                              T.C. Memo. 2014-232



                        UNITED STATES TAX COURT



   FRANK KENNETH WORTH, a.k.a. FRANK K. WORTH, a.k.a. FRANK
  WORTH AND HELEN LAURA WORTH, a.k.a. HELEN L. WORTH, a.k.a.
             HELEN WORTH, ET AL.,1 Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 12573-09, 12808-09,             Filed November 13, 2014.
                  14580-09.



      Edward M. Robbins, Jr., and Barbara E. Lubin, for petitioners in docket

Nos. 12573-09 and 12808-09.

      Donald Kenneth Worth and Marie Ann Worth, pro se in docket No.

14580-09.

      Jordan Scott Musen and Kris H. An, for respondent.



      1
      Cases of the following petitioners are consolidated herewith: Frank
Kenneth Worth, a.k.a. Frank K. Worth, a.k.a. Frank Worth, docket No. 12808-09;
and Donald Kenneth Worth and Marie Ann Worth, docket No. 14580-09.
                                        -2-

[*2]          MEMORANDUM FINDINGS OF FACT AND OPINION


       LAUBER, Judge: For the taxable years 1997-2000 the Internal Revenue

Service (IRS or respondent) determined deficiencies in petitioners’ Federal in-

come tax under section 6211 and civil fraud penalties under section 6663(a).2 The

deficiencies stem from petitioners’ underreporting of income from their family

business, White Sands, which comprised a group of surf and skateboard shops.

White Sands was owned and operated by Donald and Marie Worth and their son,

Frank Worth.

       In each case respondent filed an amended answer that alleged increased

deficiencies for certain years. In docket No. 12808-09, respondent determined

against Frank Worth deficiencies and fraud penalties, subsequently amended, as

follows:

                       Notice of deficiency                  As amended
       Year        Deficiency       Sec. 6663        Deficiency       Sec. 6663
       1998         $63,689          $47,767          $73,403          $55,052




       2
       All statutory 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. We round all monetary amounts to the nearest dollar.
                                        -3-

[*3] In docket No. 12573-09, respondent determined against Frank and Helen

Worth deficiencies and fraud penalties, subsequently amended, as follows:

                       Notice of deficiency                 As amended
      Year         Deficiency       Sec. 6663       Deficiency      Sec. 6663
      1999          $74,829          $56,122         $43,187         $32,390
      2000           99,999           74,999         171,207         128,405

      In docket number 14580-09, respondent determined against Donald and

Marie Worth deficiencies and fraud penalties, subsequently amended, as follows:

                       Notice of deficiency                 As amended
      Year         Deficiency       Sec. 6663       Deficiency      Sec. 6663
     1997           $97,756          $73,317        Conceded        Conceded
     1998            69,909           52,432         $45,277         $33,958
     1999             62,965          47,234          75,464          56,598
     2000            153,606         115,205         188,849         141,637

       Respondent has conceded the deficiency and the fraud penalty as to Donald

and Marie Worth for 1997. Frank Worth has conceded the fraud penalty for all

years in issue, and respondent does not contend that Helen Worth was involved

with White Sands or the alleged fraud. Because the deficiencies and the fraud

penalties relate to conduct involving the White Sands business, we will generally

refer to Donald, Marie, and Frank as petitioners.
                                         -4-

[*4] Apart from computational matters the remaining issues for decision are: (1)

whether petitioners failed to report income for 1998-2000 as determined by

respondent using the net worth method of reconstructing income and (2) whether

petitioners Donald and Marie Worth are liable for the fraud penalty for 1998-2000.

We answer both questions in the affirmative.

                               FINDINGS OF FACT

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

facts and the attached exhibits are incorporated by this reference. All petitioners

resided in California when they petitioned this Court.

White Sands

      Donald and Marie Worth were married in 1961. After receiving their B.A.

degrees, both earned master’s degrees in education from Washburn University in

Topeka, Kansas. Marie was employed as a schoolteacher from 1969 through

1997; she previously held positions as an order department manager, an instruc-

tional materials clerk, a secretary, and a bookkeeper. Donald and Marie have one

son, Frank Worth, who is married to Helen Worth.

      During the early 1990s Donald and Frank operated Sports Image, a sporting

goods shop in Santa Maria, California. In 1993 they converted Sports Image into

a specialty skateboard and surfing store called White Sands. By 1998 Donald and
                                         -5-

[*5] Frank had expanded their business and operated a total of four stores in Santa

Maria, Northridge, Valencia, and Ventura. During 1999-2000 they added a fifth

store in Palmdale. As of April 2002 they were operating seven White Sands stores

at various locations across southern California.

      Because the stores were a fair distance from each other, Donald and Marie

generally managed the stores nearer to them and Frank managed the stores nearer

to him. Over time Frank managed about half of the stores. As manager, Frank had

the authority to write checks on certain White Sands bank accounts. He wrote

checks on these accounts or used cash to pay vendors for merchandise as it came

in. He also wrote checks to reimburse himself for White Sands expenses that he

had paid.

      Frank’s responsibilities included selecting shopping centers at which to

open stores; managing store employees; supervising the buildout of the interior of

new stores; making decisions about which brands and products to carry; managing

inventory at the warehouse; and making deliveries of inventory and supplies to

various stores. Frank was also responsible for collecting the daily receipts (cash,

customer checks, and credit card slips) from the stores he managed and delivering

them in a sealed envelope to his mother, who did the bookkeeping for White

Sands.
                                         -6-

[*6] Petitioners used large amounts of cash in the operation of White Sands.

Many customers paid in cash, and petitioners paid many vendors in cash. Marie

and Donald had primary responsibility for depositing White Sands receipts. They

frequently made large cash deposits spread among a dozen different bank

accounts.

      Petitioners had no formal arrangements concerning the ownership of White

Sands during 1997-2000. They had what Donald called a “gentlemen’s agree-

ment,” and the actual ownership interests were a principal focus of dispute at trial.

Respondent contended that Frank should be regarded as a 50% owner of White

Sands. Petitioners contended that Frank had no ownership interest in White Sands

or, alternatively, that he owned only a minority stake, with the majority interest

split between Donald and Marie.

      Throughout White Sands’ existence, Donald and Frank both held them-

selves out as its owners. Frank represented himself as an owner to banks, vendors,

insurance companies, and the Santa Maria Police Department. Donald and Frank

both negotiated and signed (jointly or separately) lease agreements for White

Sands, including leases of stores and storage space. Donald, Marie, and Frank

jointly filed with the State of California a fictitious business name statement for
                                          -7-

[*7] White Sands, and they jointly, and later separately, obtained seller’s permits

from the State of California.

