                        T.C. Memo. 1998-389



                      UNITED STATES TAX COURT



               STEPHEN S. WANG, JR., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15228-96.                 Filed November 2, 1998.



     Mark D. Pastor and Robert T. Leonard, for petitioner.

     Ronald M. Rosen, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:   Respondent determined a deficiency in

petitioner’s Federal income tax for 1987 of $57,091, additions to

tax for fraud under section 6653(b)(1)(A)1 and (B) of $42,818 and

50 percent of the interest due on $57,091, respectively, and an

     1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code for the year in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
                               - 2 -


addition to tax for substantial understatement of tax under

section 6661 of $14,273.

     In the answer, respondent asserted additions to tax for

negligence under section 6653(a) in the alternative to additions

to tax for fraud.   At trial and on brief, respondent sought an

increased deficiency and increased additions to tax as a result

of the parties’ stipulation that petitioner had unreported income

of $4,000 for taxable year 1987 in addition to the $150,000

unreported income determined by respondent in the deficiency

notice.

     The issues for our consideration are:   (1) Whether

petitioner is entitled to deduct legal fees or disgorgement

payments as business expenses under section 162 or section 165;

(2) whether petitioner’s deductions or losses resulted in a net

operating loss (NOL); (3) if petitioner is not entitled to an

NOL, whether he is entitled to the computational benefits of

section 1341 with respect to the disgorgement payment; (4)

whether petitioner is liable, in the alternative, for additions

to tax for fraud under section 6653(b)(1)(A) and (B) or for

negligence under section 6653(a)(1)(A) and (B); and (5) whether

petitioner is liable for an addition to tax for a substantial

understatement under section 6661.
                                 - 3 -


                          FINDINGS OF FACT2

     At the time the petition was filed, petitioner resided in

Irvine, California.   From the fall of 1982 through the spring of

1986, petitioner attended the University of Illinois at Urbana-

Champaign, majoring in finance.    Petitioner left college after

the spring 1986 semester, only nine credits short of his

bachelor's degree.    In December 1989, he completed the necessary

credits and received a bachelor of science degree in finance with

high honors.

     Petitioner left college in 1986 to work for Morgan Stanley &

Co. (Morgan Stanley), a New York investment banking firm, for a

2-year internship as a junior analyst.    Initially, petitioner

worked in the Leveraged Buyout Unit of Morgan Stanley’s Merchant

Banking Department.   He was transferred to the Mergers and

Acquisitions Department in March 1987 because of unsatisfactory

work performance and remained in that department until June 1988.

During the course of his employment at Morgan Stanley, petitioner

was privy to confidential business information.    Some of the

information was nonpublic or insider information regarding Morgan

Stanley’s clients involved in actual and anticipated corporate

combinations and other transactions, such as mergers, tender

offers, and leveraged buyouts.    Petitioner was contractually and


     2
       The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
                                - 4 -


statutorily obligated to keep the information confidential and

not to use or disclose it for his personal benefit.

       In late 1986, petitioner met Mr. Fred Lee, who was then a

client of Morgan Stanley.    Mr. Lee, a Taiwanese national, owned

or had trading authority over a large number of securities and

trading accounts with several domestic and foreign brokerage

firms.    Sometime in 1987, petitioner began selling insider

information to Mr. Lee.    That information had been obtained in

the course of petitioner’s employment at Morgan Stanley.    Mr. Lee

used the insider information to buy and sell corporate

securities, earning an overall profit of approximately $19

million from June 1987 through June 1988.

       Mr. Lee paid petitioner, at minimum, $150,000 and $50,000

for the insider information during 1987 and 1988, respectively.

Petitioner admitted that he and Mr. Lee had discussed

petitioner’s receiving an additional $1 million in compensation.

Petitioner received some cash payments directly from Mr. Lee.

Petitioner also received payments in the form of deposits to a

bank account opened in fictitious or nominee names chosen by Mr.

Lee.    Petitioner had a power of attorney over the bank account.

In 1987, Mr. Lee paid petitioner at least $50,000 in cash and

$100,000 that was deposited by Mr. Lee into the bank account.

Petitioner spent the $50,000 within a year and did not deposit

any of it into a bank account or keep any record of the money.
                                - 5 -


Mr. Lee deposited an additional $50,000 into the bank account in

February 1988.    In 1987, petitioner also sold insider information

to Mr. Jerome Cronin, a former University of Illinois classmate,

in exchange for $4,000.

