                          T.C. Memo. 2003-262



                        UNITED STATES TAX COURT



           MERI R. AND WILLIAM R. KAUFMAN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 6819-98.               Filed September 9, 2003.


       Meri R. Kaufman and William R. Kaufman, pro sese.

       Frank W. Louis, for respondent.



                          MEMORANDUM OPINION


       WHERRY, Judge:   This case is before the Court on

respondent’s motion for partial summary judgment pursuant to Rule

121.    Respondent determined Federal income tax deficiencies with

respect to petitioners’ 1993, 1994, and 1995 taxable calendar

years of $6,546, $11,577, and $18,226, respectively.       Respondent

further determined that petitioner Meri R. Kaufman (Ms. Kaufman)
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was liable for section 6663 fraud penalties of $4,909.50 for

1993, $8,682.75 for 1994, and $13,669.50 for 1995.     (In the

alternative to the fraud penalties, respondent asserted accuracy-

related penalties under section 6662.)     Unless otherwise

indicated, all section references are to the Internal Revenue

Code in effect for the years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure.

                             Background

     On January 14, 1998, respondent issued to petitioners a

statutory notice determining the above deficiencies and

penalties.    The deficiencies were based on respondent’s

determination that petitioners realized unreported income from

misappropriated or embezzled funds.     On April 13, 1998,

petitioners filed a petition with this Court disputing the notice

of deficiency.    Petitioners at that time resided in Cranston,

Rhode Island.

     Respondent then answered the petition and further set forth

specific allegations of fact in support of the fraud penalties,

as follows:

          6. FURTHER ANSWERING the petition, and in support
     of the respondent’s determination that, in regard to
     Petitioner Meri R. Kaufman, a part of the underpayments
     of tax required to be shown on petitioners’ joint
     income tax returns for the taxable years 1993, 1994 and
     1995 is due to fraud, the respondent alleges:

               a. The Petitioner Meri R. Kaufman signed and
     filed joint returns with her husband for the 1993, 1994
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     and 1995 taxable years on January 17, 1995, April 17,
     1995 and April 15, 1996, respectively.

               b. During the 1993, 1994 and 1995 taxable
     years, Meri R. Kaufman misappropriated or embezzled
     funds from her employer, MIM Corporation in the amounts
     of $33,330.47, $57,095.06 and $76,574,76, respectively
     as set forth in * * * [exhibits attached to the answer
     which list the date, check number, amount, and payee
     for each MIM Corporation check representing embezzled
     funds].

               c. The Petitioner Meri R. Kaufman failed to
     accurately report this additional income when she filed
     her joint returns for the 1993, 1994 and 1995 taxable
     years.

               d. The Petitioner Meri R. Kaufman’s failure
     to report gross income in the amounts of $33,330.47,
     $57,095.06 and $76,574.76 for the 1993, 1994 and 1995
     taxable years, respectively, was fraudulent with the
     intent to evade taxes.

               e. The Petitioner Meri R. Kaufman’s
     understatement of gross income resulted in the
     understatement of her joint federal income tax
     liabilities in the amounts of $6,546.00, $11,577.00 and
     $18,226.00 for the 1993, 1994 and 1995 taxable years,
     respectively.

               f. The Petitioner Meri R. Kaufman’s
     understatement of her joint federal income tax
     liabilities in the amounts of $6,546.00, $11,577.00 and
     $18,226.00 for the 1993, 1994 and 1995 taxable years,
     respectively, was fraudulent with the intent to evade
     taxes.

               g. A part of the underpayment of tax
     required to be shown on Petitioner Meri R. Kaufman’s
     joint federal income tax returns for each of the
     taxable years 1993, 1994 and 1995 is due to fraud with
     the intent to evade taxes.

     Petitioners failed to file any reply, and on July 30, 1998,

respondent filed a motion, pursuant to Rule 37(c), for entry of

an order that the undenied allegations in the answer be deemed
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admitted.   The Court issued a notice of filing of respondent’s

Rule 37(c) motion, which indicated that the Rule required

petitioners to file a reply by August 20, 1998.   The notice

advised petitioners that filing such a reply would lead to a

denial of respondent’s motion but that upon failure to so reply

“the Court will grant respondent’s motion and deem admitted for

purposes of this case the affirmative allegations in the answer.”

