                        T.C. Memo. 1995-597



                      UNITED STATES TAX COURT



            CHONG-KAK AND SANG-OK LEE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

            HAMALEE DISTRIBUTORS INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket Nos. 4498-94, 4503-94. Filed December 19, 1995.


     Tysun Ihm, for petitioners.

     Aretha Jones and Clement Shugerman, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     LARO, Judge:   Chong-Kak and Sang-Ok Lee, and Hamalee

Distributors, Inc., separately petitioned the Court to

redetermine respondent's determinations of the following Federal

income tax deficiencies and additions thereto:
                                          - 2 -


The Lees, docket No. 4498-94
                                                 Additions to Tax
                     Sec.            Sec.        Sec.          Sec.             Sec.
Year   Deficiency 6653(b)(1)      6653(b)(2) 6653(b)(1)(A) 6653(b)(1)(B)        6661
                                     1
1985       $113,035   $56,518                         ---          ---      $28,259
                                                                    2
1986        195,770     ---         ---            $146,828                  48,943
                                                                    3
1987        182,440     ---         ---             136,830                  45,610
1988        155,509   116,632       ---               ---          ---       38,877
       1
         50% of the interest due on $113,035.
       2
         50% of the interest due on $195,770.
       3
         50% of the interest due on $182,440.

Hamalee, docket No. 4503-94

Taxable                                 Additions to Tax
 Year                Sec.       Sec.        Sec.          Sec.               Sec.
 Ended Deficiency 6653(b)(1) 6653(b)(2) 6653(b)(1)(A) 6653(b)(1)(B)          6661
                                      1
3/31/86 $245,998       $122,999                      ---            ---     $61,499
                                                                        2
3/31/87 253,945           ---       ---           $190,459                   63,486
       1
        50% of the interest due on $245,998.
       2
        50% of the interest due on $253,945.

Following the consolidation of their cases for trial, briefing,

and opinion, we must decide:

       1.     Whether Hamalee underreported its taxable income for its

taxable years ended March 31, 1986 (1985 taxable year), March 31,

1987 (1986 taxable year), December 31, 1987 (1987 taxable year),

and December 31, 1988 (1988 taxable year).                    We hold it did.

       2.     Whether Mr. Lee received unreported distributions from

Hamalee during 1985, 1986, and 1987.                We hold he did.

       3.     Whether Hamalee may deduct certain unreported expenses

that it allegedly paid in cash.             We hold it may not.
                                 - 3 -


     4.     Whether Hamalee had a net operating loss (NOL) in 1989,

that the Lees may carry back to the subject years.      We hold it

did not.1

     5.     Whether petitioners are liable for the additions to tax

for fraud determined by respondent.      We hold they are to the

extent stated herein.

     6.     Whether petitioners are liable for the additions to tax

for substantial understatements determined by respondent.      We

hold they are.

     Unless otherwise stated, section references are to the

Internal Revenue Code in effect for the years in issue.      Rule

references are to the Tax Court Rules of Practice and Procedure.

We separately refer to Chong-Kak and Sang-Ok Lee as Mr. Lee and

Mrs. Lee, respectively.     We collectively refer to Mr. Lee and

Mrs. Lee as the Lees.     We refer to the Lees' daughter, Inae Lee,

as Ms. Lee.     We refer to the Lees' son-in-law, Ick Soo Won, as

Mr. Won.     We refer to Hamalee Distributors, Inc., as Hamalee.

We refer to Myun Suk Chong as Ms. Chong.

                           FINDINGS OF FACT



     1
       Our resolution of this issue moots another issue raised by
the parties as to Mr. Lee's basis in his Hamalee stock on
Dec. 31, 1989.
                               - 4 -


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

The stipulations and attached exhibits are incorporated herein by

this reference.

     The Lees are husband and wife.     They resided in Elmhurst,

New York, when they petitioned the Court.     They filed joint

Federal income tax returns for the years in issue.     Hamalee is

Mr. Lee's wholly-owned corporation.     Hamalee was formed by Mr.

Lee in 1982 under the corporate laws of the State of New York,

and it became an S corporation as of June 1, 1987.     Hamalee's

mailing address was in Elmhurst, New York, at the time of its

petition.

     The Lees immigrated to the United States from South Korea in

1980. While in Korea, Mr. Lee received a college degree in

economics, and Mrs. Lee completed some college courses.     Mr. Lee

managed one company while in Korea, and he owned and operated a

second company there for 12 years.     When the second company

terminated in 1979, its gross sales were approximately $500,000,

and it employed approximately 300 people.     Mrs. Lee worked with

Mr. Lee at the second company before it terminated.