       On June 27, 1988, the Securities and Exchange Commission

(SEC) instituted a civil action against petitioner and Mr. Lee in

the U.S. District Court for the Southern District of New York for

alleged violations of sections 10(b) and 14(e) of the Securities

Exchange Act of 1934, 15 U.S.C. secs. 78j(b) and 78n(e), and SEC

Rules 10b-5 and 14e-3, 17 C.F.R. secs. 240.10b-5 and 240.14e-3,

promulgated thereunder.    SEC v. Wang, 88 Civ. No. 4461 (RO)

(S.D.N.Y.).    The civil complaint contained allegations that Mr.

Lee purchased insider information from petitioner about 25

companies and used that information to purchase securities.     The

SEC sought preliminary and permanent injunctions prohibiting

petitioner and Mr. Lee from participating in alleged securities

law violations and from disposing of their assets.    The SEC also

sought to have petitioner and Mr. Lee disgorge their profits

derived from the insider information petitioner had sold to Mr.

Lee.    Petitioner entered into a settlement of the civil action

with the SEC and agreed to disgorge $125,000, the amount

remaining in the nominee bank account.    In 1988, the disgorgement

was placed in a receivership fund to be used as restitution for

investors who could show a loss due to petitioner’s and Mr. Lee’s
                                 - 6 -


illegal actions.   The disgorgement was not a fine or penalty paid

to the Government within the meaning of section 162(f).

     On September 7, 1988, the Federal Government filed a three-

count criminal information against petitioner in the U.S.

District Court for the Southern District of New York, charging

him with one count each of mail fraud, 18 U.S.C. sec. 1341, wire

fraud, 18 U.S.C. sec. 1343, and securities fraud, 15 U.S.C. secs.

78j(b) and 78ff and 17 C.F.R. sec. 240.10b-5.     United States v.

Wang, docket No. 88 Commissioner. 0615 (KTD) (S.D.N.Y.).     It was

alleged that petitioner had taken or stolen confidential business

information from Morgan Stanley and its clients.     The information

contained the names of 5 companies about which petitioner

provided insider information to Mr. Lee and Mr. Cronin and also

contained charges that insider trading occurred with respect to

at least 19 companies.   Petitioner waived indictment and pled

guilty to each criminal count.    He was sentenced to 3 years’

imprisonment and 3 years’ probation.     Petitioner served

approximately 8 months in a Federal prison, from December 1988 to

August 1989.

     Petitioner engaged two law firms to represent him in legal

matters arising from his insider trading.     During 1988 and 1989,

petitioner incurred legal fees and litigation costs that totaled

$110,857.43.   Petitioner’s father, Stephen S. Wang, Sr., paid

petitioner’s legal bills in the amounts of $60,000 and $50,857.43
                               - 7 -


during 1988 and 1989, respectively.     Mr. Wang, Sr., used savings,

borrowed money, employer savings plan withdrawals, and vacation

time converted to cash in order to pay his son’s legal expenses.

Before petitioner’s incarceration, Mr. Wang, Sr., made out the

checks for the legal fees jointly to petitioner and the law firm

and gave the checks to petitioner.     After petitioner’s

incarceration, Mr. Wang, Sr., issued his checks directly to the

law firm and did not obtain petitioner’s endorsement.       Although

Mr. Wang, Sr., liquidated assets and incurred debt to pay about

$110,000 of his son’s legal expenses, in 1993 he sold stock in a

Taiwanese company for over $2 million.

     In 1988, petitioner, in connection with the legal expenses,

executed three promissory notes to his father totaling $115,000

(1988 notes).   The first note was drafted by an attorney for Mr.

Wang, Sr., and was used as a model for the two subsequent notes.

The notes were unsecured, did not require monthly payments, and

did not begin to accrue interest until 1993.     In January 1993,

petitioner executed a note to replace the 1988 notes and extended

the maturity date for 5 years, providing for accrual of interest

during the extended period.   As of the time of trial, petitioner

had not made any payments of interest or principal on the

replacement note or the 1988 notes.

     On his 1987 tax return, petitioner reported gross income of

$39,521.55, consisting of wages from Morgan Stanley and $67 of
                               - 8 -


taxable interest income.   He did not report his $154,000 insider

trading income, $150,000 of which was included in his gross

income by respondent.   On his 1988 tax return, petitioner

reported gross income of $17,026.85, his wages from Morgan

Stanley, and he did not report the $50,000 insider trading income

included in his gross income by respondent.   For 1988, respondent

allowed petitioner a $125,000 deduction for the disgorgement of

his insider trading income, which resulted in no tax deficiency

for that year.   Respondent determined, however, that the

disgorgement deduction was not in connection with a trade or

business and, accordingly, did not generate a 1988 NOL that could

be carried back to 1987.   Under respondent’s determination, most

(about $75,000) of the $125,000 disgorgement deduction remained

effectively nondeductible.

