                        T.C. Memo. 1997-285



                      UNITED STATES TAX COURT


               PATRICIA G. McCULLEY, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19520-94.              Filed June 24, 1997.



     Ronald W. Blasi, Tracey D. Mason, and Robert Kiser, for

petitioner.

     Bonnie L. Cameron, for respondent.




              MEMORANDUM FINDINGS OF FACT AND OPINION


     PARR, Judge:   Respondent determined deficiencies in

petitioner's Federal income taxes and additions to tax for the

taxable years 1984 and 1985 as follows:
                                - 2 -



                                   Additions   to Tax
Year    Deficiency   Sec. 6653(b)(1)1   Sec.   6653(b)(2)    Sec. 6661
1984    $13,599      $ 6,780                   *            $ 3,390
1985     11,358         5,679                  *               2,840

* 50 percent of the interest due on the deficiency in tax

       After concessions by the parties, the sole issue for

decision is whether petitioner, who failed to report embezzlement

income, is liable for additions to tax for fraud.      We hold she is

not.

                           FINDINGS OF FACT

       Some of the facts have been stipulated and, with one

exception, are so found.    The stipulated facts and the

accompanying exhibits are incorporated into our findings by this

reference.    Petitioner resided in Duluth, Georgia, at the time of

filing her petition in this case.

       For the taxable years 1984 and 1985, petitioner timely filed

Federal income tax returns, Forms 1040, as a head of household,

and as married filing jointly, respectively.2      On her tax returns

for 1984 and 1985, petitioner reported total income of $14,972

and $109,356, respectively.    Respondent determined deficiencies

1
     All section references are to the Internal Revenue Code in
effect for the taxable years in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. All dollar amounts are rounded to the
nearest dollar, unless otherwise indicated.
2
     In February of 1985, petitioner married her second husband,
Byron K. Griffith, and the couple filed a joint return for that
year.
                                - 3 -

against petitioner of $13,599 for 1984 and $11,358 for 1985.     In

determining the deficiencies for the taxable years in issue,

respondent made adjustments for the following items:     Unreported

rental income, embezzlement income, and improper real estate tax

and mortgage interest deductions.

Background

     Petitioner was raised in a poor neighborhood in Memphis,

Tennessee, in a low-income family.      At the age of 16, she married

her first husband, Charles Edward McCulley (McCulley).     The next

year petitioner became pregnant and dropped out of high school.

Petitioner's daughter and son were born in June of 1973, and July

of 1975, respectively.    In October of 1977, petitioner and

McCulley were divorced.

     In 1983, petitioner completed the requirements for a general

equivalency diploma (GED), the highest degree she has attained.

In 1984, petitioner took courses as a non-matriculated student at

Memphis State University for which she received an A, a B, and

two failing grades.    Petitioner has had no education or training

in business or tax matters.

     During the years in issue, petitioner became involved in a

relationship with Byron Kelly Griffith (Griffith), a man she

married in 1985.   Griffith physically, mentally, and emotionally

abused petitioner.    During their separation a neighbor once

called police, who arrested Griffith when they caught him choking
                                - 4 -

petitioner and beating her head against the garage wall.

Petitioner divorced Griffith in December of 1988.

     From June of 1980 through June of 1986, petitioner was

employed by Republic Airlines (Republic) in Memphis, Tennessee.

Petitioner was responsible for collecting liquor sales money from

a safe at the Memphis Airport where flight attendants made cash

deposits after landing.

     In November of 1988, a month before petitioner's divorce

from Griffith was final, he notified Republic that petitioner had

in the past embezzled funds.3   Republic did not press charges but

did inform the Internal Revenue Service (IRS).     Thereafter, in

May of 1989, the Criminal Investigation Department (CID) of the

IRS began auditing petitioner's tax returns for 1984 and 1985.

In June of 1989, Special Agents Robert Johnson (Agent Johnson or

the agent) and Catherine Parr went to petitioner's current work

place.   Agent Johnson told petitioner that he was conducting a

criminal investigation of her tax liability and that he needed to

question her regarding such matter.     Petitioner agreed to meet

with him to review her tax and bank records, provided her

attorney, Kemper Durand (Durand), was present. Thereafter, Agent

Johnson and Durand spoke on several occasions regarding the

investigation, but Johnson did not try again to speak with

petitioner.   In July of 1989, the agent requested a power of

attorney from Durand on behalf of petitioner, which he received 1

3
     The embezzlement had stopped years before. In fact,
petitioner had left Republic in good graces in 1986.
                                 - 5 -

week later.   On August 10, Agent Johnson contacted Durand to set

up an appointment.   During their conversation, Durand made

certain statements that Agent Johnson took as seeking a complete

concession; thereafter the agent decided "to proceed on with

[his] investigation" without ever meeting face to face with

either Durand or petitioner.    The agent’s final report (the

report), in which he recommended prosecuting petitioner for tax

evasion under section 7201, was based primarily on statements

made by petitioner's hostile and estranged husband, as well as

information supplied by people other than petitioner, to

establish her intent in failing to report the embezzled funds.