      Petitioners have admitted on prior occasions that Frank was a coowner of

White Sands. In a trademark infringement case filed against petitioners and White

Sands in 2001 Frank averred in a filing with the California superior court that he

was “a part owner in WHITE SANDS SKATE & SURF” and that Marie had no

interest in the business. Later in that litigation Frank testified during a deposition

that he and Donald were “partners” in White Sands. While stating that he and

Donald had no formal agreement for sharing the profits from White Sands, Frank

testified that they each received compensation of approximately $2,000 per month,

suggesting a 50-50 ownership split.

      Donald and Marie filed joint Federal income tax returns for all years in

issue. On these returns they reported profits from White Sands on Schedules C,

Profit or Loss From Business. For 1998 Frank filed a Federal income tax return as

married filing separately, and he likewise reported profits from White Sands on a

Schedule C. For 1999-2000 Frank and Helen filed joint Federal income tax

returns, and they reported profits from White Sands on Schedules C. Frank and

his parents obtained different employee identification numbers (EINs) for White

Sands, and they used their respective EINs on their respective Schedules C. Frank
                                        -8-

[*8] at no time reported receipt of any salary or wages from White Sands, and

White Sands did not furnish him a Form W-2, Wage and Tax Statement, for any

year in issue.

      The evidence established that Marie prepared the original tax returns filed

on behalf of all petitioners as described above. The Schedules C included in these

returns assigned roughly half of the reported gross receipts and expenses of White

Sands to Donald and Marie and roughly half of the reported gross receipts and

expenses of White Sands to Frank, as shown in the table below:

                         Donald and Marie                      Frank
     Year         Gross receipts     Expenses      Gross receipts   Expenses
     1998            $259,442        $112,525      $285,493         $113,167
     1999             283,006         105,119       254,868            112,827
     2000             353,247         124,577       398,841            177,009

      Frank testified that White Sands was incorporated in 2002 and that Donald

and Marie each were issued 50% of its stock. Apart from this testimony there is

no evidence in the record that White Sands was ever incorporated or, if it was

incorporated, as to who owned its stock. We did not find Frank’s testimony on

this point to be credible.
                                          -9-

[*9] Criminal Investigation

      In early 2001 petitioners came to the attention of Federal and State authori-

ties because of certain banking irregularities. These included numerous deposits

to multiple banks in the range of $8,000 to $9,000, slightly below the $10,000

threshold that would have required the bank to complete a currency transaction

report. The case was assigned to IRS Criminal Investigation Division Agents

Carol Broderick and Bonnie Decker (agents) to conduct an investigation of

Donald, Marie, and Frank. During this investigation the Agents spoke with

petitioners as well as with petitioners’ relatives, vendors, lessors, and other third

parties. During an interview with Agent Broderick, Frank admitted that he was a

50% owner of White Sands.

       Donald and Marie provided inconsistent and fraudulent statements during

this criminal investigation. They made inconsistent statements to the Agents con-

cerning the ownership of the White Sands stores, and they made false statements

concerning its business records. They told Agent Broderick that they could not

produce White Sands’ business records because the records had been stolen during

a theft of merchandise. However, when California Board of Equalization (BOE)

agents executed a search warrant in December 2003, they seized various items

from a White Sands warehouse, including business records. The BOE search
                                        -10-

[*10] revealed that Donald and Marie had custody of the business records they

asserted had been stolen.

      On April 11, 2007, Frank pleaded guilty to willfully making and subscribing

to a false return for 2000 in violation of section 7206(1). On April 17, 2007,

Donald and Marie each pleaded guilty to willfully making and subscribing to a

false return for 1998 in violation of section 7206(1). In their respective plea

agreements Donald, Marie, and Frank admitted that they had falsely reported their

gross receipts from White Sands on their respective Schedules C and that White

Sands’ actual gross receipts for 1998-2000 were “substantially more” than the

amounts they had reported. All three petitioners admitted that they had knowingly

and willfully understated White Sands’ gross receipts in an attempt to decrease

their taxable income and agreed that they were “liable for the civil fraud penalty

imposed by the Internal Revenue Code * * * on the understatements of tax liability

for 1998, 1999, and 2000.” Donald and Marie stipulated that the Government

suffered a “tax loss” of $210,628 on account of their crimes; Frank stipulated that

the “tax loss” attributable to his crimes was at least $50,000 and no more than

$222,000.3

      3
      Under the Federal sentencing guidelines the “tax loss” suffered by the
Government determines the “offense level,” which in turn may affect the sentence
                                                                    (continued...)
                                         -11-

[*11] Civil Examination

      The IRS subsequently conducted a civil examination of petitioners’ 1998-

2000 returns. Because petitioners lacked complete and reliable records, the IRS

had to reconstruct their incomes using an indirect method of proof. Because of

petitioners’ commingling of funds and extensive use of cash, the IRS was unable

to isolate each petitioner’s income using the “bank deposits” method. The IRS

accordingly determined to reconstruct their incomes for 1998-2000 using the “net

worth and personal expenditures” method (net worth method).

      Revenue Agent Helen Chan had principal responsibility for this exercise.

She identified the assets, liabilities, and expenses of the respective petitioners,

then reconstructed their incomes for 1998-2000 by comparing changes in their net

worths from one year to the next. For Donald and Marie, Agent Chan’s net worth

analysis was as follows:




      3
       (...continued)
received by the defendant--the higher the offense level, the longer the possible
prison term. See generally John A. Townsend, et al., Tax Crimes 321-322 (2008).
A “tax loss” of “More than $200,000” equates to an “offense level” of 18 as
compared with a maximum offense level of 36 for a “tax loss” exceeding $400
million. See U.S. Sentencing Guidelines Manual sec. 2T4.1 (2002) (Tax Table).
                                          -12-

[*12] Particulars                  1997            1998         1999         2000

Assets                           $921,860        $1,069,027   $1,597,367   $2,392,822
Less: Liabilities                 182,351          103,274      491,517      801,792
Net worth                         739,509          965,753     1,105,850    1,591,030
Less: Prior year’s net worth        ---            739,509      965,753     1,105,850
Add: Nondeductible items            ---               2,710      98,410       24,890
Add: Itemized deductions            ---             18,640       24,598       44,629
Less: Nonincome items               ---             61,713         3,686        3,000
Adjusted gross income (AGI)         ---            185,881      259,419      551,699
Less: AGI reported as adjusted      ---             57,809       48,123       83,368
Additional income to report         ---            128,072      211,296      468,331

      For Frank, Agent Chan’s net worth analysis was as follows:

         Particulars               1997            1998         1999         2000
Assets                           $348,996        $746,272     $1,053,222   $1,422,618
Less: Liabilities                 115,833         332,734       546,444      550,052
Net worth                         233,163         413,537       506,778      872,566
Less: Prior year’s net worth        ---           233,163       413,537      506,778
Add: Nondeductible items            ---            36,415        81,732      100,889
Add: Itemized deductions            ---            17,746        38,143       34,788
Less: Nonincome items               ---            11,340          1,481       -0-
Adjusted gross income (AGI)         ---           223,195       211,634      501,465
Less: Helen’s AGI                   ---            14,062         -0-          -0-
Less: AGI reported as adjusted      ---            17,858       114,634       62,399
Additional income to report         ---           191,275        97,000      439,067
                                         -13-

[*13] Agent Chan testified for nearly two days regarding the details of her net

worth calculations. Her analysis required her to marshal large amounts of data--

e.g., from bank and brokerage statements, canceled checks, credit card statements,

real estate closing documents, and vehicle leases--and feed these data into the net

worth calculus. The Court admitted her various summary charts under rule 1006

of the Federal Rule of Evidence because all entries on those charts were tied to

numbers drawn from evidence in various stipulated exhibits.