     Hamalee was a wholesale supplier of beer in the Long Island

area of New York.   The Lees were its only officers; Mr. Lee

served as its president, and Mrs. Lee served as its secretary.
                               - 5 -


Mr. Lee managed Hamalee's warehouse operation, reviewed its

accounting records and receipts, monitored its purchase and sales

orders, collected its receivables, effectuated its banking

transactions, and signed all of Hamalee's tax returns.   Mrs. Lee

dealt with Hamalee's customers, took its sales orders, checked

its deliveries, collected and accounted for moneys received by

its delivery people, and helped manage its financial records.

Mrs. Lee and Ms. Chong maintained Hamalee's accounting records

and receipts.   Mr. Lee and Mrs. Lee were the only individuals

authorized to sign checks for Hamalee.

     Hamalee's purchases, sales, and payables were primarily

transacted in cash.   Hamalee kept its business records in two

separate sets of books.   The first set (the actual books)

contained all of Hamalee's sales, listing each sale in

chronological order and referencing whether each sale was paid in

cash or by check.   The second set (the tax books) showed all of

Hamalee's sales that were paid by check and some of the sales

that were paid in cash.   Entries in the tax books, which were the

only books provided to the preparers of Hamalee's tax returns,

were the only sales reported for tax purposes.   Entries in the

tax books were underlined in red ink in the actual books, and an

invoice number was handwritten in the actual books next to each
                                - 6 -


underlined entry.    The invoices that corresponded to the invoice

numbers were "Bates-stamped" and stored in sequential order.       The

invoices for the cash sales that were recorded in only the actual

books were not Bates-stamped.    Ms. Chong destroyed most of these

invoices after she recorded them in the actual books.

     On October 13, 1989, the New York City Department of Finance

(the Finance Department) began an undercover investigation of

petitioners after an informant notified them that petitioners

were evading Federal and State income taxes through the filing of

fraudulent tax returns.    Shortly thereafter, during the course of

the Lees' efforts to sell Hamalee's business, Mrs. Lee and Ms.

Lee were introduced to two undercover agents from the Finance

Department posing as prospective buyers.2    Mrs. Lee showed the

agents Hamalee's actual books, and she explained to the agents

that Hamalee had a different set of books for tax purposes.

Mrs. Lee explained to the agents that the actual books included

sales that were not recorded in the tax books.

     In connection with the Finance Department's undercover

operation, the authorities "raided" Hamalee on October 25, 1989,

seizing most of Hamalee's business records and the Lees' personal



     2
         Ms. Lee was there primarily as an interpreter.
                                - 7 -


bank records.    The Lees and Ms. Lee were arrested, and a

resulting seventy-six count grand jury indictment was filed in

the New York County Supreme Court against them and Hamalee with

respect to the period April 1, 1985 through December 31, 1989.

Pursuant to a Plea Agreement dated September 11, 1990, the Lees

and Hamalee (through its president, Mr. Lee) pleaded guilty to a

felony charge of evading New York City corporate tax for

Hamalee's 1988 taxable year.    Mr. Lee, both individually and on

behalf of Hamalee, also pleaded guilty to a felony charge of

filing a false and fraudulent New York State franchise tax return

for Hamalee's 1986 taxable year.    Hamalee was ordered to pay

$125,000 in restitution of New York State and City taxes, Mr. Lee

was given a 1 year custodial sentence, and Mrs. Lee was given a

non-custodial sentence.

     Respondent audited petitioners for the subject years.    She

referred to Hamalee's actual books and determined that Hamalee

failed to report sales of $4,812,404, $4,623,455, $3,229,199, and

$4,589,694 for its 1985 through 1988 taxable years,

respectively.3   She referred to industry standards and determined



     3
       Respondent also determined that Hamalee had unreported
purchases in each year. These additional purchases are not at
issue here.
                               - 8 -


that Hamalee's gross profit percentage for each year was 12

percent.   Respondent determined that Hamalee constructively

distributed its unreported sales income to Mr. Lee during his

1985, 1986, and 1987 taxable years.4   Of the $577,488 in

unreported income for Hamalee's 1985 taxable year ($4,812,404 x

12%), respondent determined that $433,116 was distributed to

Mr. Lee in 1985, and $144,372 was distributed to him in 1986.     Of

the $554,815 in unreported income for Hamalee's 1986 taxable year

($4,623,455 x 12%), respondent determined that $416,111 was

distributed to Mr. Lee in 1986, and $138,704 was distributed to

him in 1987.   With respect to all of these distributions,

respondent determined that Mr. Lee received:   (1) A dividend of

$269,407 and a return of capital of $163,709 in 1985; (2) a

dividend of $349,960, a return of capital of $86,291, and a

capital gain of $124,232 in 1986; and (3) a dividend of $86,719

and a capital gain of $51,985 in 1987.   For Hamalee's 1987 and

1988 taxable years, respondent determined that the unreported

income of $387,504 ($3,229,199 x 12%) and $550,763 ($4,589,694 x

12%) was taxable to Mr. Lee as income from an S corporation.



