                              T.C. Memo. 2016-107



                        UNITED STATES TAX COURT



       JAMES A. ERICSON AND REBECCA A. ERICSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 25648-12.                         Filed June 1, 2016.



      James A. Ericson, pro se.

      Jonathan J. Ono, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      GALE, Judge: Petitioners petitioned the Court to redetermine respondent’s

determinations relating to petitioners’ Federal income tax for 2006 through 2008
                                         -2-

[*2] (years at issue). Respondent determined the following deficiencies, addition

to tax under section 6651(a)(1),1 and fraud penalties under section 6663:

                                          Addition to tax      Penalty
                Year       Deficiency     sec. 6651(a)(1)     sec. 6663
                2006         $43,576         $11,052           $32,040
                2007          30,851             -0-            19,980
                2008          39,999             -0-            28,099

Respondent determined as an alternative to the fraud penalty for 2008 that

petitioners were liable for an accuracy-related penalty under section 6662(a) for

negligence, or alternatively, for a substantial understatement of income tax.

      Respondent concedes that the assessment periods for 2006 and 2007 are

closed to the extent that we find that the fraud penalties do not apply for those

years. As discussed infra, we find that a fraud penalty does not apply for any year

at issue. We therefore do not discuss further respondent’s adjustments for 2006

and 2007, other than to the extent that they relate to respondent’s determinations of

fraud for those years. Because our analysis of respondent’s fraud determinations

for the years at issue takes into account our analysis of respondent’s nonfraud




      1
       Unless otherwise indicated, section references are to the Internal Revenue
Code (Code) in effect for the years at issue, Rule references are to the Tax Court
Rules of Practice and Procedure, and dollar amounts are rounded.
                                          -3-

[*3] determinations for 2008, for clarity we defer our analysis of respondent’s

fraud determinations until the end of this opinion.

      The issues that we decide are as follows:

      1. whether petitioners failed to report $5,552 of sole proprietorship income

for 2008. We hold that they did;

      2. whether petitioners may deduct the $92,564 of sole proprietorship

expenses in dispute for 2008. We hold that they may not;

      3. whether petitioners may deduct the $3,816 of employee business

expenses in dispute for 2008. We hold that they may not; and

      4. whether petitioners are liable for the fraud (or alternatively the

accuracy-related) penalties that respondent determined. We hold that petitioners

are not liable for the fraud penalties but are liable for the accuracy-related penalty

determined for 2008.

                                FINDINGS OF FACT

I.    Preliminaries

      The parties stipulated certain facts and exhibits. We find the stipulated facts

accordingly, and we incorporate those facts herein. Petitioners are husband and

wife, and they resided in Hawaii when their timely petition was filed. They filed a

joint Form 1040, U.S. Individual Income Tax Return, for each year at issue.
                                          -4-

[*4] II.     Mrs. Ericson

       Mrs. Ericson was employed part time during the years at issue as a registered

nurse. She also operated a sole proprietorship that primarily manufactured and

sold fashion jewelry. Her sole proprietorship secondarily bought and sold clothes

during 2006 and 2007 and manufactured and sold notions during 2008. She

generally sold her merchandise on eBay, and she had no cash sales.

       Petitioners did not keep a formal set of books for, or retain receipts

underlying the expenses of, Mrs. Ericson’s sole proprietorship (or Mr. Ericson’s

sole proprietorship discussed infra). Mr. Ericson periodically looked at petitioners’

bank and credit card statements and characterized (but did not separately record)

for Federal income tax purposes each expense shown on the statements.

III.   Mr. Ericson

       A.    Background

       Mr. Ericson earned a bachelor’s degree in business and a master’s degree.

During the years at issue, he operated a sole proprietorship in Hawaii and

conducted three activities through the business. One activity was providing

accounting services, which consisted almost entirely of preparing income tax

returns. Another activity was taking and selling photographs. The remaining

activity was selling certain merchandise. Mr. Ericson generally devoted most of
                                          -5-

[*5] his time during January through May to preparing tax returns, and he

generally devoted most of his time during the rest of the year to his photography

activity.

       B.    Mr. Ericson’s Return Preparer Activity

       At the time of trial, Mr. Ericson had operated a tax-related business for at

least the past 30 years, preparing tax returns as part of that business for at least the

last 20 years. He became interested in preparing tax returns after taking college

courses covering the concepts of income and of deductible expenses. He later

attended some seminars and established his tax preparation business shortly

thereafter. He read books on tax laws during the first four months of his business

and then began preparing tax returns through his business. During one of his

business’ initial years, he maintained a second job working for a certified public

accountant helping her prepare her clients’ tax returns. During some of his

business’ other years, he maintained a different second job, working as an

accountant first for a construction company and later for a windsurfing company.

       Mr. Ericson prepared approximately 700, approximately 850, and over 1,000

Federal income tax returns for his clients during 2006, 2007, and 2008,

respectively. Clients typically paid him by check, although a few who had given

him “bad” checks were required to pay in cash. Mr. Ericson usually did not
                                        -6-

[*6] deposit his cash receipts into a bank account but instead used them to pay

business expenses.

      Mr. Ericson made numerous cash withdrawals from automated teller

machines (ATMs) to pay individuals who worked for his sole proprietorship. He

characterized most of these individuals as independent contractors, and he

generally paid them in cash. He kept no formal records of his ATM or cash

transactions, but for each month he characterized his ATM and cash transactions as

personal or business related.

      C.     Mr. Ericson’s Photography Activity

      Mr. Ericson is a professional photographer who photographed models,

scenery, and architecture in the State of Hawaii (primarily on the Island of Maui)

and in Europe. He started this activity in 2001, and the proceeds from the sale of

his photographs over the next year approximated $10,000. He thereafter devoted

substantial time to his photography work, especially in 2008. He paid the models

whom he photographed during the years at issue.

      Mr. Ericson initially sold his photographs on eBay, receiving payment

through PayPal. He eventually developed a list of customers and sold his

photographs directly to those customers. Mr. Ericson’s customer list totaled 150

customers at its peak.
                                          -7-

[*7]   Mr. Ericson owned an old Honda Accord during 2006 and 2007 and a Ford

Escort during 2008. He sometimes used those vehicles in his photography activity,

and for Federal income tax purposes he claimed deductions for that use on the

basis of a standard mileage rate. He also routinely rented convertibles and other

automobiles for his photo shoots on Maui.

       Mr. Ericson paid third parties to develop his film, and for Federal income tax

purposes he claimed these payments as commissions and fees. He inventoried his

photographs that were printed but not sold at the end of each year.

       Mr. Ericson used cameras and lenses, as well as a computer, in his

photography activity. He also rented office space and a storage locker.

       Mr. Ericson deducted on his Federal income tax returns, as airfare and

travel, the costs (e.g., hotels) he paid incident to his travel to take photographs.2

His travel was primarily around Maui and to Honolulu, and in 2006 to Europe.

       D.    Merchandise Activity

       Mr. Ericson sold clothes (primarily aloha shirts) in 2006 and 2007, and he

sold jewelry in 2008. He generally displayed the aloha shirts in his office, and he




       2
      For 2006, Mrs. Ericson also deducted expenses for business travel to
Europe. Petitioners, when they traveled together, apportioned their travel expenses
between themselves.
                                          -8-

[*8] mainly sold the shirts to clients when they visited his office. Mr. Ericson sold

most of his other merchandise on eBay.

        Petitioners purchased from secondhand stores most of the clothes they sold.

IV.     Petitioners’ Children

        Petitioners had two children, a son and a daughter, during the years at issue.

For Federal income tax purposes, petitioners claimed their daughter as a dependent

for each year at issue. Petitioners claimed their son as a dependent for 2006 and

2007.

        Petitioners’ children sometimes worked in petitioners’ sole proprietorships.

Petitioners’ daughter assisted them with their clothing and jewelry businesses,

including making much of the jewelry they sold. Petitioners compensated her for

her services with cash or by paying her rent or other personal expenses.

Petitioners’ son performed administrative services for Mr. Ericson’s sole

proprietorship, and Mr. Ericson paid him by check.

        Mr. Ericson and his son played golf together twice a week, and Mr. Ericson

paid for these outings. Petitioners deducted these payments on their Federal

income tax returns as business expenses. In Mr. Ericson’s view, the deductions

were appropriate because he and his son discussed petitioners’ businesses during

these outings.
                                          -9-

[*9] V.     Petitioners’ Bank Accounts

       Petitioners’ only bank accounts during the years at issue were a joint savings

account, a joint checking account, and a few joint certificate of deposit accounts.

