petitioner and Edgar did not deposit some client payments in

the law firm’s business account.    Petitioner sometimes told Edgar
                                - 13 -

to cash cashier's checks or other client checks payable to him

and to give him the cash.    He sometimes endorsed client checks to

Edgar, who deposited them in her personal account and wrote a

check in an equal amount to petitioner.    Edgar’s checks to

petitioner were deposited in his business account but recorded on

the books as nontaxable loans.    Petitioner cashed some client

checks and deposited some in Sieveke’s account instead of

depositing them in the business account.

     Edgar kept a record of client checks that were not deposited

in the business account.    She and petitioner referred to that

record as the “secret list”.    The secret list showed the client’s

name and the amounts of the payments.    Edgar kept the “secret

list” in the bottom drawer of the credenza in her office.

Petitioner knew it was there.

     Edgar occasionally signed blank checks drawn on her personal

account and gave them to petitioner.     Before going on vacation in

1997, Edgar gave petitioner a blank personal check that she had

signed and made payable to him.    He dated the check June 9, 1997,

and wrote the amount, $25,000, and the notation “LOAN” in the

memo section.   He deposited that check in his business account

and recorded it on his books as a nontaxable loan.    When Edgar

returned from her trip, petitioner told her he had written a

$25,000 check on her account.    He gave her nine client checks
                              - 14 -

totaling $25,296 that he had endorsed to her to reimburse her.

Edgar deposited those checks in her account on June 17, 1997.

     On August 22, 1997, Edgar wrote a check to petitioner in the

amount of $6,210.   On August 27, 1997, a $6,310 American Savings

Bank cashier’s check payable to petitioner was deposited in

Edgar’s account instead of petitioner’s business account.

          b.   Askew Legal Fees

     In 1997, a client, Mr. Askew (Askew), owed a substantial

amount of legal fees to petitioner.    When Askew filed for

bankruptcy, Sieveke filed a claim in bankruptcy court for

petitioner for unpaid attorney’s fees.    Sieveke collected

$14,704.67 from Askew and, on August 22, 1997, deposited those

funds in Sieveke’s client trust account.

     Instead of depositing the $14,704.67 in the law firm’s

business account, on petitioner’s instructions: (a) Sieveke wrote

checks to the IRS for $10,000 and to the Franchise Tax Board for

$3,000 to pay petitioner’s personal taxes, and (b) Sieveke paid

the $1,704.67 balance to Edgar.

          c.   Other Legal Fees Paid to Petitioner and Not
               Deposited in the Business Account

     In 1998, petitioner collected fees totaling $135,421.64

($100,000 + $22,000 + $13,421.64) from former clients Donald

Arnett (Arnett), Angela Chen (Chen), and Brian Markam (Markam).

None of these amounts were deposited in petitioner’s business
                              - 15 -

account; instead, these amounts were deposited in O’Leary’s money

market account at Merrill Lynch in 1998.

     In 1998, Sieveke collected $100,000 in disputed legal fees

from Arnett and deposited it in his attorney-client trust

account.   Petitioner told Sieveke to pay the $100,000 to O’Leary.

Around March 13, 1998, petitioner delivered Sieveke’s $100,000

check, which contained the notation “Al Graham loan repayment”,

to O'Leary.   O’Leary had not lent $100,000 to petitioner,

however.   O’Leary deposited the $100,000 in his money market

account at Merrill Lynch on March 17, 1998.   Several days later,

petitioner told O’Leary to write a $42,500 check to Edgar and a

$3,500 check to petitioner’s interior decorator.

     Chen paid legal fees of $22,000 to petitioner.    Petitioner

sent Chen’s check to O'Leary, who deposited it in his Merrill

Lynch account around May 1, 1998.

     Attorney John Gueren collected $13,421.64 in legal fees from

Markam for legal services rendered by petitioner.     Markam’s

payment was delivered to O'Leary.   O’Leary deposited it in his

Merrill Lynch account on July 14, 1998.

     From March to September 1998, at petitioner’s direction,

O’Leary wrote the following checks totaling $119,561 from his

Merrill Lynch account:
                               - 16 -

     Date                  Amount         Payee

11 checks issued on
various dates             $109,061        Charlene Edgar
March 18                     3,500        Interiors
June 24                      2,500        Drew Graham
Sept. 1                      4,000        Donald Lewellen
                Total:    $119,561

            d.   Payment of Petitioners’ Personal Expenses From the
                 Business Account

     Petitioner sometimes told Edgar to pay petitioners’ personal

expenses from the law office’s business account and to record

them as business expenses.   He also sometimes told Edgar to pay

his personal expenses from her personal account at Union Bank.

For example, Edgar wrote checks to American Express to pay

petitioner’s wife’s bills, Best Buy for new appliances for

petitioner’s Big Bear cabin, Interiors for remodeling work done

on petitioner’s cabin, and Big Bear Glass to buy materials for

petitioner’s cabin.   Edgar also wrote a check to Union Bank of

California to buy two cashier’s checks, one for $25,000 payable

to the IRS and one for $8,200 payable to the Franchise Tax Board,

to pay petitioner’s personal tax bills.   Petitioner repaid Edgar

by checks drawn on the business account and asked her to record

those payments as a reimbursement for office supplies.

     Edgar wrote 10 checks from her account in 1998 totaling

$46,898.22 payable to petitioner, and she also wrote the

following checks in 1998 to pay petitioner’s personal expenses or

to obtain cash for him:
                                - 17 -

     Date                   Amount        Payee

10 checks issued on
various dates            $46,898.22       Albert Graham
April 8                   $2,470.79       Cash
April 10                  $2,203.52       American Express
April 13                  $1,437.48       Best Buy
April 17                    $500.00       Cash
August 8                  $1,000.00       Cash
August 8                 $33,210.00       Union Bank
August 20                 $1,361.76       Interiors
August 21                 $1,060.35       Bear City Glass
August 28                 $3,800.00       Interiors

     7.     Edgar’s Diversion of Money Without Petitioner’s
            Knowledge

     The parties stipulated that, from 1993 to 1998, without

petitioner’s knowledge, Edgar deposited some unreported client

payments in petitioner’s Big Bear account and wrote checks on

that account to pay some of her personal expenses.    Edgar

deposited $67,437 in 1995, and $87,943 in 1998 in petitioner’s

Big Bear account.

     In October 1998, petitioner discovered that Edgar had been

depositing client checks in one of his personal bank accounts

that she handled for him.    Petitioner told Lewellen late in 1998

that he thought Edgar had embezzled money from his law practice.

In November 1998, petitioner and Lewellen went to the bank and

obtained a copy of the October 1998 statement for petitioner’s

business checking account.    The statement petitioner obtained

from the bank showed greater withdrawal and deposit activity and

more checks written on the account than did the copy of the

October 1998 statement that Edgar had given to Lewellen.
                              - 18 -

     Over the next few months, petitioner and Lewellen met

several times at petitioner's office and at the bank to discuss

Edgar's actions.   In January 1999, petitioner told police that he

believed Edgar had embezzled funds from his law practice.

Detective Perry Francis (Detective Francis) of the Santa Ana

Police visited petitioner’s office early in February 1999.