     4
       Respondent determined that all of these distributions
occurred when Hamalee was a C corporation.
                               - 9 -


                              OPINION

      Except for respondent's allegations of fraud, petitioners

must prove that respondent's determinations set forth in her

notices of deficiency are incorrect.5    Rule 142(a) and (b); Welch

v. Helvering, 290 U.S. 111, 115 (1933).     Petitioners must also

prove their entitlement to any deduction.     New Colonial Ice Co.

v. Helvering, 292 U.S. 435, 440 (1934).     Deductions are matters

of legislative grace, and petitioners must show that their

deductions are allowed by the Code.     Petitioners must also keep

sufficient records to substantiate any deduction that would

otherwise be allowed by the Code.   Sec. 6001.

1.   Profit on Sales

      Petitioners do not dispute that Hamalee failed to report the

sales set forth in the notices of deficiency.    The dispute rests

on the calculation of Hamalee's gross profit percentage



      5
       Petitioners allege in their brief that respondent must
prove her determination of constructive distributions because
this determination is arbitrary and capricious. We refuse to
consider this allegation because petitioners raised it for the
first time on brief. If petitioners had wanted to place this
allegation before us, they should have made the allegation in
their petition or taken other steps to preserve it. By failing
to do so, petitioners have conceded it. See, e.g., Merlino v.
Commissioner, T.C. Memo. 1993-200, and the cases cited therein;
see also Rule 34(b)(4) and (5).
                               - 10 -


attributable to these sales.   At trial, respondent supported her

determination with the testimony of two experts who concluded

that Hamalee's gross profit percentage could be as high as 24.9

percent.   In reaching their conclusions, respondent's experts

considered various factors (e.g., economic, investment market,

and industry conditions) related to the selling of beer during

the relevant time frame.   Respondent's experts also reviewed

Hamalee's sales and purchases journals, as well as its tax

returns, and referred to several relevant financial publications.

Petitioners argue that Hamalee's gross profit percentages were

9.7568 percent, 8.9763 percent, 7.9707 percent, and 7.612 percent

for its 1985 through 1988 taxable years, respectively.    At trial,

petitioners presented an "expert" to attempt to disprove

respondent's determination and to support their claim to the

lower gross profit percentages.   Petitioners' "expert", Stan Lee,

concluded that Hamalee's gross profit percentages equalled the

percentages claimed by petitioners.     In reaching his conclusions,

Stan Lee reviewed some of Hamalee's purchases and sales

documents, and he assumed that this sample was representative of

all of Hamalee's purchases and sales documents.    Stan Lee did not
                              - 11 -


review all of Hamalee's purchases and sales documents, and he did

not consider any extrinsic evidence.

     We agree with respondent's determination of Hamalee's gross

profit percentages.   We found her experts to be credible, and

we found their presentations to be methodical, empirical, and

persuasive.   Respondent's lead expert, the president of a

valuation company headquartered in New York, New York, has given

expert testimony on fair market valuation and financial analysis

for over 30 years in this and other Courts.   He is a graduate of

Princeton University, Phi Beta Kappa (junior year), Magna Cum

Laude, and Lyman Biddle Senior Scholar.   He has authored numerous

books and articles, and he is a member of numerous professional

associations, many of which he has chaired.   In addition to the

weight that we give the testimony of respondent's experts, we

also find relevant the fact that respondent conservatively

determined Hamalee's gross profit percentage at 12 percent for

each year, although her experts testified that the percentages

could be as high as 24.9 percent.

     Petitioners argue that respondent's determination is

erroneous because it is based on industry standards rather than

the "better data" of Hamalee's actual purchases and sales.
                              - 12 -


Petitioners argue that Stan Lee used this "better data" and

computed Hamalee's gross profit percentages at the amounts that

petitioners ask us to find.   We are unpersuaded.   In addition to

the fact that petitioners have failed to convince us that

respondent's method of computation was less accurate than

petitioners' "better method", we bear in mind that Hamalee's cash

sales accounted for a large portion of its total sales and that

most of Hamalee's cash sale invoices were destroyed.    Thus, even

if we were to agree with petitioners that the use of Hamalee's

actual data was the better method for computing its gross profit

percentages, we could not have applied the "better method" in the

case at hand because the record contains insufficient data.

     We also were not impressed with the presentation of Stan

Lee, and we view most of his conclusions to be unpersuasive.