     Despite the report, petitioner was not prosecuted under

section 7201 for tax evasion.    On March 12, 1991, she was

indicted, instead, for the lesser offense of willfully filing a

false tax return for 1984 (count one) and 1985 (count two) in

violation of section 7206(1).    Petitioner entered into a

negotiated plea (plea) in the United States District Court for

the Northern District of Georgia, wherein she pleaded guilty to

count one of the indictment.    Count two was dismissed.

     Petitioner was sentenced to 5 years’ probation, 200 hours of

community service, and was ordered to pay $16,552, plus interest

and penalties, in restitution.    This amount appears to represent

the 1984 deficiency plus then-accrued interest.4   Petitioner has

4
     Although the parties stipulated (without any explanation)
that the restitution was based on the deficiencies for the two
years in issue, we do not see how this is mathematically
                                                   (continued...)
                                - 6 -

paid the full restitution amount and served all of the community

hours required of her.    Petitioner's probation was terminated

early, because she completed the terms of her probation in an

exceptional manner.

                               OPINION

     Respondent, pursuant to section 6653(b), determined that

petitioner is liable for additions to tax for fraud and interest

thereon for failing to report embezzled income on her 1984 and

1985 tax returns.    Petitioner admits that she embezzled money

from her former employer and that she did not report the income.

She asserts, however, that she did not intend to evade taxes.

Rather, petitioner claims that she did not know that embezzlement

income is taxable.    If petitioner prevails, respondent is barred

by the section 6501(a) limitations period from assessing and

collecting any tax and additions thereto from her for the years

in issue.

     Respondent argues that petitioner's failure to report the

embezzlement income in 1984 and 1985, her guilty plea under

section 7206(1), combined with withholding bank records from tax

preparers and respondent, and refusing to sign an amended return

reporting the embezzled funds, establishes petitioner's requisite

intent to commit fraud.    For the reasons discussed below, we

agree with petitioner.


4
 (...continued)
possible. We therefore disregard the stipulation as clearly
erroneous.
                               - 7 -

     Under section 6653(b) respondent has the burden of proving

by clear and convincing evidence that there is an underpayment of

tax and that some part of the underpayment was due to fraud.     See

sec. 7454(a); Rule 142(b).   Respondent must show that petitioner

intended to evade taxes known to be owing by conduct intended to

conceal, mislead, or otherwise prevent the collection of such

taxes.   Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).    Where

a taxpayer claims ignorance of the law or a good-faith belief

that he was not violating any of the provisions of the tax laws,

the Commissioner must negate that claim by clear and convincing

evidence.   Cheek v. United States, 498 U.S. 192, 202 (1991); see

also Niedringhaus v. Commissioner, 99 T. C. 202, 217 (1992).     For

purposes of the section 6653(b)(2) interest computation,

respondent must also prove the portion of the underpayment

attributable to fraud.   Sec. 6653(b)(2); DiLeo v. Commissioner,

96 T.C. 858, 873 (1991), affd. 959 F.2d 16 (2d Cir. 1992).

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

upon consideration of the entire record.   Gajewski v.

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

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

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

may, however, be proved by circumstantial evidence, because

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

Rowlee v. Commissioner, supra.   The taxpayer's entire course of

conduct may establish the requisite fraudulent intent.     Stone v.
                               - 8 -

Commissioner, 56 T.C. 213, 223-224 (1971).    The intent to conceal

or mislead may be inferred from a pattern of conduct.   See Spies

v. United States, 317 U.S. 492, 499 (1943).

1.   Guilty Plea Under Section 7206(1)

     A conviction5 under section 7206(1)6 does not collaterally

estop a taxpayer from denying fraud under section 6653(b).

Wright v. Commissioner, 84 T.C. 636 (1985); see also Considine v.

United States, 683 F.2d 1285 (9th Cir. 1982); Cox v.

Commissioner, T.C. Memo. 1985-324; Wheadon v. Commissioner, T.C.

Memo. 1992-633.