     On February 4, 1999, petitioner sued Edgar in the Superior

Court of Orange County, California, alleging embezzlement,

conversion, fraud, breach of fiduciary duty, and unjust

enrichment.

     Edgar was taken away from petitioner’s office by the Santa

Ana Police on February 5, 1999, a few days after Detective

Francis visited petitioner’s office.   She did not remove any

files from the office at that time, and she never returned to the

office.   Petitioner fired Edgar shortly after February 5.

     Sometime after February 5, 1999, petitioner retrieved copies

of two altered bank statements from Edgar’s computer, and he

faxed them to the police.   Detective Francis did not seize

Edgar’s computer or make a copy of the computer’s hard drive.

     On October 27, 1999, petitioner sued Lewellen in the

Superior Court of Orange County, California, for negligence and

breach of contract.   Petitioner claimed that Lewellen had failed

to detect Edgar's embezzlement.
                               - 19 -

     At petitioner’s request, Detective Francis prepared a letter

dated March 3, 2000, in which he stated that, based on his review

of available records, he thought Edgar had embezzled $393,953.88

from petitioner.    In reaching that conclusion, Detective Francis

assumed that any payment to one of Edgar’s charge accounts was an

embezzlement.    Detective Francis retired from the Santa Ana

Police force on January 1, 2002, before the investigation of

Edgar’s actions was completed.

     After Detective Francis retired, and while the Santa Ana

Police criminal investigation of Edgar’s embezzlement was

ongoing, Edgar's criminal attorney sent a letter to the Orange

County District Attorney's Office alleging that petitioner had

used Edgar to conceal income and to fraudulently encumber his

assets.   Under the direction of Assistant District Attorney

Richard Welsh (Welsh), the Santa Ana Police investigated Edgar’s

allegations.    After the investigation was completed, Welsh

concluded that he did not have enough evidence to file

embezzlement charges against Edgar.

     8.    Results of Petitioner’s Legal Actions Against Edgar and
           Lewellen

     As a result of petitioner’s lawsuit against Edgar, in 2001

petitioner obtained a prejudgment attachment in the amount of

$541,915.90 of Edgar’s only significant asset, a retirement

account at Pershing Royal Alliance.     As a result Edgar filed a

petition in bankruptcy in 2001, transferred her $68,000
                                - 20 -

retirement account to petitioner in 2003, and lost three houses

in foreclosure.

     Lewellen settled the case with petitioner in October 2001,

and agreed to pay petitioner $220,000 in 2002.

D.   Preparation and Filing of Petitioners’ Tax Returns

     Petitioners filed income tax returns for 1995, 1998, and

1999.     Lewellen prepared the 1995, 1998, and amended 1998 tax

returns, but not the 1999 return.

     Lewellen recorded petitioner’s law firm's gross receipts for

1995 and 1998 on Schedule C, Profit or Loss From Business, based

on the total amount of revenues deposited in the firm's business

account and recorded as income in the general ledger under

“client billings”.     Petitioners did not give Lewellen the law

firm’s accounts receivable, client billings, invoices or receipts

supporting the law firm’s expenses for 1995 and 1998.

     Petitioners deducted personal expenses of $27,636 and

$4,476, respectively, as business expenses on their 1998 and 1999

tax returns.

     1.      1995

     Petitioner did not tell Lewellen that petitioner or his

children had received cash and an interest in two parcels of real

property through the Anis partnership in 1995.     Petitioners did

not report on their initial or amended 1995 return income or loss
                                - 21 -

from the Anis partnership or from the May 30, 1995, transfer of

assets from the Stovers.

     2.     1998

     Petitioners obtained extensions to file their 1998

individual income tax return on April 15, 1999, and October 15,

1999.     Petitioners estimated that their tax liability for 1998

was $41,000, which they paid when they requested the first

extension.

     Petitioner took various documents, including the Schedules

K-1 issued to Drew and Allison Graham for 1998 by the Anis

partnership, to Lewellen around October 10, 1999, so he could

prepare petitioners’ 1998 return.    Petitioners gave Lewellen

their Quicken records for 1998 so Lewellen could prepare the

Schedule C for petitioner’s law practice.     These included a

profit and loss statement dated October 12, 1999, a check

register report dated July 28, 1999, and monthly statements and

canceled checks for the business bank account.

     Petitioners reported $503,549 as gross revenue from

petitioner's law practice on their original 1998 income tax

return.     Lewellen did not include fees totaling $135,421.64 that

petitioner received from Arnett, Chen, and Markam in the income

reported on petitioners’ 1998 return.     Lewellen reported the

distributive loss from the partnership on Schedule E,

Supplemental Income and Loss, of petitioners’ 1998 return, and
                             - 22 -

thus petitioners claimed an ordinary loss of $672 ($336 x 2) on

their 1998 return.

     Petitioners signed their 1998 return on October 15, 1999.

They did not tell Lewellen that he had erroneously reported on

that return an ordinary loss from the Anis partnership.

Petitioners’ 1998 return was mailed on October 15, 1999, and

received by the Fresno Service Center on October 18, 1999.

     Sometime around November 10, 1999, petitioner called

Lewellen and asked him if he had reported “that other income.”

Petitioner said there was other income that he needed to report

on the return, that he did not know the amount, and that he would

get back to Lewellen with the exact amount.   Petitioner had not

previously told Lewellen about the other income.   During that

phone call, petitioner asked Lewellen to backdate the amended

return to Monday, November 8, 1999.   On either the afternoon of

petitioner’s phone call to Lewellen or the next day, petitioner

called Lewellen’s office and left a message stating the

additional amount of income ($135,422).   A C.P.A. on Lewellen’s

staff prepared an amended 1998 return for petitioners on November

10, 1998, on which that additional amount of income from

petitioner’s law practice was reported.   She recorded one hour on

her billing sheet for preparing petitioners’ 1998 amended return.

Lewellen did not bill petitioners for preparing their amended
                              - 23 -

return.   Lewellen signed it on November 10 or 11, 1998.4

Petitioners did not correct their reporting of the $672 ordinary

loss on their 1998 amended return.

     Petitioners’ signatures on their amended 1998 return are

dated November 8, 1999.   Petitioners’ amended 1998 return was

stamped received by the Fresno Service Center on November 22,

1999.

     3.     1999

     Petitioners reported gross receipts of $606,753 from

petitioner’s law practice on their 1999 return.    Petitioners did

not report any income from the Anis partnership on their 1999

return.   The IRS received petitioners’ 1999 return on September

21, 2000.

E.   Audit of Petitioners’ Returns

     During the audit, petitioner told the revenue agent, K.C.

Peredo (Peredo), that payments to contractor Bill Thomas (Thomas)

were for building a cabinet for the computer in petitioner’s

office.   However, petitioner paid Thomas with business checks for

remodeling the kitchen of his cabin in Big Bear.

     During the audit, petitioner denied that he had improperly

deducted personal expenses as business expenses.   For example, he

said he paid Kim Sterling for flowers used solely for his office


     4
       Petitioner did not allege in the complaint in the lawsuit
he filed against Lewellen that Lewellen had failed to include
client fees of $135,422 in petitioners’ original 1998 return.
                              - 24 -

that were used for both his home and office.   He said Edgar had

misclassified personal expenses as business expenses; however,

petitioners improperly deducted $4,476 of personal expenses as

business expenses in 1999 after Edgar was fired.