     On January 25, 1994, petitioner executed a Form 872, Consent

to Extend the Time to Assess Tax, intended to extend the 1987

assessment period to December 31, 1994.   The Form 872 was

executed after April 15, 1991, after the normal 3-year period for

assessment under section 6501(a) had expired.   The Form 872 was

executed before April 15, 1994, within the 6-year period for

assessment under section 6501(e)(1) (that section applies where

substantial omissions from gross income exist).   The Form 872,

however, did not contain any explanation or indication of whether

the period for assessment was then open or under which particular
                               - 9 -


provision it may be open for the 1987 tax year.    When he signed

the Form 872, petitioner was represented by an attorney who also

signed the form.   Subsequently, on or about June 1, 1994, and

August 2, 1995, the parties executed Forms 872 to extend the 1987

assessment period to December 31, 1995, and December 31, 1996,

respectively.   The notice of deficiency was mailed on April 16,

1996.

                              OPINION

1987--Period for Assessment

     As a preliminary matter, we consider petitioner’s contention

that the 1987 assessment period had expired before respondent

mailed the notice of deficiency.    There was in excess of a 25-

percent omission of gross income on petitioner’s 1987 tax return,

and the 6-year period for assessment is applicable.     See sec.

6501(e)(1).   Petitioner executed a Form 872 in January 1994,

before the 6-year assessment period expired.    Petitioner contends

that the Form 872 is invalid or without effect because it did not

specify that the 6-year assessment period was applicable.

Accordingly, petitioner argues that the assessment period expired

before the notice of deficiency was mailed.

     An agreement to extend the assessment period must be

executed before the expiration of the applicable statutory period

for assessment or the period agreed upon by the taxpayer and the

Secretary in a prior agreement.    Sec. 6501(c)(4).   There is no
                              - 10 -


requirement, however, that the parties’ consent or agreement

contain a reference to the applicable statutory provision under

which the assessment period remains open.

     Additionally, our holding that petitioner filed a fraudulent

1987 return would also permit the tax for that year to be

assessed at any time.   See sec. 6501(c)(1).   Therefore, the 1987

assessment period had not expired at the time respondent mailed

the notice of deficiency to petitioner.

Was Petitioner’s Activity a Trade or Business?

     Petitioner has admitted that he had unreported income in the

amounts of $154,000 and $50,000 for 1987 and 1988, respectively.

Petitioner’s $125,000 deduction claimed for the 1988 disgorgement

was allowed, but it only affected the $50,000 of the insider

information income earned for 1988, because respondent disallowed

any carryback to the $154,000 earned in 1987.3   Petitioner also

seeks to claim legal expenses of $60,000 and $50,857.43 paid

during 1988 and 1989, respectively.    Respondent disallowed those

deductions on the grounds that they were not paid by petitioner

and/or were not incurred in a trade or business.




     3
       Because of respondent’s allowing $50,000 of the $125,000
disgorgement deduction against the $50,000 of unreported income,
no deficiency was determined for 1988. Because respondent
determined that petitioner was not in a trade or business, no
part of the $75,000 difference that was not deductible in 1988
could be carried to other taxable years.
                                - 11 -


     The parties advanced several arguments, and the pivotal

question for each is whether petitioner was in a trade or

business.     Although respondent determined that petitioner is

entitled to a deduction for the disgorgement, an NOL was

disallowed because of the determination that petitioner’s

activity was not a trade or business, a prerequisite here for a

carryback.4    In that context, we must decide whether petitioner

was in a separate trade and/or business of selling insider

information or whether the expenses were connected with

petitioner’s status as an employee.

     Petitioner stipulated that he had unreported income of

$154,0005 in 1987 from the sale of insider information.

