                        T.C. Memo. 2001-194



                      UNITED STATES TAX COURT



          ESTATE OF HARVEY FEINSMITH, DECEASED, BETTY
              FEINSMITH, EXECUTRIX, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16334-99.                       Filed July 27, 2001.



     William S. Seplowitz, for petitioner.

     Robin L. Peacock and Lydia A. Branche, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Betty Feinsmith, in her individual capacity

and as executrix of the Estate of Harvey Feinsmith, Deceased (the

estate), petitioned the Court to redetermine respondent’s

determination as to the 1983 and 1984 Federal income taxes of her

and her deceased husband, Harvey Feinsmith (Mr. Feinsmith).
                                - 2 -

Respondent determined that Mr. Feinsmith was liable under section

6653(b)(1) for $5,812 and $17,476 in additions to his 1983 and

1984 taxes, respectively.    Respondent also determined that Mr.

Feinsmith was liable for time-sensitive additions to those taxes

under section 6653(b)(2).    Respondent determined no deficiency as

to Betty Feinsmith in her individual capacity.

      Following the Court’s dismissal of Betty Feinsmith in her

individual capacity for lack of jurisdiction, and our amendment

to the caption to reflect the same, we must determine whether the

estate is liable for the additions to tax.    We hold it is not.

Section references are to the Internal Revenue Code applicable to

the relevant years.    Rule references are to the Tax Court Rules

of Practice and Procedure.    Some dollar amounts have been

rounded.

                          FINDINGS OF FACT

      Some facts have been stipulated.   We incorporate herein by

this reference the parties’ stipulation of facts and the exhibits

submitted therewith.   We find the stipulated facts accordingly.

Mr. Feinsmith, whose education lasted through high school and

possibly 1 year of college, died on June 6, 1995, at the age of

68.   His widow, Betty Feinsmith, is the executrix of the estate.

She resided in Deal, New Jersey, when the petition was filed.

      Mr. Feinsmith and Betty Feinsmith filed joint 1983 and 1984

Federal income tax returns.    They filed their 1983 return on or
                                - 3 -

about October 5, 1984.    They filed their 1984 return on or about

October 17, 1985.    Randy Hall, Inc. (Randy Hall), a corporation

in which petitioner was a shareholder, filed its 1982 Federal

income tax return for its fiscal year ended January 31, 1983, on

April 30, 1983.    Randy Hall filed its 1983 Federal income tax

return for its fiscal year ended January 31, 1984, on April 28,

1984.

     Randy Hall manufactured T-shirts and ladies sportswear.

During the subject years, its common stock was owned equally by

Mr. Feinsmith, Carl Perry (Mr. Perry), and Donald Rosenthal (Mr.

Rosenthal).    Mr. Feinsmith served as its president and production

manager.    Mr. Perry served as its secretary/treasurer and

salesman.    Mr. Rosenthal served as its vice president and

designer.    Randy Hall’s shareholders during its fiscal year ended

January 31, 1981, were Mr. Perry, Mr. Rosenthal, and Samuel

Mandel (Mr. Mandel).    Mr. Feinsmith replaced Mr. Mandel as a

Randy Hall shareholder towards the end of 1982 and began working

for Randy Hall at that time.    Mr. Mandel retired at the same

time.

     During its fiscal years ended January 31, 1981, 1983, and

1984, Randy Hall participated in a massive false invoice scheme

(the scheme) in which it bought invoices listing falsely that it

purchased yarn from various vendors.    The scheme was promoted by

Schnejer Zalman Gurary, Nochum Sternberg (Gurary’s son-in-law),
                                - 4 -

and Esther Sternberg (Nochum’s wife) (collectively, the

promoters).   Under the scheme, the promoters sold invoices to

corporations in the garment industry, falsely reflecting that one

of the promoters’ companies had sold yarn to the invoice-

purchasing company.   Principals of the invoice-purchasing

companies provided the promoters with company checks in the

amounts of the false invoices, and the promoters returned cash to

the principals in the amount of the checks less a processing fee.

No actual yarn was involved.    The invoice-purchasing companies

included the purported cost of the nonexistent yarn in their

calculations of cost-of-goods-sold for tax purposes, fraudulently

misstating their taxable income.    The principals converted some

of the cash to their personal use without declaring those funds

as income on their tax returns.    Ultimately, the promoters were

convicted for their parts in the scheme, and their convictions

were affirmed on appeal.   See United States v. Gurary, 860 F.2d

521 (2d Cir. 1988).

     Randy Hall began participating in the scheme before Mr.