     Petitioner incorrectly told Peredo that he did not have any

books or billing records because Edgar had them.

     Petitioner incorrectly told Peredo that he did not engage in

bartering.   Petitioner bartered his services in exchange for

services provided by some of his clients.   For example, Thomas

owed petitioner $2,300 for petitioner’s representation of Thomas

in a custody battle with his ex-wife over visitation rights of

their son.   Thomas subtracted that amount from the amount

petitioner owed him for the kitchen remodeling job.

F.   Respondent’s Bank Deposits Analysis

     The revenue agent performed a bank deposits analysis and

characterized each of petitioner’s deposits in his business

account as taxable or nontaxable.

     Petitioner deposited $572,284 in his law firm's business

checking account in 1998.   Included in those deposits were

$55,971 from nontaxable sources, as follows: (a) $40,873 allowed

by the revenue agent in preparing the notice of deficiency; (b)

$10,098 in checks from Edgar traceable to the funds transferred

to her from the $135,422 deposited in O’Leary’s account; and (c)
                                - 25 -

$5,000 medical reimbursement to Martha Graham from State Farm

insurance.

     Petitioner deposited $750,046 in his law firm's business

checking account during 1999, of which $140,558 was deposits from

a nontaxable source.

                                OPINION

A.   Whether Distributable Shares Issued to Petitioners’ Children
     by the Anis Partnership Are Taxable to Petitioners

     1.      Statute of Limitations

     Respondent assessed tax relating to the Anis partnership

more than 3 years after petitioners filed their 1995 return.

Petitioners contend that assessment of tax on that amount of

income is barred by the statute of limitations.

     We disagree.    Generally, the Commissioner must assess tax

within 3 years after the date of filing of the return.      Sec.

6501(a).     However, the 3-year limit does not apply if the

underpayment was due to fraud.     Sec. 6501(c)(1).   That is the

case here.     See paragraph D-3-a, below.   Thus, the statute of

limitations does not bar assessment of tax on the amounts at

issue distributed from Smith’s client trust account and the fair

market value of a 22.375-percent interest in the property of the

Anis partnership.
                             - 26 -

     2.   Value of a 22.375-percent Interest in the Property of
          the Anis Partnership

     We next decide the fair market value of a 22.375-percent

interest in the property of the Anis partnership.

          a.   Positions of the Parties

     Respondent contends that, on May 30, 1995, the fair market

value of petitioner’s 22.375-percent interest in the Anis

partnership was $112,255.84, consisting of $47,443.51 cash and

interest in two parcels of real property having a fair market

value of $64,812.33, calculated as follows:

     $425,637 (½ interest in the Riverside property)*
     $ 20,000 (1/4 interest in the Kansas farm)*
     $445,637
     x 22.375% (Graham’s partnership interest)
     $99,711.28
     x 65%      (35% minority/marketability discount)
     $64,812.33

* per partnership’s balance sheet

     Petitioners contend that the value of a 22.375-percent

interest in the cash and property received by the Anis

partnership in 1995 was $70,587, calculated as follows: (1)

$33,383 for a cash payment to the partnership (cash of $229,538

received by the partnership times 22.375 percent = $51,359,

discounted 35 percent = $33,383), plus (2) $35,750 for a one-half

interest in the Riverside property ($250,000 fair market value

(50 percent interest received by the partnership) times 22

percent = $55,000, discounted 35 percent = $35,750), plus

(3) $1,454 for a one-fourth interest in the Kansas farm ($10,000
                                  - 27 -

fair market value for a 25 percent interest received by the

partnership, times 22.375 percent = $2,237, discounted 35 percent

= $1,454).

          b.        Cash

     Smith distributed $47,443.51 in cash to petitioners’

children in 1995, which was petitioner’s 22.375-percent share of

the $229,530 cash received under the Stover bankruptcy

settlement.       Petitioners included the cash in calculating the

value of a 22.375-percent interest in the Anis partnership, to

which they applied a 35-percent minority discount.       However,

petitioners are taxable on the $47,443.51 received by their

children because those funds were paid by Smith directly to the

children, and that amount is not subject to a minority discount.

             c.     The Riverside Property

     A one-half interest in the Riverside property was

transferred to the partnership on May 30, 1995.

     Based on the book value for the property shown on the Anis

partnership’s balance sheet, respondent contends that the value

of petitioner’s 22.375 percent interest in the Riverside property

in 1995 was $61,903.58, calculated as follows:

     $425,637 (½ interest in the Riverside property)*
     x 22.375% (petitioner’s partnership interest)
     $95,236.28
     x 65%      (35% minority/marketability discount)
     $61,903.58

* per partnership’s balance sheet
                              - 28 -

     Based on an appraisal provided by petitioners’ expert

witness, petitioners contend that the fair market value of a one-

half interest in the Riverside property was $35,750, calculated

as follows:

     $250,000 (½ interest in the Riverside property)
     x 22%     (petitioner’s partnership interest)
      $55,000
     x 65%     (35% minority discount)
      $35,750

     Petitioners’ expert testified that he relied on several

comparables within 10 miles of the Riverside property and

adjusted the value for usability of the property and for the time

of the comparable sale.   He concluded that a 22-percent interest5

in the partnership’s interest in the Riverside orchard had a

value of $35,750.   Petitioners contend that his appraisal is the

only credible evidence of the value of the Riverside property.

Petitioners also contend that respondent’s reliance on the

partnership’s unsupported estimate of the value of the Riverside

property is unwarranted because Smith testified that the

estimated value was not based on an appraisal.

     We disagree.   First, petitioners’ expert’s appraisal was a

single page of conclusions with no analysis.   Second, the balance

sheets attached to the Anis partnership returns for 1995-99

stated that the book value for the Riverside property was



     5
        The 22-percent amount slightly understated petitioner’s
interest, which was 22.375 percent.
                               - 29 -

$425,637 ($325,637 for depreciable assets and $100,000 for land).

The balance sheet entries are a reasonable indicator of the fair

market value of the Riverside property on May 30, 1995, because

they were prepared relatively close in time to when the property

was placed in the partnership, were made long before the value of

the Riverside property was in issue, and were not made in

anticipation of litigation.

     Third, Smith testified that he thought a one-half interest

in the Riverside property had a fair market value of $425,000

when negotiations between the parties in the Stover bankruptcy

ended in March 1995.    Smith based his estimate on his visit to

the property, the documents filed in the Stover bankruptcy, and

his discussions with the Anises.

     Fourth, Stover listed a value of $400,000 for his one-half

interest in the Riverside property on a bankruptcy schedule he

filed in August 1993.    An owner of property is generally

qualified to testify as to the property’s value.    Fed. R. Evid.

702; see LaCombe v. A-T-O, Inc., 679 F.2d 431, 435 (5th Cir.

1982); Estate of Dunia v. Commissioner, T.C. Memo. 2004-123.