Petitioners used their joint checking account for both personal and business

purposes, typically using a debit card to draw on the account. The checking

account statements generally listed the establishments where petitioners used the

debit card. Petitioners sometimes used checks and occasionally noted thereon the

expenses to which the checks related.

       Mr. Ericson and his daughter also had a joint checking account during the

years at issue.

VI.    Petitioners’ Returns

       A.     Overview

       Petitioners’ returns for the years at issue reported the following items:
                                            - 10 -

[*10]                 Item                             2006         2007           2008

        Wages, salaries, tips, etc.                  $54,764      $61,001        $62,322
        Taxable interest                                2,190         1,960            384
        Taxable refunds of State income taxes              877         -0-             817
        Business income (loss)                           (372)        2,041        12,683
          Total income                                 57,459       65,002         76,206
        Self-employed health insurance deduction          -0-        (2,990)          -0-
        Penalty on early withdrawal                       -0-          -0-               (6)
        One-half of self-employment tax                  (735)         (721)        (1,526)
          Adjusted gross income                        56,724       61,291         74,674
        Itemized deductions                           (14,160)     (12,204)       (19,068)
        Exemptions                                    (13,200)     (13,600)       (10,500)
          Taxable income                               29,364       35,487         45,106
        Tax                                             3,651         4,539          5,966
        Education credits                                 (198)        (360)          (250)
        Self-employment tax                             1,470         1,442          3,051
          Total tax                                     4,923         5,621          8,767

        B.     Business Income

               1.     Overview

        Petitioners reported their business income on Schedules C, Profit or Loss

From Business (Sole-Proprietorship). The Schedules C reported that the sole

proprietorships’ net income or loss for each year was as follows:

                       Source                         2006         2007         2008
        Mr. Ericson’s sole proprietorship          $10,404        $10,207      $21,595
        Mrs. Ericson’s sole proprietorship           (10,776)      (8,166)      (8,912)
         Net income (loss)                              (372)       2,041       12,683
                                            - 11 -

[*11]          2.        Mr. Ericson’s Sole Proprietorship

        Petitioners reported that the gross receipts, expenses, and net income of

Mr. Ericson’s sole proprietorship were as follows:

                         Item                         2006      2007          2008

        Gross receipts                               $79,640   $91,760     $107,450

        Expenses:
         Cost of goods sold                           34,797    37,310       57,120
         Advertising                                     260       540         -0-
         Car and truck                                 1,882     4,675        1,029
         Commission & fees                               984       722         -0-
         Contract labor                                 -0-      1,510         -0-
         Depreciation                                  2,358       877          870
         Interest--Other                                -0-        260         -0-
         Office                                          987     1,977         -0-
         Rental:
          Vehicles, machinery, equipment               3,220      -0-          -0-
          Other business property                     11,106    15,137       14,260
         Repairs & maintenance                           590       896         -0-
         Supplies                                        917     2,694        3,860
         Taxes & licenses                              3,469     3,356        3,166
         Travel                                        2,862     3,961          942
         Deductible meals & entertainment                461       430          845
         Other                                         5,343     7,208        3,763
          Total                                       69,236    81,553       85,855

        Net income                                    10,404   10,207        21,595

               3.        Mrs. Ericson’s Sole Proprietorship

        Petitioners reported that the gross receipts, expenses, and net loss of Mrs.

Ericson’s sole proprietorship were as follows:
                                            - 12 -

[*12]                    Item                         2006     2007       2008

        Gross receipts                               $9,420   $9,830    $14,090

        Expenses:
         Cost of goods sold                           7,050    8,260      7,640
         Advertising                                    240      310        360
         Car and truck                                1,304    1,756       -0-
         Commission & fees                            1,194      496      2,290
         Contract labor                               3,000    1,200      4,800
         Depreciation                                  -0-       490       -0-
         Employee benefit programs                    1,200     -0-        -0-
         Office                                         160      210       -0-
         Rental:
          Vehicles, machinery, equipment               -0-      -0-       1,682
         Repairs & maintenance                         -0-       360       -0-
         Supplies                                     1,281      784        722
         Taxes & licenses                              -0-        49       -0-
         Travel                                       1,820      966      1,614
         Deductible meals & entertainment               208      230       -0-
         Other                                        2,739    2,885      3,894
           Total                                     20,196   17,996     23,002

        Net loss                                     10,776    8,166      8,912

        C.     Itemized Deductions

        Petitioners claimed the following itemized deductions on their Schedules A,

Itemized Deductions:
                                        - 13 -

[*13]                                             2006         2007        2008

   Medical and dental expenses                   $7,280         -0-         -0-
   Less: 7.5% limit                               (4,254)       -0-         -0-
    Net                                            3,026        -0-         -0-

   State and Local income taxes                   3,040      $3,303       $3,400
   Other taxes                                     -0-         -0-        11,405
    Total                                         3,040       3,303       14,805

   Home mortgage interest                         5,000       5,000         -0-

   Gifts to charity                                 370         980        1,940

   Employee business expenses                      3,829      4,147        3,816
   Tax preparation fees                               29       -0-          -0-
    Total                                          3,858      4,147        3,816
   Less: 2% limit                                 (1,134)    (1,226)      (1,493)
    Net                                            2,724      2,921        2,323
     Total                                       14,160      12,204       19,068

        Petitioners paid the reported mortgage interest to Mr. Ericson’s uncle. The

mortgage was a second mortgage on petitioners’ vacation home in the State of

Washington.

        Petitioners filed Forms 2106, Employee Business Expenses, in connection

with the employee business expense deductions claimed. These deductions were

claimed with respect to Mrs. Ericson’s work as a nurse. The employee business

expenses reflected payments that petitioners claimed they made for union dues,

uniforms, and seminars related to Mrs. Ericson’s work.
                                        - 14 -

[*14] D.     Education Credits

       Petitioners filed Forms 8863, Education Credits (Hope and Lifetime

Learning Credits), to claim certain education credits. Petitioners claimed education

(lifetime learning) credits for 2006 and 2008 with respect to college tuition ($900

and $1,250, respectively) that they paid for their daughter. Petitioners claimed the

education (lifetime learning) credit for 2007 with respect to $1,800 of expenses

related to Mr. Ericson.

VII.   Mr. Ericson’s Return Preparer Clients

       A.    Overview

       Mr. Ericson’s tax return preparation clients included Mr. and Mrs. K and

Mr. and Mrs. J.3 Mr. Ericson prepared the joint Federal income tax returns that the

Ks and the Js filed for 2007 and 2008. Mr. Ericson prepared those returns

primarily on the basis of a wide range of information that he elicited from the Ks

and from the Js, as to their finances and activities, in meetings with them. The Ks

and the Js gave Mr. Ericson very few documents to support that information.




       3
       These clients’ surnames are irrelevant and we see no purpose in revealing
them in this opinion.
                                        - 15 -

[*15] B.      The Ks’ Returns

              1.        Background

       The Ks each worked for a resort hotel in Hawaii during 2007 and 2008.

Mr. K worked in security and Mrs. K in guest relations. Mrs. K was unemployed

at the start of 2007.

       Mr. Ericson met with the Ks twice with respect to each return, the first time

for a consultation to enable Mr. Ericson to prepare the return and the second time

for the Ks to pick up the return. Mr. Ericson questioned Mr. K at the consultation

meetings concerning the Ks’ financial and personal circumstances. The only

documents that the Ks gave Mr. Ericson to prepare their 2007 and 2008 returns

were the Forms W-2, Wage and Tax Statement, issued to them by their employer.

The Ks filed their 2007 and 2008 returns after reviewing and signing them.