Feinsmith was a Randy Hall shareholder.    Mr. Mandel originally

purchased the false invoices on behalf of Randy Hall, and he did

so with the knowledge of the other two shareholders (i.e.,

Messrs. Perry and Rosenthal).    Randy Hall continued to purchase

the false invoices after Mr. Mandel’s retirement.    At all times,

Randy Hall paid for the false invoices by checks, and the
                                    - 5 -

promoters returned to Randy Hall cash equal to the amount of the

checks less the commission.        Randy Hall bought the invoices to

generate documentation to support an inflated cost of goods sold

deduction reported on its tax returns.1         None of the yarn

referenced in the false invoices was ever delivered to Randy

Hall.

     Randy Hall issued checks to the false invoice sellers for 35

false invoices.    Randy Hall required that all of these checks be

signed by two of its shareholders.          The date and amount of each

of the 35 false invoices is as follows:

                  Invoice Date         Invoice Amount

               Oct.    6,   1980            $13,328
               Oct.    8,   1980             12,826
               Oct.    9,   1980             10,472
               Oct.   10,   1980             14,111
               Oct.   15,   1980              8,119
               Nov.    5,   1980             17,494
               Nov.    6,   1980              6,098
               Nov.    7,   1980              8,033
               Nov.   10,   1980             10,151
               Nov.   12,   1980             16,190
               Nov.   14,   1980             13,619
               Jan.    2,   1981             11,866
               Jan.    5,   1981             14,345
               Jan.    6,   1981              8,340
               Jan.    8,   1981             15,406
               Jan.    9,   1981             13,523
                                            193,922 ($1 rounding error)

               Dec. 8, 1982                 $15,988
               Dec. 10, 1982                 13,812
               Dec. 14, 1982                 16,403


     1
       Although cost of goods sold is not actually a “deduction”,
the parties and many of the exhibits in evidence sometimes refer
to it as such. We do the same.
                                     - 6 -

                 Dec. 17, 1982                13,319
                 Jan. 10, 1983                15,477
                 Jan. 14, 1983                19,200
                                              94,199

                 Dec.    2,   1983           $16,052
                 Dec.    5,   1983            16,933
                 Dec.    6,   1983            14,607
                 Dec.    7,   1983            15,701
                 Dec.    9,   1983            12,831
                 Dec.   12,   1983            14,644
                 Dec.   16,   1983            15,255
                 Dec.   20,   1983            17,231
                 Dec.   27,   1983            16,344
                 Jan.    4,   1984            17,363
                                             156,961

                 Jan.   4, 1984              $17,363
                 Jan.   6, 1984               16,114
                 Jan.   9, 1984               15,702
                                              49,179

     The United States Attorney’s Office for the Southern

District of New York (U.S. Attorney’s Office) began investigating

the scheme and included Randy Hall and its shareholders within

its investigation.      In connection therewith, the U.S. Attorney’s

Office proposed to Mr. Feinsmith an agreement (the cooperation

agreement) under which Mr. Feinsmith would agree with the U.S.

Attorney’s Office to cooperate in its investigation in exchange

for immunity from criminal prosecution for any offense connected

to the scheme.   The U.S. Attorney’s Office proposed the agreement

to Mr. Feinsmith in order to secure his cooperation in its

investigation into the scheme.        On March 29, 1985, Mr. Feinsmith

agreed to the terms of the cooperation agreement, which had been
                              - 7 -

drafted by the U.S. Attorney’s Office.2   In part, Mr. Feinsmith

agreed in the cooperation agreement:

     that Randy Hall, Inc. will pay to the Internal Revenue
     Service all federal income taxes due and owing by Randy
     Hall, Inc. for the fiscal years ending January 31, 1981
     to the present; and that Harvey Feinsmith will pay all
     personal income taxes due and owing for the period
     February 1, 1980 to the present. Mr. Feinsmith
     acknowledges that Randy Hall, Inc. claimed nonexistent
     and fraudulent business deductions of approximately
     $337,000 on its federal income tax returns for the
     years 1980 to the present; and that Harvey Feinsmith
     received approximately $48,000 of income which he did
     not report on his federal income tax returns for the
     years 1982 to the present. Mr. Feinsmith agrees that
     he will set forth in a sworn affidavit the false
     invoices (including date, amount and issuing company)
     that created the fraudulent business deductions and the
     unreported income and will admit in the affidavit that
     Randy Hall, Inc. claimed nonexistent and fraudulent
     business deductions of approximately $337,000 on its
     federal income tax returns for the fiscal years ending
     January 31, 1981 to the present, and that Harvey
     Feinsmith received approximately $48,000 of income
     which he did not report on his federal income tax
     returns for the years 1982 to the present. Mr.
     Feinsmith further agrees to provide this affidavit to
     officials of the Internal Revenue Service at this
     Office’s request. Mr. Feinsmith further agrees that
     Randy Hall, Inc. will file amended federal income tax
     returns with the affidavit attached as an exhibit for
     the fiscal years ending January 31, 1981 to the present
     no later than December 31, 1985; and Mr. Feinsmith
     further agrees that he will file amended personal