His testimony and report lacked coherence, and they were not

helpful to the Court.   His conclusions were partially based on

Hamalee's sales invoices, which did not include the ones that

were destroyed, and he reviewed only a fraction of the already

incomplete records to arrive at his conclusions.    We need not

follow an expert's conclusions that are contrary to our better

judgment, see, e.g., Helvering v. National Grocery Co., 304 U.S.
                               - 13 -


282, 294-295 (1938); Seagate Technology v. Commissioner, 102 T.C.

149, 186 (1994), and we refuse to follow Stan Lee's conclusions

here.   We sustain respondent's determination that Hamalee's gross

profit percentage is 12 percent for each relevant year, and that

Hamalee has unreported sales income of $577,488 for its 1985

taxable year, $554,815 for its 1986 taxable year, $387,504 for

its 1987 taxable year, and $550,763 for its 1988 taxable year.

Because Hamalee is an S Corporation for its 1987 and 1988 taxable

years, we also sustain respondent's determination that Hamalee's

income for those years is includable in the Lees' 1987 and 1988

taxable incomes.

2.   Constructive Distributions

      A distribution may constructively arise when corporate funds

are diverted to a shareholder's personal use; e.g., to pay a

shareholder's personal expense or to discharge his or her

personal obligation.   A constructive distribution may arise even

when the distributing corporation does not formally declare that

it is making a distribution.      Crosby v. United States, 496 F.2d

1384, 1388 (5th Cir. 1974); Tollefsen v. Commissioner, 431 F.2d

511 (2d Cir. 1970), affg. 52 T.C. 671 (1969); Dean v.

Commissioner, 57 T.C. 32 (1971); Challenge Manufacturing Co. v.

Commissioner, 37 T.C. 650 (1962).     When a constructive
                                - 14 -


distribution arises, the amount (if any) of the distribution that

is taxable to the recipient shareholder is determined by

reference to section 301(c).    Section 301(c)(1) provides that the

amount of the distribution that is a dividend is included in

gross income.   Section 301(c)(2) provides that the amount of the

distribution that is not a dividend reduces the adjusted basis of

the related stock.   Section 301(c)(3)(A) generally provides that

the amount of the distribution that is not a dividend, and that

exceeds the adjusted basis of the related stock, is gain from the

sale or exchange of property.

     Petitioners argue that respondent's determination of the

constructive distributions is erroneous because the Lees did not

receive the subject distributions.       In support of petitioners'

argument, the Lees, a number of their relatives, and Ms. Chong

testified:   (1) The Lees did not receive any distributions from

Hamalee during the relevant years, and (2) most of the unreported

income was attributable to moneys and/or inventory stolen from

Hamalee by Mr. Won and his brother.       With respect to petitioners'

latter contention, their witnesses generally testified that the

Lees learned in 1989 that Mr. Won and his brother had been

stealing money and/or inventory from Hamalee since 1986.       To

attempt to support this testimony, petitioners presented some
                               - 15 -


documents showing that the Lees hired a law firm allegedly to

recover Hamalee's stolen property, and that the firm sent a

letter to both Mr. Won and his brother in May 1990, asking them

to compensate Hamalee for the thefts or face criminal prosecution

if they did not.    When the letters received no response, the

witnesses testified, no further action was taken to recover the

allegedly stolen amounts.

     We are not persuaded by petitioners' arguments.    Simply put,

they have failed to show us that the Lees did not actually or

constructively receive these distributions.    Petitioners rely

mainly on the testimony of the Lees and numerous "family" members

to support their allegations for a contrary result.    We give this

testimony little weight.    In addition to the fact that much of it

is self-serving and/or biased, we find that none of the relevant

testimony is corroborated by uninterested persons or any other

reliable evidence.    Under the circumstances, we are not required

to, and we do not, rely on that testimony to support petitioners'

positions herein.    LaBow v. Commissioner, 763 F.2d 125, 131 (2d

Cir. 1985), affg. in part and revg. in part on other grounds T.C.

Memo. 1983-417; Lifschultz v. Commissioner, 393 F.2d 232, 234 (2d

Cir. 1968), affg. T.C. Memo. 1966-225; Tokarski v. Commissioner,

87 T.C. 74, 77 (1986).
                              - 16 -


      Petitioners also rely on the fact that the Lees hired a law

firm allegedly to recover the stolen funds.   We give this fact

little weight.   The law firm merely mailed demand letters to

Mr. Won and his brother, and neither the firm nor the Lees took

any meaningful steps, after these letters were mailed, to recover

the amounts claimed stolen.   The Lees, for example, could have

(but did not) seek criminal charges against Mr. Won or his

brother with respect to the alleged theft.    The Lees also could

have (but did not) make a claim on Hamalee's then-existing

insurance policy.   While we can understand the delicate and

difficult familial situation that the Lees may have faced with

regard to criminally prosecuting their daughter's husband with

respect to this purported matter, we cannot excuse the lack of

evidentiary support for the claimed thefts.   Petitioners have not

convinced us that these "thefts" occurred.