      Agent Chan testified as to how she had characterized certain elements of

these data in some cases. For example, for a real estate closing document, she

broke out separately the “cost basis” of the property, any tax-deductible items

(such as real property taxes), and nondeductible items (such as prepaid insurance

premiums). In those cases the Court accepted her testimony and admitted

schedules of this type, not for the purpose of demonstrating the correctness of her

methodology, but solely for the purpose of explaining what she had done.

Petitioners had the opportunity to challenge all aspects of her methodology

through cross-examination at trial and in posttrial briefs.

      Agent Chan began her analysis by determining petitioners’ net worths at the

end of 1997. Donald and Marie asserted that Agent Chan’s opening net worth

figure for them was low because it did not account for a “cash hoard,” namely,
                                        -14-

[*14] cash in excess of $200,000 that they had allegedly received from Donald’s

father, Fred Worth. However, according to Social Security Administration (SSA)

records, Fred’s total income during the 40-year period ending in 1977 was

$185,430. Fred started living in a federally subsidized housing unit for

low-income seniors in 1985, and by 1986 his income consisted solely of Social

Security and retirement payments totaling approximately $1,000 a month. Agent

Chan determined that the “cash hoard” lead that petitioners suggested was not

reasonable, and she did not adjust Donald and Marie’s opening net worth on this

account.

      Petitioners also asserted that they had on hand large amounts of cash de-

rived from White Sands’ operations. Agent Chan did not dispute that assertion,

but she was unable to determine exact changes in cash balances because of peti-

tioners’ incomplete records and commingling of funds. She therefore used the

“floating cash” or “dash method” as approved in United States v. Giacalone, 574

F.2d 328, 333 (6th Cir. 1978). Under this formula Agent Chan assumed that the

amounts of cash petitioners had on hand were relatively consistent from year to

year and thus did not affect the annual change in their respective net worths.

      In determining petitioners’ respective assets Agent Chan identified property

that included bank accounts, brokerage statements, mutual funds, real estate, vehi-
                                       -15-

[*15] cles, and inventory. The principal uncertainty concerned how White Sands’

assets should be allocated among petitioners. Agent Chan determined that 50% of

its assets should be allocated to Donald and Marie and 50% to Frank. She based

this allocation on (among other things) the facts that: (1) Frank and Donald held

themselves out to numerous third parties as coowners of White Sands; (2) Frank

and Donald admitted in civil litigation that they were coowners of (or “partners”

in) White Sands; (3) Frank admitted to Agent Broderick that he was a 50% owner

of White Sands; (4) Frank managed about half of the White Sands stores;

(5) Frank and his parents each obtained EINs for White Sands; (6) Frank and his

parents each reported shares of White Sands’ profits on their respective Schedules

C; and (7) the White Sands gross receipts and expenses reported on those

Schedules C were divided roughly 50-50 between Frank on the one hand and

Donald and Marie on the other.4

      Frank’s construction of a house in Santa Barbara during 1998-2000

evidenced significant increases to his net worth. He purchased the lot for

$400,000 and tore down the existing dwelling unit. He then began construction of

a 5,000-square-foot home that entailed at least $400,000 in construction costs, as

      4
       In one instance, Agent Chan did not allocate to Frank any portion of the
funds in a bank account opened in White Sands’ name because he lacked signatory
authority over that account.
                                        -16-

[*16] reported to Santa Barbara County authorities. Agent Chan allocated the

construction costs to tax year 1998, 1999, or 2000 primarily on the basis of in-

voices from contractors or similar evidence. She allocated costs for which she did

not have invoices to tax year 2000, the year construction was completed. All con-

struction costs served to increase Frank’s net worth for the relevant year.

      Agent Chan next determined petitioners’ respective liabilities for each year.

These liabilities included mortgages on real estate, credit card debt, and vehicle

loans. For each year in issue Agent Chan subtracted liabilities from assets to

produce closing net worth, then offset the prior year’s closing net worth to

produce the annual change in net worth.

      The next step in Agent Chan’s analysis was to “tax effect” the annual

changes in net worth to produce AGI figures for each year. She therefore added

“nondeductible items” and “itemized deductions” and subtracted “non-income

items.” For the most part “nondeductible items” consisted of personal living

expenses. Such expenses must be paid from some source and, under the net worth

theory, Agent Chan assumed that petitioners defrayed these expenses using

unreported income. In adding back “nondeductible items” to petitioners’ annual

changes in net worth, Agent Chan included only those items (such as rent or car

lease payments) for which she had clear evidence of the amount and purpose, as
                                         -17-

[*17] evidenced by canceled checks, invoices, or credit card statements. For this

reason her implementation of the net worth methodology consistently understated

petitioners’ actual personal living expenses and hence understated their AGI for

each year.

      For example, Agent Chan had evidence that petitioners paid residential

water bills, and she included these expenses as “nondeductible items” in her

calculation. However, she did not add back any other residential utility charges--

e.g., for telephone, cable, gas, or electric service--because she did not have

definitive evidence of such payments. Further, although Agent Chan had bank

statements for most of Donald and Marie’s accounts, she had canceled checks

showing the payee for only a small number of the checks that cleared these

accounts. In computing “nondeductible items” she added back only those ex-

penses for which she had a canceled check denoting a personal type of expenditure

(e.g., a check payable to a pharmacy). The effect was to treat all other checks as

allocable to deductible business expenditures. Similarly, Agent Chan did not add

back any expenses for items like groceries, restaurant meals, clothing, or gasoline

for which petitioners paid cash. In all these respects she resolved uncertainties in

petitioners’ favor, consistently understated their “nondeductible items,” and cor-

respondingly understated their AGI for each year in issue.
                                        -18-

[*18] After adding back nondeductible expenses and petitioners’ reported item-

ized deductions, Agent Chan subtracted “non-income items,” that is, receipts from

nontaxable sources. Frank asserted that certain funds he had received from his

parents constituted a loan rather than a division of White Sands’ profits and hence

that these funds should have been treated as a “non-income item.” However,

Frank failed to present Agent Chan or the Court with any documentation of such a

loan, any loan terms, or any proof of repayment. Without any proof that the

transferred funds were nontaxable, Agent Chan declined to subtract this amount in

determining Frank’s AGI for the relevant year.