     2
       The record does not indicate why Mr. Feinsmith agreed to
enter into the cooperation agreement. We surmise that he faced
the possibility of criminal prosecution, but whether that
prosecution would come in his capacity as Randy Hall’s president
or in his individual capacity we do not know. We do know,
however, that the assistant U.S. attorney who conducted the
investigation and drafted the cooperation agreement was unable in
this proceeding to acknowledge that Mr. Feinsmith knew at the
time of the agreement that Randy Hall’s 1982 and 1983 tax returns
contained false deductions.
                               - 8 -

     income tax returns for the period February 1, 1980 to
     the present, attaching the affidavit to the returns as
     an exhibit, no later than December 31, 1985.

     Pursuant to the cooperation agreement, Mr. Feinsmith filed

an amended 1983 personal income tax return on January 6, 1986.

He reported on that return additional income of $31,667,

representing what he believed was his 1/3 share of Randy Hall’s

false invoice deduction attributable to its taxable year ended

January 31, 1983.   Mr. Feinsmith’s 1/3 share was actually

$31,399.81.   The parties agree that $31,399.81 is a constructive

dividend to Mr. Feinsmith for 1983, arising out of deductions not

allowable on Randy Hall’s 1982 corporate income tax return.

     Pursuant to the cooperation agreement, Randy Hall filed an

amended 1983 return on January 7, 1986.   Randy Hall reported on

that return a $49,179 increase in income resulting from its

reduction of its cost of goods sold as originally reported.

Randy Hall acknowledged on the return that the reduction was

required because it had originally included in its cost of goods

sold computation nonexistent business deductions totaling

$337,300.   Randy Hall reported that the following shareholders

had “ADDITIONAL INCOME ARISING FROM THE AFOREMENTIONED

DEDUCTIONS” in the corresponding calendar years:3




     3
       The total of some of the rows and columns is off by $1.
This discrepancy is attributable to rounding.
                                - 9 -

                      Total       1981      1983       1984

     Mr. Perry     $112,433     $64,641   $31,400   $16,393
     Mr. Rosenthal 112,433       64,641    31,400    16,393
     Mr. Mandel      64,641      64,641         0         0
     Mr. Feinsmith   47,793           0    31,400    16,393
        Total       337,300     193,922    94,199    49,179

Randy Hall attached to this amended return the affidavits of

Messrs. Rosenthal and Perry.    Mr. Perry’s affidavit, which is

virtually verbatim with Mr. Rosenthal’s affidavit, stated as

follows:

           CARL PERRY, being duly sworn, deposes and says:

          1. I am the Secretary-Treasurer and a shareholder
     of Randy Hall, Inc. Randy Hall, Inc. is filing amended
     federal income tax returns (Form 1120) for the fiscal
     years ending January 31, 1981, January 31, 1983, and
     January 31, 1984. I am filing amended personal tax
     returns (Form 1040) for calendar years 1981, 1983 and
     1984. An original of this affidavit is being attached
     to each of the above-described amended returns to
     explain the purpose of the amendments and the nature of
     the adjustments to income.

          2. During the period for which amended returns
     are being filed, Randy Hall, Inc. claimed false, non-
     existent business deductions in the amount of
     $337,300.28 for purported purchases which were not, in
     fact, made. * * *

          3. The false deductions claimed by Randy Hall,
     Inc. were in the following amounts for each of the
     years for which amended returns are being filed:

                                     Amount of False
           Fiscal Year Ending            Deduction
                1981                    $193,922.15
                1983                      94,199,43
                1984                      49,178.70
                Total:                  $337,300.28

          4. During this same time period, and because of
     the false deductions referred to above, I received a
                              - 10 -

     total of $112,433.43 in income which I did not report
     on my personal income tax returns during the period.
     The amount of additional income omitted in each of the
     years for which amended returns are being filed by me
     is as follows:

                                    Amount of
               Year             Unreported Income
               1981                 $64,640.72
               1983                  31,399.81
               1984                  16,392.90
               Total:              $112,433.43

     Randy Hall also filed an amended 1982 return in early 1986

pursuant to the cooperation agreement.   On that return, Randy

Hall reported a $94,199 increase in income resulting from its

reduction of its cost of goods sold as originally reported.