      Under section 7206(1) it is a crime to willfully make and

submit any return verified by a written declaration that is made

under penalties of perjury which the taxpayer does not believe to




5
     A guilty plea is equivalent to a conviction after trial for
the purpose of collateral estoppel. See, e.g., Johnson v.
Sawyer, 47 F.3d 716, 722 (5th Cir. 1995).
6
      SEC. 7206 provides, in relevant part:

      Any person who--

                (1) Declaration under penalties of perjury--
      Willfully makes and subscribes any return, statement, or
      other document, which contains or is verified by a written
      declaration that it is made under the penalties of perjury,
      and which he does not believe to be true and correct as to
      every material matter; *   *   *

      *           *       *            *       *         *          *

shall be guilty of a felony and, upon conviction thereof, shall
be fined not more than $100,000 * * * or imprisoned not more than
3 years, or both, together with the costs of prosecution.
                              - 9 -

be true and correct as to every material matter.7   The intent to

evade taxes is not an element of the crime charged under section

7206(1).   Wright v. Commissioner, supra at 643; see also United

States v. Tsanas, 572 F.2d 340, 343 (2d Cir. 1978); United States

v. DiVarco, 484 F.2d 670, 673-674 (7th Cir. 1973); Siravo v.

United States, 377 F.2d 469, 472 n.4 (1st Cir. 1967).

     Thus, although petitioner’s conviction under section 7206(1)

may be some evidence of fraudulent intent, it does not establish

as a matter of law that she intended to evade taxes.    Wright v.

Commissioner, supra.

2. Badges of Fraud

     A pattern of consistent underreporting of income, especially

when accompanied by other circumstances showing an intent to

conceal, justifies the inference of fraud.   See Holland v. United

States, 348 U.S. 121, 137 (1954).   The mere failure, however, to

report income is not sufficient to establish fraud.     Merritt v.

Commissioner, 301 F.2d 484, 487 (5th Cir. 1962), affg. T.C. Memo.

1959-179; Korecky v. Commissioner, 781 F.2d 1566, 1568 (11th Cir.

1986), affg. T.C. Memo. 1985-63).   Fraud may not be found under

"circumstances which at the most create only suspicion."     Katz v.

Commissioner, 90 T.C. 1130, 1144 (1988).

     Besides failure to report income, other badges of fraud

which may be taken into account include:   the making of false and

inconsistent statements to revenue agents, Grosshandler v.

7
     Petitioner's plea did not specifically mention the
embezzlement income.
                             - 10 -

Commissioner, 75 T.C. 1, 20 (1980); the filing of false

documents, Stephenson v. Commissioner, 79 T.C. 995, 1007 (1982),

affd. 748 F.2d 331 (6th Cir. 1984); understatement of income,

inadequate records, failure to file tax returns, implausible or

inconsistent explanations of behavior, concealment of assets, and

failure to cooperate with tax authorities. Bradford v.

Commissioner, 796 F.2d 303 (9th Cir. 1986), affg. T.C. Memo.

1984-601; Korecky v. Commissioner, supra.

     The taxpayer's education and sophistication are also

relevant to the determination of fraud.   Halle v. Commissioner,

175 F.2d 500, 503 (2d Cir. 1949), affg. 7 T.C. 245 (1946);

Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

     Petitioner admits that she failed to report income of

$57,470 in 1984 and $18,524 in 1985.   Accordingly, pursuant to

section 6653(b)(1), respondent has proven that an underpayment of

tax exists for each of the years in issue.   Thus, we now must

decide whether petitioner intended to conceal, mislead, or

otherwise prevent the collection of such taxes.    Rowlee v.

Commissioner, 80 T.C. at 1123, and cases cited therein.

     Petitioner testified that she did not know, until the IRS

investigation began, that embezzlement income was taxable, and at

that point she cooperated fully with respondent.   Respondent

points to petitioner's failing to report the embezzlement income,

withholding bank records from tax preparers and respondent, and

refusing to sign an amended return reporting the embezzled funds,
                               - 11 -

as evidence of attempts to conceal.     The problem with

respondent’s scenario is that--except for the failure to report

the embezzlement income--it is not supported by the facts.

     First, the evidence does not show that petitioner withheld

any information from respondent or refused to cooperate in any

way with respondent.

     During the 10 months Agent Johnson spent investigating

petitioner, he never interviewed her in an effort to establish

her state of mind in failing to include the illegal income on her

returns.   In fact, Agent Johnson testified that on the only

occasion when he met with petitioner she was pleasant,

cooperative, and willing to review her tax and bank records with

him if her attorney were present.   This was perfectly reasonable,

since Agent Johnson was conducting a criminal investigation.

Durand, petitioner's attorney, did in fact speak with the agent

on several occasions about the ongoing investigation and promptly

provided a power of attorney when requested.     At trial, Agent

Johnson acknowledged that petitioner cooperated with the

investigation, and that he did not intend in his report to

indicate otherwise.    It was Agent Johnson who severed all contact

with petitioner after Durand allegedly gave Agent Johnson the

impression that he, Durand, was "looking for a letter from the

IRS forgiving someone for stealing money from the airlines."