     We believe the balance sheets, Smith’s testimony, and the

Stover bankruptcy schedule, which all are in the same range

($400,000-425,000) for a one-half interest in the Riverside

property, are entitled to more weight than petitioners’ expert’s

appraisal.   We conclude that the fair market value of the
                              - 30 -

partnership’s one-half interest in the Riverside property was

$400,000, and that the fair market value of a 22.375-percent

interest in the partnership’s interest in that property (after

applying a 35-percent discount for marketability) was $58,175.

          d.    Value of the Kansas Farm

     A one-fourth interest in the Kansas farm was transferred to

the partnership on May 30, 1995.

     The parties stipulated (in paragraph 57 of the stipulation

of facts) that the fair market value of a 100-percent interest in

the Kansas farm on May 30, 1995, was $40,000.   Respondent

contends that stipulation 57 should have stated that the

partnership’s 25-percent interest in the Kansas farm had a fair

market value of $40,000.

     After trial, respondent filed a motion for relief from

stipulation 57 on the grounds that, due to a scrivener’s error,

it contains a mutual mistake of fact relating to the value of the

Kansas farm.   Petitioners contend that there was no mutual

mistake and that any mistake was solely respondent’s.   See Stamm

Intl. Corp. v. Commissioner, 90 T.C. 315 (1988).

     We agree with petitioners.    Generally, a stipulation of fact

is binding on the parties, and the Court is bound to enforce it.

Rule 91(e); Stamos v. Commissioner, 87 T.C. 1451, 1454 (1986).

The draft of stipulation 57 exchanged by the parties stated that

the Kansas farm had a fair market value of $40,000.   There is no
                             - 31 -

evidence that the parties made a mutual mistake.   Thus, we will

enforce the stipulation, and we conclude that the value of a 25-

percent interest in the Kansas farm was $10,000, and that the

fair market value of a 22.375-percent interest in the Kansas farm

(after applying a 35-percent discount) was $1,454.38.

          e.   Conclusion

     We conclude that the total fair market value of petitioner’s

22.375-percent interest in the Riverside property and the Kansas

farm was $59,629.38, and that the value of petitioner’s interest

in the cash and the Anis partnership property was $107,072.89.

B.   Whether Petitioners Had Unreported Income in 1998 and 1999

     Respondent’s determination that petitioners had unreported

income is presumed to be correct, and petitioners bear the burden

of proving that it is incorrect.6   Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).   Thus, petitioners have the

burden of proving that the Commissioner's use of the bank

deposits method is inaccurate, for example, by showing that the

deposits made into their personal bank accounts are not taxable.

Marcello v. Commissioner, 380 F.2d 509, 511 (5th Cir. 1967),

affg. T.C. Memo. 1964-303; Price v. United States, 335 F.2d 671,


     6
       The burden of proof for a factual issue relating to
liability for tax may shift to the Commissioner under certain
circumstances. Sec. 7491(a). Taxpayers bear the burden of
proving that they have met the requirements of sec. 7491(a). H.
Conf. Rept. 105-599, at 239 (1998), 1998-3 C.B. 747, 993; S.
Rept. 105-174, at 45 (1998), 1998-3 C.B. 537, 581. Petitioners
do not contend that sec. 7491(a) applies in this case.
                              - 32 -

678 (5th Cir. 1964); DiLeo v. Commissioner, 96 T.C. 858, 871

(1991), affd. 959 F.2d 16 (2d Cir. 1992).

     According to respondent’s bank deposits analysis,

petitioners had unreported income of $12,764 for 1998 and $2,735

for 1999.   Petitioners concede that they had unreported income of

$2,735 for 1999, and they do not generally dispute respondent’s

use of the bank deposits method to reconstruct their income for

1998 and 1999.   Petitioners contend, however, that they

overreported the gross revenue of petitioner’s law practice for

1998 by $3,036 ($572,284 deposited less nontaxable deposits of

$71,771 = $500,513; $503,549 originally reported less $500,513 =

$3,036) because, in addition to $55,971 of nontaxable deposits

allowed by respondent, they had the following nontaxable sources

of income in 1998:

     Two checks from Edgar payable to petitioner
     (#5472, 5475)                                         $1,800

     Check from Pershing Royal Alliance retirement account
     payable to Edgar and endorsed to petitioner       $7,500

     Check payable to Drew Graham from Mrs. Graham
     and deposited in petitioners’ account                 $3,250

     Check payable to Allison Graham from Mrs. Graham
     and deposited in petitioners’ account                 $3,250

     Petitioners’ total claimed additional
     nontaxable sources for 1998                         $15,800

     We conclude that respondent did not subtract all nontaxable

sources of deposits to petitioners’ account.   Specifically, we

conclude that the two $3,250 checks written by Mrs. Graham to
                                - 33 -

petitioners’ children and redeposited in petitioners’ account are

from nontaxable sources.

       Petitioners do not explain why they are not taxable on the

two checks from Edgar.    Both checks were written by Edgar in

November 1998 and were not included in the $135,422 deposited in

O’Leary’s account or reported on petitioners’ amended 1998

return.     Petitioner’s testimony that the $7,500 check from Edgar

was a loan is unconvincing.    He testified that he did not intend

to repay Edgar because he believed that she had stolen money from

him.    Petitioners did not prove that the checks from Edgar

($1,800) or the retirement account check ($7,500) were from a

nontaxable source.

       We conclude that petitioners had unreported income of $6,264

($572,284 deposited - $55,971 nontaxable deposits allowed by

respondent - $6,500 additional nontaxable deposits - $503,549

reported on return) for 1998 and $2,735 for 1999.

C.     Whether Petitioners Are Liable for Increased Deficiencies
       for the Years in Issue

       1.    Burden of Proof

       The Commissioner has the burden of proving increased

deficiencies and penalties pleaded in the answer.    Rule 142(a).

Thus, respondent bears the burden of proving that petitioners are

liable for increased deficiencies and penalties due to their

failure to report specific items of business income totaling

$67,437 for 1995 and $87,942.76 for 1998 representing client
                                 - 34 -

checks and rent checks that Edgar diverted to petitioner’s

personal Big Bear bank account and their failure to report

distributions from the Anis partnership in 1998 and 1999.

      2.     Petitioners’ Unreported Income for the Years in Issue

      Petitioners deducted theft losses based on Edgar’s

unauthorized use of petitioner’s funds deposited in the Big Bear

account.      To support their theft loss deduction, petitioners

admitted that they had failed to report legal fees and rental

income of $67,437 for 1995 and $87,942.76 for 1998 which had been

deposited by Edgar in petitioners’ Big Bear account but not

deposited in petitioner’s law firm account, recorded in his

client billings records, or reported on their returns for 1993-

98.   Respondent contends that petitioners are liable for tax on

(a) those amounts, and (b) distributions from the Anis

partnership consisting of an ordinary loss of $2,240 for 1995, a

capital gain of $5,594 for 1998, and income of $9,127 for 1999.

These amounts were not taken into account in the notice of

deficiency.

      3.      Whether To Allow Respondent To Amend the Answer

        After trial, respondent filed a motion for leave to file

amendment to answer asserting increased deficiencies and

additions to tax as a result of respondent’s allegation that

petitioners failed to report $67,437 for 1995 and $87,942.76 for

1998.      The parties may amend their pleadings only by leave of the
                               - 35 -

Court, and leave shall be given freely when justice so requires.