Randy Hall acknowledged on that return that the reduction was

required because it had originally included in its cost of goods

sold computation nonexistent business deductions totaling

$337,300.   Randy Hall reported that its four shareholders during

the relevant time period had “ADDITIONAL INCOME ARISING FROM THE

AFOREMENTIONED DEDUCTIONS” in the amounts set forth in the

schedule shown above as to Randy Hall’s amended 1983 return.

Randy Hall attached to its amended 1982 return the same

affidavits attached to its amended 1983 return.

     Mr. Feinsmith filed an amended 1984 personal income tax

return in early 1986 (or possibly late 1985) pursuant to the

cooperation agreement.   On that return, Mr. Feinsmith reported

additional income of $16,333, representing what he believed was

his 1/3 share of Randy Hall’s false invoice deduction
                                  - 11 -

attributable to its taxable year ended January 31, 1984.       His 1/3

share was actually $16,392.90.      The parties agree that $16,392.90

is a constructive dividend to Mr. Feinsmith arising out of

deductions not allowable on Randy Hall’s 1983 corporate income

tax return.    Mr. Feinsmith attached to his amended 1984 return an

affidavit that stated in relevant part:

             HARVEY FEINSMITH, being duly sworn, deposes and
     says:

          1. I am the President and a shareholder of Randy
     Hall, Inc. Randy Hall, Inc. is filing amended federal
     income tax returns (Form 1120) for the fiscal years
     ending January 31, 1981, January 31, 1983, and January
     31, 1984. I am filing amended personal tax returns
     (Form 1040) for calendar years 1983 and 1984. An
     original of this affidavit is being attached to each of
     the above-described amended returns to explain the
     purpose of the amendments and the nature of the
     adjustments to income.

          2. During the period for which amended returns
     are being filed, Randy Hall, Inc. claimed false, non-
     existent business deductions in the amount of
     $337,300.28 for purported purchases which were not, in
     fact, made. * * *

          3. The false deductions claimed by Randy Hall,
     Inc. were in the following amounts for each of the
     years for which amended returns are being filed:

                                       Amount of False
             Fiscal Year Ending           Deduction
                  1981                   $193,922.15
                  1983                     94,199,43
                  1984                     49,178.70
                  Total:                 $337,300.28

          4. During the years 1983 and 1984, and because of
     the false deductions referred to above, I received a
     total of $47,792.71 in income which I did not report on
     my tax returns for those two years. I did not receive
     any income as a result of Randy Hall, Inc.’s false
                                - 12 -

     deductions for the fiscal year ending January 31, 1981
     because I was not a shareholder for any portion of that
     year.

          5. The amount of additional income omitted in
     each of the years for which amended returns are being
     filed by me is as follows:

                                      Amount of
                  Year            Unreported Income
                  1983                $31,399.81
                  1984                 16,392.90
                  Total:              $47,792.71

     Pursuant to the cooperation agreement, Mr. Feinsmith filed a

second amended 1984 personal income tax return on September 2,

1987.   On this return, Mr. Feinsmith reported that, in addition

to the income reported on his original and first amended return

for 1984, he received from Randy Hall during that year a

“Constructive Dividend” of $52,320.      Mr. Feinsmith attached an

affidavit to this second amended return stating:

             HARVEY FEINSMITH, being duly sworn, deposes and
     says:

          1. I am the President and a shareholder of Randy
     Hall, Inc. On or about December 31, 1985, Randy Hall,
     Inc. filed amended federal income tax returns (Form
     1120) for the fiscal years ending January 31, 1981,
     January 31, 1983, and January 31, 1984. At the same
     time, I filed amended personal tax returns (Form 1040)
     for calendar years 1983 and 1984. An affidavit was
     attached to each of the above-described amended returns
     to explain the purpose of the amendments and the nature
     of the adjustments to income.

          2. During the period for which amended returns
     were filed, Randy Hall, Inc. claimed false, non-
     existent business deductions for purported purchases
     which were not, in fact, made. At the time of filing
     the amended returns, the officers of Randy Hall, Inc.
     believed that the false deductions totalled
                              - 13 -

     $337,300.28. During the years 1983 and 1984, and
     because of the false deductions of $337,300.28 on the
     corporate tax returns, I received a total of $47,792.71
     in income which I did not report on my tax returns for
     those two years, but which was reported on my amended
     returns. I did not receive any income as a result of
     Randy Hall, Inc.’s false deductions for the fiscal year
     ending January 31, 1981 because I was not a shareholder
     for any portion of that year.