              2.        2007 Return

                        a.   Overview

       The Ks’ 2007 return included (in relevant part) a Schedule A, a Schedule C

for Mr. K, a Form 2106 for Mr. K, a Form 2106 for Mrs. K, and a Form 8863.
                                        - 16 -

[*16]               b.     Schedule A

        The Schedule A reported, among other things, that the Ks paid $16,460 4 in

employee business expenses, as detailed in attached Forms 2106 for Mr. K and

Mrs. K listing each spouse’s total employee business expenses of $6,315 and

$10,145, respectively, incurred in connection with their employment. The Forms

2106 reported the breakdown of the paid amounts as follows:

                   Expense                               Mr. K            Mrs. K
    Overnight travel                                     $660              $730
    Meals and entertainment                               870             1,630
    Less: 50% of meals and entertainment                 (435)              (815)
    Other business                                      5,220              8,600
        Total                                            6,315            10,145

The Ks did not provide any information or documents to Mr. Ericson concerning

employee business expenses they incurred during 2007.

                    c.     Schedule C

        Mr. K’s Schedule C reported that his business or profession was

“professional artist” and “athlete”. The Schedule C further reported that Mr. K’s

sole proprietorship’s gross income was $4,260 (i.e., gross receipts or sales of



        4
        The Schedule A itemized a $15,828 deduction with respect to the $16,460
(after a reduction equal to 2% of the K’s adjusted gross income).
                                       - 17 -

[*17] $4,620 less cost of goods sold of $360) and that its expenses totaled $24,826,

resulting in a net loss of $20,566. The Schedule C further reported that Mr. K

operated this sole proprietorship in a prior year. Mr. K did not advise Mr. Ericson

that he had any sole proprietorship during 2007.

                   d.     Form 8863

       The Ks’ Form 8863 reported that they were entitled to claim an $1,180

education (Hope) credit. The form reported Mrs. K as the student qualifying for

the credit.

              3.   2008 Return

                   a.     Overview

       The Ks’ 2008 return included (in relevant part) a Schedule A, a Schedule C

for Mrs. K, a Form 2106 for Mr. K, and a Form 2106 for Mrs. K. The Ks’ 2008

return did not report any income or expense for Mr. K’s sole proprietorship

reported on the Ks’ 2007 return.

                   b.     Schedule A

       The Schedule A reported, among other things, that the Ks paid $9,001 5 in

employee business expenses, as detailed in attached Forms 2106 for Mr. and

Mrs. K listing each spouse’s total employee business expenses of $4,459 and

       5
        The Schedule A itemized a $7,498 deduction with respect to the $9,001
(after a reduction equal to 2% of the K’s adjusted gross income).
                                        - 18 -

[*18] $4,542, respectively, incurred by them in connection with their employment.

The Forms 2106 reported the breakdown of the claimed amounts as follows:

                    Expense                            Mr. K         Mrs. K

      Meals and entertainment                          $810           $685
      Less: 50% of meals and entertainment              (405)          (342)
      Other business                                   4,054          4,199
       Total                                           4,459          4,542

      The Ks never provided any information or documents to Mr. Ericson that

Mr. K believed indicated that the Ks incurred any employee business expense

during 2008.

                    c.    Schedule C

      Mrs. K’s Schedule C reported that she worked during the year as a

“professional artist” and “sports promo”. The Schedule C further reported that

Mrs. K’s sole proprietorship’s gross income was $1,460 and that its expenses

totaled $15,446, resulting in a net loss of $13,986. The Schedule C further

reported that Mrs. K started this business in 2008.

               4.   Respondent’s Examination of the Ks’ Returns

      Respondent examined the Ks’ 2007 and 2008 returns. After questioning Mr.

K concerning his 2007 business activity, the examiner concluded that Mr. K was

not engaged in the claimed business. The examiner also disallowed the claimed

employee business expense deductions.
                                         - 19 -

[*19] C.      The Js’ Returns

              1.    Background

        During 2007 and 2008 Mr. J worked primarily as general manager of a

swimming pool maintenance business. He worked in that capacity during 2007 as

an employee and during 2008 as the owner of a sole proprietorship that he started

that year. Mrs. J, his then wife, was primarily a homemaker during 2007 and

provided administrative assistance for Mr. J’s pool maintenance business during

2008.

        Mr. Ericson met with the Js twice with respect to each return. Before

preparing each return, Mr. Ericson asked the Js questions about their income-

producing activities and expenses (primarily Mr. J’s). Mr. J informed Mr. Ericson

that he enjoyed auto racing, that he spent a lot of money on this activity, and that

he expected to profit from the activity because of the prize money that could be

won. The Js also advised Mr. Ericson that Mrs. J performed administrative duties

for Mr. J’s pool maintenance business during 2008, that the value of these services

was $300 a month, and that Mrs. J used her personal automobile to perform some

of those administrative services. Mrs. J also advised Mr. Ericson that she took

dance classes at a cost of $100 per month.
                                         - 20 -

[*20]         2.     2007 Return

                     a.    Overview

        The Js’ 2007 return included (in relevant part) a Schedule C for Mr. J and a

Form 8863.

                     b.    Schedule C

        Mr. J’s Schedule C reported that he worked during the year in “vehicle

racing”, “dance”, and “sports promos”. The Schedule C reported that the sole

proprietorship’s gross receipts and gross income were both $2,320 and that its

expenses totaled $21,578, resulting in a net loss of $19,258. The Schedule C

reported that Mr. J had conducted this activity in a prior year.

                     c.    Form 8863

        The Js’ Form 8863 claimed an education (lifetime learning) credit of $240

with respect to Mrs. J. The form reported that the credit was claimed with respect

to $1,200 of qualifying expenses. The expenses reflected the cost of dance classes

which Mrs. J took during 2007. Mrs. J aspired to be a dance teacher, and at the

time of trial she had recently started a business teaching dance.
                                         - 21 -

[*21]         3.     2008 Return

                     a.    Overview

        The Js’ 2008 return included (in relevant part) Schedules C for both Mr. J

and Mrs. J.

                     b.    Schedules C

        Mr. J’s Schedule C reported that he operated a sole proprietorship involving

“pool repair”, “competitive sports”, and “musician”. The Schedule C further

reported that the sole proprietorship’s gross income was $32,660 (gross receipts of

$41,290 less cost of goods sold of $8,630) and that its expenses totaled $19,716,

resulting in a net profit of $12,944. One reported expense was contract labor of

$3,600.

        Mrs. J’s Schedule C reported that she operated a sole proprietorship

involving “administrative” and “dance competitions”. The Schedule C further

reported that the sole proprietorship’s gross income and receipts were both $3,600

and that its expenses totaled $2,640, resulting in a net profit of $960. The $3,600

in income was attributable to the administrative services that Mrs. J performed for

Mr. J’s pool maintenance business. The expenses related mainly to Mrs. J’s use of

her automobile in performing some of those services.
                                        - 22 -

[*22]          4.   Respondent’s Examination of the Js’ Returns

        Respondent examined the Js’ 2007 and 2008 returns. Respondent

disallowed some expense deductions that Mr. J claimed with respect to a computer

that he bought for his business. Respondent also made an adjustment with respect

to Mrs. J’s reported dance expenses, the nature of which is not disclosed in the

record. The record does not reveal what further adjustments, if any, were made to

the returns.

VIII. Examination of Petitioners’ Returns

        Petitioners’ returns for the years at issue were examined. Carl Van Zweden

was the Internal Revenue Service (IRS) revenue agent who performed the

examination. Previously, Mr. Van Zweden had examined various returns that

Mr. Ericson had prepared for clients (client returns). Mr. Van Zweden’s

examination of the client returns stemmed from complaints the IRS had received

from local tax practitioners concerning returns they had become aware of that

Mr. Ericson prepared. Mr. Van Zweden initially reviewed approximately 30 client

returns and selected approximately 15 for examination. Mr. Van Zweden

concluded after examining the 15 client returns that they tended to have at least one

questionable Schedule C and oftentimes inflated employee business expenses and

unallowable education credits.
                                        - 23 -

[*23] Mr. Van Zweden concluded from the examination of the approximately 15

returns that Mr. Ericson was a “problem return preparer”. As a consequence,

Mr. Van Zweden examined petitioners’ returns for the years at issue. In the course

of his examination, Mr. Van Zweden interviewed Mr. Ericson. During the

interview, Mr. Ericson did not specify the manner in which petitioners kept records

for their sole proprietorships. Mr. Van Zweden also requested various documents

concerning the years at issue. Petitioners did not timely respond to Mr. Van

Zweden’s requests but at various times provided him with summary schedules that

they prepared in response to the requests. Petitioners also gave Mr. Van Zweden

bank and credit card statements substantiating payment of some, but not all,

expenses claimed.

