                         T.C. Memo. 2001-166



                       UNITED STATES TAX COURT



          MARIE KEY AND DAVID GLEN KEY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15117-98.                        Filed July 5, 2001.


     Marie Key and David Glen Key, pro sese.

     S. Katy Lin and Caroline Tso Chen, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:    Respondent determined a deficiency of

$246,169 in petitioners’ 1995 Federal income tax.     Unless

otherwise indicated, all section references are to the Internal

Revenue Code in effect for the year in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.
                                - 2 -

     After concessions,1 the issues for decision are (1) whether

petitioners underreported their income for 1995 from their

business reported on Schedule C, Profit or Loss From Business,

and (2) whether petitioners are liable for self-employment tax on

the net profit of the Schedule C business.

                          FINDINGS OF FACT

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

The stipulation of facts, first supplemental stipulation of

facts, and the attached exhibits are incorporated herein by this

reference.   At the time they filed their petition, Marie Key and

David Glen Key resided in California.

Multilevel Marketing Business

     In early 1995, until approximately April 1995, Mr. Key sold

self-help motivational tapes for a multilevel marketing business

called Commonwealth.    After being terminated from Commonwealth in

April or May 1995, Mr. Key started his own multilevel marketing

business, modeled after Commonwealth, called The Winning Edge.

Mr. Key later changed the business’ name to The Ultimate

Comeback.    Marie Key did administrative work for The Ultimate

Comeback.

     The Ultimate Comeback marketed and sold a product called

“The Credit Maze Program” (the Credit Maze).    The Credit Maze was


     1
        Respondent concedes that petitioners are not liable for
$203,440 of the $545,715 of additional Schedule C business income
determined in the statutory notice of deficiency.
                                   - 3 -



a “credit repair” program.       The Ultimate Comeback offered three

“phases” for the marketing and sale of the Credit Maze.

        The Ultimate Comeback’s orientation guide states that in

order to be a member in phase I an interested party paid $1,250

plus a $50 administrative fee for a copy of the Credit Maze

product.       The broker2 for the phase I member received 90 percent

of the $1,250 payment.

     The Ultimate Comeback’s orientation guide states that in

order to be a member in phase II, an interested party paid $6,250

plus a $75 administrative fee for a seminar related to the Credit

Maze.       The broker3 for the phase II member received 90 percent of

the $6,250 payment.

     The Ultimate Comeback’s orientation guide states that in

order to be a member in phase III, an interested party paid

$31,250 for a financial education seminar in Hawaii.       The broker4

for the phase III member received 90 percent of the $31,250

payment.

     Not all new phase I, II, and III members paid the amounts

listed in the orientation guide.       Everyone who transferred from


        2
        In order to be a phase I broker, a member had to recruit
six additional phase I members.
        3
        In order to be a phase II broker, a member had to recruit
six additional phase II members.
        4
        In order to be a phase III broker, a member had to
recruit two additional phase III members.
                                - 4 -

Commonwealth to The Ultimate Comeback was “grandfathered” in and

paid zero for their membership in phase I.    Some members paid a

reduced amount for their phase I, II, and/or III memberships, and

brokers sold the memberships at cost ($125 for phase I, $625 for

phase II, and $3,125 for phase III).    Additionally, many members

did not pay administrative fees.

     The Ultimate Comeback offered another program unrelated to

the Credit Maze.    The Ultimate Comeback’s orientation guide

states that in the “Wealth Preservation” program (Wealth

Preservation), participants paid $625 to purchase a manual that

discussed financial instruments used to preserve assets.    The

broker5 for the Wealth Preservation member received 80 percent of

the $625 payment.

     The Ultimate Comeback maintained membership lists for Wealth

Preservation and phases I, II, and III compiled by phase, member

name, and broker name.    Mr. Key’s name is listed as the broker

for 21 people in Wealth Preservation, 67 people in phase I, 40

people in phase II, and 13 people in phase III.

     Mr. Key requested that payments to himself and The Ultimate

Comeback be made in cash, cashier’s checks, or money orders.

Petitioners failed to maintain any tax records (i.e., general




     5
        In order to be a Wealth Preservation broker, a member had
to recruit two additional Wealth Preservation members.
                                 - 5 -

ledgers, check disbursement records, cash receipts journals,

income or sales journals, or records of summaries).