Petitioner contends that he is not liable for an income tax

deficiency for 1987 because he sustained NOL’s for 1988 and 1989

that may be carried back to 1987.     In particular, petitioner

argues that he is entitled to deduct legal expenses in 1988 and

1989 and the disgorgement of his insider trading profits in 1988

as business expenses.    He contends that the legal fees and


     4
       Respondent did not argue or determine that the deduction
for the disgorgement or the allowance of a net operating loss
(NOL) was against public policy.
     5
       In the deficiency notice, respondent determined unreported
income of $150,000. Respondent did not seek to amend the answer,
but at trial and on brief sought an increased deficiency and
additions to tax. Petitioner’s admission that he had unreported
income of $154,000 caused the issue to have been tried by consent
of the parties. See Rule 41(b).
                              - 12 -


disgorgement were related to “his business activities in the

securities industry” and, therefore, are deductible business

expenses.   Respondent maintains that petitioner’s expenditures

are not business expenses because his insider trading activity

was not related to his employment at Morgan Stanley and

petitioner was not in a separate trade or business of selling

insider information.   Respondent has permitted petitioner to

deduct the disgorgement under section 165(c)(2) as a loss

incurred in an activity entered into for profit that does not

constitute a trade or business.   A section 165(c)(2) nonbusiness

loss deduction cannot create an NOL carryback.   Sec. 172(d)(4).

Respondent also argues that petitioner is not entitled to deduct

the legal expenses under either section 162 or 212 because the

expenses were paid by petitioner’s father.

     The first issue for our consideration is whether

petitioner’s selling of insider information constituted a trade

or business.   Petitioner asserts that the sale of insider

information was in connection with his employment at Morgan

Stanley and that his job provided him with the opportunity and

means to engage in insider trading.    Petitioner also argues that

he made the disgorgement to protect his business reputation and

future employment.   Although petitioner obtained the insider

information in the course of his position with Morgan Stanley,

his use and disclosure of the information for profit was not
                               - 13 -


within the scope of his employment.     Petitioner violated his

confidentiality agreement with Morgan Stanley by disclosing and

using for his personal gain confidential information that he

acquired through his employment.

     Respondent attempts to analogize petitioner’s actions to

those of an employee who embezzles money from his employer.

Repayment of embezzled funds is not an ordinary and necessary

business expense of being an employee because an embezzler does

not act in the course of his employment when taking the money.

See, e.g., Yerkie v. Commissioner, 67 T.C. 388, 393-394 (1976);

Morrison v. Commissioner, T.C. Memo. 1981-617; Whitler v.

Commissioner, T.C. Memo. 1980-214.      Petitioner’s use and

disclosure of the insider information was not in connection with

or furtherance of his employment or for a business purpose of his

employer, Morgan Stanley.    Cf. O’Malley v. Commissioner, 91 T.C.

352, 363-364 (1988) (bribery charge against taxpayer related to

his employment because bribe advanced purposes of employer

although taxpayer's employer did not instruct him to offer

bribe).   While petitioner’s sale of insider information was

facilitated by his employment, it was not directly or proximately

related to his job at Morgan Stanley.     Petitioner is not entitled

to deduct the legal fees or disgorgement as business expenses of

being a financial analyst.
                                - 14 -


     Next we consider whether petitioner is entitled to deduct

the disgorgement payment or the legal fees in connection with the

separate trade or business of selling insider information.      To be

a trade or business, a taxpayer’s activity must be frequent,

regular, and continuous.   Commissioner v. Groetzinger, 480 U.S.

23, 35 (1987); Juda v. Commissioner, 90 T.C. 1263, 1287 (1988),

affd. 877 F.2d 1075 (1st Cir. 1989).     Activities that are

sporadic do not qualify as a trade or business.     See Polakis v.

Commissioner, 91 T.C. 660, 670-672 (1988).     Whether petitioner

was engaged in a trade or business is a question of fact.

Higgins v. Commissioner, 312 U.S. 212, 217 (1941).

     It has not been established on this record that petitioner’s

sales of insider information were continuous and occurred

regularly.   He obtained insider information and sold it to others

until his activities were discovered by the SEC.     However, his

internship with Morgan Stanley was intended for a limited period,

after which petitioner intended to finish his college education.

The civil complaint filed by the SEC contained accusations that

petitioner sold insider information involving at least 25

companies resulting in $19 million in profits in connection with

Mr. Lee’s trading securities.    The criminal charges against

petitioner identified five companies about which petitioner sold

insider information to Mr. Lee and Mr. Cronin.     The criminal

information also contained allegations that petitioner had sold
                                - 15 -


insider information with respect to at least 19 companies.    The

five instances of selling insider information to Mr. Lee and Mr.

Cronin as set forth in the criminal charges were separate and

occurred over several months.    With respect to the other

instances alleged in the civil and criminal documents, there is

insufficient detail to determine that petitioner's activity was

“frequent, regular, and continuous”.

     On the basis of this record, we conclude and hold that

petitioner’s sale of insider trading information was sporadic and

represented a limited opportunistic transactional relationship

with Mr. Lee. Accordingly, petitioner was not in a trade or

business in connection with his insider trading activities.

