The opinion
T.C. Memo. 2014-6
UNITED STATES TAX COURT
DAVID L. CARREON, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 22720-11, 22729-11, Filed January 9, 2014.
22747-11, 22871-11.
R determined that Ps were engaged in a civil fraud scheme and
liable for the I.R.C. sec. 6663 75% civil fraud penalty for the tax
years at issue.
Held: R did not prove by clear and convincing evidence that
Ps’ underpayments were attributable to fraud. Accordingly, Ps are
not liable for the I.R.C. sec. 6663 civil fraud penalty.
Richard A. Carpenter and Kevan P. McLaughlin, for petitioners.
Monica D. Polo, for respondent.
1
Cases of the following petitioners are consolidated herewith: David L.
Carreon, docket No. 22729-11; Bancard Solutions, LLC, docket No. 22871-11;
and Merchants Payment Processing, Inc., docket No. 22747-11.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
WHERRY, Judge: These consolidated cases are before the Court on
petitions for redetermination of four determinations by respondent, in notices of
deficiency, that petitioners owe Federal income tax deficiencies for the 2005 and
2006 taxable years.2 Respondent determined the following Federal income tax
deficiencies3 and penalties for petitioners David L. Carreon’s and Carrie Portugal
Carreon’s (Ms. Portugal) 2005 taxable calendar year and Mr. Carreon’s 2006
taxable calendar year as follows:
Penalty
Year Deficiency sec. 6663
2005 $54,992 $41,244
2006 10,981 8,236
Respondent determined a Federal income tax deficiency and a penalty for
petitioner BanCard Solutions, LLC’s (Bancard Solutions) 2005 taxable fiscal year
as follows:
2
Unless otherwise indicated, all section references are to the Internal
Revenue Code of 1986 (Code), as amended and in effect for the taxable years at
issue. All Rule references are to the Tax Court Rules of Practice and Procedure.
3
All dollar amounts are rounded to the nearest dollar unless otherwise
specified.
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[*3] Penalty
Year Deficiency sec. 6663
7/31/2005 $72,457 $54,343
Respondent determined Federal income tax deficiencies, penalties, and an addition
to tax for petitioner Merchants Payment Processing, Inc.’s (Merchants, Inc.) 2005
and 2006 taxable calendar years as follows:
Penalty Addition to tax
Year Deficiency sec. 6663 sec. 6651(a)(1)
2005 $89,899 $67,425 -0-
2006 75,074 56,306 3,754
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[*4] After concessions by petitioners and respondent,4 the only issue for decision
is whether petitioners Mr. Carreon, Bancard Solutions, and Merchants, Inc. are
liable for the civil fraud penalty pursuant to section 6663(a) for the taxable years
at issue.
4
On December 11, 2012, the parties filed with the Court a stipulation of
settled issues stating the following: (1) Mr. Carreon failed to report qualified
dividend income of $355,000 and on Schedule E, Supplemental Income and Loss
rents received of $9,300 for the taxable year 2005; (2) Mr. Carreon is entitled to a
Schedule E depreciation deduction of $7,815, a Schedule E mortgage interest
deduction of $1,366, a Schedule E other expense deduction of $22,575, itemized
deductions as claimed subject to limitation based on his adjusted gross income,
and exemptions as claimed subject to limitation based on his adjusted gross
income for the taxable year 2005; (3) Mr. Carreon failed to report qualified
dividend income of $101,000 and Schedule E rents received of $15,925 for the
taxable year 2006; (4) Mr. Carreon is entitled to a Schedule E depreciation
deduction of $3,908, a Schedule E mortgage interest deduction of $10,427, a
Schedule E other expense deduction of $3,454, itemized deductions as claimed
(subject to limitation based on his adjusted gross income), and exemptions as
claimed (subject to limitation based on his adjusted gross income) for the taxable
year 2006; (5) Bancard Solutions failed to report gross receipts of $215,000, the
addition of which made the total gross receipts $440,040 for the 2005 taxable
year; (6) Merchants, Inc. failed to report gross receipts of $270,000, the addition
of which made the total gross receipts $549,352 for the 2005 taxable year; (7)
Merchants, Inc. failed to report gross receipts of $202,000, the addition of which
made the total gross receipts $556,467 for the 2006 taxable year; and (8) all
petitioners also orally conceded at the start of their trial that if they are not found
liable for the sec. 6663 civil fraud penalty, they would all be liable for the sec.
6662(a) accuracy-related penalty for all of the taxable years at issue.
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[*5] FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of
the parties with accompanying exhibits are incorporated herein by this reference.
At all relevant times throughout the years in issue, at the time the petitions in these
cases were filed, and at the time of trial, petitioners resided or had their principal
office in California.
General Background
Mr. Carreon graduated with a business degree from National University,
where he had taken one accounting course and no tax courses. He later attended
the San Diego Regional Sheriff’s Department Sheriff’s Academy and completed a
nine-month training program. He then volunteered as a reserve deputy sheriff
until 1996. In 1999 Mr. Carreon married Ms. Portugal. Throughout the 2005 and
2006 taxable years Mr. Carreon and Ms. Portugal were married.