      Because petitioners have failed to disprove respondent's

determination on this issue, we sustain it.

3.   Unreported Cash Expenditures

      Petitioners argue that Hamalee may deduct certain cash

expenditures that were made in each year in issue, but for which

Hamalee did not claim a deduction on its corresponding tax

returns.   Petitioners allege that these cash expenditures were
                                - 17 -


payments for:    (1) Wages of temporary employees, (2) meals

provided to Hamalee's employees on its premises, and (3) fuel and

tolls.    Petitioners generally rely on the testimony of Ms. Chong

to support their allegations of these unreported expenditures and

the amounts thereof.    Hamalee has no records to support these

purported expenditures, and petitioners ask the Court to estimate

the expenditures' dollar amounts.

     We decline petitioners' invitation to estimate the amount of

Hamalee's claimed expenditures.     Although petitioners are correct

in that we may estimate the amount of unsubstantiated expenses

when we have a basis to do so, Cohan v. Commissioner, 39 F.2d 540

(2d Cir. 1930), we do not have a sufficient basis to make an

estimate here.     See Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985).    In fact, the record does not even persuade us that

Hamalee incurred the claimed expenditures, or, if it had, that

these expenditures were ordinary and necessary business expenses

under section 162.     Whereas petitioners would have us find, based

solely on the testimony of Ms. Chong, that Hamalee incurred the

purported expenditures in the amounts that she so claimed, we

refuse to do so.     Ms. Chong's testimony on this issue is

unsupported by the record, and we find it to be somewhat

incredible.     We will not rely on it.   LaBow v. Commissioner,
                                - 18 -


supra at 131; Lifschultz v. Commissioner, supra at 234; Tokarski

v. Commissioner, supra at 77.     Because petitioners have not

proven that Hamalee incurred any unreported expenditures that

were deductible under section 162, and because the record

contains no reliable evidence upon which we could have otherwise

estimated the amounts of these expenditures, had we found them to

have been incurred, we hold that Hamalee is not entitled to any

additional deductions.

4.   Net Operating Loss Carryback

      Petitioners argue that Hamalee has an NOL in 1989, and that

the Lees may carry it back to the subject years.    Petitioners

allege that the NOL stems from:     (1) The thefts mentioned above

and (2) cash expenditures made by Hamalee in 1989, but for which

it did not claim a deduction on its 1989 tax return.    The cash

expenditures are generally asserted to be of the same type as the

cash expenditures mentioned above.

      Petitioners must prove their right to deduct an NOL in the

subject years.   United States v. Olympic Radio & Television,

Inc., 349 U.S. 232, 235 (1955).     Such a deduction is a matter of

legislative grace; it is not a matter of right.     Id. at 235;

Deputy v du Pont, 308 U.S. 488, 493 (1940).
                              - 19 -


      We have previously indicated that Hamalee is not entitled to

deduct a theft loss in 1989, and we see no purpose that would be

served by repeating our discussion here.    We hold that Hamalee

has not substantiated the claimed theft loss in 1989.    The same

is true with respect to the claimed cash expenditures.    Suffice

it to say, once again, that petitioners have not proven that

Hamalee is entitled to any of them.    We hold that the Lees may

not carryback any of the purported 1989 NOL.

5.   Additions to Tax For Fraud

      Turning to respondent's allegations of fraud, respondent

must meet her burden of proving fraud through affirmative

evidence because fraud is never imputed or presumed.     Beaver v.

Commissioner, 55 T.C. 85, 92 (1970).    Whether fraud exists in a

given situation is a factual determination that must be made

after reviewing the particular facts and circumstances of the

case.   DiLeo v. Commissioner, 96 T.C. 858, 874 (1991), affd.

959 F.2d 16 (2d Cir. 1992).   Respondent must prove both prongs of

the often-cited two-prong test for fraud (i.e., whether

petitioners underpaid tax in the relevant year, and whether some

part of the underpayment was due to fraud), in order to sustain

her allegations under:   (1) Section 6653(b)(1) for petitioners'
                             - 20 -


1985 taxable years,6 (2) section 6653(b)(1)(A) for petitioners'

1986 taxable years and the Lees' 1987 taxable year,7 and


     6
       Sec. 325(a) of the Tax Equity and Fiscal Responsibility
Act of 1982, Pub. L. 97-248, 96 Stat. 616-617, amended sec.
6653(b) effective for taxes the last day prescribed by law for
the payment of which, without regard to extensions, was after
Sept. 3, 1982. Following its amendment, sec. 6653(b) provides in
relevant part:

          (1) In General.--If any part of any underpayment * * *
     of tax required to be shown on a return is due to fraud,
     there shall be added to the tax an amount equal to 50
     percent of the underpayment.