Rule 41(a).   A party may move to amend the pleadings to conform

to the proof presented at trial.    Rule 41(b)(2).   Prejudice to

the other party is the key factor in deciding whether to allow an

amendment to the pleadings.    Kroh v. Commissioner, 98 T.C. 383,

389 (1992).

     To support their claim for a theft loss deduction,

petitioners provided evidence showing that they had not reported

certain income.    We believe they are not prejudiced by

respondent’s request that the Court also consider that evidence

to find increased deficiencies.    See Sharvy v. Commissioner, 67

T.C. 630, 641-642 (1977), affd. 566 F.2d 1118 (9th Cir. 1977).

Respondent may amend the pleadings to conform to the proof.     Rule

41(b)(2).

     4.     Whether Petitioners Are Liable for Increased
            Deficiencies Due to Their Failure To Report Legal Fees
            and Rental Income

     Petitioners contend that they are not taxable on unreported

legal fees and rental income of $67,437 for 1995 and $87,942.76

for 1998 because Edgar embezzled at least that much from them

without petitioners’ knowledge.

     We disagree that petitioners are not taxable on these

amounts.    Edgar diverted legal fees and rental checks by

depositing them into petitioner’s Big Bear account.     Petitioner

had access to those funds, which were commingled with other funds
                                - 36 -

in his Big Bear account.   Income earned by the taxpayer and

deposited into his bank account is taxable to him, even if he

fails to keeps track of how much money he has in the account.

See Donohue v. Commissioner, 323 F.2d 651 (7th Cir. 1963), affg.

39 T.C. 91 (1962).

     Petitioner discovered the losses in 1998, and he sued Edgar

and Lewellen in 1999.   The Lewellen lawsuit was resolved in 2002

and the Edgar lawsuit in 2003.    If a casualty or other event

occurs which results in a loss and there exists a claim for

reimbursement with respect to which there is a reasonable

prospect of recovery, no loss is allowable as a deduction until

the tax year in which the taxpayer can ascertain with reasonable

certainty whether reimbursement will be received.    Secs. 1.165-

1(d)(2)(i), 1.165-1(d)(3), 1.165-8(a)(2), Income Tax Regs.

     A reasonable prospect of recovery exists when the taxpayer

has a bona fide claim for reimbursement from a third party and

when there is a substantial possibility that such claim will be

resolved in the taxpayer’s favor.    See Ramsay Scarlett & Co v.

Commissioner, 61 T.C. 795, 811 (1974), affd. 521 F.2d 786 (4th

Cir. 1975).   Petitioners may not deduct embezzlement losses for

any of the years in issue because (1) Edgar had a retirement

account and three houses in the years in issue, and (2)

petitioners conceded at trial that they still had a reasonable

prospect of recovery in 1999.
                               - 37 -

     5.   Whether Petitioners Are Liable for Increased
          Deficiencies Due to Their Failure To Report Their
          Distributable Shares in the Anis Partnership

     Petitioners contend that they are not taxable on their

distributable shares in the Anis partnership (an ordinary loss of

$2,240 for 1995, a capital gain of $5,594 for 1998, and income of

$9,127 for 1999) because these amounts were not paid for

petitioner’s personal services.    Petitioners contend that

petitioner gave his 22.375-percent interest in the Anis

partnership to his children and that the income in dispute was

generated by the Anis assets and thus is not includable in

petitioners’ income.

     We disagree.   Petitioner was the beneficial owner of and was

taxable on these items for the following reasons.    First,

petitioner’s interest in the partnership derived from the

services he performed in the Anis litigation.    Income is taxable

to the taxpayer who earns and controls it.    Lucas v. Earl, 281

U.S. 111 (1930).

     Second, petitioner intended to be a partner in the Anis

partnership.   He attended partnership meetings.   Smith contacted

petitioner, not his children, regarding partnership decisions and

other partnership matters.    Partnership distributions and

correspondence were sent to petitioner’s office.    Petitioner was

the only person who made cash contributions to the partnership

when there was a cash call.
                                - 38 -

     Third, petitioner controlled the disposition of and

benefited from the partnership distributions.   For example,

petitioner owed Smith about $41,000 from his Redlands

representation, and he used the 1996 and 1998 partnership

distributions ($5,146.25 from the Kansas farm and $10,292.50 from

the Riverside property) to reduce his debt to Smith.    In 1999,

the partnership distributed checks in the amounts of $75,747.60

and $1,118.75, both jointly payable to petitioners’ children.

Both checks were endorsed to O’Leary who deposited them in his

investment account.    O’Leary then paid $55,615.64 of this money

to petitioner as a purported loan from his children, and he kept

the rest.   Petitioner treated the partnership distributions as if

they were his, and he told Smith that they were his.

     Fourth, petitioners reported the partnership loss on their

1998 return, which is an admission that petitioner, and not his

children, owned the partnership interest.   See Waring v.

Commissioner, 412 F.2d 800, 801 (3d Cir. 1969), affg. per curiam

T.C. Memo 1968-126.

     For these reasons, we do not recognize petitioner’s transfer

of his Anis partnership interest to his children for Federal

income tax purposes.    Estate of Sanford v. Commissioner, 308 U.S.

39 (1939); sec. 25.2511-2(b), (g)(1), Gift Tax Regs.    Thus,

petitioners are taxable on the distributions from the Anis

partnership in 1998 and 1999.
                                 - 39 -

D.   Whether Petitioner Is Liable for the Penalty for Fraud Under
     Section 6663(a)

     1.     Background

     Respondent contends that petitioner is liable for the

penalty for fraud under section 6663(a) for 1995, 1998, and 1999.

Respondent has the burden of proving fraud by clear and

convincing evidence.      Sec. 7454(a); Rule 142(b).   Respondent must

establish:    (a) Petitioner underpaid tax for each year in issue,

and (b) some part of the underpayment is due to fraud.        Sec.

6653(b); Parks v. Commissioner, 94 T.C. 654, 660-661 (1990);

Petzoldt v. Commissioner, 92 T.C. 661, 699 (1989).       Petitioners

concede that they underpaid tax for 1995, 1998, and 1999.        If

respondent shows that any part of an underpayment is due to

fraud, the entire underpayment is treated as due to fraud unless

the taxpayer shows by a preponderance of the evidence that part

of the underpayment is not due to fraud.      Sec. 6663(b).