Petitioners’ Personal Expenses

     During 1995, petitioners spent $2,586.87 a month on personal

expenditures that included, among other things, utilities,

clothing, storage, housewares, automotive, and leisure expenses.

From January through July 1995, petitioners paid $1,700 a month

rent on a residence known as “100/101 Santes”.   On or about July

2, 1995, petitioners paid a $1,500 deposit on a rental home

located in Wildomar, California (Wildomar home).     From July

through December 1995, petitioners paid $1,190 a month rent for

the Wildomar home.

     On or about March 11, 1995, petitioners paid $7,000 in cash

to purchase a Mercedes.   On June 27, 1995, petitioners paid off

their Astro minivan with a $2,135 cashier’s check.     On August 5,

1995, petitioners purchased appliances for $2,368.02 and $473.02.

During 1995, petitioners purchased an Acura NSX for $40,000 in

cash.

Petitioners’ Bank Accounts

     Petitioners maintained bank accounts at Great Western Bank.

As of January 1, 1995, petitioners had a zero balance in their

accounts.
                               - 6 -

Mr. Key’s Arrest, the Money in His Possession When Arrested, and
Petitioners’ Conviction

     On or about November 28, 1995, under an alias, Mr. Key was

staying at the Hilton Hotel in Anaheim, California.   On that

date, the Anaheim Police Department arrested Mr. Key and seized

from him cash totaling $302,515.25 and postal money orders

totaling $15,750.

     In November 1995, the Riverside County Sheriff’s Department

seized from Mr. Key 24 cashier’s checks, made out to him,

totaling $105,175.   These checks were for the following amounts:

1 for $2,250, 1 for $3,000, 1 for $4,325, 2 for $1,300, 2 for

$4,000, and 17 for $5,000.   Many of the checks are numbered

sequentially and were purchased on the same date.

     On June 29, 1998, petitioners were convicted of separate

counts of unlawfully preparing and operating an endless chain

scheme in violation of California Penal Code section 327 for

their activities in connection with The Ultimate Comeback.6

Petitioners’ Tax Returns

     Petitioners informed a revenue officer that they did not

have any income for 1993 and 1994 for which U.S. Individual

Income Tax returns needed to be filed.   During 1993, petitioners

filed bankruptcy and were discharged in 1994.

     On February 24, 1997, petitioners filed their 1995 joint


     6
        The appellate court affirmed petitioners’ convictions and
the Supreme Court of California denied petitioners’ petition for
review. People v. Key, No. S091405, (Cal., Nov. 15, 2000).
                               - 7 -

individual Federal income tax return (the return).   The return

included a Schedule C.   The Schedule C lists Mr. Key as the sole

proprietor of a “multi-level marketing” activity with the name

The Ultimate Comeback.   Petitioners reported $495,000 of gross

receipts, $153,816 of expenses, and $341,184 of net profit from

The Ultimate Comeback.   The return reported total adjusted gross

income of $341,184 and listed a tax due of $103,273.   Petitioners

did not pay any of this amount when they filed the return.

Petitioners did not report or pay any self-employment taxes on

the net profit of The Ultimate Comeback.   Petitioners reported no

income from Commonwealth.

                              OPINION

I.   Unreported Income

     Every individual liable for tax is required to maintain

books and records sufficient to establish the amount of his or

her gross income.   Sec. 6001; DiLeo v. Commissioner, 96 T.C. 858,

867 (1991), affd. 959 F.2d 16 (2d Cir. 1992).   For the years in

question, we find that petitioners maintained inadequate books

and records--in fact, they maintained no tax records whatsoever

(i.e., general ledgers, check disbursement records, cash receipts

journals, income or sales journals, or records of summaries).

     Where a taxpayer fails to maintain or produce adequate books

and records, the Commissioner is authorized to compute the

taxpayer's taxable income by any method that clearly reflects
                                 - 8 -

income.    Sec. 446(b); Holland v. United States, 348 U.S. 121

(1954); Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir.

1968), affg. T.C. Memo. 1966-81.    The reconstruction of income

need only be reasonable in light of all surrounding facts and

circumstances.    Giddio v. Commissioner, 54 T.C. 1530, 1533

(1970).    The Commissioner is given latitude in determining which

method of reconstruction to apply when a taxpayer fails to

maintain records.    Petzoldt v. Commissioner, 92 T.C. 661, 693

(1989).