        At this step Agent Chan also made assumptions that benefited petitioners.

For example, during one year in issue, Frank sold a house and realized a gain of

$60,000. Agent Chan treated this as nontaxable gain from the sale of a principal

residence under section 121 and thus subtracted it when computing Frank’s AGI

for that year. Agent Chan later learned that the house may not in fact have quali-

fied as Frank and Helen’s principal residence at the time they sold it. Agent Chan

nevertheless left this as a nontaxable item, giving them the benefit of the doubt.

Trial

        Donald and Marie, who appeared pro se at trial, requested that they be

allowed to present their case after respondent had put on his case. The Court
                                        -19-

[*19] granted this request. After respondent rested, Donald and Marie decided to

rest without putting on an affirmative case. The Court noted that Donald and

Marie had included in the stipulation of facts a number of documents to which

respondent had reserved objections and explained that these documents could not

come into evidence unless they put on their case. They still wished to rest. The

Court, on its own initiative, then examined the documents in question and

admitted into evidence those for which there were no hearsay objections.

      After trial respondent filed a motion to amend to conform the pleadings to

the proof. The purpose of this motion was to revise Agent Chan’s net worth

calculation to correct two minor errors that came to light during her testimony.

Specifically, respondent revised her calculation: (1) to move from 1999 to 2000,

in determining Frank and Helen’s net worth increases for those years, construction

expenses of $7,268 on the Santa Barbara home and (2) to subtract, in determining

Frank and Helen’s AGI for 1999, an additional nontaxable item of $481. The

revised deficiencies and fraud penalties for Frank and Helen are as follows:

                                                                  Penalty
           Year                     Deficiency                   sec. 6663
           1999                       $39,793                     $29,845
           2000                       174,327                     130,745
                                        -20-

[*20] Because the Court instructed respondent to make these changes on the basis

of the evidence heard at trial, we will grant respondent’s motion.

                                     OPINION

I.    Burden of Proof

      The IRS’ determinations in a notice of deficiency are generally presumed

correct, and the taxpayer bears the burden of proving those determinations errone-

ous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). For the pre-

sumption to adhere in cases involving receipt of unreported income, the deficiency

determination must be supported by “some evidentiary foundation linking the

taxpayer to the alleged income-producing activity.” See Weimerskirch v. Com-

missioner, 596 F.2d 358, 362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). Once

respondent has produced evidence linking the taxpayer to an income-producing

activity, the burden of proof shifts to the taxpayer to prove by a preponderance of

the evidence that respondent’s determinations are arbitrary or erroneous. Helver-

ing v. Taylor, 293 U.S. 507, 515 (1935); Tokarski v. Commissioner, 87 T.C. 74

(1986).

      To satisfy his initial burden of production, respondent introduced records

that he obtained during the criminal investigation and the civil examination.

Those records establish that petitioners received during 1998-2000, but did not
                                         -21-

[*21] report, substantial amounts of additional income from operation of White

Sands. On the basis of this credible evidence, we are satisfied that the IRS’

determinations as set forth in the notices of deficiency are entitled to the general

presumption of correctness. See Hardy v. Commissioner, 181 F.3d 1002, 1004

(9th Cir. 1999) (deficiency determinations are entitled to presumption of

correctness if the IRS relies on “substantive evidence that the taxpayer received

unreported income”), aff’g T.C. Memo. 1997-97; Powerstein v. Commissioner,

T.C. Memo. 2011-271.

      As relevant here, the presumption of correctness is modified in one respect.

Respondent in his answers asserted increased deficiencies as to Donald and Marie

for 1999 and 2000, as to Frank for 1998, and as to Frank and Helen for 2000.

Respondent bears the burden of proof as to these increased deficiencies. See Rule

142(a)(1). As explained more fully below, we find that respondent’s position on

all factual issues is supported by the preponderance of the evidence. The

allocation of the burden of proof thus makes no difference.

II.   Analysis

      A.     Net Worth Framework

      Section 61(a) defines gross income as “all income from whatever source

derived,” including income derived from business. A taxpayer must maintain
                                        -22-

[*22] books and records establishing the amount of his or her gross income. See

sec. 6001. When a taxpayer keeps no books of account or keeps books that are de-

monstrably inaccurate, the IRS may determine his income “under such method as,

in the opinion of the Secretary, does clearly reflect income.” Sec. 446(b); see

Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989). When a taxpayer fails to

maintain or produce adequate records, the IRS may reconstruct his income using

an indirect method of proof. Choi v. Commissioner, 379 F.3d 638, 639-640 (9th

Cir. 2004), aff’g T.C. Memo. 2002-183.

      The IRS has great latitude in reconstructing a taxpayer’s income, and the

reconstruction “need only be reasonable in light of all surrounding facts and cir-

cumstances.” Petzoldt, 92 T.C. at 687. One method of reconstructing income,

long recognized by courts as reasonable, is the net worth method. See Holland v.

United States, 348 U.S. 121, 131 (1954). By its nature the net worth method seeks

an approximation, rather than a precise determination, of the taxpayer’s gross

income. A lack of exactitude is inevitable where, as here, “[t]he * * * [IRS] was

forced to use the imprecise net worth method of estimating income because the

taxpayers’ records were unreliable and did not accurately reflect income.” United

States v. Stonehill, 702 F.2d 1288, 1296 (9th Cir. 1983).
                                         -23-

[*23] Under the net worth method the IRS reconstructs a taxpayer’s income by

determining his net worth (excess of assets at cost over liabilities) at the beginning

and end of each year in issue. The difference between those amounts is the tax-

payers’ annual net worth increase (or decrease). The net worth increase for each

year is then adjusted by adding nondeductible expenses (such as everyday living

costs) and subtracting receipts from nontaxable sources (such as gifts, inheri-

tances, and loans). See Holland, 348 U.S. at 125. An increase in net worth for a

given year creates an inference of additional gross income for that year, provided

that the IRS: (1) establishes the taxpayer’s opening net worth with reasonable

certainty and (2) either shows a likely source of unreported income or negates

possible nontaxable sources. Id. at 132-138; Brooks v. Commissioner, 82 T.C.

413, 431-432 (1984), aff’d without published opinion, 772 F.2d 910 (9th Cir.