     Fraud is the intentional evasion of a tax believed to be

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

affg. T.C. Memo. 1966-81.      Fraud is never presumed; it must be

established by affirmative evidence.      Beaver v. Commissioner, 55

T.C. 85, 92 (1970).      The Commissioner may prove fraud by

circumstantial evidence because direct evidence of the taxpayer's

intent is rarely available.      See Stephenson v. Commissioner, 79

T.C. 995, 1005-1006 (1982), affd. 748 F.2d 331 (6th Cir. 1984).
                                - 40 -

     2.   Badges of Fraud

     Courts have developed several objective indicators, or

"badges", of fraud.     Recklitis v. Commissioner, 91 T.C. 874, 910

(1988).   The following badges of fraud are present in this case

as to petitioner for the years shown: (a) Substantially

understating his income by diverting it to his children (1995,

1998, 1999), attorney (1998), C.P.A. (1998), and office manager

(1995, 1998); (b) concealing income from petitioners' tax return

preparer (1998); (c) having false or inadequate books and

records; (d) creating false legal documents and concealing assets

from potential creditors (1995); (e) disguising personal expenses

as business expenses (1998, 1999); (f) concealing income through

complex series of transactions and nominees (1995, 1998); and (g)

giving implausible or inconsistent explanations to respondent’s

examiner and in court about events during the years in issue.

           a.     Substantially Understating Income

     A pattern of substantially underreporting income for several

years is strong evidence of fraud.       Holland v. United States, 348

U.S. 121, 137-139 (1954); Spies v. United States, 317 U.S. 492,

499 (1943).     Petitioners substantially underreported their income

in 1995, 1998, and 1999.

     Petitioner testified that he thought the partnership income

was not taxable to him because it was “vested” in the partnership
                                - 41 -

and not in him, and that he thought it was a loan from his

children.     Petitioner’s testimony in this regard is not credible.

     Petitioners contend that Lewellen and Smith told petitioner

he did not need to report the Anis income.      We disagree.

Petitioners’ claimed reliance on Lewellen and Smith for failure

to report the Anis income in 1995 is not credible.      First,

Lewellen did not know about the Anis partnership distributions in

1995.     Second, in an April 28, 1994, letter to petitioner and the

Anises, Smith specifically advised that any cash received from

the Stovers would be taxable on receipt.

             b.   Concealing Income From the Taxpayer’s Return
                  Preparer

        Concealing income from one’s return preparer can be evidence

of fraud.     Korecky v. Commissioner, 781 F.2d 1566, 1569 (11th

Cir. 1986), affg. T.C. Memo. 1985-63; Farber v. Commissioner, 43

T.C. 407, 420 (1965), modified 44 T.C. 408 (1965).      Petitioner

did not tell Lewellen until after Lewellen had filed petitioners’

1998 return in October 1999 that petitioner had received client

fees of $135,422 in 1998 and had arranged to have those fees

deposited in O’Leary’s account.

        Petitioners contend that petitioner told Lewellen about the

$135,422 before Lewellen prepared their original 1998 return, and

that Lewellen was to blame for their failure to report the

$135,422 in income.     We disagree.   Petitioner did not tell

Lewellen or give Lewellen records showing that petitioner had
                                - 42 -

received the $135,422 in client fees collected from Arnett, Chen,

and Markham in 1998.    Petitioner had those funds sent to O’Leary

and did not deposit them in his law firm account.     Petitioner

concealed those items from Lewellen.     Similarly, there is no

evidence that petitioner gave Lewellen information about or, with

the exception of the 1998 Schedules K-1, records of the cash and

property distributed by the Anis partnership in 1995 and 1998.

     Petitioner testified that he realized Lewellen had not

included the $135,422 of legal fees in petitioners’ 1998 income

because the figure on the Quicken printout “matched the figure on

the original tax return.”    Petitioner’s claim is implausible

because the Quicken printout did not include the $135,422.

     Similarly, petitioner did not tell Lewellen that $47,443.51

and an interest in two parcels of real property were acquired in

1995 by petitioners’ children as partners in the Anis partnership

in return for services petitioner performed in the Anis

litigation.    Thus, petitioners’ claim that his failure to report

that income for 1995 was due to his reliance on Lewellen’s advice

is implausible.

          c.      Having False or Inadequate Books and Records

     Petitioner’s Quicken records failed to include payments for

his services that were listed in the “secret list” kept by Edgar.

Petitioner knew about the secret list.     The secret list

disappeared while it was in petitioner’s control.     A taxpayer's
                               - 43 -

failure to maintain accurate records or concealment of records

may be a badge of fraud.   Merritt v. Commissioner, 301 F.2d 484,

487 (5th Cir. 1962), affg. T.C. Memo. 1959-172; Reaves v.

Commissioner, 295 F.2d 336, 338 (5th Cir. 1961), affg. 31 T.C.

690 (1958); Grosshandler v. Commissioner, 75 T.C. 1, 20 (1980).

           d.   Creating False Legal Documents and Concealing
                Assets From Potential Creditors

     Backdating or creating false documents may be a badge of

fraud.    See Tyrell v. Commissioner, T.C. Memo. 1995-568; Smith v.

Commissioner, T.C. Memo. 1995-402, affd. 116 F.3d 492 (11th Cir.

1997); Savage v. Commissioner, T.C. Memo. 1992-129.     Concealing

assets from potential creditors may be evidence of a taxpayer’s

willingness to conceal income from the Internal Revenue Service.

See Freidus v. Commissioner, T.C. Memo. 1999-195; McDonald v.

Commissioner, T.C. Memo. 1996-87, affd. 114 F.3d 1194 (9th Cir.

1997); Ashdown v. Commissioner, T.C. Memo. 1989-40; Gay v.

Commissioner, T.C. Memo. 1968-226; see also United States v.

Scott, 37 F.3d 1564 (10th Cir. 1994).

     In 1995, petitioners created bogus promissory notes and

deeds of trust in favor of Cogan, Edgar, Lewellen, and O’Leary to

make it falsely appear that petitioners’ properties were

encumbered and to protect them from potential creditors.

     e.    Disguising Personal Expenses as Business Expenses

     The practice of claiming personal expenses as business

expenses may be evidence of fraud.      Lowy v. Commissioner, 262
                                - 44 -

F.2d 809 (2d Cir. 1959), affg. T.C. Memo. 1957-77; Am. Rolbal

Corp. v. Commissioner, 220 F.2d 749 (2d Cir. 1955), affg. per

curiam T.C. Memo. 1954-67; Hicks Co. v. Commissioner, 56 T.C.

982, 1019, 1030 (1971), affd. 470 F.2d 87 (1st Cir. 1972); Benes

v. Commissioner, 42 T.C. 358, 383 (1964), affd. 355 F.2d 929 (6th

Cir. 1966).     Petitioners deducted personal expenses as business

expenses on their 1998 and 1999 returns, such as payments to

American Express for petitioner’s wife’s bills, Best Buy for new

appliances for petitioners’ Big Bear cabin, Interiors for

remodeling work done on petitioners’ cabin, Big Bear Glass to buy

materials for petitioners’ cabin, and Union Bank of California to

buy two cashier’s checks to pay petitioners’ personal taxes.      We

reject petitioners’ attempt to blame Edgar for their deduction of

personal expenses as business expenses because petitioners

continued to improperly deduct personal expenses, such as

payments to their home gardener and to Kim Sterling for flowers,

in 1999 after Edgar left, and we believe Edgar’s testimony that

she did what petitioner told her to do.

           f.     Concealing Income Through a Complex Series of
                  Transactions and Nominees

     A taxpayer’s use of a complex series of financial

transactions and nominees may be evidence of the taxpayer’s

attempt to conceal income and remove it from the Government’s

reach.   Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.