     The Commissioner's determinations generally are presumed

correct, and the taxpayer bears the burden of proving that those

determinations are erroneous.7    Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933); Durando v. United States, 70 F.3d 548,

550 (9th Cir. 1995).   The U.S. Court of Appeals for the Ninth

Circuit, to which an appeal of this case would lie, has held that

in order for the presumption of correctness to attach to the

notice of deficiency in unreported income cases,8 the


     7
        Petitioners argue that, pursuant to sec. 7491(b),
respondent bears the burden of proof because respondent used
statistical methods to reconstruct petitioners’ income. Sec.
7491(b) was enacted as part of the Internal Revenue Service
Restructuring and Reform Act of 1998 (RRA 1998), Pub. L. 105-206,
sec. 3001(c), 112 Stat. 685, 726, and is effective for
examinations commenced on or after July 22, 1998. See Higbee v.
Commissioner, 116 T.C. ___, ___ (2001) (slip op. at 5); RRA 1998
sec. 3001(c), 112 Stat. 685, 727. The examination in this case
commenced prior to July 22, 1998. Accordingly, sec. 7491 is
inapplicable.
     8
          Although Weimerskirch v. Commissioner, 596 F.2d 358 (9th
                                                     (continued...)
                               - 9 -

Commissioner must establish "some evidentiary foundation" linking

the taxpayer to the income-producing activity, Weimerskirch v.

Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), revg. 67

T.C. 672 (1977), or “demonstrating that the taxpayer received

unreported income”, Edwards v. Commissioner, 680 F.2d 1268, 1270

(9th Cir. 1982); see also Rapp v. Commissioner, 774 F.2d 932, 935

(9th Cir. 1985).   Once there is evidence of actual receipt of

funds by the taxpayer, the taxpayer has the burden of proving

that all or part of those funds are not taxable.   Tokarski v.

Commissioner, 87 T.C. 74 (1986).

     There is ample evidence linking petitioners to an income-

producing activity, and respondent has demonstrated that

petitioners received unreported income.

     A.   Unit and Volume Method

     The first method respondent employed on brief to reconstruct

petitioners’ gross receipts from the multilevel marketing

business was the unit and volume method.   This method of proof is

an established method accepted by the Court.   See King v.

Commissioner, T.C. Memo. 1998-69, affd. without published opinion

182 F.3d 903 (3d Cir. 1999); Park v. Commissioner, T.C. Memo.



     8
      (...continued)
Cir. 1979), revg. 67 T.C. 672 (1977), was an unreported income
case regarding illegal source income, the U.S. Court of Appeals
for the Ninth Circuit applies the Weimerskirch rule in all cases
involving the receipt of unreported income. See Edwards v.
Commissioner, 680 F.2d 1268, 1270-1271 (9th Cir. 1982); Petzoldt
v. Commissioner, 92 T.C. 661, 689 (1989).
                              - 10 -



1994-343; Rowell v. Commissioner, T.C. Memo. 1988-410, affd. 884

F.2d 1085 (8th Cir. 1989).

     To determine gross receipts, respondent used information

contained in The Ultimate Comeback’s orientation guide and

membership lists.   Respondent determined how many units Mr. Key

handled (i.e., transactions for which Mr. Key was the broker).

Respondent multiplied the units by the full amount listed in the

orientation guide as the cost of each unit (i.e., $1,250 for

phase I, $6,250 for phase II, $31,250 for phase III, and $625 for

Wealth Preservation).   Respondent then added the administrative

fees charged for each phase and Wealth Preservation.

     On brief, respondent notes that he modified this analysis to

account for testimony received at trial from witnesses who

testified they paid less than the value listed in the orientation

guide.   Using this methodology, respondent computed petitioners'

total gross receipts to be $868,400.   Petitioners reported

$495,000 of gross receipts on their Schedule C.   Thus, respondent

calculated a $373,400 understatement of income.

     We conclude that this analysis is flawed in two respects.

The first flaw in respondent’s analysis is that respondent

attributed 100 percent of the payments for each phase and Wealth

Preservation to Mr. Key.   According to the orientation guide, the

broker on a transaction for phase I, II, and III received only 90
                              - 11 -

percent of the fee and for Wealth Preservation received only 80

percent of the fee.