          (2) Additional Amount for Portion Attributable to
     Fraud.--There shall be added to the tax (in addition to the
     amount determined under paragraph (1)) an amount equal to
     50 percent of the interest payable under section 6601--

               (A) with respect to the portion of the
          underpayment described in paragraph (1) which is
          attributable to fraud, and

               (B) for the period beginning on the last day
          prescribed by law for payment of such underpayment
          (determined without regard to any extension) and ending
          on the date of the assessment of the tax (or, if
          earlier, the date of the payment of the tax).
     7
       Sec. 1503(a) of the Tax Reform Act of 1986, Pub. L. 99-
514, 100 Stat. 2085, 2742-2743, amended sec. 6653(b) effective
for returns the due date of which, without regard to extensions,
was after Dec. 31, 1986. Following its amendment, sec. 6653(b)
provides in relevant part:

          (1) In general.--If any part of any underpayment * * *
     of tax required to be shown on a return is due to fraud,
     there shall be added to the tax an amount equal to the sum
     of--
                                                   (continued...)
                             - 21 -


(3) section 6653(b)(1) for the Lees' 1988 taxable year.8   For

purposes of section 6653(b)(2), which is applicable to


     7
      (...continued)
               (A) 75 percent of the portion of the underpayment
          which is attributable to fraud, and

               (B) an amount equal to 50 percent of the interest
          payable under section 6601 with respect to such portion
          for the period beginning on the last day prescribed by
          law for payment of such underpayment (determined
          without regard to any extension) and ending on the date
          of the assessment of the tax or, if earlier, the date
          of the payment of the tax.

          (2) Determination of portion attributable to fraud.--
     If the Secretary establishes that any portion of an
     underpayment is attributable to fraud, the entire
     underpayment shall be treated as attributable to fraud,
     except with respect to any portion of the underpayment which
     the taxpayer establishes is not attributable to fraud.
     8
       Sec. 1015(b)(2)(B) of the Technical and Miscellaneous
Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, 3569,
amended sec. 6653(b) effective for returns the due date of which,
without regard to extensions, was after Dec. 31, 1988. Following
its amendment, sec. 6653(b) provides in relevant part:

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

          (2) Determination of portion attributable to
     fraud.--If the Secretary establishes that any portion
     of an underpayment is attributable to fraud, the entire
     underpayment shall be treated as attributable to fraud,
     except with respect to any portion of the underpayment
     which the taxpayer establishes is not attributable to
     fraud.
                                 - 22 -


petitioners' 1985 taxable years, respondent must prove the

portion of the deficiency that is attributable to fraud.      Cooney

v. Commissioner, T.C. Memo. 1994-50; Franklin v. Commissioner,

T.C. Memo. 1993-184.      For purposes of section 6653(b)(1)(B)

(which is applicable to petitioners' 1986 taxable years and the

Lees' 1987 taxable year) and section 6653(b)(1) (which is

applicable to the Lees' 1988 taxable year), when respondent shows

that some part of the underpayment is due to fraud, the whole

underpayment is treated as attributable to fraud unless the

taxpayer proves otherwise.

     a.   Underpayments

     Based on our careful review of the record, we find that

respondent has clearly and convincingly proven that Hamalee

underpaid its taxes for its 1985 and 1986 taxable years, and that

the Lees underpaid their taxes for 1987 and 1988.      See sec.

6653(c)(1) (an "underpayment" generally is the same as a

"deficiency" under sec. 6211).      The record clearly convinces us

that Hamalee had significant amounts of income that were not

reported on its 1985 and 1986 tax returns, and that the Lees had

significant amounts of income that were not reported on their

1987 and 1988 tax returns.      The record also clearly convinces us

that these amounts were subject to tax.      Thus, with respect to
                                - 23 -


Hamalee's 1985 and 1986 taxable years, and the Lees' 1987 and

1988 taxable years, we hold that respondent has met her burden on

the first prong of the two-prong test for fraud.

     In the case of the Lees' 1985 and 1986 taxable years,

however, the answer is not so clear.     Respondent determined a

deficiency in each of those years based on her determination that

Mr. Lee received constructive distributions from Hamalee equal to

the unreported income.    As set forth above, we sustained those

determinations because petitioners did not disprove them.     The

mere fact that we have sustained a deficiency determined by

respondent, however, does not mean that an individual has

underpaid his or her taxes for purposes of the additions to tax

for fraud.    DiLeo v. Commissioner, supra ("clear and convincing"

standard applies to both prongs of the two-prong test); Parks

v. Commissioner, 94 T.C. 654, 663-664 (1990); Hebrank v.