1986), affg. T.C. Memo. 1984-601.    Petitioner concealed income by
                                - 45 -

having Sieveke and John Gueren collect attorney’s fees owed to

petitioner and delivering them to O’Leary, who deposited those

funds in his money market account and then funneled the funds to

Edgar and back to petitioner.    Petitioner told Edgar he was doing

this because he thought he was paying too much tax.

          g.   Giving Implausible or Inconsistent Explanations

     Implausible or inconsistent explanations of behavior by a

taxpayer can show fraudulent intent.     Korecky v. Commissioner,

781 F.2d 1566, 1568 (11th Cir. 1986), affg. T.C. Memo. 1985-63;

Bradford v. Commissioner, supra at 307; Bahoric v. Commissioner,

363 F.2d 151, 153 (9th Cir. 1966), affg. T.C. Memo. 1963-333.

Many of petitioner’s explanations of his behavior were

implausible or inconsistent.

     Petitioner testified inconsistently regarding the

distributions from the Anis partnership.    He testified that his

children received a $47,000 distribution in 1995, which they lent

to him, but he thought the money was theirs because they were

members of the Anis partnership.    He also testified that any cash

that came out of the Anis partnership in 1995 belonged to him,

that he didn’t know whether the money was received by himself or

his children, and that he chose not to be a partner in the

partnership only with respect to the parcels of real property

held by the partnership.

     Petitioner’s testimony concerning Edgar’s computer records

was vague and contradictory.    He testified that he did not print
                                - 46 -

a copy of his billing records for the revenue agent because she

never asked him to do so.     Petitioner could have, but did not,

print copies of the billing records from Edgar’s computer for the

revenue agent.   Instead, when the revenue agent asked for his

billing records, petitioner said he “didn’t have any.”

Petitioner falsely said that he did not know what records were on

Edgar’s computer, did not know how to use it, and never asked

anyone for help printing billing records.     He testified that a

computer expert helped him retrieve password-protected documents

from Edgar’s computer after she was fired.     Petitioner testified

that he used Edgar’s computer after she was fired, but he stated

at a deposition in 2001 that he would not have been able to point

out which computer was hers.

     Petitioner testified that he did not know that O’Leary was

paying money to Edgar, even though petitioner told O’Leary to

send money to Edgar.   Petitioner incorrectly told the revenue

agent that he had told Lewellen about the Anis partnership

distribution and Lewellen included it in income.

          h.     Conclusion

     Respondent has proven by clear and convincing evidence that

petitioner underpaid tax due to fraud for 1995, 1998, and 1999.

     3.   Items Attributable to Fraud

      The entire underpayment is treated as attributable to

fraud, except to the extent petitioners establish otherwise.
                               - 47 -

Sec. 6663(b); Marretta v. Commissioner, T.C. Memo. 2004-128;

Peyton v. Commissioner, T.C. Memo. 2003-146.

          a.    Omission of Anis Partnership Income in 1995

     Petitioner contends that his failure to include in income

for 1995 amounts he received from the Anis partnership was not

due to fraud.   We disagree.

     Petitioner testified that he gave his interest in the Anis

partnership to his children in 1995 to divest himself of assets

that could be seized to satisfy his potential liability in the

Redlands litigation.   Petitioner testified that the $47,443 he

received from his children was a loan.    However, no documentary

evidence supports petitioner’s claim.    Petitioner’s books for

1995 do not show deposits of loan proceeds in the amount of

$47,443 or during June 1995, when petitioners’ children allegedly

lent him the money.    Petitioner does not explain why his children

received $47,443.51 in cash, converted it to cashier’s checks,

and then purportedly lent it to petitioner.    We believe

petitioner tried to conceal his receipt of attorney’s fees from

the Anis partnership by diverting them through his children.

     Petitioner testified that he did not report the amounts that

petitioners’ children received from the Anis partnership because

Lewellen told him it was not income to him.    Petitioner’s claim

is unconvincing in view of Lewellen’s credible testimony that

petitioner did not tell him that petitioner or his children had
                              - 48 -

received cash and an interest in two parcels of real property

through the Anis partnership in 1995.

     Petitioner has not shown that his failure to include in

income for 1995 amounts from the Anis partnership ($107,073) for

settlement of his claim for attorney’s fees was not due to fraud.

Thus, petitioner is liable for the addition to tax under section

6663 with respect to the underpayment for 1995 attributable to

the Anis partnership distributions.

          b.   Income Diverted by Edgar in 1995 and 1998

     The parties stipulated that Edgar deposited $67,437 in 1995

and $87,943 in 1998 in petitioner’s Big Bear checking account and

paid some of her personal expenses from that account, and we have

found that she did so without his knowledge or consent.    Thus,

petitioners’ failure to report income of $67,437 in 1995 and

$87,943 in 1998 attributable to Edgar’s diversion of those funds

was not due to fraud.

          c.   Client Fees Omitted From Original 1998 Return and
               Reported on Amended 1998 Return

     Petitioner admits that client fees of $135,422 were

deposited in O’Leary’s account in 1998 and were not deposited in

petitioner’s law firm account.   Petitioner contends that these

fees were sent to O’Leary to be invested, not to be concealed

from respondent.   Petitioner claims that he told Lewellen about

those fees, but Lewellen erroneously failed to report them on

petitioners’ original 1998 return.     Petitioner claims that he and
                              - 49 -

Mrs. Graham signed the amended 1998 return on November 8, 1999.

Petitioners point out that Lewellen did not charge for his

service for preparing the amended 1998 return, and argue that

this suggests that the error was Lewellen’s, not petitioners’.

We disagree.

     Lewellen credibly testified that he did not know petitioner

had received client fees of $135,422 in 1998 until petitioner

telephoned him shortly after the original 1998 return was filed.

He also credibly testified that petitioners’ amended 1998 return,

dated November 8, 1999, was prepared several days after that date

and backdated at petitioner's request.   In his 1999 lawsuit

alleging that Lewellen had negligently prepared petitioners’ 1998

tax return, petitioner did not refer to the fact that Lewellen

had not included client fees of $135,422 in petitioners’ original

1998 return.

     Petitioner contends that he discovered the omission of the

$135,422 when he looked at a Quicken printout of law office

income and compared it to his original 1998 return several days

after mailing that return.   Petitioner’s claim is unconvincing

because the parties stipulated and he admitted at trial that the

Quicken printout he gave to Lewellen on October 13, 1999, to

prepare the 1998 return did not include the $135,422.

     Petitioner contends that the omission of $135,422 was an

innocent oversight, and that he had no fraudulent intent
                                   - 50 -

regarding his failure to report that income on the original 1998

return as shown by the fact that he acted to amend his return to

report this amount a few weeks after he filed his original 1998

return.       We disagree.   Petitioner used a complex series of

transactions and transfers of funds through several individuals

in an attempt to conceal this income both from Lewellen and the

IRS.       Petitioner’s explanations for these transactions are

implausible.        For example, his claim that he gave O’Leary the

$135,422 to invest for him is belied by the fact that O’Leary

transferred the funds back to petitioner shortly thereafter.          We

conclude that petitioner fraudulently failed to include the

$135,422 in income on the original 1998 return.7

               d.    Personal Expenses Claimed as Business Deductions

       Petitioners admitted that they improperly deducted personal

expenses of $27,636 in 1998 and $4,476 in 1999 as business

expenses on their 1998 and 1999 tax returns.        However, they

contend that they did not fraudulently deduct those expenses.