1985).5

      In the instant cases petitioners failed to maintain accurate books or records

from which their Federal tax liabilities could be computed. Frank admitted during

      5
        Because the goal of the net worth method is to generate an approximation
of the taxpayer’s AGI for a given year, any itemized deductions claimed by the
taxpayer, which serve to reduce AGI, are initially added back along with personal
living expenses in order to calculate omitted gross income. See Brazwell v. Com-
missioner, T.C. Memo. 1992-463. After AGI is determined, taxable income is
determined in the normal way by subtracting itemized deductions and allowing for
personal exemptions.
                                          -24-

[*24] trial and in posttrial briefs that he failed to report at least $200,000 of

income from White Sands. In their criminal tax case Donald and Marie stipulated

that the tax loss attributable to their underreporting of income from White Sands

was $210,628. Although this prior stipulation does not collaterally estop them

from challenging the specific tax deficiencies asserted here, it does constitute an

admission that their tax returns omitted substantial amounts of gross income. See

Livingston v. Commissioner, T.C. Memo. 2000-121, 79 T.C.M. (CCH) 1828,

1833. Use of the net worth method is clearly proper where, as here, the “tax-

payer’s records do not accurately reflect income.” United States v. Shetty, 130

F.3d 1324, 1331-1332 (9th Cir. 1997).

      Petitioners do not question respondent’s use of the net worth method to re-

construct their incomes for 1998-2000. They likewise do not challenge the ana-

lytical approach that Agent Chan adopted in implementing this methodology or

the manner in which she resolved most subsidiary issues. Petitioners contest re-

spondent’s position on five main grounds. First, they contend that Agent Chan

testified as an expert and that her testimony and exhibits were inadmissible

because respondent did not follow Tax Court Rules regarding the submission of

expert testimony. Second, petitioners contend that Agent Chan did not accurately

calculate their net worths because she failed to take into account “cash hoards”
                                        -25-

[*25] that they allegedly derived from gifts and/or from operation of White Sands.

Third, Frank contends that the increase in his net worth derived in part from a

nontaxable source, namely, a loan from his parents. Fourth, Frank contends that

Agent Chan erred in determining that he was a 50% owner of White Sands.

Finally, Donald and Marie contend that the net worth calculation did not take into

account their outstanding liability for California sales tax. We address these

contentions below.

      B.     Agent Chan’s Testimony

      Petitioners argue that Agent Chan testified as an expert by providing scien-

tific, technical, and specialized knowledge. See Fed. R. Evid. 702. Because

Agent Chan was not designated an expert and did not furnish an expert report as

required by Tax Court Rules, petitioners contend that her testimony should have

been ruled inadmissible. See Rule 143(g) (expert report); Rule 102 (continuing

duty to disclose expert). Respondent counters that “[i]n civil tax cases, especially

in unreported income cases, respondent’s revenue agents testify, not as experts,

but rather to describe the methodology used by respondent to ascertain the

taxpayers’ unreported income.” We agree with respondent.6

      6
      Petitioners also contend that Agents Broderick and Decker were improperly
allowed to testify as experts. There is no substance whatever to this argument.
                                                                       (continued...)
                                         -26-

[*26] Rule 702 of the Federal Rules of Evidence defines an expert as a “witness

who is qualified as an expert by knowledge, skill, experience, training, or educa-

tion.” An expert may testify in the form of an opinion or otherwise if her “scien-

tific, technical, or other specialized knowledge will help the trier of fact to under-

stand the evidence.” Id. Conversely, a lay witness may not offer an opinion based

on scientific, technical, or other specialized knowledge. Id. 701.

       An IRS revenue agent who reconstructs a taxpayer’s income and later testi-

fies as to the methodology she employed generally is not an expert witness. For

example, in Gudenschwager v. Commissioner, T.C. Memo. 1989-6, 56 T.C.M.

(CCH) 1010, an IRS revenue agent determined the taxpayer’s unreported income

by using Bureau of Labor Statistics tables for a similarly sized family with an

intermediate standard of living in the same metropolitan area. The taxpayer

objected to the agent’s testimony, asserting that she was not qualified as an expert

to testify concerning the figures used. The Court overruled this objection:

      [T]he witness was not testifying as an expert when she described the
      methodology used by respondent to ascertain petitioner’s unreported
      income. The witness testified regarding what methodology was used,
      not the validity of that methodology. Since the witness was not pro-
      viding scientific, technical, or other specialized knowledge to assist

      6
       (...continued)
Both agents testified solely as fact witnesses by recounting events that occurred
during the criminal investigation of petitioners.
                                         -27-

      [*27] the court to understand the evidence in this case, rule 702 * * *
      is not applicable and the witness’s testimony will not be treated as
      expert testimony.

Id., 56 T.C.M. (CCH) at 1012 (fn. ref. omitted).

      We agree with the Court’s reasoning in Gudenschwager. Agent Chan did

not offer any opinion based on scientific, technical, or other specialized know-

ledge. Rather she testified as to the facts of the civil tax audit that she conducted,

including the documents she collected, the interviews she held, and the observa-

tions she made. She also explained in detail the methodology she followed, which

is explicitly laid out in the Internal Revenue Manual (IRM). See IRM pt.

4.10.4.6.7 (June 1, 2004). In allowing her to testify, the Court repeatedly stated

that her testimony would be accepted, not for the purpose of demonstrating the

correctness of her methodology, but solely for the purpose of explaining what she

did. Because Agent Chan was not qualified as an expert and did not testify as an

expert, respondent was not required to follow this Court’s expert witness rules.7

      7
       In United States v. Frantz, No. CR 02-01267(A)-MMM, 2004 WL
5642909, at *12 (C.D. Cal. Apr. 23, 2004), the District Court for the Central
District of California held that:

      [p]ursuant to Rule 701, * * * [the IRS agents] may explain their role
      as auditors and testify about how an audit is generally conducted.
      They may also testify to the documents and information they
      obtained, the research they conducted, the conversations they had,
                                                                      (continued...)
                                        -28-

[*28] In the criminal tax context, “testimony by an IRS agent that allows the wit-

ness to apply the basic assumptions and principles of tax accounting to particular

facts is appropriate.” United States v. Stierhoff, 549 F.3d 19, 28 (1st Cir. 2008).

Courts have held, and petitioners concede, that a lay summary witness may offer

tax calculations if the calculations are “straightforward and transparent.” See, e.g.,

United States v. Diez, 515 F.2d 892, 905 (5th Cir. 1975); United States v. Baras,

CR 11-00523 YGR, 2013 WL 6502846, at *4 n.4 (N.D. Cal. Dec. 11, 2013). “The

key to admissibility is that the summary witness’s testimony does no more than

analyze facts already introduced into evidence and spell out the tax consequences

that necessarily flow from those facts.” Stierhoff, 549 F.3d at 28.