          3. Subsequent to the filing of these amended
     returns, it came to our attention that certain
     additional false deductions for non-existent purchases
     had been claimed on one of the original corporate tax
     returns, but these deductions had not been discovered
     at the time of filing the amended returns.

          4. The additional false deductions amounted to
     $156,960.90, and affected the corporate tax return for
     the tax year ending January 31, 1984, and my personal
     return for the calendar year ended December 31, 1984.
     * * * These false deductions resulted in additional
     income to me of $52,320.20 which I did not report on my
     original or amended tax return but which is being
     reported on my second amended return which is being
     filed along with a second amended corporate return.

     Pursuant to the cooperation agreement, Randy Hall filed a

second amended 1983 return on or about September 2, 1987.     On

that return, Randy Hall reported a $156,961 increase in income

resulting from a reduction of cost of goods sold due to

additional false deductions and an offset to that amount by a

$206,651 net operating loss carryback from its fiscal year ended

January 31, 1987.   Randy Hall attached to its second amended

return a statement which provided that it had ascertained after

filing its first amended return for that year that it had claimed

on its original 1983 return additional false deductions

aggregating $156,961.   The statement provided that these
                               - 14 -

deductions resulted in $156,961 of additional income that was to

be reported $52,321 by Mr. Perry, $52,320 by Mr. Rosenthal, and

$52,320 by Mr. Feinsmith.   Randy Hall attached to that second

amended return the affidavits of Messrs. Feinsmith, Rosenthal,

and Perry, which read virtually verbatim.    The affidavit of Mr.

Feinsmith was the one that he attached to his second amended

return for 1984.4

                              OPINION

     We decide whether the estate is liable for the additions to

tax for fraud determined by respondent.   Respondent must prove

this determination by clear and convincing evidence.   Sec.

7454(a); Rule 142(b); Rowlee v. Commissioner, 80 T.C. 1111, 1113

(1983).   Fraud requires a showing that the taxpayer intended to

evade a tax known or believed to be owing.    Stoltzfus v. United

States, 398 F.2d 1002, 1004 (3d Cir. 1968).   Here, respondent

must prove:   (1) Mr. Feinsmith underpaid his taxes for each of

the subject years and (2) some part of each underpayment was due

to fraud.   Respondent must also prove for purposes of section

6653(b)(2) the portion of the underpayments attributable to

fraud.    See sec. 6653(b)(2); see also Cooney v. Commissioner,

T.C. Memo. 1994-50.



     4
       The parties agree that Randy Hall’s second amended return
overstated by $17,362.80 its income for the fiscal year ended
Jan. 31, 1984, and that Mr. Feinsmith's 1984 income from the
scheme should be reduced by $5,787.60.
                              - 15 -

     We begin our analysis with the first prong of section

6653(b)(1); i.e., whether Mr. Feinsmith underpaid his taxes in

1983 and/or 1984.   Mr. Feinsmith amended his personal income tax

returns for both of those years to report additional income.

Because those amended returns are admissions of tax

underpayments, Badaracco v. Commissioner, 464 U.S. 386, 399

(1984), we hold for respondent as to this prong.

     Turning to the second prong of section 6653(b)(1), i.e., the

presence of fraud, the existence of fraud is a question of fact.

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

published opinion 578 F.3d 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 (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 (1943); Stephenson v. Commissioner, 79 T.C. 995

(1982), affd. 748 F.2d 331 (6th Cir. 1984).

     We often rely on certain indicia of fraud to decide the

existence of fraud.   The presence of several indicia is

persuasive circumstantial evidence of fraud.   Beaver v.

Commissioner, 55 T.C. 85, 93 (1970).   The "badges of fraud"

include:   (1) The filing of false documents, (2) understatement
                              - 16 -

of income, (2) maintenance of inadequate records, (3) implausible

or inconsistent explanations of behavior, (4) concealment of

assets, (5) failure to cooperate with tax authorities,

(6) engaging in an illegal activity, (7) attempting to conceal an

illegal activity, and (8) dealing in cash.     Bradford v.

Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo.

1984-601; Petzoldt v. Commissioner, 92 T.C. 661, 700 (1989).