Petitioners argue that Edgar is to blame for the majority of

these errors in 1998, and point out that the amount of

misclassified expenses dropped from $27,636 in 1998 to $4,476 in

1999 when Edgar was no longer responsible for petitioner’s


       7
       See Badaracco v. Commissioner, 464 U.S. 386, 394 (1984);
United States v. Hanson, 2 F.3d 942, 946 n.1 (9th Cir. 1993) (a
taxpayer who files a fraudulent return does not purge the fraud
by subsequent voluntary disclosure; the fraud was committed, and
the offense completed, when the original return was filed).
                                 - 51 -

business records.   Lewellen credibly testified that he did not

know that petitioners improperly deducted personal expenses as

business expenses on their 1998 return.   We reject petitioners’

attempt to shift the blame to Edgar for their deduction of

personal expenses as business expenses because petitioners

continued to improperly deduct personal expenses, such as

payments to their home gardener and to Kim Sterling for flowers,

in 1999 after Edgar left.

E.    Accuracy-Related Penalty

      Respondent contends that petitioners are liable for the

accuracy-related penalty for negligence on the portion of the

underpayment of their tax for each of the years 1998 and 1999

that is not due to fraud.   A taxpayer may be liable for a penalty

of 20 percent on the portion of an underpayment of tax due to

negligence or disregard of rules or regulations.   Sec. 6662(b).

However, section 6662 does not apply to any portion of an

underpayment subject to the fraud penalty under section 6663.

Id.   In the case of a joint return where one spouse is found

liable for fraud, the accuracy-related penalty cannot be imposed

on the other spouse because imposing the accuracy-related penalty

on the other spouse, sec. 6663(c), would result in “impermissible

stacking”.   Zaban v. Commissioner, T.C. Memo. 1997-479.

      In court proceedings arising in connection with examinations

beginning after July 22, 1998, section 7491(c) places on the
                               - 52 -

Commissioner the burden of producing evidence that it is

appropriate to impose the accuracy-related penalty for negligence

under section 6662(a).   Section 7491(c) applies because the

examination of petitioners’ returns for 1998 and 1999 (two of the

tax years in issue) began after July 22, 1998.

     To meet the burden of production under section 7491(c), the

Commissioner must produce evidence showing that it is appropriate

to impose the particular penalty, but need not produce evidence

relating to defenses such as reasonable cause or substantial

authority.    Higbee v. Commissioner, 116 T.C. 438, 446 (2001); H.

Conf. Rept. 105-599, at 241 (1998), 1998-3 C.B. 747, 995.

     Respondent has met the burden of production with respect to

the negligence penalty because the record shows that petitioners

knowingly understated their income and claimed improper

deductions for personal expenses.    See Snyder v. Commissioner,

T.C. Memo. 2001-255; Caralan Trust v. Commissioner, T.C. Memo.

2001-241.    Petitioners have not shown that they acted with

reasonable cause or in good faith.      They claim that they took

reasonable steps to report their income and that the deficiencies

were de minimis.    We disagree that they acted reasonably to avoid

the errors discussed herein, and that the negligence penalty does

not apply to errors of this magnitude.      See sec. 6662(b)(1).
                                - 53 -

F.   Whether Petitioners’ Forms 4868 Are Valid

     1.     Petitioners’ Contentions and Background

     Petitioners contend that the Form 4868 request for automatic

4-month extension that they filed for 1998 is valid because they

took reasonable steps to report their income to Lewellen, he

inadvertently failed to include $135,422 in income for 1998, and

they corrected that error by filing an amended return for 1998

three weeks after they filed their original return.

     A calendar year taxpayer generally must file returns by

April 15 after the close of the calendar year.    Sec. 6072(a).

The Commissioner may grant a reasonable extension of time to file

a return.    Sec. 6081(a).   A 4-month extension is automatic if a

taxpayer timely files a properly prepared Form 4868.      Sec.

1.6081-4(a)(1) and (2), Income Tax Regs.

     A Form 4868 is invalid if the taxpayer fails to properly

estimate his or her tax liability based on information available

to the taxpayer when the extension is requested.       Clayton v.

Commissioner, 102 T.C. 632, 650 (1994); Crocker v. Commissioner,

92 T.C. 899, 908, 911 (1989).    A taxpayer must estimate his or

her tax liability carefully and must make a reasonable attempt to

find information on which to base the estimate.       Crocker v.

Commissioner, supra.    The mere fact that a taxpayer

underestimates his or her tax liability does not invalidate a

Form 4868 or void an automatic extension.     Id. at 907.
                              - 54 -

     2.   Whether Petitioners Properly Estimated Their Tax

     Petitioners contend that they estimated their tax with

reasonable care on Form 4868 for 1998.   Petitioners estimated

that their tax liability for 1998 was $41,000, which they paid

when they filed their Form 4868.   This amount was less than one-

half of their actual liability.    They contend that their error in

underreporting $135,422 on their extension request and their

original 1998 return was attributable to Lewellen, not to

petitioners.

     We disagree.   Lewellen credibly testified that he was

unaware that petitioner had received client fees of $135,422 in

1998 until petitioner telephoned him shortly after the original

1998 return was filed.   Lewellen did not know that petitioners

improperly deducted $27,000 of personal expenses as business

expenses on their 1998 return.    Petitioners’ failure to properly

estimate their 1998 tax liability invalidates their extension.

     3.   Whether Petitioners Are Liable for an Addition to Tax
          for Failure To Timely File and Pay Under Section
          6651(a)(1) and (2)

     Section 6651(a)(1) provides for an addition to tax up to 25

percent for failure to timely file Federal income tax returns.

Section 6651(a)(2) provides for an addition to tax for failure to

pay taxes shown on a return on or before the payment due date.

The additions to tax under section 6651(a)(1) and (2) do not

apply if the failure was due to reasonable cause and not willful
                               - 55 -

neglect.    United States v. Boyle, 469 U.S. 241, 245 (1985);

Baldwin v. Commissioner, 84 T.C. 859, 870 (1985); Davis v.

Commissioner, 81 T.C. 806, 820 (1983), affd. without published

opinion 767 F.2d 931 (9th Cir. 1985).

     Respondent bears the burden of production under section

7491(c) and the burden of proving whether petitioners are liable

for the addition to tax for failure to timely file and timely pay

because it was first raised in respondent’s answer under Rule

142(a).    Petitioners relied on the automatic extension for 1998

as a defense to the addition to tax for failure to timely file

under section 6651(a).   Reliance on an automatic extension is not

reasonable cause for a taxpayer's failure to timely file a return

or timely pay if the taxpayer failed to properly estimate his or

her tax liability in requesting the extension.    Crocker v.

Commissioner, supra at 913.    We conclude that petitioners are

liable for the addition to tax under section 6651(a)(1) and (2)

for 1998.

     To reflect the foregoing and the concessions of the parties,


                                          Decision will be entered

                                     under Rule 155.