When petitioners did not reply, the Court granted respondent’s

motion on August 27, 1998.

     Respondent thereafter sent to the Court a document that Ms.

Kaufman mailed to respondent and which appeared to be a photocopy

of a reply to answer by Ms. Kaufman.   On September 30, 1998, the

Court entered an order vacating its grant of respondent’s Rule

37(c) motion and extending to October 30, 1998, the time for

petitioners to file an originally signed reply.   When this order

was returned to the Court unclaimed by the U.S. Postal Service,

reflecting another address for petitioners, the Court again

extended the date for a reply, to December 4, 1998, and directed

service of the order to the new address.

     On December 18, 1998, having received no reply from

petitioners, the Court granted respondent’s Rule 37(c) motion and

ordered that “the affirmative allegations of fact set forth in

subparagraphs (a) through (g) of paragraph 6 of respondent’s
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Answer are deemed to be admitted for purposes of this case by

petitioner Meri R. Kaufman.”

     In due course, the case was set for trial at sessions

commencing January 31, 2000; January 22, 2001; March 4, 2002;

January 6, 2003; and September 15, 2003.   The case was continued

on three occasions by motions from petitioners and on one

occasion by motion from respondent.    Each motion was premised at

least in part on awaiting resolution of a criminal case in Rhode

Island against Ms. Kaufman on embezzlement and fraudulent

conversion charges.   Ms. Kaufman pleaded guilty on February 2,

2000, and was sentenced to 6 months’ home confinement, but

determination of the amounts of misappropriated funds and of

restitution was deferred.   In late summer of 2002, the amount of

restitution was set; however, apparently no determination was

made as to the amount of misappropriated funds.

     On August 5, 2003, respondent filed the instant motion for

“a partial summary adjudication in respondent’s favor in this

case upon the issue of the liabilities of Meri R. Kaufman for

deficiencies in income tax and fraud penalties for 1993 through

1995.”   Respondent submits that “Upon the granting of this

motion, the following issues remain for trial: the liability of

William R. Kaufman for 1993, 1994 and 1995 income taxes based on

unreported taxable embezzlement income received in those years.”

Petitioners were ordered to file any response to respondent’s
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motion on or before August 20, 2003, but no such response has

been received by the Court.

                               Discussion

      Rule 121(a) allows a party to move “for a summary

adjudication in the moving party’s favor upon all or any part of

the legal issues in controversy.”     Rule 121(b) directs that a

decision on such a motion shall be rendered “if the pleadings,

answers to interrogatories, depositions, admissions, and any

other acceptable materials, together with the affidavits, if any,

show that there is no genuine issue as to any material fact and

that a decision may be rendered as a matter of law.”        The moving

party bears the burden of demonstrating that no genuine issue of

material fact exists and that he or she is entitled to judgment

as a matter of law.      Marshall v. Commissioner, 85 T.C. 267, 271

(1985).   Facts are viewed in the light most favorable to the

nonmoving party.   Id.    However, where a motion for summary

judgment has been properly made and supported by the moving

party, the opposing party may not rest upon mere allegations or

denials contained in that party’s pleadings but must by

affidavits or otherwise set forth specific facts showing that

there is a genuine issue for trial.       Rule 121(d).

I.   Income Tax Deficiencies

      The Internal Revenue Code imposes a Federal tax on the

taxable income of every individual.       Sec. 1.   Section 61(a)
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defines gross income for purposes of calculating taxable income

as “all income from whatever source derived”.    This broad

definition includes income obtained from illegal sources.      James

v. United States, 366 U.S. 213, 218 (1961); sec. 1.61-14(a),

Income Tax Regs.    Respondent has determined that Ms. Kaufman

received unreported income through embezzlement of funds from her

employer.

       As a general rule, the taxpayer bears the burden of proving

error in the Commissioner’s determinations.    Rule 142(a).