      In Stierhoff, a tax evasion case, the Government presented the testimony of

IRS Agent Pleshaw as a summary witness. The defendant objected to Agent

Pleshaw’s testimony on the ground that he was not qualified as an expert. The

Court of Appeals for the First Circuit disagreed, holding that Agent Pleshaw could

testify as a summary witness to explain the “unremarkable” methodology, id. at

27, that he employed to reconstruct the taxpayer’s income:

      7
       (...continued)
      and the factual observations they made during the course of their
      audit, to the extent these matters are based on their rational perception
      of information and events, and do not rely on specialized or technical
      knowledge. * * *
                                         -29-

      [*29] Using bank deposit records, Pleshaw computed the defendant’s
      gross receipts * * *. He then set to one side non-taxable receipts
      (such as loan proceeds) and subtracted business expenses (treating all
      non-cash withdrawals from the defendant’s accounts as deductible)
      * * *. To the 2002 total, he added the cash found during the search
      (which the defendant had admitted * * * emanated from his business
      dealings).

             In that manner, Pleshaw arrived at an estimate of the
      defendant’s net profits for each year. Thereafter, he adjusted for
      self-employment taxes, took the standard deduction, and factored in
      personal exemptions. These computations yielded the defendant’s
      putative taxable income for each of the four years in question. * * *

      The Court of Appeals held that the characterizations Agent Pleshaw had

made en route to his conclusions, e.g., classifying receipts as “income” and with-

drawals as “expenses,” did not represent impermissible legal opinions, but rather

“were part of a mechanical sorting of entries” under the methodology he had

employed. Stierhoff, 549 F.3d at 28. The Court of Appeals concluded that it was

within the District Court’s discretion to allow Agent Pleshaw to testify without

first qualifying him as an expert because he “simply did the math.” Id. at 29.

      We reach the same conclusion here. Agent Chan testified about facts and

numerical data that were admitted into evidence, generally by stipulation. She

testified as to the methodology she employed in reconstructing petitioners’

incomes on the basis of these data. This methodology occasionally required her to

characterize certain data, e.g., to break out cost basis, tax-deductible items, and
                                        -30-

[*30] nondeductible items from a real estate closing document. But in so doing

she was not offering legal opinions. She was simply explaining the “mechanical

sorting of entries” in which she engaged using the methodology she had

employed. Stierhoff, 549 F.3d at 28.

      Petitioners contend that the analysis set forth above “stems from case law

that has been superseded by an amendment to the Federal Rules of Evidence.”

According to petitioners, before 2000 courts routinely allowed lay witnesses to

offer opinion testimony in tax cases under rule 701 of the Federal Rules of

Evidence. In 2000, however, that rule was amended to disallow lay opinion

testimony that is based on “scientific, technical, or other specialized knowledge

within the scope of Rule 702.” See Fed. R. Evid. 701. This amendment required

all opinion testimony based on a witness’ scientific, technical, or other specialized

knowledge to be rendered by a properly qualified expert. In petitioners’ view,

Gudenschwager and certain other cases cited above have been superseded by this

amendment.

      Petitioners are mistaken. Rule 701 of the Federal Rules of Evidence as

amended disallows a lay witness’ testimony only if it is “based on scientific,

technical, or other specialized knowledge.” The Court in Gudenschwager, 56

T.C.M. (CCH) at 1012, held that the IRS revenue agent who testified as a sum-
                                         -31-

[*31] mary witness “was not providing scientific, technical, or other specialized

knowledge”; that her testimony was therefore outside the scope of rule 702 of the

Federal Rules of Evidence; and that her testimony “will not be treated as expert

testimony.”

      The same conclusion follows here. Since Agent Chan’s testimony was not

based on scientific, technical, or other specialized knowledge, it fell outside the

scope of rule 702 of the Federal Rules of Evidence. The 2000 amendment to rule

701 thus has no effect on the admissibility of her testimony or on the continuing

vitality of the Gudenschwager line of cases. Under established caselaw Agent

Chan was competent to testify as a summary witness to explain her

implementation of the net worth method, and her testimony was properly admitted

for that purpose.8




      8
        Petitioners contend that Agent Chan’s net worth schedules were inadmis-
sible under Fed. R. Evid. 1006. We admitted these schedules as summary charts to
assist the Court in evaluating the evidence because of the voluminous stipulated
exhibits. See United States v. Anekwu, 695 F.3d 967, 981-982 (9th Cir. 2012)
(holding that trial court did not abuse its discretion in admitting summary charts
and underlying records into evidence). Petitioners also contend that the summary
charts are inadmissible hearsay. They do not develop this argument, and the Court
finds it meritless. All of the entries on Agent Chan’s charts were linked to admis-
sible evidence, and she testified about the math she employed in creating these
charts on the basis of that evidence.
                                       -32-

[*32] C.    Cash on Hand

      Proper implementation of the net worth method requires the IRS to establish

the taxpayer’s opening net worth with reasonable certainty. Holland, 348 U.S. at

132. Donald and Marie contend that Agent Chan’s analysis fails this threshold

test because she did not give them credit for a large “cash hoard.” This contention

is not without precedent. “A favorite defense in net worth cases is that taxpayer

had a large amount of undeposited cash on hand at the beginning of the

investigation period. This may explain the disproportionate increase in net worth

over the increase of taxable income.” Schwarzkopf v. Commissioner, 246 F.2d

731, 734 (3d Cir. 1957), aff’g and remanding T.C. Memo. 1956-155; Light v.

Commissioner, T.C. Memo. 1987-572. The claim that a substantial cash hoard

exists is often “met with some suspicion.” De Venney v. Commissioner, 85 T.C.

927, 933 (1985). We are more than somewhat suspicious of petitioners’ claims.

      Donald and Marie allege that they had an undeposited cash hoard of about

$200,000 at the end of 1997, supposedly resulting from a gift from Donald’s

father, Fred. The evidence established, however, that Fred was not in a financial

position to make such a gift. According to SSA records Fred’s total income

during the 40-year period ending in 1977 was $185,430. Fred retired in 1985 and

moved into a federally subsidized housing unit for low-income seniors. By 1986
                                         -33-

[*33] his income consisted solely of Social Security and retirement payments

totaling about $1,000 a month. This evidence was clearly sufficient to support the

inference that Fred lacked the wherewithal to make a $200,000 cash gift to Donald

and Marie. See United States v. Giacalone, 574 F.2d 328, 333 (6th Cir. 1978);

McGarry v. United States, 388 F.2d 862 (1st Cir. 1967); Unger v. Commissioner,

T.C. Memo. 2000-267. There was no evidence to support the existence of such a

gift apart from Donald’s testimony, which the Court did not find credible.

