                        T.C. Memo. 2003-146



                      UNITED STATES TAX COURT



                 LOUIS E. PEYTON, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16468-98.             Filed May 22, 2003.



     Louis E. Peyton, pro se.

     Veena Luthra, for respondent.



                        MEMORANDUM OPINION


     COHEN, Judge:   Respondent determined the following

deficiencies and penalties with respect to petitioner’s Federal

income taxes for 1990 and 1991:
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                                                Penalty
             Year          Deficiency       I.R.C. Sec. 6663

             1990           $29,538             $22,154
             1991            32,493              24,370

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.    Increased deficiencies and penalties were alleged in

respondent’s answer.    After concessions, the issues for decision

are:

       (1) Whether, and to what extent, petitioner received

unreported income from marijuana sales during 1990 and 1991 and

from certain construction activities during 1991;

       (2) whether petitioner is liable for self-employment tax for

these years; and

       (3) whether there exist underpayments due to fraud for 1990

and 1991 such that (a) petitioner is liable for civil fraud

penalties pursuant to section 6663 and (b) respondent’s proposed

deficiency assessments are not barred by the statute of

limitations.

                             Background

       For 1990 and for 1991, petitioner and his wife filed a joint

Form 1040, U.S. Individual Income Tax Return.    The Forms 1040

listed the occupation of petitioner as “construction worker”.

Each return reported wages earned by petitioner’s wife.    The 1990
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return also included income from an attached Schedule C, Profit

or Loss From Business, for petitioner’s construction activities.

No such Schedule C was included or construction income shown for

1991.

     In January 1997, petitioner was indicted on multiple counts

in the United States District Court for the Eastern District of

Virginia.    After trial, petitioner was found guilty on one count

of conspiracy to distribute marijuana and cocaine and on four

counts of filing false tax returns for 1990, 1991, 1992, and

1993, in violation of section 7206(1).   The indictment named

various persons as conspirators, including Stephen C. Hatcher

(Hatcher).   With respect to the counts concerning section

7206(1), the indictment charged that petitioner:

     did wilfully make and subscribe a U.S. Individual
     Income Tax Return, Form 1040, for the calendar year
     1990 [or 1991, etc.] which was verified by a written
     declaration that it was made under the penalties of
     perjury and was filed with the Internal Revenue
     Service, which said U.S. Individual Income Tax Return,
     Form 1040, he did not believe to be true and correct as
     to every material matter in that the said U.S.
     Individual Income Tax Return, Form 1040, failed to
     disclose that he engaged in the operation of a business
     activity from which he derived gross receipts or sales
     and incurred deductions, whereas, as he then and there
     well knew and believed, he was required by law and
     regulation to disclose the operation of this business
     activity, the gross receipts or sales he derived
     therefrom, and the deductions he incurred.

     (In violation of Title 26, United States Code, Section
     7206(1))
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     Judgment was entered against petitioner on July 8, 1997, and

petitioner was sentenced to imprisonment for a term of 151 months

on the conspiracy count and for terms of 36 months for each

section 7206(1) count, all terms to run concurrently and to be

followed by supervised release.

     On September 24, 1998, respondent sent to petitioner the

statutory notice of deficiency described above.   The deficiencies

were based in large part upon respondent’s determination that

petitioner received unreported income of $85,000 from marijuana

sales in 1990 and in 1991.   Among other adjustments, respondent

also determined that petitioner had unreported income for 1991 of

$9,171 from M.J. Lord.   On October 8, 1998, a petition was filed

with this Court disputing the full amount of the deficiencies and

penalties.   At that time, petitioner was incarcerated in

Pennsylvania.   The petition further asserted indigence, averred

that respondent bore the burden of proof “as to newly enacted

statute and T.C. R.142(b)”, alleged the bar of the statute of

limitations, and set forth erroneous and nonsensical references

to various provisions of the U.S. Constitution.

     Respondent answered the petition and additionally specified

facts in support of the fraud allegations.   The answer also

asserted a claim for increased deficiencies of $28,050 and

$29,313 for 1990 and 1991, respectively, and corresponding

increases in penalties of $21,037 for 1990 and $21,984.50 for
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1991.   The answer explained that respondent “erroneously

calculated the profit per pound of marijuana at $200.00, rather

than $400.00 per pound”, with the result that the unreported

income from marijuana sales should be $170,000 for each year.

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

commencing February 14, 2000; January 8, 2001; January 14, 2002;

and November 18, 2002.   The case was consecutively continued on

the first two occasions by motions from petitioner.   On the

latter two occasions, motions to continue were filed by

respondent.   Each motion was based on petitioner’s incarceration.