      Mr. Van Zweden performed a bank deposits analysis to ascertain petitioners’

gross receipts from their sole proprietorships. In connection with that analysis,

Mr. Van Zweden also estimated Mr. Ericson’s gross receipts from his tax

preparation activity for each year at issue by consulting IRS records and documents

regarding the number of income tax returns that Mr. Ericson prepared. Mr. Van

Zweden concluded from his examination that petitioners had unexplained deposits

(and thus that Mr. Ericson’s sole proprietorship had unreported gross receipts) of
                                         - 24 -

[*24] $64,905, $7,502, and $20,552 for 2006, 2007, and 2008, respectively.6

Respondent has since conceded that petitioners’ unreported sole proprietorship

income was $4,905 and $5,552 for 2006 and 2008, respectively, and that they

overreported such income by $1,855 for 2007.

IX.   Notice of Deficiency

      A.      Petitioners’ Schedules C

      Respondent issued a notice of deficiency to petitioners determining that they

had unreported gross receipts in the amounts just noted ($64,905, $7,502, and

$20,552 for 2006, 2007, and 2008, respectively). The notice also disallowed most

of the expense deductions that petitioners claimed with respect to their sole

proprietorships, on the grounds that petitioners had failed to show that the expenses

were paid or incurred or had the requisite business purpose. The gross receipts and

expenses, as reported, and the amounts of the disallowed expense deductions were

as follows:




      6
       Respondent did not make any adjustment to the gross receipts reported on
the Schedules C filed for Mrs. Ericson’s sole proprietorship.
                                                      - 25 -

[*25]                                        Mr. Ericson’s Schedules C


                                         2006                             2007                  2008

        Item                   Reported        Disallowed      Reported Disallowed        Reported Disallowed

Gross receipts                     $79,640                     $91,760                    $107,450
Cost of goods sold                  34,797      $24,212         37,310       $36,250        57,120     $57,120
Advertising                            260           -0-           540           -0-           -0-         -0-
Car and truck expenses               1,882        1,882          4,675         4,675        1,029        1,029
Commissions & fees                     984          341            722           722          -0-         -0-
Contract labor                         -0-          -0-          1,510         1,510          -0-         -0-
Depreciation                         2,358          725            877           -0-          870         -0-
Interest--other                        -0-          -0-            260           260          -0-         -0-
Office expenses                        987          733          1,977         1,977          -0-         -0-
Rental expenses:
 Vehicles, machinery, equip.         3,220        3,220            -0-              -0-       -0-            -0-
 Other bus. property                11,106           30         15,137            5,979    14,260           2,359
Repairs & maintenance                  590          590            896              -0-       -0-            -0-
Supplies                               917          571          2,694            2,694     3,860           3,860
Taxes & licenses                     3,469        3,469          3,356            3,356     3,166           3,166
Travel                               2,862        2,862          3,961            3,961       942             942
Deductible meals & entertainment       461          461            430              430       845             845
Other expenses                       5,343        3,540          7,208            7,208     3,763           3,763
 Total                              69,236       42,576         81,553           69,022    85,855          73,084

Expense deductions allowed                       26,660                          12,531                    12,771

                                             Mrs. Ericson’s Schedules C

                                              2006                         2007                     2008

        Item                   Reported Disallowed             Reported     Disallowed    Reported Disallowed

Gross receipts                   $9,420                         $9,830                    $14,090
Cost of goods sold                7,050          $4,450          8,260           $5,420     7,640          $4,840
Advertising                         240             240            310              310       360             360
Car and truck expenses            1,304           1,304          1,756            1,756       -0-             -0-
Commissions & fees                1,194           1,194            496              496     2,290           2,290
Contract labor                    3,000           3,000          1,200            1,200     4,800           4,800
Depreciation                        -0-             -0-            490              490       -0-             -0-
Employee benefit programs         1,200           1,200            -0-              -0-       -0-             -0-
Office expenses                     160             160            210              210       -0-             -0-
Rental expenses:
 Vehicles, machinery, equip.        -0-             -0-             -0-             -0-     1,682           1,682
Repairs & maintenance               -0-             -0-            360              360       -0-             -0-
Supplies                          1,281           1,074            784              -0-       722             -0-
Taxes & licenses                    -0-             -0-              49             -0-       -0-             -0-
Travel                            1,820           1,820            966              966     1,614           1,614
Deductible meals & entertainment    208             208            230              230       -0-             -0-
Other expenses                    2,739           2,739          2,885            2,885     3,894           3,894
 Total                           20,196          17,389         17,996           14,323    23,002          19,480
Expense deductions allowed                        2,807                           3,673                     3,522
                                        - 26 -

[*26] B.     Other Income

      Respondent determined for 2006 that petitioners failed to report $3,520 of

income from the cancellation of debt. Two entities reported to the IRS on Forms

1099-C, Cancellation of Debt, that they forgave debt totaling $3,520. Respondent

also determined for 2006 and 2008, respectively, that petitioners failed to report

$262 of income from a State income tax refund and overreported $817 of income

from a State income tax refund. Respondent’s determinations as to the State

income tax refunds arose from Forms 1099-G, Certain Government Payments,

filed by the Hawaii Department of Taxation.

      C.     Other Items

      Respondent also determined that petitioners owed additional self-

employment tax of $15,772, $13,125, and $17,227 for 2006, 2007, and 2008,

respectively. Respondent correspondingly determined for those respective years

that petitioners were entitled to additional self-employment tax adjustments of

$7,151, $5,842, and $7,088.

      Respondent further disallowed all of petitioners’ claimed itemized

deductions for 2006 and 2007, on the grounds that petitioners had not shown that

the expenses were paid or incurred or, where relevant, had the requisite business

purpose. Respondent instead allowed the standard deductions for those years. For
                                        - 27 -

[*27] 2008 respondent disallowed only miscellaneous deductions of $2,522

claimed on the Schedule A, allowing the remaining $16,546 of itemized deductions

claimed.

      Respondent disallowed the education credits claimed for all years at issue

because, respondent determined, those credits were limited by petitioners’

“modified adjusted gross income”. (Respondent’s adjustments to petitioners’

income caused computational adjustments to their “modified adjusted gross

income” reported on the returns.)

                                     OPINION

I.    Burden of Proof

      The Commissioner’s determinations of deficiencies in tax as set forth in a

notice of deficiency are generally presumed correct, and the taxpayer bears the

burden of proving those determinations wrong. See Welch v. Helvering, 290 U.S.

111, 115 (1933); see also Rule 142(a)(1).7

      The Court of Appeals for the Ninth Circuit, to which an appeal of this case

would ordinarily lie, has held that the presumption of correctness attaches to a

notice of deficiency in the case of unreported income only when the Commissioner

establishes a minimal evidentiary foundation demonstrating that the taxpayer

      7
       Petitioners have not claimed or shown entitlement to any shift in the burden
of proof to respondent pursuant to sec. 7491(a).
                                        - 28 -

[*28] received unreported income. See Palmer v. U.S. IRS, 116 F.3d 1309, 1312-

1313 (9th Cir. 1997); Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir.

1982). Once such a foundation is established, the burden shifts to the taxpayer to

prove the portion of the unreported income that is not taxable. See Hardy v.

Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo. 1997-97;

Palmer, 116 F.3d at 1312-1313.

      As to the fraud penalties, as more fully discussed infra, the burden of proof

rests with respondent to demonstrate fraud by clear and convincing evidence. See

sec. 7454(a); Rule 142(b); Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).

II.   Sole Proprietorship Income

      Gross income includes all income from whatever source derived, see sec.

61(a), and taxpayers are required to keep books and records sufficient to establish

their Federal income tax liabilities, see sec. 6001; DiLeo v. Commissioner, 96 T.C.

858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); see also sec. 1.6001-1(a), (b),

(e), Income Tax Regs. If a taxpayer fails to maintain adequate records, the

Commissioner may determine the taxpayer’s income by using the bank deposits

method. See DiLeo v. Commissioner, 96 T.C. at 868. A bank deposit is prima

facie evidence of income. See id. Once the Commissioner has made a prima facie

case, the taxpayer bears the burden of showing that deposits made into the account
                                         - 29 -

[*29] represent nontaxable income (e.g., deposits related to gifts, inheritances,

loans, or transfers between bank accounts). See id. at 869.

       Petitioners failed to maintain adequate records for the years at issue.