     Respondent argues that he has clearly and convincingly

proven fraud by virtue of the following claimed actions on the

part of Mr. Feinsmith:   (1) That he understated his income and

the income of Randy Hall for the relevant years, (2) that he

failed to maintain adequate records for Randy Hall, including

that some of the maintained records were false invoices, (3) that

his accountant testified that Mr. Feinsmith did not tell the

accountant when the accountant prepared Mr. Feinsmith’s 1983 and

1984 personal income tax returns that he had income from the

scheme, (4) that he was engaged in the scheme, an illegal

activity, (5) that the scheme involved the use of cash, and (6)

that he was an astute businessman.     Petitioner argues that

respondent has not proven fraud either clearly or convincingly.

We agree with petitioner.   We are unconvinced by the record that

Mr. Feinsmith filed either his 1983 or 1984 Federal income tax

return with the requisite intent to evade a personal Federal

income tax known or believed to be owing.
                               - 17 -

     Respondent focuses in part on the operations of Randy Hall

to deduce that Mr. Feinsmith had the requisite fraudulent intent.

We do not do similarly.   The fact that Randy Hall may have been

involved in a fraudulent scheme to attempt to evade its Federal

income tax obligation, or that Mr. Feinsmith may have

participated in such an attempt, does not necessarily mean that

Mr. Feinsmith was involved in a scheme to attempt to evade his

Federal income tax obligation as well.   Nor does the fact that

Randy Hall may have understated its income for the subject years,

or kept inadequate records, impute to Mr. Feinsmith the requisite

fraudulent intent to avoid his Federal income tax obligation.

The fact that Randy Hall may have participated in an illegal

activity (the scheme) and that this activity involved cash also

does not establish fraud on the part of Mr. Feinsmith in his

individual capacity.

     When we focus as we should on Mr. Feinsmith’s personal

income tax obligation, we are unconvinced by the record that he

filed his 1983 and/or 1984 Federal income return intending to

evade that obligation.    We simply cannot find that Mr. Feinsmith

was actually involved with the scheme in his individual capacity

or that he converted any of the proceeds from the scheme to his

personal use.   In fact, when Mr. Feinsmith first became

affiliated with Randy Hall, it had been participating in the

scheme for at least 2 years.    We find no reliable evidence in the
                                - 18 -

record to suggest that Mr. Feinsmith, in his individual capacity,

was involved in the scheme either when he joined Randy Hall or at

any time thereafter.   Although respondent invites the Court to

find as facts that Mr. Feinsmith was the mastermind of the scheme

as it related to Randy Hall, that he was in charge of Randy

Hall’s finances, that he handled all of the checks and cash which

passed between Randy Hall and the promoters, and that he

converted some of the cash to his personal use, we decline to do

so on the basis of the record.

     Respondent relies solely on Mr. Perry’s answer to a question

asked by respondent’s counsel at trial to support a finding that

Mr. Feinsmith personally received cash from the scheme.    The

question and answer are as follows:

          Q Okay. And did you know if Harvey Feinsmith
     also received income back?

          A Of course, we were partners, so we shared
     equally.

     We find Mr. Perry’s testimony unpersuasive (both as to this

point and generally overall).    Mr. Perry’s testimony was vague,

uncorroborated, and sometimes inconsistent.   Mr. Perry testified,

for example, that Mr. Feinsmith maintained Randy Hall’s books but

later testified that Mr. Feinsmith asked him for the books so

that Mr. Feinsmith could give them to the Government.   Mr. Perry

also testified adamantly that Randy Hall’s involvement with the

scheme began with the arrival of Mr. Feinsmith but later admitted
                                - 19 -

that Randy Hall’s involvement in the scheme began before that

time.    Mr. Perry also testified that Mr. Feinsmith was the only

one who dealt with the promoters on behalf of Randy Hall and that

Mr. Feinsmith was the only Randy Hall shareholder who actually

knew the promoters’ identity.    The record indicates that Randy

Hall purchased almost half of the false invoices before Mr.

Feinsmith joined the company and that one of the promoters was

wary that either Mr. Perry or Mr. Rosenthal would reveal the

promoters’ identity to the authorities.

     We also bear in mind that Mr. Perry is an indicted criminal

who pleaded guilty to his part in the scheme.    Given the

additional fact that Mr. Feinsmith was not charged in the scheme

and that Mr. Feinsmith cooperated with the investigation of the

U.S. Attorney’s Office, including on at least one occasion

secretly recording a conversation with an unidentified

individual, we view Mr. Perry as a biased witness with animosity

towards Mr. Feinsmith.    In fact, Mr. Perry even indicated during

his testimony that he has ill will towards Mr. Feinsmith and that

he has an amiable, longstanding relationship with the other

shareholder, Mr. Rosenthal.5    We also note that Mr. Feinsmith,

because he is dead, is unable to rebut personally Mr. Perry’s

testimony and that Mr. Perry displayed during his testimony a

poor memory as to many facts, even acknowledging on various


     5
       Mr. Perry even went so far as to testify baldly that Mr.
Rosenthal had received none of the cash paid by the promoters.
                              - 20 -

occasions that he has trouble remembering events of the prior day

let alone events that occurred during the subject years.