Commissioner, 81 T.C. 640 (1983); see also Habersham-Bey v.

Commissioner, 78 T.C. 304, 312 (1982), and the cases cited

therein.     As the Court observed in Parks v. Commissioner, supra

at 660-661:

     Where, as here, respondent has prevailed on the issue
     of the existence of a deficiency by virtue of a
     taxpayer's failure to carry his burden of proof,
     respondent cannot rely on that failure to sustain his
     burden of proving fraud. We must be careful in such
                              - 24 -


     cases not to bootstrap a finding of fraud upon a
     taxpayer's failure to prove respondent's deficiency
     determination erroneous. * * * [Citations omitted.]

     With this well-settled law in mind, we are not clearly

convinced that the Lees actually or constructively received the

distributions from Hamalee determined by respondent.   Whereas

petitioners presented little evidence to show that Mr. Lee failed

to receive these distributions, respondent presented practically

no evidence at all to show that he did receive them.   We hold for

petitioners on this issue; respondent has failed to meet her

burden of proof.9   See also Drieborg v. Commissioner, 225 F.2d

216, 219-220 (6th Cir. 1955), affg. in part and revg. in part a

Memorandum Opinion of this Court (where fraud is determined for

each of several years, respondent's burden applies separately to

each of the years); Estate of Stein v. Commissioner, 25 T.C. 940,

959-963 (1956), affd. sub nom. Levine v. Commissioner, 250 F.2d

798 (2d Cir. 1958).   Thus, the Lees are not liable for the 1985

and 1986 additions to tax for fraud determined by respondent.



     9
       Our holding on this issue is not inconsistent with our
prior holding that included the distributions in the Lees' 1985
and 1986 taxable income. Our first holding is based on the fact
that petitioners failed to prove by a preponderance of the
evidence that the Lees did not receive the subject distributions.
Our second holding is based on the fact that respondent has not
proven by clear and convincing evidence that they did.
                                - 25 -


     b.    Fraudulent Intent

     For Hamalee's 1985 and 1986 taxable years, and the Lees'

1987 and 1988 taxable years, we turn to the second prong of the

two-prong test.    The existence of fraud is a question of fact.

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

published opinion 578 F.2d 1383 (8th Cir. 1978).    Fraud is never

presumed or imputed; it must be established by independent

evidence that establishes a fraudulent intent on the taxpayer's

part.     Otsuki v. Commissioner, 53 T.C. 96, 106 (1969).   Because

direct proof of a taxpayer's intent is rarely available, fraud

may be proven by circumstantial evidence and reasonable

inferences may be drawn from the relevant facts.     Spies v. United

States, 317 U.S. 492, 499 (1943); Stephenson v. Commissioner,

79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th Cir. 1984).

An intent to conceal or mislead may be inferred from a pattern of

conduct, Spies v. United States, supra at 499, or from a

taxpayer's entire course of conduct, Stone v. Commissioner,

56 T.C. 213, 223-224 (1971).    A pattern showing a consistent

underreporting of income, when accompanied by other facts

evidencing an intent to conceal, also justifies an inference of

fraud.    Holland v. United States, 348 U.S. 121, 137 (1954);

Parks v. Commissioner, supra; Otsuki v. Commissioner, supra at
                               - 26 -


664.   Certain indicia of fraud help us decide the existence of

fraud; the presence of several indicia may be persuasive

circumstantial evidence of fraud.    These "badges of fraud"

include:    (1) The filing of false documents; (2) understatement

of income; (3) maintenance of inadequate records; (4) implausible

or inconsistent explanations of behavior; (5) concealment of

assets; (6) failure to cooperate with tax authorities;

(7) engaging in an illegal activity; (8) attempting to conceal

the illegal activity; and (9) dealing in cash.    Bradford v.

Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg.

T.C. Memo. 1984-601; Petzoldt v. Commissioner, 92 T.C. 661, 700

(1989).

       Based on our careful review of the record, we conclude that

respondent has clearly and convincingly proven the requisite

fraudulent intent in each of petitioners' relevant years.

Petitioners' clear pattern of intentional underreporting of

taxable income, coupled with their two sets of books and lack of

recordkeeping, leads to a particularly strong inference of fraud.

We also consider it significant that the Lees and Hamalee

(through Mr. Lee) pleaded guilty to State income tax violations.

Although this conviction does not, in and of itself, establish a

fraudulent intent, we consider the crime evidence of a propensity
                               - 27 -


to defraud.   McGee v. Commissioner, 61 T.C. 249, 260 (1973),

affd. 519 F.2d 1121 (5th Cir. 1975); Petzoldt v. Commissioner,

supra at 701-702.