In respondent’s motion to continue the case from the November 18,

2002, session, it was represented that petitioner’s “expected

release date is April 24, 2008.”   None of the motions indicated

any attempt by either party to secure petitioner’s presence at

trial of this matter.    None of the motions reflected any efforts

by the parties to preserve evidence for trial, although there was

some indication of attempts to compromise petitioner’s liability

based on his claimed indigence.    In view of the unreasonableness

of deferring trial until 2008 or later with the probable loss of

evidence necessary for a determination on the merits,

respondent’s motion to continue from the November 18, 2002,

session was denied.

     The case was called for trial in Richmond, Virginia, on

November 18, 2002.    Neither petitioner nor any representative for
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him appeared, and no request to secure his appearance by writ of

habeas corpus or otherwise had been made.   The parties had not

entered into a stipulation, although they had exchanged

correspondence concerning a stipulation.    Respondent introduced

into evidence various documents, including copies of the

indictment and judgment in the criminal case, of petitioner’s tax

returns for 1990 and 1991, and of checks payable to petitioner.

Respondent also called as a witness a special agent of the

Internal Revenue Service (IRS) who had attended petitioner’s

criminal trial.   The special agent recounted aspects of the

testimony given at the criminal trial, particularly that of

alleged coconspirator Hatcher, and explained how respondent had

calculated the unreported income at issue in the present

proceeding.

     Upon the conclusion of the proceedings, the Court issued an

order directing petitioner to show cause why the case should not

be decided on the record made at trial.

     Petitioner filed a response to the order to show cause and a

motion to reopen the record.   These papers, and items attached

thereto, generally attacked the testimony given at the criminal

trial, quarreled with respondent’s computation of the unreported

income, and asserted petitioner’s indigence and inability to pay

the amounts sought by the IRS.    The response to the order to show

cause also included the following statement:
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          It has been over twelve years since this alleged
     underpayment occurred. The Petitioner has no
     documentation at all with regard to these years. As
     far as witnesses are concerned, I have had no contact
     with any of the individuals who could have testified at
     trial. * * *

Consistent with the above representation, none of the five items

attached to the motion to reopen the record constituted

documentation or records germane to any transaction purportedly

underlying respondent’s determinations.   Four of the documents

consisted of copies of correspondence sent by petitioner to

respondent and related primarily to negotiation of a stipulation

that was never received by the Court and to an unsuccessful

attempt to compromise the case.   The remaining item merely

summarized petitioner’s contentions in the face of various of

respondent’s allegations.

     Respondent objected to the motion to reopen the record,

citing rule 408 of the Federal Rules of Evidence and additionally

protesting that petitioner’s documents contained arguments rather

than evidence.   Petitioner’s motion to reopen the record was

denied, the order to show cause was made absolute, and respondent

was directed to file with the Court proposed findings of fact and

a memorandum of law.   Respondent filed the requested materials,

setting forth in detail respondent’s position and also making

certain concessions.   In particular, respondent asserted that

petitioner received unreported income from marijuana sales of

$160,000 for each year in issue, rather than $170,000 as asserted
                                 - 8 -

in the answer.     The change was based on respondent’s decision to

rely on an amount from the lower end of a range of values

purportedly supported by the testimony given at petitioner’s

criminal trial.

      Petitioner filed a response to respondent’s proposed

findings and memorandum.    In this document, petitioner again

attacked his criminal conviction and the testimony given at the

criminal trial and largely repeated or augmented many of the

contentions made in previous filings.      Additionally, in response

to allegations by respondent that petitioner deposited cash into

his personal bank account of $21,000 in 1990 and $24,000 in 1991,

petitioner admitted cash deposits were made but claimed, without

any documentary support, that the funds represented loans from

Hatcher.

                              Discussion

I.   Unreported Income

      The Internal Revenue Code imposes a Federal tax on the

taxable income of every individual.      Sec. 1.   Section 61(a)

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 petitioner
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received unreported income from marijuana sales and from

construction activities.

     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), 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

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.
                              - 10 -

     Here, respondent has come forward with the indictment and

judgment from petitioner’s criminal trial sufficiently linking

petitioner to illegal income from sales of marijuana.

Additionally, respondent has introduced documentary evidence,

primarily checks payable to petitioner, in support of the

unreported construction income received from M.J. Lord.    Thus, as

to the amounts in the notice of deficiency (other than those

adjustments conceded by respondent), petitioner bears the burden

of showing error in the determinations of income from both

marijuana distribution and construction operations.    Petitioner

has not done so.   The record contains only petitioner’s

uncorroborated assertions to the contrary, which in essence are a

collateral attack on his criminal conviction.   We therefore

sustain respondent’s determination of $85,000 in unreported

income from marijuana sales for 1990 and for 1991 and $9,171 in

unreported construction income from M.J. Lord in 1991.