     For some undisclosed reason, respondent chose not to

introduce into evidence other testimony and/or exhibits to

support his proposed finding that Mr. Feinsmith actually received

cash from the scheme.   Respondent could have presented the

testimony of one or more of the promoters as to which Randy Hall

shareholders they dealt with in the scheme.   We understand from

the record that the promoters insisted that their identity be

known by only a limited number of individuals from each invoice-

purchasing company.   We are skeptical that the promoters would

have agreed to deal with Mr. Feinsmith upon his joining Randy

Hall, when at that time their identity was already known by Mr.

Perry and/or Mr. Rosenthal.   Such is especially true given the

fact that the promoters knew when Mr. Feinsmith joined Randy Hall

that respondent was investigating either or both of the other

shareholders and were edgy about respondent’s learning their (the

promoters’) identity.   Respondent also could have presented the

testimony of Mr. Rosenthal as to his understanding of Mr.

Feinsmith’s involvement in the scheme.   Respondent also could

have introduced into evidence one or more Randy Hall checks that

were paid to the promoters for the false invoices and that were

traceable to Mr. Feinsmith; e.g., by his signature.   Although the

record contains many of the false invoices, it contains none of
                                - 21 -

the Randy Hall checks which were given to the promoters in

consideration for those invoices.6

     Nor do we read the cooperation agreement or affidavits to

support a finding of fraud.   Mr. Feinsmith’s affidavits, for

example, merely state that he agrees that he received income

“because of the false deductions”.       The cooperation agreement

states similarly that “the false invoices * * * created the

fraudulent business deductions and the unreported income”.       None

of these documents states specifically that the income is

attributable to Mr. Feinsmith’s receipt (in either his individual

capacity or on behalf of Randy Hall) of any of the proceeds of

the scheme.7   Nor does either document indicate why Mr. Feinsmith

realized that income in the first place.       The mere fact that a

closely held corporation has claimed improper deductions does not

necessarily mean that its shareholders have realized income in

the amount of the deductions.    A shareholder such as Mr.

Feinsmith realizes income through a constructive distribution



     6
       We also would have liked to have heard from Mr. Feinsmith
as to his understanding of his part in the scheme. For some
unexplained reason, however, respondent waited until almost 4
years after Mr. Feinsmith’s death to issue the notice of
deficiency to his estate. In fact, respondent did not issue the
notice of deficiency to the estate until more than 10 years after
the Court of Appeals for the Second Circuit affirmed the
promoters’ convictions.
     7
       We also note that the parties have stipulated that Mr.
Feinsmith’s approximately $48,000 of income is taxable to him as
“constructive dividend income * * * arising out of deductions not
allowable on the corporate tax return of Randy Hall”.
                               - 22 -

only when the corporation uses its money or property primarily to

benefit the shareholder.   See Laure v. Commissioner, 70 T.C.

1087, 1108 (1978), affd. in part, revd. in part and remanded 653

F.2d 253 (6th Cir. 1981); see also Wilkof v. Commissioner, T.C.

Memo. 1978-496 (“Laure does support the proposition * * * that to

the extent that a taxpayer can show an absence of direct benefit

to himself he may escape constructive dividend treatment”), affd.

636 F.2d 1139 (6th Cir. 1981).   We are unable to find that Randy

Hall used its money or property primarily to benefit Mr.

Feinsmith.8

     We also do not view Mr. Feinsmith’s amended returns as

indicating that he received cash from the scheme.   The fact that

Mr. Feinsmith considered the reported income attributable to the

disallowed deductions, rather than to his conversion of corporate

cash, is seen quickly from the fact that he recognized most of

that income in years other than the years in which the cash was

purportedly received by him upon conversion.   A shareholder’s

conversion of cash for his or her personal use is treated as a

constructive distribution of that cash, and such a distribution

is realized by a cash basis shareholder such as Mr. Feinsmith in

the year of conversion.    See secs. 301(c), 316; Truesdell v.