     Petitioner contends that the legal expenses paid for his

defense in civil and/or criminal litigation that arose in

connection with his sale of insider information are deductible

under section 162.    Respondent, however, argues that petitioner

is not entitled to a deduction because the legal expenses were

paid by his father.   Petitioner maintains that his father lent

him money to pay his legal expenses and argues that he intended

to repay his father as evidenced by promissory notes.

Alternatively, petitioner argues that he is entitled to deduct

the legal fees because his father paid his legal expenses as a

gift to petitioner.   Because we have decided that petitioner was

not engaged in a trade or business in connection with his sales
                              - 16 -


of insider information, it is unnecessary to decide whether he

paid the legal expenses.   That is so because respondent has

already allowed the deduction of the disgorgement under section

165(c)(2) consuming all of the income reportable for 1988.

Petitioner’s ability to deduct any portion of the 1988 or 1989

legal payments is governed by the section 172 net operating loss

provisions.

     A taxpayer engaged in a trade or business may be entitled to

carry a resulting NOL deduction to other taxable years.    An NOL

is the excess of deductions over the taxpayer's gross income,

subject to certain modifications specified in section 172(d)(4).

Sec. 172(c).   Nonbusiness expenses and losses are not included in

NOL’s and may not be carried back.     Sec. 172(d)(4); Todd v.

Commissioner, 77 T.C. 246, 248 (1981), affd. per curiam 682 F.2d

207 (9th Cir. 1982).   The section 165(c)(2) loss (not from a

trade or business)6 of the disgorgement would not create an NOL

for petitioner’s 1988 or 1989 tax year that could be carried back

to prior years, including 1987.   Sec. 172(d)(4).   Likewise,

because petitioner is not in a trade or business in connection



     6
       The disgorgement of petitioner’s profits is governed by
sec. 165(c)(2). The distinction between losses and expenses is
found primarily in the nature and occasion of the expenditure.
It is well settled that deductions for cash forfeitures and
confiscations, if allowed at all, are normally allowed as loss
deductions under sec. 165. Holt v. Commissioner, 69 T.C. 75, 78
(1977), affd. per curiam 611 F.2d 1160 (5th Cir. 1980).
                              - 17 -


with his sales of insider information, an NOL would not result

from the payment of the legal expenses incurred in 1988 or 1989.

     We hold that petitioner is not entitled to carry back an NOL

deduction from 1988 or 1989 to the year in controversy in this

case (1987).

Does Section 1341 Apply to Petitioner’s Disgorgement Payment?

     Having decided that petitioner is not entitled to an NOL

carryback to 1987, we consider his alternative argument that

section 1341 applies to the 1988 disgorgement payment.   In

particular, petitioner argues that he is entitled to a tax credit

under section 1341(a)(5) equal to the 1987 tax attributable to

the inclusion of the $125,000 disgorgement in his 1987 income.

Section 1341 permits a special computation method for the tax

liability of a taxpayer who has:   (1) Received income (in excess

of $3,000) in 1 year under a claim of right; (2) included the

amount in income; and (3) in a subsequent taxable year, was

required to make restoration of the income to another because it

was established that the taxpayer did not have an unrestricted

right to the income.   Sec. 1341; sec. 1.1341-1(a)(1), Income Tax

Regs.

     Section 1.1341-1(a)(2), Income Tax Regs., continues with the

definition:

     “income included under a claim of right” means an item
     included in gross income because it appeared from all
     the facts available in the year of inclusion that the
     taxpayer had an unrestricted right to such item, and
                                - 18 -


     “restoration to another” means a restoration resulting
     because it was established after the close of such
     prior taxable year (or years) that the taxpayer did not
     have an unrestricted right to such item (or portion
     thereof).

     Section 1341 is titled “CLAIM OF RIGHT”, but the statutory

language used to describe that concept is that the income item

must have been includable because it “appeared” that the taxpayer

had an “unrestricted right” to it.       (Emphasis added.)   The above-

quoted regulations, however, again use the term “claim of right”

in the process of defining the operative terms of section 1341.

The concept of claim of right, accordingly, must be part of our

consideration of section 1341 issues.