      Frank makes a somewhat different argument concerning his alleged unde-

posited cash. He contends that he derived large amounts of cash from White

Sands’ operations and that Agent Chan’s net worth analysis failed to take this into

account. The principal support for Frank’s “cash hoard” argument was his own

testimony, which we did not find credible. Having observed his demeanor on the

witness stand, we found him evasive and lacking in candor. We have considered

his conviction for willfully making and subscribing to false returns as an

additional factor bearing on his credibility.

      Credibility apart, Frank’s “cash hoard” argument has no support in the re-

cord. Although Frank used cash to pay White Sands’ expenses, there is no evi-

dence that he accumulated a cash hoard from White Sands’ operations. Quite the

contrary: Frank testified that he collected the daily receipts from the stores he
                                        -34-

[*34] managed, put them into a sealed envelope, and gave the envelope to his

mother. The best evidence was that the store receipts constituting White Sands’

profits were deposited by Marie or Donald into various bank accounts. There was

no evidence that Frank “skimmed” profits from the stores he managed before

delivering the sealed envelopes to Marie.

      White Sands was a cash-intensive business, and petitioners kept substantial

amounts of cash on hand to pay its vendors and expenses. Changes in these cash

balances theoretically could affect annual changes in their net worths. But the

records petitioners supplied, which were incomplete and often unreliable, did not

enable Agent Chan to determine with any precision annual changes in cash

balances. Petitioners can hardly complain of this. As the Court of Appeals for the

Ninth Circuit put it: “Arithmetic precision was originally and exclusively in * * *

[the taxpayer’s] hands, and he had a statutory duty to provide it. * * * [H]aving de-

faulted in his duty, he cannot frustrate the Commissioner’s reasonable attempts by

compelling investigation and recomputation under every means of income

determination.” Adamson v. Commissioner, 745 F.2d 541, 548 (9th Cir. 1984)

(quoting Webb v. Commissioner, 394 F.2d 366, 373 (5th Cir. 1968)), aff’g T.C.

Memo. 1982-371.
                                        -35-

[*35] For these reasons Agent Chan relied on the so-called dash method of ac-

counting for undeposited cash. Instead of trying to calculate annual cash balances,

Agent Chan assumed that the amounts of cash petitioners kept on hand for use in

their business were relatively constant from year to year. In her net worth calcu-

lations, she accordingly placed a dash, or zero, in the column labeled “cash on

hand.” As a result the annual change in petitioners’ net worths was not affected,

positively or negatively, by the undeposited cash they held. Because it is impos-

sible to ascertain, in unreported income situations, precisely how much cash a

taxpayer has at any particular time, courts have consistently approved the use of

the “dash method.” See Giacalone, 574 F.2d at 332-333; Roberts v. Commiss-

ioner, T.C. Memo. 1987-182; United States v. Goichman, 407 F. Supp. 980, 995

(E.D. Pa. 1976), aff’d, 547 F.2d 778 (3d Cir. 1976). We conclude that Agent Chan

established petitioners’ opening net worths with reasonable certainty and that she

properly accounted for the cash they kept on hand in subsequent years.

      D.     Alleged Loans

      Proper implementation of the net worth method requires the IRS to adjust

annual net worth increases by subtracting amounts received from nontaxable

sources, such as gifts, inheritances, and loans. See Holland, 348 U.S. at 125, 137-

138. The Court of Appeals for the Ninth Circuit has not required the IRS to run
                                         -36-

[*36] down every conceivable rabbit hole when investigating leads about possible

nontaxable receipts. Rather, “[t]he government must investigate and negate a

taxpayer’s explanation only if it is ‘reasonable’ and ‘reasonably susceptible of

being checked.’” United States v. Anderson, 642 F.2d 281, 285 (9th Cir. 1981)

(quoting Holland, 348 U.S. at 135).

      Frank contends that he “took out a variety of short-term personal loans from

White Sands or his parents that were always repaid.” A loan is “an agreement,

either express or implied, whereby one person advances money to the other and

the other agrees to repay it upon such terms as to time and rate of interest, or

without interest, as the parties may agree.” Calloway v. Commissioner, 135 T.C.

26, 36-37 (2010). A transfer of funds constitutes a loan only if, when the funds

were advanced, the parties actually intended repayment. See Clark v.

Commissioner, 266 F.2d 698, 710-711 (9th Cir. 1959), remanding T.C. Memo.

1957-129.

      Agent Chan thoroughly investigated the transfers to Frank from his parents

and determined that these transfers were not loans. There was no evidence

whatsoever, apart from petitioners’ uncorroborated testimony, that the sums trans-

ferred were loans as opposed to a division of White Sands’ profits. No promissory

notes were executed. There was no evidence of a stated interest rate. There was
                                         -37-

[*37] no instrument establishing a repayment schedule. And there was no

evidence that Frank ever repaid his parents or that his parents ever sought

repayment. We found Frank’s testimony on this point to be vague, conclusory,

and unworthy of belief. Considering all the facts and circumstances, we find that

Agent Chan correctly determined that these transfers were not loans.

      E.     Ownership of White Sands

      Frank contends that Agent Chan erred in allocating half of White Sands’

assets to him. Before the IRS criminal investigation began, Frank repeatedly

represented himself as a coowner of White Sands to vendors, landlords, banks,

lessors, insurance companies, municipal officials, and the State of California.

During the criminal investigation Frank admitted in an interview with Agent

Broderick that he was a 50% owner of White Sands. He reported White Sands’

profits on his Schedules C, and its reported gross receipts and expenses were

divided roughly 50-50 between his Schedules C and his parents’ Schedules C.

Considering all this evidence, Agent Chan reasonably concluded that 50% of

White Sands’ assets should be allocated to Frank.

      Frank testified inconsistently on this point at trial. He initially asserted that

he had no ownership interest in White Sands but was a mere employee.

Confronted with the facts that White Sands did not pay him a regular salary and
                                         -38-

[*38] never issued him a Form W-2, he admitted that he might have had some

ownership interest in the business. He then suggested that his ownership interest

was, at most, one-third, with the remaining two-thirds split between his parents.

His testimony to this effect was impeached by his averment, in a 2001 filing with

the California superior court, that his mother had no ownership interest in the

business. All in all we find that the evidence conclusively supports Agent Chan’s

determination that 50% of White Sands’ assets should be allocated to Frank for

purposes of the net worth analysis.

      F.     Reduction for Alleged Sales Tax Liabilities

      Donald and Marie contend that Agent Chan erred, in determining their

liabilities, by failing to consider their “unpaid, outstanding debts to the California

State Board of Equalization.” Donald and Marie presented no affirmative case at

trial and introduced no evidence to establish the fact of these liabilities. The only

evidence they point to is a one-page exhibit captioned “Sales Tax Schedule.” This

schedule is not an official BOE document and appears to have been created using

a Microsoft Excel program. The evidence does not establish that these amounts

were bona fide liabilities that were due but unpaid. Absent such proof, they have

failed to show any error in Agent Chan’s calculations.
                                         -39-

[*39] G.     Conclusion

       Respondent has shown, by a preponderance of the evidence, that Agent

Chan’s net worth calculations were reasonable and free of arbitrariness and error.