Respondent therefore reconstructed petitioners’ sole proprietorship income for

those years by using the bank deposits method. On the basis of respondent’s bank

accounts analysis, as later adjusted to reflect additional information that petitioners

gave respondent after the initial analysis, respondent asserts that petitioners failed

to report $5,552 of sole proprietorship income for 2008. Petitioners offer no

explanation as to why the $5,552 is not from a taxable source. We sustain

respondent’s determination that the $5,552 is from a taxable source (specifically,

Mr. Ericson’s sole proprietorship) and that the $5,552 is includible in petitioners’

taxable income for 2008.

III.   Sole Proprietorship Expenses

       Section 162(a) entitles a taxpayer to deduct “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business”. Under that section, an expenditure is deductible if it is: (1) an expense,

(2) an ordinary expense, (3) a necessary expense, (4) paid (in the case of a cash

method taxpayer) or incurred (in the case of an accrual method taxpayer) during

the taxable year, and (5) made to carry on a trade or business. See Commissioner
                                        - 30 -

[*30] v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352-353 (1971); Lychuk v.

Commissioner, 116 T.C. 374, 386 (2001). Deductions are a matter of legislative

grace, and taxpayers bear the burden of proving that they are entitled to any

claimed deduction. See INDOPCO Inc. v. Commissioner, 503 U.S. 79, 84 (1992);

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). This burden

includes substantiating the amount and purpose of each expense claimed as a

deduction, see Higbee v. Commissioner, 116 T.C. 438, 440 (2001), and

maintaining records relating to the expense, see sec. 6001.

      Taxpayers aiming to deduct expenses for (among other things) travel,

entertainment, and the use of a vehicle also must meet strict substantiation rules set

forth in section 274(d). See sec. 274(d); see also sec. 280F(d)(4)(A)(i). These

rules require that a taxpayer substantiate, by adequate records or by other sufficient

evidence corroborating his or her own statement, each of the following elements:

(1) the amount of an expense; (2) the time and place the expense was incurred;

(3) the business purpose of the expense; and (4) in the case of entertainment

expenses, the business relationship to the taxpayer of the person entertained. See

sec. 274(d); see also sec. 1.274-5T, Temporary Income Tax Regs., 50 Fed. Reg.

46014 (Nov. 6, 1985). Adequate records for this purpose require that the taxpayer

provide (1) an account book, a log, or a similar record and (2) documentary
                                         - 31 -

[*31] evidence (e.g., receipts, paid bills, or similar evidence), which together are

sufficient to establish each element of an expenditure. See sec. 1.274-5T(c)(2)(i),

Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985). Section 274(d)

supersedes the general rule of Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d

Cir. 1930), which allows the Court to estimate an expense where the record is

insufficient to establish the specific amount of the expense, and precludes the

Court from estimating a taxpayer’s expenses subject to the strict substantiation

requirement. See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per

curiam, 412 F.2d 201 (2d Cir. 1969); see also sec. 1.274-5T(a), Temporary Income

Tax Regs., supra.

      Respondent disallowed petitioners’ deductions of $92,564 in sole

proprietorship expenses for 2008 (i.e., $73,084 from Mr. Ericson’s sole

proprietorship plus $19,480 from Mrs. Ericson’s sole proprietorship). We sustain

this disallowance because petitioners failed to offer evidence that showed their

entitlement to any of the claimed deductions. While respondent concedes that

petitioners’ sole proprietorships are valid businesses, and we consider it reasonable

to assume petitioners in conducting those businesses incurred many deductible

expenses, petitioners have left us with an insufficient evidentiary basis to conclude

that they are entitled to any deduction in an amount greater than respondent
                                        - 32 -

[*32] allowed. See Sparkman v. Commissioner, 509 F.3d 1149, 1159 (9th Cir.

2007) (noting that taxpayers bear the burden of “clearly showing” their right to a

claimed deduction), aff’g T.C. Memo. 2005-136. Nor do we consider it

appropriate to estimate any additional deductible expense under Cohan, and as

applicable here. Edelson v. Commissioner, 829 F.2d 828, 831-832 (9th Cir. 1987),

aff’g T.C. Memo. 1986-223. The Cohan rule, as trumped by the strict

substantiation regulations, does not allow us to estimate petitioners’ expenses for

entertainment, travel, and meals, and the record does not allow us to comfortably

estimate any of petitioners’ other claimed expense deductions in greater amounts

than respondent allowed. See also Norgaard v. Commissioner, 939 F.2d 874, 879

(9th Cir. 1991) (stating that, under the Cohan rule, a court “may not be compelled

to guess or estimate * * * even though such an estimate, if made, might have been

affirmed” (alteration in original) (quoting Williams v. United States, 245 F.2d 559,

560 (5th Cir. 1957))), aff’g in part, rev’g in part on another ground T.C. Memo.

1989-390.

IV.   Employee Business Expenses

      Respondent disallowed petitioners’ deduction of $3,816 in employee

business expenses for 2008. Petitioners claimed the employee business expense

deductions with respect to Mrs. Ericson’s work as a nurse. Although we do not
                                         - 33 -

[*33] consider it unreasonable to conclude that Mrs. Ericson’s work as a nurse

required that she pay for seminars, uniforms, and membership in a union, the

record does not establish (and we decline to find) that petitioners did in fact pay

these expenses or, even if they did, the specific or approximate amounts of the

expenses. We sustain respondent’s determination on this matter in full for reasons

similar to those set forth in our discussion of petitioners’ sole proprietorship

expenses.

V.    Fraud and Accuracy-Related Penalties

      Respondent determined that both petitioners are liable for section 6663 fraud

penalties for each year at issue. In relevant part, section 6663 provides:

      SEC. 6663. IMPOSITION OF FRAUD PENALTY.

             (a) Imposition of Penalty.--If any part of any underpayment of
      tax required to be shown on a return is due to fraud, there shall be
      added to the tax an amount equal to 75 percent of the portion of the
      underpayment which is attributable to fraud.

             (b) Determination of Portion Attributable to Fraud.--If the
      Secretary establishes that any portion of an underpayment is
      attributable to fraud, the entire underpayment shall be treated as
      attributable to fraud, except with respect to any portion of the
      underpayment which the taxpayer establishes (by a preponderance of
      the evidence) is not attributable to fraud.

      We may sustain respondent’s determinations of fraud only if respondent

proves clearly and convincingly that (1) petitioners underpaid their tax and (2) at
                                         - 34 -

[*34] least some part of each underpayment was due to fraud (two-prong test). See

sec. 7454(a); Rule 142(b); Estate of Trompeter v. Commissioner, 279 F.3d 767,

773 (9th Cir. 2002), vacating and remanding on other grounds T.C. Memo. 1998-

35 supplemented by 111 T.C. 57 (1998); see also Parks v. Commissioner, 94 T.C.

654, 663-664 (1990) (noting that the Commissioner must clearly and convincingly

prove both prongs of the two-prong test). “Clear and convincing evidence is that

measure or degree of proof which will produce in the mind of the trier of facts a

firm belief or conviction as to the allegations sought to be established. It is

intermediate, being more than a mere preponderance, but not to the extent of such

certainty as is required beyond a reasonable doubt as in criminal cases. It does not

mean clear and unequivocal.” Ohio v. Akron Ctr. for Reprod. Health, 497 U.S.

502, 516 (1990) (quoting Cross v. Ledford, 120 N.E.2d 118, 123 (Ohio 1954)).

Where, as here, respondent determined that both petitioners are liable for the fraud

penalty for multiple years, respondent must prove his fraud determinations

separately for each year and each petitioner. See Estate of Stein v. Commissioner,

25 T.C. 940, 959-963 (1956), aff’d sub nom. Levine v. Commissioner, 250 F.2d

798 (2d Cir. 1958).

      We decide first whether respondent adequately proved that petitioners both

had the requisite fraudulent intent for each year at issue. A fraudulent intent is
                                          - 35 -

[*35] present if petitioners filed their tax returns for the years at issue intending to

conceal, mislead, or otherwise prevent the collection of tax that they knew was

owed. See Spies v. United States, 317 U.S. 492, 499 (1943); Akland v.