     Respondent contends that petitioner is not entitled to use

section 1341 because:     (1) Petitioner never included the proceeds

of the illegal sale of insider information in his gross income

for 1987; (2) petitioner did not have an unrestricted right to

the income; i.e., in cases usually involving embezzlement, courts

have held that the illegal income is not held under a claim of

right; and (3) in general, illegally obtained income does not,

per se, give rise to a claim of right.      Petitioner disagrees with

respondent’s contentions and argues that Barrett v. Commissioner,

96 T.C. 713 (1991), a case involving a securities trader who was

allowed section 1341 relief, is substantially similar factually

and should be followed.
                              - 19 -


     Section 1341 was enacted in 1954 to address the type of

situation that existed in United States v. Lewis, 340 U.S. 590

(1951).   In that case, the taxpayer repaid, in a later year, part

of a bonus received erroneously in a prior year that was closed

for tax purposes.   Because of those circumstances, the taxpayer

lost the benefits of being able to calculate the reduction of

income in the year of receipt of the bonus.   Those benefits

included interest from a refund of the tax paid earlier and

differing tax rates between the years of receipt and repayment.

Although section 1341 does not address the question of interest,

it does address other possible benefits that might have been

available from the deduction or computation of the tax in the

earlier year.

     Respondent contends that section 1341 generally does not

apply to circumstances where the income is obtained through

illegal means.   The cases that have addressed this issue,

however, generally involve embezzlement or a similar circumstance

where the taxpayer was entrusted with another's cash or assets.7

We could find only one section 1341 illegal income case that did

not involve embezzlement or similar circumstances.   On the basis


     7
       One case involved the misappropriation of a lawyer’s
clients’ trust funds, which in all material respects is the same
as embezzlement, especially with respect to the question of
whether a taxpayer has a claim of right (appearance of an
unrestricted right) with respect to the item in question. See
O'Hagan v. Commissioner, T.C. Memo. 1995-409.
                               - 20 -


of the embezzlement cases, the court, in that case, decided, that

the result in the embezzlement case(s) “cannot be limited only to

embezzlers; instead, the statute’s ‘unrestricted right’ language

must be read to exclude from its coverage all those who receive

earnings knowing themselves to have no legal right thereto.”

Perez v. United States, 553 F. Supp. 558, 561 (M.D. Fla. 1982).

     In a memorandum opinion of this Court, the generalized

holding of Perez was relied upon in circumstances where a lawyer

converted his client’s trust fund to his own use.      O’Hagan v.

Commissioner, T.C. Memo. 1995-409.      Factually, however, it is

difficult to distinguish a lawyer’s conversion of a client’s

funds entrusted to him from other forms of embezzlement.     In both

instances, the taxpayer did not have and knew he did not have a

claim of right or appearance of unrestricted right to the funds.

     Any analysis of the “claim of right” concept in conjunction

with embezzlement cases must focus on a line of cases surrounding

James v. United States, 366 U.S. 213 (1961).      In James, the

Supreme Court reversed its holding in Commissioner v. Wilcox, 327

U.S. 404 (1946), that embezzled funds were not includable in

gross income.   Wilcox was, in part, predicated on the embezzler’s

lack of “a claim of right to the alleged gain”.     327 U.S. at 408.

In James v. United States, supra at 219, the Court reasoned that

          When a   taxpayer acquires earnings, lawfully or
     unlawfully,   without the consensual recognition, express
     or implied,   of an obligation to repay and without
     restriction   as to their disposition, “he has received
                              - 21 -


     income which he is required to return, even though it
     may still be claimed that he is not entitled to retain
     the money, and even though he may still be adjudged
     liable to restore its equivalent”. * * * [Citation
     omitted.]

     The requirement to report embezzled funds for tax purposes

even though the embezzler/taxpayer may not have had a claim of

right to the funds was analyzed in Yerkie v. Commissioner, 67

T.C. 388 (1976).   In that case, an embezzler failed to meet the

first qualification of section 1341; i.e., the embezzler did not

have a claim of right to the embezzled funds.   Id. at 392.    We

agree with respondent that with respect to embezzlement gains it

is well established that section 1341 is not available.    It does

not necessarily follow, however, that taxpayers with illegal

income, per se, are not entitled to use section 1341.   With

respect to each taxpayer it would be necessary to decide whether

his circumstances meet the requirements of section 1341.

Embezzlers do not meet the claim of right requirement of section

1341 because there was no claim of right, not because the income

or gain was illegally obtained.   Section 1341 applies only if the

taxpayer appeared to have an unrestricted right to the income in

the year of receipt.   Sec. 1341(a)(1); sec. 1.1341-1(a)(1),

Income Tax Regs.