Although section 7491 may shift the burden to the Commissioner in

certain circumstances, the section is applicable only to court

proceedings that arise in connection with examinations commencing

after July 22, 1998.    Internal Revenue Service Restructuring &

Reform Act of 1998, Pub. L. 105-206, sec. 3001(c)(2), 112 Stat.

727.    It is apparent from the record in this case that the

examination commenced prior to July 22, 1998, and, therefore,

section 7491 has no application.

       Courts have recognized a limited exception to the general

rule where the notice of deficiency determines that the taxpayer

failed to report income, particularly income derived from illegal

activities.    Llorente v. Commissioner, 649 F.2d 152, 156 (2d Cir.

1981), affg. in part and revg. in part 74 T.C. 260 (1980);

Weimerskirch v. Commissioner, 596 F.2d 358, 360-362 (9th Cir.

1979), revg. 67 T.C. 672 (1977); Petzoldt v. Commissioner, 92
                                - 8 -

T.C. 661, 687-688 (1989).    In such circumstances, respondent must

come forward with evidence establishing a minimal foundation,

which may consist of evidence linking the taxpayer with an

income-producing activity.    Weimerskirch v. Commissioner, supra

at 360-361; Petzoldt v. Commissioner, supra at 689.

      Here, all of the facts upon which respondent relies to link

Ms. Kaufman with criminal activity and to demonstrate the amount

of misappropriated funds have been deemed admitted by operation

of Rule 37(c).   It is well established that “Facts deemed

admitted pursuant to Rule 37(c) are considered conclusively

established and may be relied upon by the government even in

relation to issues where the government bears the burden of

proof.”   Baptiste v. Commissioner, 29 F.3d 1533, 1537 (11th Cir.

1994), affg. T.C. Memo. 1992-198.    Based on the deemed admissions

in this case, we conclude that there exists no issue of material

fact as to Ms. Kaufman’s receipt of unreported income and her

liabilities for the income tax deficiencies thereon for 1993

through 1995.    Accordingly, we sustain as a matter of law

respondent’s determination with respect to the income tax

deficiencies in the statutory notice.

II.   Fraud Penalties

      Section 6663(a) provides for the imposition of a penalty in

“an amount equal to 75 percent of the portion of the underpayment

which is attributable to fraud.”    In addition, section 6663(b)
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specifies that, if any portion of the underpayment is

attributable to fraud, the entire underpayment is treated as

attributable thereto, except and to the extent that the taxpayer

establishes some part is not due to fraud.

     Respondent bears the burden of proving the applicability of

the civil fraud penalty by clear and convincing evidence.    Sec.

7454(a); Rule 142(b).   To sustain this burden, respondent must

establish by this level of proof both (1) that there was an

underpayment of tax for the taxable year in issue and (2) that at

least some portion of such underpayment was due to fraud.     DiLeo

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

Cir. 1992); Petzoldt v. Commissioner, supra at 699.     Again, it is

clear that deemed admissions are sufficient to satisfy

respondent’s burden of proving fraud.     Marshall v. Commissioner,

supra at 272-273; Doncaster v. Commissioner, 77 T.C. 334, 337-338

(1981).

     Here, Ms. Kaufman is deemed to have admitted that she

fraudulently and with intent to evade taxes omitted from her

returns $33,330.47, $57,095.06, and $76,574.76 of taxable income

for 1993, 1994, and 1995, respectively.    She further is deemed to

have admitted that the foregoing omissions of income resulted in

understatements of Federal income tax liabilities of $6,546,

$11,577, and $18,226 for the respective 1993 through 1995 years,

and that such understatements were fraudulent with intent to
                              - 10 -

evade taxes.   We therefore conclude that respondent has satisfied

the burden of proving, by clear and convincing evidence, that the

entire underpayment of tax for each of the years in issue was due

to fraud on her part.   We sustain respondent’s determination that

Ms. Kaufman is liable for penalties under section 6663 for 1993,

1994, and 1995.

     To reflect the foregoing,



                                         An appropriate order

                                    granting respondent’s motion

                                    for partial summary judgment

                                    as to petitioner Meri R.

                                    Kaufman will be issued.