Commissioner, 767 F.2d 618, 621 (9th Cir. 1985), aff’g T.C. Memo. 1983-249;

Conforte v. Commissioner, 692 F.2d 587, 592 (9th Cir. 1982), aff’g in part, rev’g

in part on other grounds 74 T.C. 1160 (1980); Rowlee v. Commissioner, 80 T.C. at

1123. A fraudulent intent may be proven by circumstantial evidence because

direct proof of a taxpayer’s intent is rarely available, see Rowlee v. Commissioner,

80 T.C. at 1123; Beaver v. Commissioner, 55 T.C. 85, 92 (1970); and reasonable

inferences may be drawn from the relevant facts, see Spies, 317 U.S. at 499;

Akland v. Commissioner, 767 F.2d at 621; Stephenson v. Commissioner, 79 T.C.

995, 1006 (1982), aff’d, 748 F.2d 331 (6th Cir. 1984). Whether fraud exists in a

given situation is a factual determination that must be made after reviewing the

particular facts and circumstances of the case. See DiLeo v. Commissioner, 96

T.C. at 874.

      Courts usually rely on certain indicia (or badges) of fraud in deciding

whether a taxpayer had the requisite fraudulent intent. The badges of fraud

include: (1) understated income; (2) maintaining inadequate records; (3) failing to

file tax returns; (4) implausible or inconsistent explanations of behavior;
                                         - 36 -

[*36] (5) concealing income or assets; (6) failing to cooperate with tax authorities;

(7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated

tax payments; and (10) filing false documents. See Estate of Trompeter v.

Commissioner, 279 F.3d at 773; Bradford v. Commissioner, 796 F.2d 303,

307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Recklitis v. Commissioner,

91 T.C. 874, 910 (1988); see also Spies, 317 U.S. at 499-500. These badges of

fraud are nonexclusive. See Niedringhaus v. Commissioner, 99 T.C. 202, 211

(1992). The taxpayer’s education and business background are also relevant to the

determination of fraud. See id.

      Respondent argues that “[m]ost significantly, petitioner James A. Ericson’s

methodology in preparing his clients’ returns demonstrates a pattern of conduct

which infers [sic] a clear intent to mislead. In preparing tax returns for his clients,

petitioner James A. Ericson consistently fabricated various schedules and forms

that had no factual basis.” Respondent points to the Ks’ and the Js’ returns for

2007 and 2008 as support for this argument. Respondent asserts that Mr. Ericson

prepared those returns to report the results of sole proprietorships that never

existed. Respondent asserts that Mr. Ericson also prepared the Ks’ returns to

report employee business expenses for which the Ks did not provide Mr. Ericson

any information. Respondent concludes that Mr. Ericson’s preparation of the Ks’
                                          - 37 -

[*37] and the Js’ 2007 and 2008 returns “was part of a consistent pattern of

preparing returns for clients that included fabricated or inflated schedules”, that

“[t]his pattern of conduct is indicative of * * * [Mr. Ericson’s] clear intent to

deceive or mislead the respondent with regard to his clients’ tax returns”, and that

“[a] strong inference arising from this pattern of conduct is * * * [Mr. Ericson’s]

intent to deceive or mislead regarding his own income tax returns.” Respondent

also discusses some of the badges of fraud as further support for his determinations

of fraud. The badges of fraud upon which respondent relies are understated

income, failure to maintain adequate books and records, dealing in cash, providing

implausible or inconsistent explanations of behavior with an intent to mislead,

failing to provide documents to respondent during the audit, and Mr. Ericson’s

knowledge and experience as a tax return preparer.

      We begin our analysis with respondent’s “most significant” indicia of fraud;

i.e., his claim that Mr. Ericson’s preparation of the Ks’ and the Js’ tax returns for

2007 and 2008 establishes a clear, consistent pattern of fraudulent conduct. We do

not agree that the record establishes the proffered pattern of fraudulent conduct.

Respondent had more than the customary three years to examine petitioners’ tax

returns for two of the years at issue, yet he has opted to rest his assertions of a

consistent pattern of fraudulent conduct on only four of the over 2,500 Federal
                                         - 38 -

[*38] income tax returns that Mr. Ericson prepared for his clients for the years at

issue. See Avenell v. Commissioner, T.C. Memo. 2012-32, 103 T.C.M. (CCH)

1180, 1181 (2012) (noting that the Commissioner failed to build the requisite

record to prove fraud, although he had an extraordinarily long period of time to do

so). The four client returns do not clearly and convincingly lead to a finding that

petitioners’ returns are tainted by fraud.

      Petitioners objected at trial to respondent’s offer of information concerning

the preparation of the client returns. That information was admitted over

petitioners’ objection. Evidence of an individual’s crimes, wrongs, or other acts is

generally not admissible to prove the character of the individual to show action in

conformity therewith. See Fed. R. Evid. 404(b). Such evidence is generally

admissible, however, to show motive, opportunity, intent, preparation, plan,

knowledge, identity, or absence of mistake or accident. See id. The Court of

Appeals for the Ninth Circuit views rule 404(b) of the Federal Rules of Evidence

as a “rule of inclusion”, see United States v. Ayers, 924 F.2d 1468, 1472-1473 (9th

Cir. 1991), and has held that evidence of other acts is admissible under that rule

where the evidence (1) proves a material issue in the case, (2) if admitted to prove

intent, is similar to the offense charged, (3) is based on sufficient evidence, and

(4) is not too remote in time, see United States v. Ramirez-Robles, 386 F.3d 1234,
                                          - 39 -

[*39] 1242 (9th Cir. 2004); see also Sherrer v. Commissioner, T.C. Memo. 1999-

122, 77 T.C.M. (CCH) 1795, 1804-1805 (1999), aff’d, 5 F. App’x 719 (9th Cir.

2001).

         The probative value of the four returns and their preparation is weak,

however, when viewed in the light of Mr. Van Zweden’s testimony that he

discerned a consistent pattern of fraudulent conduct from his belief that the client

returns had at least one improper Schedule C and sometimes inflated employee

business expenses and unallowable education credits.8 We acknowledge that the

Ks’ returns tend to confirm such a pattern. The record establishes that upon

examination the purported business reflected on Mr. K’s Schedule C for 2007 was

found to be essentially fictitious. Likewise the employee business expense

deductions claimed by Mr. and Mrs. K for 2007 and 2008 were disallowed (and

they are quite improbable on their face, given the Ks’ occupations). Yet the record




      8
        In reaching our conclusion concerning the probative value of the client
returns that are in evidence, we are mindful that in February 2015 a U.S. District
Court permanently enjoined Mr. Ericson from acting as a paid Federal tax return
preparer. See United States v. Ericson, No. 13-00551 (D. Haw. filed Oct. 23,
2013) (orders of Feb. 20, 2015, and Nov. 30, 2014). The District Court granted
summary judgment on most of the Government’s claims, and a permanent
injunction, on the basis of considerably more extensive proof concerning
Mr. Ericson’s return preparer activity. See id. That additional activity is not a part
of the record in this case, and we reach our decision on the basis of the record
before us.
                                         - 40 -

[*40] is also incomplete, as there is no evidence concerning whether Mrs. K’s

claimed Schedule C business for 2008 was found during the examination to be

fictitious.9

       By contrast, the Js’ returns tend to rebut the pattern that respondent would

have us find. The evidence does not persuade us that the Schedules C the Js filed

for each year were for fictitious businesses and therefore evidence of fraudulent

intent--certainly not under a clearly and convincingly standard. The Schedule C

Mr. J filed for 2007 reported the sole proprietorship’s business as including

“vehicle racing”. Given the undisputed testimony that Mr. J had advised

Mr. Ericson that he engaged in auto racing at considerable expense but that sizable

monetary awards could be won, we are not persuaded that the Schedule C reported

a fictitious business. The Schedule C may instead have represented an aggressive

claim (given the section 183 restrictions on the deduction of losses from activities

not engaged in for profit) that Mr. J’s auto racing activities constituted a trade or

business engaged in for profit, the losses of which could be deducted. On this

record it is impossible to say more, but a fictitious business has not been clearly

and convincingly shown. Nor, it should be added, does the record establish that


       9
       Presumably, statutory notices of deficiency were issued to the Ks for 2007
and 2008. Such documents might have clarified the nature of the examination
adjustments, but they are not in the record.
                                         - 41 -

[*41] respondent disallowed any deductions arising from that Schedule C.10 The

evidence surrounding the Js’ claim of an education credit for 2007 is also muddled,

as Mrs. J paid for dance classes at an institution not revealed in the record and the

record does not establish whether respondent in fact disallowed the credit.