     However, with respect to the increased deficiencies asserted

by respondent subsequent to issuance of the statutory notice,

respondent bears the burden of proof.   Rule 142(a).   The record

falls short of carrying this burden.    The only support offered by

respondent for the $160,000 amount from marijuana sales is the

testimony of the special agent as to what was said by a single

witness, Hatcher, at petitioner’s criminal trial.   The absence of

the criminal trial transcript deprives us of any ability to
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review the testimony, to compare statements made on direct versus

cross-examination, or to consider potential conflicts with

testimony of other witnesses (to which petitioner repeatedly

alludes).   We decline to uphold the increased deficiencies.

II.   Self-Employment Tax

      Section 1401 imposes a tax “on the self-employment income of

every individual”.   Self-employment income is defined generally

as “net earnings from self-employment”, which in turn means “the

gross income derived by an individual from any trade or business

carried on by such individual, less the deductions allowable by

this subtitle which are attributable to such trade or business”.

Sec. 1402(a) and (b).   “Trade or business” as used in this

context has been construed to encompass not only legal but also

illegal business activities.   See Petzoldt v. Commissioner, supra

at 668-669; Sundel v. Commissioner, T.C. Memo. 1998-78, affd.

without published opinion 201 F.3d 428 (1st Cir. 1999).

      Petitioner bears the burden of proving error in respondent’s

notice of deficiency in this regard, Rule 142(a), and petitioner

has offered no evidence or argument pertaining to the self-

employment tax.   Hence, to the extent that we have sustained

respondent’s determinations of unreported income, we likewise

sustain the imposition of corresponding self-employment tax

thereon.
                                   - 12 -

III.   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)

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.

       A.   Underpayments of Tax

       An underpayment will exist in a scenario such as that

presented by the case at bar where unreported gross receipts are

not exceeded by costs of goods sold and deductible expenses.       In

establishing the requisite underpayment, the Commissioner may not

simply rely on the taxpayer’s failure to prove error in the

deficiency determination.     DiLeo v. Commissioner, supra at 873;

Parks v. Commissioner, 94 T.C. 654, 660-661 (1990); Otsuki v.
                               - 13 -

Commissioner, 53 T.C. 96, 106 (1969).   However, upon clear proof

of unreported receipts, the burden of coming forward with

offsetting costs or expenses shifts to the taxpayer.     Siravo v.

United States, 377 F.2d 469, 473-474 (1st Cir. 1967); Elwert v.

United States, 231 F.2d 928, 933 (9th Cir. 1956); United States

v. Bender, 218 F.2d 869, 871-872 (7th Cir. 1955); United States

v. Stayback, 212 F.2d 313, 317 (3d Cir. 1954).   In addition,

section 280E disallows deductions and credits (but not costs of

goods sold) with respect to the sale of controlled substances.

See S. Rept. 97-494, at 309 (1982).

     1.   Receipts

     The record contains substantial evidence to support the

existence of unreported receipts from marijuana sales.

Petitioner was convicted, under the criminal standard of proof

beyond a reasonable doubt, of conspiracy to possess and

distribute marijuana.   Petitioner has admitted in various papers

filed with this Court that one of the witnesses at the criminal

trial testified that petitioner sold marijuana to her.

Petitioner was convicted under section 7206(1), beyond a

reasonable doubt, for failure to disclose that during the years

in issue he “engaged in the operation of a business activity from

which he derived gross receipts or sales and incurred

deductions”.   Supra p. 3.   The derivation of gross receipts was

thus an explicit part of the charge upon which petitioner was
                                - 14 -

found guilty.    While a conviction under section 7206(1)

establishes neither intent to evade tax nor the existence of an

underpayment, since neither is an element of the crime, the

indictment and judgment here are nonetheless clear and convincing

evidence that petitioner received unreported receipts from the

marijuana operations.    See Wright v. Commissioner, 84 T.C. 636,

643 (1985); Goodwin v. Commissioner, 73 T.C. 215, 229 (1979),

overruled on another issue Wright v. Commissioner, supra.

     Respondent has also introduced into evidence copies of

checks written by Mederic J. Lord payable to, and endorsed by,

petitioner.     These checks total $6,171.04, and several have

notations that allude to “siding”.       Additionally, respondent

introduced a copy of a document handwritten by petitioner

referencing certain of the foregoing checks and also

acknowledging receipt of $3,000 in cash.       This document is

supported by copies of bank slips showing a “cash out”

transaction from an account of M.J. Lord.       We conclude that

respondent has adduced clear proof of receipts of unreported

construction income from M.J. Lord in 1991.

     2.   Underpayment

     As previously explained, the above unreported gross receipts

will translate into an underpayment only if not exceeded by costs

of goods sold and deductible expenses.       We thus turn to the

extent to which petitioner has carried his burden of coming
                                 - 15 -

forward with such offsets.     On the issue of the marijuana sales,

the sole information in the record pertaining to costs of goods

sold is the testimony of Hatcher, indicating purchases of the

drugs for $1,000 to $1,100 per pound.     Respondent used the higher

value in calculating the claimed underpayments, and petitioner

has offered nothing to suggest any further allowance.