     Here, petitioner’s and Mr. Lee’s activities were illegal in

every respect.   Petitioner’s act of obtaining the insider

information, his sale of insider information to others, and the
                                - 22 -


use of the information by others were all illegal acts.      Although

Mr. Lee did not place any restrictions on use of the funds paid

to petitioner, under securities laws petitioner did not have a

claim of right or the appearance of an unrestricted right to the

money.   He had then knowingly committed a crime, and he was

subject to criminal penalties and to the SEC’s remedy of

disgorgement.8    In 1988, petitioner’s disgorged profits were

placed in a receivership fund to be used as restitution for

investors who could show a loss due to petitioner’s and/or Mr.

Lee’s illegal actions.     Under these circumstances, we hold that

petitioner does not pass the section 1341(a)(1) requirement and

that he is not entitled to section 1341 relief.

     Petitioner argued that his circumstances were similar to

those of Barrett v. Commissioner, 96 T.C. 713 (1991).       In that

case the taxpayer, a shareholder in a stock brokerage, purchased

stock options on the basis of insider information and realized

gain from the sale of the options.       Although the taxpayer was not

criminally prosecuted, he was sued by the option brokers with

whom he had made the trades and profit due to insider

information.     In a year subsequent to the option transactions,

     8
       Disgorgement is used as a deterrent and is intended to
make the improper use of security information unprofitable.
Hateley v. SEC, 8 F.3d 653, 655 (9th Cir. 1993); SEC v. Rind, 991
F.2d 1486, 1490 (9th Cir. 1993); SEC v. Wang, 944 F.2d 80, 85 (2d
Cir. 1991). The amount disgorged must be reasonable; i.e.,
approximately equal to the violator’s profits. Hateley v. SEC,
supra at 656.
                              - 23 -


the taxpayer settled the civil suit by disgorging to the option

brokers part of his profit from the sale of the options.     In

Barrett, the taxpayer was allowed to use section 1341 after the

Court found “that the taxpayer did not have an unrestricted

right” to the profits, or in other words, “that the taxpayer had

a legal obligation to restore the item.”   Id. at 718-719.

     Although Barrett is factually similar to the case under

consideration, the holding in that case concerned section

1341(a)(2).   The Court in Barrett, however, did not consider

whether there was a claim of right or the appearance of

unrestricted right to income from option purchases.   The focus in

Barrett was whether the repayment was due to a restriction on the

taxpayer; i.e., whether the taxpayer had an obligation to pay the

option brokers who had sued him.   Because of our holding that

petitioner did not meet the first prong of the section 1341

requirements, we need not consider whether petitioner met the

other requirements of section 1341.

     Accordingly, petitioner does not qualify for section 1341

treatment with respect to the disgorgement payment.

Additions to Tax for Fraud Under Section 6653

     The next issue for our consideration is whether petitioner

is liable for additions to tax for fraud under section

6653(b)(1)(A) and (B) or, in the alternative, for negligence
                              - 24 -


under section 6653(a)(1)(A) and (B).9    Section 6653(b)(1)(A)

imposes an addition to tax equal to 75 percent of the

underpayment attributable to fraud.     Additionally, section

6653(b)(1)(B) imposes an addition to tax equal to 50 percent of

the interest due on an underpayment attributable to fraud.

Respondent has the burden of proving fraud by clear and

convincing evidence.   Rule 142(b).    To satisfy this burden,

respondent must prove that petitioner intended to evade taxes by

conduct intended to conceal, mislead, or otherwise prevent the

collection of taxes.   Parks v. Commissioner, 94 T.C. 654, 661

(1990); Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).




     9
       Respondent determined additions to tax for 1987 under sec.
6653(b)(1)(A) and (B), the version of sec. 6653(b) that applied
to petitioner’s 1987 return. See Tax Reform Act of 1986 (TRA),
Pub. L. 99-514, sec. 1503(a), 100 Stat. 2085, 2742. In the
answer, respondent incorrectly alleged that the fraud additions
for 1987 should have been asserted under sec. 6653(b)(1) and (2),
a prior version of sec. 6653(b). Similarly, in the answer,
respondent asserted alternate additions to tax for negligence for
1987 under sec. 6653(a)(1) and (2), a prior version of sec.
6653(a). The version of sec. 6653(a) applicable to taxable year
1987 is sec. 6653(a)(1)(A) and (B). TRA sec. 1503(a).
     With respect to the fraud additions to tax, the deficiency
notice cited the version of sec. 6653(b) applicable to the year
in issue and properly informed petitioner of respondent’s
determination. Respondent’s assertion in the answer of a prior
version of sec. 6653(a) and (b) for the additions is an error in
form only and does not have a substantive effect on this case.
In any event, citation of a prior version of sec. 6653(a) and (b)
is immaterial to the outcome of the case because respondent bears
the burden on both the fraud and negligence additions to tax.
See Rule 142.
                              - 25 -


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

upon consideration of the entire record.     DiLeo v. Commissioner,

96 T.C. 858, 874 (1991), affd. 959 F.2d 16 (2d Cir. 1992); Estate

of Pittard v. Commissioner, 69 T.C. 391 (1977).    Fraud is never

presumed and must be established by affirmative evidence of

fraudulent intent.   Edelson v. Commissioner, 829 F.2d 828, 833

(9th Cir. 1987), affg. T.C. Memo. 1986-223; Beaver v.