       As for the Schedule C Mr. J filed for 2008, there is undisputed evidence that

at least some portion of the business activity reflected thereon was not fictitious;

namely, that Mr. J conducted a pool maintenance business as a sole proprietor

during 2008, the results of which were reflected on his Schedule C. Certainly

respondent has not clearly and convincingly shown otherwise. Similarly, the

nonfictional nature of the Schedule C Mrs. J filed for 2008 finds support in her

testimony to the effect that she provided administrative assistance to her husband’s

pool maintenance business during 2008 and was compensated for those services in

an amount that was treated as gross receipts on her Schedule C. Whether in these

circumstances it was proper for Mr. Ericson to treat Mrs. J’s income as reportable

on a Schedule C is beside the point; what matters is that Mrs. J’s undisputed

testimony precludes a finding that respondent has clearly and convincingly shown

that Mr. Ericson caused a Schedule C for a fictitious business to be filed on

Mrs. J’s behalf.

      10
        As is the case with the Ks, any notices of deficiency that may have been
issued to the Js for 2007 and 2008 are not in the record.
                                        - 42 -

[*42] In short, the evidence surrounding the 2007 and 2008 returns that

Mr. Ericson prepared for the Js does not support the pattern that respondent would

have us find. There is substantial evidence that the businesses reflected on the Js’

Schedules C were not fictitious, the circumstances concerning the education credit

are muddled, there is no evidence concerning the extent to which the examining

agent actually disallowed any of the Schedule C or education credit claims, and the

Js’ returns did not claim any employee business expense deductions.

Consequently, we conclude that respondent has not clearly and convincingly

shown that Mr. Ericson exhibited a pattern of preparing returns with Schedules C

for fictitious businesses, inflated employee business expenses, and invalid

education credit claims.

      We also take into account that petitioners’ returns for the years at issue are

outside of the mold of the fraudulent conduct described by Mr. Van Zweden.

While Mr. Van Zweden testified that he discerned a pattern of fraudulent conduct

in the client returns on the basis of illegitimate Schedules C, respondent agrees that

the sole proprietorships reported on petitioners’ Schedules C were legitimate

businesses. In addition, while Mr. Van Zweden testified that he further discerned a

pattern of fraudulent conduct evidenced by invalidly claimed education credits,

respondent did not determine (1) that petitioners failed to pay or substantiate the
                                          - 43 -

[*43] expenses underlying their claimed education credits, (2) that the expenses

failed to qualify for the education credits, or (3) that petitioners failed to meet any

of the other requirements for the education credits. Instead, respondent determined

that petitioners’ claiming of the education credits was computationally limited to

zero because of upward adjustments that respondent made to petitioners’ income.

While respondent also determined that petitioners’ employee business expenses

were inflated because of a lack of substantiation and the inability to show the

requisite business purpose, we decline to find that this fact standing alone

establishes the fraudulent pattern of conduct that respondent seeks to establish.

         We turn to analyze the badges of fraud, giving no regard to respondent’s

claimed pattern of fraudulent conduct. The presence of several badges is

persuasive circumstantial evidence of fraud. See Beaver v. Commissioner, 55 T.C.

at 93.

         1.    Understating Income

         Understating income may reflect a fraudulent intent. See Bradford v.

Commissioner, 796 F.2d at 307. An understatement of income can be

accomplished by an overstatement of deductions as well as by an omission of

income. See Gould v. Commissioner, 139 T.C. 418, 446-447 (2012), aff’d, 552
                                         - 44 -

[*44] F. App’x 250 (4th Cir. 2014); Estate of Temple v. Commissioner, 67 T.C.

143, 161 (1976).

      Respondent asserts that petitioners failed to report income for 2006 and

2008, and we agree at least with respect to 2008. Petitioners also claimed

deductions the disallowance of which we sustain, which results in a further

understatement of income. All the same, however, we disagree with respondent’s

view that petitioners’ understatements of income necessarily lead to a conclusion

that petitioners intended to evade Federal income tax. Instead, it appears that the

understatements may have been due to petitioners’ filing of their tax returns

without maintaining adequate records. See Knutsen-Rowell, Inc. v. Commissioner,

T.C. Memo. 2011-65, 101 T.C.M. (CCH) 1293, 1305 (2011).

      2.     Maintaining Inadequate Records

      Lack of records may reflect fraudulent intent. See Bradford v.

Commissioner, 796 F.2d at 307.

      Respondent finds fraud in the fact that petitioners produced few

contemporaneous records during the examination and were unable to reconcile

their records to their returns. Respondent also finds fraud in the fact that

petitioners lacked a formal recordkeeping system. Petitioners reply that their bank

and credit card statements support most of the amounts deducted on their returns.
                                         - 45 -

[*45] To be sure, petitioners failed to maintain adequate contemporaneous records

for their sole proprietorships.11 We disagree with respondent’s position, however,

that petitioners’ failure to maintain adequate records was with the requisite intent

to evade Federal income tax. Rather, as previously indicated, petitioners’ failure to

maintain adequate records may have been the result of their negligent or reckless

behavior. See Knutsen-Rowell, Inc. v. Commissioner, 101 T.C.M. (CCH) at 1305.

This case is not one in which a taxpayer reported expenses attributable to a

fictitious business. Respondent agrees that the sole proprietorships which

petitioners reported were legitimate businesses, that those businesses generated

income, and (to a limited extent) that those businesses incurred valid business

expenses. Moreover, petitioners eventually produced documentation disproving

most of respondent’s determinations of unreported income and produced other

records (mainly bank and credit statements and later some summary schedules)

supporting their payment of expenses. Petitioners failed, however, to produce the

source documents underlying their records, and they failed to produce any other


      11
         Mr. Ericson and his son each testified that petitioners lost their accounting
records when Mr. Ericson’s computer crashed after the years at issue. We decline
to find on the basis of the credible evidence in the record that petitioners
maintained their accounting records on a computer, or that the computer later
crashed. The Court invited Mr. Ericson to offer into evidence any document
prepared contemporaneously with the examination wherein he made the claim that
his computer had crashed. Petitioners presented the Court with no such document.
                                            - 46 -

[*46] reliable documentation supporting their payment of the disallowed expenses.

The fact that petitioners did not substantiate the reported expenses for which

respondent disallowed deductions does not necessarily mean (as respondent would

have us conclude) that petitioners inflated those expenses with an intent to avoid

Federal income tax.

         3.    Failing To File Tax Returns

         Failing to file tax returns may reflect fraudulent intent. See Bradford v.

Commissioner, 796 F.2d at 307.

         Petitioners filed a tax return for each year at issue.

         4.    Implausible or Inconsistent Explanations of Behavior

         Giving implausible or inconsistent explanations of behavior may reflect

fraudulent intent. See id.

         Respondent finds fraud in the fact that Mr. Ericson testified that he lost his

records when his computer failed. Respondent asserts that this testimony reflects

an implausible or inconsistent explanation of behavior that leads to a finding of

fraud. We rejected this testimony, as discussed above, and take this into account in

deciding whether respondent has met his burden of proving fraud for each year at

issue.
                                         - 47 -

[*47] 5.     Concealing Income or Assets

      Concealing assets may reflect fraudulent intent. See id.

      Petitioners have not concealed any asset. Respondent initially determined

that petitioners had unreported Schedule C gross receipts from Mr. Ericson’s return

preparer business of $64,905, $7,502, and $20,552 for 2006, 2007, and 2008,

respectively. However, after reviewing information petitioners provided,

respondent now asserts, and we agree, that petitioners failed to report $5,552 of

sole proprietorship income for 2008 (and respondent asserts that petitioners failed

to report $4,905 of sole proprietorship income for 2006). We do not find that this

more modest amount of unreported income evidences fraudulent intent. Rather,

bearing in mind the additional fact that respondent now concedes that petitioners

overreported their sole proprietorship income for 2007 by $1,855, we conclude that

the unreported income is attributable to petitioners’ negligence in failing to

maintain adequate records for purposes of filing their returns.

      6.     Failing To Cooperate With Tax Authorities

      Failure to cooperate with tax authorities may reflect fraudulent intent. See

id.