If anything, her calculations were generous to petitioners: she resolved numerous

doubts in their favor, and she made assumptions that uniformly tended to under-

state their AGIs. She established petitioners’ opening net worths with reasonable

certainty; reasonably determined that White Sands was the likely source of their

omitted income; and negated all plausible nontaxable sources of income. Peti-

tioners have identified no errors in her implementation of the net worth method,

other than the minor errors that respondent conceded in his posttrial motion to

amend to conform pleadings to proof. As thus adjusted we sustain respondent’s

determinations of petitioners’ unreported income for 1998, 1999, and 2000 and his

assertions of increased deficiencies for certain of these years.

III.   Civil Fraud Penalty

       Respondent determined fraud penalties against petitioners for 1998, 1999,

and 2000. Frank conceded the fraud penalties determined against him, and

respondent does not contend that any of the underpayments were due to fraud

perpetrated by Helen. See sec. 6663(c) (“In the case of a joint return, this section

shall not apply with respect to a spouse unless some part of the underpayment is
                                       -40-

[*40] due to the fraud of such spouse.”). Donald and Marie contest the fraud

penalties determined against them. In their 2007 plea agreements Donald and

Marie agreed that they were “liable for the civil fraud penalty imposed by the

Internal Revenue Code * * * on the understatements of tax liability for 1998,

1999, and 2000.” The evidence at trial clearly established that they are indeed

liable for these fraud penalties.

      “If any part of any underpayment of tax required to be shown on a return is

due to fraud,” section 6663(a) imposes a penalty of 75% of the portion of the

underpayment due to fraud. Respondent has the burden of proving fraud, and he

must prove it by clear and convincing evidence. Sec. 7454(a); Rule 142(b);

Richardson v. Commissioner, 509 F.3d 736, 743 (6th Cir. 2007), aff’g T.C. Memo.

2006-69. To sustain his burden respondent must establish two elements: (1) that

there was some underpayment of tax for each taxable year in issue; and (2) that at

least some portion of the underpayment for each year was due to fraud. Hebrank

v. Commissioner, 81 T.C. 640, 642 (1983). As explained above, respondent has

carried his burden of proving that Donald and Marie underreported their income

and underpaid their tax for 1998, 1999, and 2000. The remaining question is

whether these underpayments were due to fraud.
                                         -41-

[*41] Fraud is intentional wrongdoing designed to evade tax believed to be owing.

Neely v. Commissioner, 116 T.C. 79, 86 (2001). The existence of fraud is a ques-

tion of fact to be resolved upon consideration of the entire record. Estate of

Pittard v. Commissioner, 69 T.C. 391, 400 (1977). Fraud is not to be presumed or

based upon mere suspicion. Petzoldt, 92 T.C. at 699-700. However, because

direct proof of a taxpayer’s intent is rarely available, fraudulent intent may be

established by circumstantial evidence. Grossman v. Commissioner, 182 F.3d

275, 277-278 (4th Cir. 1999), aff’g T.C. Memo. 1996-452.

      Circumstances that may indicate fraudulent intent, commonly referred to as

“badges of fraud,” include but are not limited to: (1) understating income;

(2) maintaining inadequate records; (3) giving implausible or inconsistent

explanations of behavior; (4) concealing income or assets; (5) failing to cooperate

with tax authorities; (6) engaging in illegal activities; (7) providing testimony that

lacks credibility; (8) filing false documents, including false income tax returns; (9)

failing to file tax returns; and (10) dealing extensively in cash. Spies v. United

States, 317 U.S. 492, 499 (1943); Morse v. Commissioner, T.C. Memo. 2003-332,

86 T.C.M. (CCH) 673, 675, aff’d, 419 F.3d 829 (8th Cir. 2005). No single factor

is dispositive; however, the existence of several factors “is persuasive
                                          -42-

[*42] circumstantial evidence of fraud.” Vanover v. Commissioner, T.C. Memo.

2012-79, 103 T.C.M. (CCH) 1418, 1420-1421.

      Donald and Marie pleaded guilty to willfully making and subscribing to a

false tax return for 1998. In their plea agreement they admitted that the “mistakes”

they made on their 1999 and 2000 returns were the same as those they had made

on their 1998 return. While willfully making and subscribing to a false return

does not in itself establish liability for the civil fraud penalty, such activity may

properly be considered in connection with other facts in determining whether an

underpayment of tax was due to fraud. See Wright v. Commissioner, 84 T.C. 636,

643-644 (1985); Unger v. Commissioner, T.C. Memo. 2000-267 (citing Stoltzfus

v. United States, 398 F.2d 1002, 1004 (3d Cir. 1968)). Consistent and substantial

understatement of income is itself evidence of fraud. See Laurins v.

Commissioner, 889 F.2d 910, 913 (9th Cir. 1989), aff’g Norman v. Commissioner,

T.C. Memo. 1987-265.

      Numerous badges of fraud demonstrate that Donald and Marie intentionally

evaded the payment of tax they knew to be owed. They substantially understated

their income for all three years in issue. See Stone v. Commissioner, 56 T.C. 213,

214, 224-226 (1971). They maintained inadequate records. See Ark. Oil & Gas,

Inc. v. Commissioner, T.C. Memo. 1994-497. They gave IRS agents inconsistent
                                        -43-

[*43] explanations concerning ownership of White Sands and made false

statements concerning their possession of its business records. See Morse, 419

F.3d at 833. Their testimony at trial lacked credibility concerning their alleged

receipt of a $200,000 gift from Fred Worth. See Scott v. Commissioner, T.C.

Memo. 2012-65, slip op. at 33. They dealt extensively in cash throughout the

years in issue. See Evans v. Commissioner, T.C. Memo. 2010-199, aff’d, 507 Fed.

Appx. 645 (9th Cir. 2013). They attempted to conceal assets by structuring bank

deposits below the $10,000 threshold to avoid bank reporting to the IRS. See

McClellan v. Commissioner, T.C. Memo. 2013-251, at *27-*28. And they filed a

false income tax return for each year. See Potter v. Commissioner, T.C. Memo.

2014-18.

      We find that the facts, taken as a whole, clearly and convincingly establish

that Donald and Marie acted with fraudulent intent and that each of their

underpayments of tax for 1998, 1999, and 2000 was due to fraud. We accordingly

sustain respondent’s imposition of the civil fraud penalty under section 6663(a)

for each year.
                                   -44-

[*44] To reflect the foregoing,


                                          An appropriate order and decision

                                  will be entered.