     We also find that most of the badges of fraud are present.10

Petitioners' income was consistently underreported, and, in toto,

Hamalee did not report more than $17 million in sales.   Hamalee

kept separate tax books, and those books did not list all of

Hamalee's sales.    Most of Hamalee's cash invoices were destroyed

by its bookkeeper.   Petitioners' tax returns, as filed, did not

accurately report their taxable income as it was known to be.

Petitioners maintained at least 11 bank accounts.   The Lees,

individually and as officers of Hamalee, admitted guilt to

evading State income tax laws.   Petitioners attempted to conceal

Hamalee's unreported funds through the use of separate books.

Hamalee's business was "cash oriented".11   Although petitioners



     10
       Indeed, the only badge of fraud that may not be present
concerns a taxpayer's cooperation with taxing authorities. The
record shows neither that the Lees (individually, or on behalf of
Hamalee) cooperated with the taxing authorities, nor that they
failed to do so.
     11
       Indeed, Mrs. Lee testified that she usually kept a large
amount of money at the warehouse, and that Mr. Lee sometimes
found it necessary to carry a gun because he carried so much
cash. Ms. Chong also testified that Hamalee typically paid their
bills in cash.
                                - 28 -


called several witnesses to try to explain Hamalee's separate

books, the witnesses' implausible and inconsistent explanations

leave us with the firm belief that the sole reason for the dual

books was to hide income from the Government.12    To restate what

was stated by the Court of Appeals for the Second Circuit in a

setting of fraud, "We look at the record as a whole which has a

constant drum beat of fraud to which our ears are not deaf."

Geller v. Commissioner, 556 F.2d 687, 691 (1977), affg. T.C.

Memo. 1976-257.

     For the foregoing reasons, we hold that:     (1) Hamalee is

liable for the additions to its 1985 and 1986 taxes determined by

respondent under section 6653(b)(1) and section 6653(b)(1)(A),

respectively, and (2) the Lees are liable for the additions to

their 1987 and 1988 taxes determined by respondent under section

6653(b)(1)(A) and section 6653(b)(1), respectively.     In so

holding, we have considered all arguments made by the parties

and, to the extent not addressed above, have found them to be

without merit.13


     12
       Mrs. Lee, for example, gave at least five different
answers to the question of why Hamalee had two sets of books, and
why its tax preparers were only given one of those sets.
     13
          In particular, petitioners cite Kiyono v. Commissioner, a
                                                      (continued...)
                                 - 29 -


      c.    Time-Sensitive Additions to Tax

      Respondent also determined additions to Hamalee's 1985 and

1986 taxes under section 6653(b)(2) and section 6653(b)(1)(B),

respectively, and additions to the Lees' 1987 tax under section

6653(b)(1)(B).      In accordance with our discussion above, we find

that:      (1) The entire amount of Hamalee's 1985 and 1986

underpayments was due to fraud, and (2) the entire amount of the

Lees' 1987 underpayment was due to fraud.      We so hold.

6.   Additions to Tax for Substantial Understatement

      Additions to tax for substantial understatement of income

tax equal 25 percent of the amount attributable to the

substantial understatement.      Sec. 6661(a); Pallottini v.

Commissioner, 90 T.C. 498, 500-503 (1988).      An understatement is

substantial if it exceeds the greater of 10 percent of the tax


      13
      (...continued)
Memorandum Opinion of this Court, dated Oct. 17, 1949, and allege
that the Lees had a limited knowledge of the English language
that hindered their ability to understand the tax practices of
the United States, and, thus, they are not liable for fraud. We
disagree. Although we acknowledge the similarity in these cases
on the narrow point of unfamiliarity of business customs, the
evidence adduced at trial, especially undercover transcripts and
the tax books that omitted large amounts of income, leads us to
conclude that the Lees were not as unfamiliar as they claim.
While this Court can understand the difficulties presented to
those who do not speak the English language, this fact, standing
alone, does not offset the overwhelming indicia of fraud against
the Lees and Hamalee.
                              - 30 -


required to be shown on the return or $5,000 ($10,000 in the case

of a corporation other than an S corporation).    Sec. 6661(b)(1).

An understatement is reduced to the extent it is: (1) Based on

substantial authority, or (2) adequately disclosed in the return

or in a statement attached to the return.    Sec. 6661(b)(2).

     Petitioners did not adequately disclose the amounts leading

to the understatements on their returns.    They also have not

cited any relevant authority to support any part of the

understatements.   We sustain respondent's determinations on this

issue.

     To reflect the foregoing,

                                           Decisions will be entered

                                    under Rule 155.