      Respondent asserts that petitioners’ response to respondent’s request to view

their records, petitioners’ explanation underlying their claimed deductions, and
                                        - 48 -

[*48] petitioners’ failure to reconcile their summary schedules to their returns

evidence a failure to cooperate with tax authorities which leads to a finding of

fraud. We disagree.

      While Mr. Ericson did not fully cooperate with Mr. Van Zweden’s requests

during the examination, Mr. Ericson did honor Mr. Van Zweden’s request for an

interview and repeatedly provided Mr. Van Zweden with documents and with

answers. While it appears that Mr. Ericson may have made some inconsistent and

implausible statements to Mr. Van Zweden during the examination, we are not

persuaded on the basis of the record as a whole that Mr. Ericson consciously did so

to hinder the examination. See Knutsen-Rowell, Inc. v. Commissioner, 101

T.C.M. (CCH) at 1305-1306. Nor are we persuaded that petitioners’ failure to

reconcile their summary schedules to their returns was part of a plan to evade

Federal income tax. We note that Mr. Ericson informed Mr. Van Zweden during

the examination that Mr. Ericson was suffering from a significant health problem.

      7.     Engaging in Illegal Activities

      Engaging in illegal activities may reflect fraudulent intent, as may an attempt

to conceal those activities. See Bradford v. Commissioner, 796 F.2d at 308.

      Petitioners have not engaged in any illegal activity. Nor have they tried to

conceal an illegal activity. While respondent essentially asserts that Mr. Ericson
                                        - 49 -

[*49] engaged in an illegal activity concerning the preparation of tax returns for his

clients, we conclude that respondent has not established that on this record.

       8.    Dealing in Cash

       A taxpayer’s insistence that income be paid in cash may reflect fraudulent

intent, as may a taxpayer’s dealing in cash to avoid the scrutiny of the taxpayer’s

finances. See Spies, 317 U.S. at 499-500; Bradford v. Commissioner, 796 F.2d at

308.

       Respondent finds fraud in the fact that Mr. Ericson sometimes received cash

payments for his services, that he used that cash directly to pay expenses (as

opposed to depositing the cash in his bank account), and that he sometimes

withdrew cash from his bank account to pay expenses. We do not find similarly.

       Mr. Ericson’s sole proprietorship was generally not a cash business in that

his clients typically paid him by check. Although Mr. Ericson sometimes

demanded that a client pay him in cash, the demand was driven by the legitimate

business reason that Mr. Ericson did not want to receive another “bad” check from

the client. We do not find that Mr. Ericson’s demand to be paid in cash stemmed

from an intent to evade Federal income tax.

       Nor do we find fraud in the fact that Mr. Ericson sometimes paid expenses in

cash. The cash payment of expenses is less troublesome than the receipt of income
                                        - 50 -

[*50] in cash. Business expenses generally reduce taxable income, and taxpayers

typically want to document and report all of their expenses to minimize their

taxable income. Income received in cash, on the other hand, is more likely not to

be documented or reported by a taxpayer aiming to evade tax. The desire to inflate

expenses paid in cash, as opposed to deflating income received in cash, is also

controlled by the requirement that expenses be adequately substantiated to be

properly deducted. We do not find a significant underreporting of cash receipts to

convince us clearly that Mr. Ericson’s practice not to deposit his cash receipts into

his bank account, but instead to use the receipts to pay business expenses, was

done with an intent to avoid tax.

      9.     Failing To Make Estimated Tax Payments

      Failing to make required estimated tax payments is indicative of fraud. See

Bradford v. Commissioner, 796 F.2d at 308.

      The record does not establish that petitioners failed to make any required

estimated tax payment.

      10.    Filing False Documents

      Filing false documents, such as a form to evade the withholding of Federal

income tax, is indicative of fraud. See Recklitis v. Commissioner, 91 T.C. at 911.
                                           - 51 -

[*51] The record does not establish that petitioners filed any false document

related to the filing of their tax returns for the years at issue.

       11.    Other Considerations

       Respondent argues that Mr. Ericson’s education and sophistication are

circumstantial factors establishing fraud. To that end, respondent asserts,

Mr. Ericson is a sophisticated tax preparer with a master’s degree. Respondent

also notes that Mr. Ericson worked as an accountant, that he worked for a certified

public accountant, and that he prepared thousands of tax returns during a period of

more than 20 years.

       We disagree with respondent’s view that Mr. Ericson’s education, his work

as an accountant, and his profession as a tax preparer lead to a finding of fraud.

First, the record does not persuade us that Mr. Ericson is the sophisticated tax

preparer that respondent makes him out to be. Mr. Ericson had minimal education

on the preparation of income tax returns before he started his return preparation

business, and we do not find that his preparation of tax returns for his clients

strengthened his understanding of the tax law to any significant extent. In fact, the

record establishes to the contrary that Mr. Ericson is misguided in his

understanding of many areas of tax law, including, for example, the requirements

that taxpayers maintain records for their businesses and maintain sufficient
                                           - 52 -

[*52] documents to support their claims to deductions.12 Second, even if

Mr. Ericson was sufficiently knowledgeable with respect to tax law, we are not

persuaded, as discussed above, that petitioners’ failure to maintain the requisite

records was part of a plan to conceal, mislead, or otherwise prevent the collection

of tax.

          Respondent also finds fraud in the fact that petitioners claimed deductions

for “seemingly” personal items, such as expenses incurred at gas stations,

restaurants, and grocery stores, and claimed other deductions for amounts paid to

or for the benefit of their children. We disagree. The fact that an expenditure may

seem personal does not necessarily mean that the expenditure fails to be a business

expense. The deductibility of an expense also does not necessarily turn on the

identity of the payee.

          12.   Conclusion

          On the basis of our detailed review of the facts and circumstances of this

case, together with our analysis of the factors mentioned above and the other

considerations discussed, we conclude that respondent has not clearly and

          12
         We recognize that we find that Mr. Ericson took some college courses
discussing the concepts of income and deductions, that he attended some seminars,
and that he read some books on tax law. The record does not establish the
specifics of the seminars that Mr. Ericson attended following his college studies or
the matter covered in those seminars. Nor does the record establish the breadth of
his college courses or the specifics concerning the books that he read on tax law.
                                         - 53 -

[*53] convincingly proven that either petitioner filed any return for the years at

issue intending to conceal, mislead, or otherwise prevent the collection of tax.

While respondent may have a strong suspicion that petitioners filed their returns

for these years with the requisite fraudulent intent, such a suspicion of fraud (to the

extent it exists) is not enough to establish fraud clearly and convincingly. See

King’s Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 517 (1992).

We hold that petitioners are not liable for the fraud penalties for any of the years at

issue.

VI.      Negligence

         Section 6662(a) imposes a 20% penalty on that portion of an underpayment

of tax attributable to, among other things, negligence or disregard of rules or

regulations. See also sec. 6662(b)(1). Negligence includes any failure to make a

reasonable attempt to comply with the provisions of the Code, including a failure

to keep adequate books and records and/or to substantiate items properly. See sec.

6662(c); see also sec. 1.6662-3(b)(1), Income Tax Regs. Negligence also has been

defined as a lack of due care or failure to do what a reasonable person would do

under the circumstances. See Allen v. Commissioner, 925 F.2d 348, 353 (9th Cir.

1991), aff’g 92 T.C. 1 (1989). The term “disregard” indicates any careless,

reckless, or intentional disregard. See sec. 6662(c).
                                            - 54 -

[*54] The Commissioner bears the burden of production as to the applicability of

an accuracy-related penalty. See sec. 7491(c). To satisfy his burden, the

Commissioner must produce sufficient evidence showing that it is appropriate to

impose the penalty. See Higbee v. Commissioner, 116 T.C. at 446. Once the

Commissioner has met his burden of production, the burden of proof remains on

the taxpayer, including the burden of proving that a penalty is inappropriate. See

id. at 446-447.

       Respondent has met his burden of production in that he has established that

petitioners failed to maintain adequate records for their sole proprietorships and

failed to substantiate their reported expenses for 2008. Petitioners advance no

specific argument as to why they are not liable for the accuracy-related penalty for

negligence for 2008. We sustain respondent’s determination on this matter.

VII.   Conclusion

       We have considered all arguments that the parties made for holdings

contrary to those that we reach herein and, to the extent not discussed, we have

rejected those arguments as without merit.

       In order to reflect the foregoing,


                                                     Decision will be entered under

                                            Rule 155.