From that point forward, Agent Johnson made no further effort to
                              - 12 -

schedule an appointment with petitioner, even though she

consistently expressed a willingness to meet.

     At trial and in his report, Agent Johnson indicated that

petitioner "withheld bank statements" from the preparers of

petitioner's 1984 and 1985 returns, Patricia Montague (Montague)

and Louis Traylor (Traylor), respectively.   However, Montague and

Traylor testified that they never asked petitioner for any bank

records, that she was cooperative and provided them with all of

the tax information that they requested, and that she did not in

any way hinder them in preparing the returns.

     Moreover, the evidence specifically rebuts respondent's

claim that petitioner failed to furnish Agent Johnson with her

bank records and that summonses had to be served on petitioner's

banks to obtain them.   At trial Agent Johnson himself admitted

that he never asked petitioner for any bank statements, or for

that matter, any other documentary information relating to her

tax liability for the years in issue.

     Respondent’s case is based almost entirely on allegations

made by Griffith, petitioner's ex-husband, to Agent Johnnson.8

However, Griffith was not a reliable source.    At the time he was

interviewed, Griffith had a strong motive to lie.   He and


8
     The bias of witnesses giving contradictory evidence must be
considered. See Anderson v. Bessemer City, 470 U.S. 564, 575
(1985); Henson v. Commissioner, 835 F.2d 850, 853 (11th Cir.
1988), affg. in part, revg. in part and remanding T.C. Memo.
1986-303; Ishijima v. Commissioner, T.C. Memo. 1994-353.
Griffith, who was suffering from liver cancer, did not testify at
trial.
                              - 13 -

petitioner were in the midst of a fractious divorce.   Apparently

in an effort to hurt petitioner (or at least to gain the upper

hand) Griffith reported petitioner to the authorities.   Griffith

physically, mentally, and emotionally abused petitioner during

the entire course of their relationship.   Moreover, Griffith had

other credibility issues.   In 1989, Griffith, a securities

broker, was fined and barred from the National Association of

Securities Dealers (NASD) for converting the funds of three

different clients to his own use.

     We also note that respondent afforded Griffith innocent

spouse protection for 1985, despite the fact that he co-signed

the joint return with full knowledge of the embezzled funds.    If

the agent had spoken to petitioner, he would have known that

Griffith knew petitioner was stealing before he married her, that

the stealing continued throughout their marriage, and that

Griffith never asked petitioner to stop.

     We also find misleading respondent's characterization of

petitioner's "refusal to sign" an amended return prepared by her

ex-husband's accountant as further evidence of her intent to

willfully evade her Federal income tax for the years in issue.

It was Griffith, not Agent Johnson, who asked petitioner to sign

the amended return.   At that time the couple was in the middle of

a difficult divorce, and her refusal to trust Griffith was not

unreasonable.   Moreover, Griffith's accountant testified that he

had prepared the amended return exclusively on information
                                - 14 -

supplied by Griffith and that he had no contact with petitioner

during the preparation process.    Petitioner testified that her

attorneys advised her not to sign the amended return.    Based on

the testimony of petitioner, the tax preparers, and Agent Johnson

himself, we disagree with respondent's assertion that

petitioner's failure to sign the amended return shows her intent

to evade taxes.

     Finally, in addressing the other so-called badges of fraud,

we find that Agent Johnson's own testimony exonerates petitioner.

He testified that petitioner never denied receipt of the

embezzled funds, nor did she attempt to conceal the money from

the IRS.   She made no false entries on any book or records, she

did not backdate or postdate any documents, she did not maintain

two sets of books, nor did she claim fictitious deductions.    She

did not hide any bank accounts, she did not maintain a safe

deposit box or otherwise hoard any funds, nor did she keep

accounts under false names.   She did not make any false

statements related to the preparation and examination of her 1984

and 1985 tax returns, nor in any other way did she hinder the

examination of those returns.

     In addition, we had an opportunity to closely observe

petitioner's demeanor at trial.    She answered questions freely

and without evasion, and we found her testimony credible.

     In light of the foregoing, we find that respondent has not

proven by clear and convincing evidence that petitioner engaged
                             - 15 -

in conduct intended to conceal, mislead, or otherwise prevent the

collection of her 1984 and 1985 taxes.   Accordingly, respondent

is barred by the section 6501(a) limitations period from

assessing a deficiency against petitioner for the years in issue.

     To reflect the foregoing,



                                         Decision will be entered

                                   for petitioner.