     The second flaw is respondent’s assumption that everyone who

purchased into Wealth Preservation and phase I, II, and III,

other than the witnesses who testified at trial, paid these full

amounts.   Several witnesses credibly testified that they

themselves and others they recruited into The Ultimate Comeback

did not pay the amounts listed in the orientation guide.     Some

paid a slightly reduced amount, some paid cost, others paid

nothing at all, and many did not pay an administration fee.     We

conclude that respondent’s application of the unit and volume

method does not clearly reflect petitioners’ income; therefore,

we shall not adopt the figures determined by respondent under

this method.   See sec. 446(b); Holland v. United States, 348 U.S.

121 (1954); Webb v. Commissioner, supra at 371-372.

     B.    Net Worth Method

     An alternative method respondent employed on brief to

reconstruct petitioners’ income from the multilevel marketing

business was the net worth method.     This method of proof is an

established method accepted by the courts.     See Holland v. United

States, supra.

     Under the net worth method, the taxpayers’ opening net worth

for the taxable year is established.     Increases in net worth are

added to the opening net worth.   Nondeductible expenditures
                                - 12 -

increase this amount.    Items attributable to nontaxable sources

decrease this amount.    If the resulting figure for the year is

greater than the taxable income reported, then the excess

represents unreported taxable income.      See id. at 125.   The

Commissioner must establish the opening net worth with reasonable

certainty and show a likely source of unreported income or negate

nontaxable sources.     See id. at 132-138; Brooks v. Commissioner,

82 T.C. 413, 431-432 (1984), affd. without published opinion 772

F.2d 910 (9th Cir. 1985).

     As of January 1, 1995, petitioners had a zero balance in

their bank accounts.    Petitioners testified that they did not

file income tax returns for 1993 and 1994 because they made less

than the amount required to “trigger” the filing requirement.

Mr. Key testified that in 1993 petitioners filed for bankruptcy.

Mr. Key further testified petitioners had absolutely nothing when

they started The Ultimate Comeback.      Based on the evidence, we

conclude that respondent correctly began the net worth analysis

with a zero net worth for petitioners as of January 1, 1995.

     Respondent then multiplied petitioners’ monthly personal

expenditures for 1995 ($2,586.87) by 12.      This totals $31,042.44.

Next, respondent multiplied petitioners’ monthly rental expense

times 12.   Respondent adopted $1,190 as the amount of rent.       We

found that petitioners paid $1,700 for the first 6 months of 1995

and $1,190 for the last 6 months of 1995.      Petitioners’ rental
                              - 13 -

expenses for 1995 therefore total $17,340.   Petitioners’ total

yearly expenses for 1995 equal $48,382.44.

      Respondent then added in petitioners’ “one time” personal

expenditures (i.e., the rent deposit, the Mercedes purchase, the

Astro Minivan payment, the appliance purchases, and the Acura

purchase).   These expenses total $53,476.04.   Thus, petitioners’

total personal expenditures for 1995 equal $101,858.48.

      Next, respondent added the cash ($302,515.25), money orders

($15,750), and cashier's checks ($105,175) seized from Mr. Key in

November 1995.   This amount totals $423,440.25.   Responded added

this amount to petitioners’ total personal expenditures for 1995

($101,858.48) bringing the final total to $525,298.73.

      Subtracting petitioners’ reported adjusted gross income

($341,184) from the amount calculated via the net worth method

results in unreported income of $184,114.73.    Based upon the

foregoing, we conclude that in 1995 petitioners had $184,114.73

of unreported income from The Ultimate Comeback.

II.   Self-Employment Tax

      Respondent argues that in 1995 petitioners had self-

employment income based on petitioners’ reported and unreported

income from The Ultimate Comeback, and petitioners owe self-

employment tax based on that income.

      Section 1401 imposes self-employment tax on self-employment

income.   Section 1402 defines net earnings from self-employment

as the gross income derived by an individual from the carrying on
                             - 14 -

of any trade or business by such individual less allowable

deductions attributable to such trade or business.

     We agree with respondent.   We conclude that petitioners are

liable for self-employment tax in 1995 in accordance with section

1401 based upon petitioners’ self-employment income (including

the reported and unreported income) from The Ultimate Comeback.

     To reflect the foregoing,

                                         Decision will be entered

                                    under Rule 155.