Commissioner, 55 T.C. 85, 92 (1970).   Fraud may be proven by

circumstantial evidence because direct proof of the taxpayer’s

intent is seldom available.   Spies v. United States, 317 U.S. 492

(1943); Rowlee v. Commissioner, supra.     Courts have developed a

nonexclusive list of factors that establish fraudulent intent:

(1) Understatement of income; (2) inadequate records; (3)

implausible or inconsistent explanations of behavior; (4)

concealment of assets; (5) failure to file tax returns; (6)

filing false documents; (7) failure to cooperate with tax

authorities; (8) dealing in cash; and (9) engaging in illegal

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

Cir. 1986), affg. T.C. Memo. 1984-601; Miller v. Commissioner, 94

T.C. 316, 334 (1990); Recklitis v. Commissioner, 91 T.C. 874, 910

(1988).   A taxpayer’s intelligence, education, and experience are

relevant in determining fraudulent intent.     Niedringhaus v.

Commissioner, 99 T.C. 202, 211 (1992).
                                - 26 -


     From the record in this case, we hold that petitioner’s 1987

return was fraudulent.    He pled guilty to securities, mail, and

wire fraud in connection with his acquisition and sale of insider

information.   He failed to report any of the income he received

from the sales in either 1987 or 1988.     Reporting the illegal

income would have increased the risk that petitioner’s illegal

activities would be detected.    Reluctance to report illegal

income because of the chances that the illegal source of the

income will be discovered does not preclude a tax evasion motive.

Recklitis v. Commissioner, supra at 909.     Moreover, participation

in illegal activities is a badge of fraud.     Bradford v.

Commissioner, supra.     In addition, petitioner attempted to

conceal his illegal activities and income by dealing in cash and

using a bank account under fictitious names.     He did not maintain

any records of the illegal income or how he used the money

received from selling insider information.

     Petitioner argues that he did not have fraudulent intent

because he did not consider whether or not to report the illegal

income.   Petitioner’s argument is unpersuasive.    He is a well-

educated and knowledgeable taxpayer.     In college, he took a

number of business courses, including a class on Federal income

tax accounting.   Petitioner does not deny that he knew that

illegal income was taxable and was aware of his reporting

obligations.   In addition, petitioner understood that he received
                                - 27 -


cash; he did not use his own name on the bank account to avoid

detection of his illegal activity and income.      We are satisfied

that respondent has proven by clear and convincing evidence that

petitioner had a fraudulent intent.      Petitioner is liable for the

additions to tax for fraud under section 6653(b)(1)(A) and (B).

Consequently, we do not need to consider respondent’s alternate

assertion that petitioner is liable for additions to tax for

negligence.

Addition to Tax Under Section 6661

      The final issue for our consideration is whether petitioner

is liable for a section 6661 addition to tax.      Section 6661(a)

imposes an addition to tax of 25 percent of any underpayment

attributable to a substantial understatement of tax.      An

understatement is the excess of the correct tax over the tax

reported on the return.     Sec. 6661(b)(2)(A).   An understatement

is substantial if it exceeds the greater of 10 percent of the

correct tax or $5,000.     Sec. 6661(b)(1)(A).    The understatement

can be eliminated if substantial authority existed for the

taxpayer’s treatment of the item in dispute or if the taxpayer

adequately disclosed relevant facts regarding treatment of the

item on the return.     Sec. 6661(b)(2)(B); sec. 1.6661-4(a), Income

Tax Regs.     Petitioner has the burden to show that he is not

liable for the section 6661 addition to tax.      Rule 142(a).

Petitioner has not made any arguments or presented any evidence
                              - 28 -


regarding the section 6661 addition to tax.   Accordingly, we find

that petitioner is liable for an addition to tax under section

6661 for 1987.   See Cluck v. Commissioner, 105 T.C. 324, 340

(1995).


                                    Decision will be entered under

                               Rule 155.