     8
       Of course, a taxpayer such as Mr. Feinsmith may agree to
recognize an item as income in lieu of criminal prosecution. The
fact that he agrees to recognize that income in a year for which
a return has already been filed does not necessarily mean that he
filed that return fraudulently.
                              - 23 -

Commissioner, 89 T.C. 1280, 1295 (1987); see also Toushin v.

Commissioner, T.C. Memo. 1999-171, affd. 223 F.3d 642 (7th Cir.

2000).   The $31,667 recognized by Mr. Feinsmith as income for

1983 was mainly attributable to false invoices purchased in 1982.

The $52,320 recognized by Mr. Feinsmith as income for 1984 (by

way of the second amended return) was almost entirely

attributable to false invoices purchased in 1983.   Given the fact

that the purchase of the false invoices by the corporations and

the conversion of the cash by the principals appears to us to

have occurred contemporaneously, that income, were it in fact

attributable to Mr. Feinsmith’s conversion of cash, as respondent

asserts, would have been properly recognized on Mr. Feinsmith’s

personal income tax returns for 1982 and 1983, respectively.

Moreover, Mr. Feinsmith recognized in income his portion of the

full amount of the false invoices which entered into the cost of

goods sold deductions.   The Court of Appeals for the Second

Circuit stated that principals participating in the scheme

converted to their personal use only part of the false invoice

amounts.9




     9
       We also note that Mr. Feinsmith indicated explicitly in
his affidavits that his recognition of income from the scheme
rested on whether he was a Randy Hall shareholder, rather than on
whether he personally received cash from the scheme. As he
stated in his affidavits: “I did not receive any income as a
result of Randy Hall, Inc.’s false deductions for the fiscal year
ending January 31, 1981 because I was not a shareholder for any
portion of that year.”
                             - 24 -

     We are similarly unconvinced that Mr. Feinsmith knew that

either of his returns was fraudulent when he filed it.    In order

to support a determination of fraud, respondent must prove

clearly and convincingly that Mr. Feinsmith had at the time he

filed his personal income tax returns the requisite intent to

evade taxes known or believed to be owing.   As we read the

cooperation agreement and the affidavits, those documents were

carefully worded so as to speak as of the time that the documents

were prepared and not as of the time that the returns were filed.

Those documents merely establish that Mr. Feinsmith knew about

the unreported income when the documents were prepared.    They do

not establish that he knew about that income when the returns

were filed.

     Moreover, as of March 29, 1985, the date of the cooperation

agreement, Mr. Feinsmith’s 1984 return had not yet been filed.

The cooperation agreement provided explicitly that it would be

void (meaning that Mr. Feinsmith would be subject to prosecution,

including through the use of any statement or document that he

made or gave to the U.S. Attorney’s Office during its

investigation) were Mr. Feinsmith not to comply fully with the

expressed understandings of the parties thereto.    One of those

understandings was that Mr. “Feinsmith must at all times give

complete, truthful and accurate information and testimony and

must not commit any further crimes whatsoever.”    We find it

unlikely that Mr. Feinsmith would have intentionally omitted
                             - 25 -

income from his 1984 return had he known of the income.10   Such

an intentional omission would have voided the cooperation

agreement and would have subjected Mr. Feinsmith to criminal

prosecution in addition to any taxes payable on the omitted

income.11

     We conclude that respondent has failed to carry his burden

of proving fraud for both of the subject years.   Respondent has

failed to convince us clearly that Mr. Feinsmith was liable for

fraud in either year.

                                        Decision will be entered

                                   under Rule 155.




     10
       We also disagree with respondent’s assertion that Mr.
Feinsmith’s intent to file a false return may be found in the
fact that he did not tell his accountant about his income from
the scheme. As discussed above, we are unable to find as a fact
that Mr. Feinsmith knew about the unreported income when he filed
his returns. Thus, he could not have told his accountant about
it beforehand. Nor do we believe that Mr. Feinsmith was as
“astute” as respondent claims.
     11
       We note in passing that the cooperation agreement
provided that Mr. Feinsmith would “file amended personal income
tax returns for the period February 1, 1980 to the present [i.e.,
Mar. 29, 1985]” in order to report his agreed-upon income
attributable to the scheme. We do not understand this provision
to mean that Mr. Feinsmith knew that he would be filing a
fraudulent return for 1984 and would later have to amend it. We
read this provision simply to require that Mr. Feinsmith report
on his personal income tax returns all of the agreed-upon income,
let it be by way of an amended return or by way of an original
return. In fact, whereas the cooperation agreement literally
requires that Mr. Feinsmith amend each of his returns from 1980
through 1985, he actually amended only his 1983 and 1984 returns.