     Concerning the payments from M.J. Lord, petitioner contends

that the amounts were solely for materials and that the job was

done “out of kindness, and not for profit.”     Elsewhere he claims

that he did not report the payments because the proceeds went to

Raintree Contracting, an entity allegedly owned by Rick Guevarra,

with whom petitioner worked on the M.J. Lord project.     Once

again, however, these statements are nothing more than unsworn

and uncorroborated assertions, not evidence showing costs or

expenses.

     Hence, as to both the marijuana sales and the construction

payments, respondent has carried the burden of establishing

underpayments by clear and convincing evidence.

     B.   Fraudulent Intent

     The second prong of the fraud test requires respondent to

show that a portion of the underpayment is attributable to fraud.

Fraud for this purpose is defined as intentional wrongdoing on

the part of the taxpayer, with the specific purpose of avoiding a

tax believed to be owed.      Stoltzfus v. United States, 398 F.2d
                                - 16 -

1002, 1004 (3d Cir. 1968); Webb v. Commissioner, 394 F.2d 366,

377 (5th Cir. 1968), affg. T.C. Memo. 1966-81; Powell v.

Granquist, 252 F.2d 56, 60 (9th Cir. 1958).    Stated differently,

imposition of the civil fraud penalty is appropriate upon a

showing that the taxpayer intended to evade taxes believed to be

owing by conduct designed to conceal, mislead, or otherwise

prevent the collection of taxes.    DiLeo v. Commissioner, 96 T.C.

at 874.

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

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

supra at 874; 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.    Recklitis v. Commissioner, 91 T.C.

874, 909-910 (1988); Beaver v. Commissioner, 55 T.C. 85, 92

(1970).   However, because direct proof of a taxpayer’s intent is

seldom available, fraud may be established by circumstantial

evidence.   Spies v. United States, 317 U.S. 492, 499-500 (1943);

DiLeo v. Commissioner, supra at 874.     In this connection, courts

have developed a nonexclusive list of circumstantial indicia, or

“badges”, of fraud that will support a finding of fraudulent

intent.

     Among the badges of fraud that can be distilled from caselaw

are the following:   (1) Understatement of income; (2) maintenance

of inadequate records; (3) failure to file tax returns;
                              - 17 -

(4) implausible or inconsistent explanations of behavior;

(5) concealment of income or assets; (6) failure to cooperate

with tax authorities; (7) engaging in illegal activities;

(8) dealing in cash; (9) failure to make estimated tax payments;

and (10) filing false documents.   Spies v. United States, supra

at 499-500; Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.

1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.

1986), affg. T.C. Memo. 1984-601; Recklitis v. Commissioner,

supra at 910.   In addition, a conviction pursuant to section

7206(1), while not operating collaterally to estop a taxpayer

from denying fraudulent intent, is a fact to be considered and

may give rise to an inference of intent to evade.   Wright v.

Commissioner, supra at 643-644; see also Biaggi v. Commissioner,

T.C. Memo. 2000-48, affd. 8 Fed. Appx. 66 (2d Cir. 2001); Wilson

v. Commissioner, T.C. Memo. 1994-454; Avery v. Commissioner, T.C.

Memo. 1993-344.

     Applying these considerations to this case, we conclude that

petitioner fraudulently intended to underpay tax for each of the

years in issue.   The record demonstrates that petitioner

understated his income, maintained inadequate records, engaged in

illegal activities, and dealt in cash.   Moreover, the convictions

under section 7206(1) are highly probative.   The logical

inference to be drawn from such circumstances is that petitioner

structured his affairs with a purpose of avoiding his Federal tax
                               - 18 -

obligations.   Accordingly, we conclude that at least a portion of

the underpayment for each year is due to fraud.      Because

petitioner has failed to submit credible evidence showing that

some specific part is not due to fraud, we hold that petitioner

is liable for the section 6663 civil fraud penalties.      See sec.

6663(b).

IV.   Statute of Limitations

      As a general rule, section 6501 provides that any tax must

be assessed within 3 years of the date on which the pertinent tax

return was filed.    However, an exception exists in the case of a

“false or fraudulent return”, under which exception tax may be

assessed “at any time.”    Sec. 6501(c)(1).    Respondent bears the

burden of proving fraud in this context.      Sec. 7454(a); Rule

142(b).    Because respondent has done so here for the reasons

explained above, assessment of petitioner’s 1990 and 1991 tax

liabilities is not barred by the statute of limitations.

      To reflect concessions made and the foregoing,


                                           Decision will be entered

                                     under Rule 155.