Mr. Carreon’s Businesses
In 1999 Mr. Carreon and Ms. Portugal were introduced by a mutual friend
to Clementine Estrada. Ms. Estrada provided advice to Mr. Carreon and Ms.
Portugal on how to set up entities for their business. Ms. Estrada also gave them
advice about asset management protection and a financial strategy referred to as
the “agent-principal” relationship. Mr. Carreon understood that the concept was
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[*6] set up to operate by taking the net gross receipts from their credit card
processing business (which, starting in 1999, they had conducted through
Merchant Payment Processing L.L.C., which changed its name on December 31,
1999, to Bancard Solutions LLC) after business expenses including their salaries
and put those funds into other entities such as a trust. These other entities were to
be designated as a business trust, a charitable trust, and a management trust. There
was also to be a “living trust” to hold and protect their property, such as their
home, personal property, etc.
Additionally, Ms. Estrada explained that the management trust would be
managed by a company called Builders, which would charge a fee for services of
11% of the first $70,000 of credit card processing receipts and 6% for any excess
money managed beyond $70,000. Ms. Estrada also referred Mr. Carreon and Ms.
Portugal to Robert Holcomb in order to hear more about the “agent-principal”
relationship, since they were equal owner members of the business and Ms.
Portugal was the managing member.
Mr. Holcomb elaborated on the “agent-principal” relationship to Mr.
Carreon and Ms. Portugal. Mr. Holcomb described the relationship as having held
up in several cases with the Internal Revenue Service (IRS) and stated that there
were even tax rulings that condoned the relationship. Mr. Holcomb, like Ms.
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[*7] Estrada, condoned the relationship as a legal one. Mr. Carreon and Ms.
Portugal decided to employ the “agent-principal” relationship. Mr. Carreon and
Ms. Portugal had about four meetings with Mr. Holcomb.
In 2000 Mr. Holcomb referred Mr. Carreon and two other taxpayers to John
Betts, a California certified public accountant (C.P.A.). There is no evidence in
the record that, other than the three referrals, Mr. Betts had any professional or
untoward business relationship with Mr. Holcomb or that they shared any fees or
paid anything to one another. Mr. Betts, at that time, had over 20 years of practice
experience and had previously worked for 2 years as an IRS auditor. Mr. Betts
had no previously known professional disciplinary actions and was in good
standing with the State of California. Mr. Carreon and Ms. Portugal hired Mr.
Betts for their personal and business Federal income tax preparation. During this
period they also began to use the “agent-principal” relationship. Mr. Betts
prepared Mr. Carreon and Ms. Portugal’s joint Federal tax returns for the calendar
years 2000 through 2005 and Bancard Solutions’ Federal income tax return for the
fiscal years July 31, 2000 through 2005. Once a month Mr. Betts would receive
from Mr. Carreon the QuickBooks accounts for Bancard Solutions and Merchants,
Inc. Once a month Mr. Betts would also receive from Mr. Holcomb the agent-
principal relationship records in the form of the chart of accounts for Bancard
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[*8] Solutions and Merchants, Inc. Mr. Holcomb had discussed this “agent-
principal” relationship with Mr. Betts and had assured him about its validity.
Bancard Solutions
On August 25, 1999, Mr. Carreon and Ms. Portugal started Merchants
Payment Processing, L.L.C. (Merchants Processing). Merchants Processing
provided credit card processing services to businesses, primarily in the restaurant
industry. Bancard Solutions was taxed as a corporation for its 2005 taxable fiscal
year. Mr. Carreon and Ms. Portugal were Bancard Solutions’ only members. Mr.
Carreon served as the secretary and treasurer, Ms. Portugal was the manager, and
they were the only individuals with bank account signature authority.
Per his Form W-2, Wage and Tax Statement, Mr. Carreon received
compensation of $12,137 from Bancard Solutions during his 2005 taxable year.
Bancard Solutions reported gross receipts of $225,040 for the taxable fiscal year
ending July 31, 2005.
In the 2005 taxable fiscal year, Bancard Solutions issued and Mr. Carreon
signed checks in the total amount of $159,000 to the Mission Federal Credit Union
(MFCU). Using these funds, Mr. Carreon obtained and then transferred $159,000
in cashier’s checks from MFCU payable to “Builders”. Bancard Solutions issued
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[*9] and Mr. Carreon signed two checks numbered 15585 and 2571 payable to
“Builders” totaling $56,000 during the period from August 1, 2004, through
March 31, 2005. Thus, Bancard Solutions transferred $215,000 which ended up in
two MFCU Builders’ accounts numbered 1153 and 1483. Bancard Solutions and
Builders never entered into any written agreements or written contracts.
Bancard Solutions underreported its taxable income for its 2005 taxable
fiscal year by the $215,000, which was paid to Builders. Had Bancard Solutions
reported the $215,000, it would have incurred an additional income tax liability of
$72,457 for its 2005 fiscal taxable year. On Bancard Solutions’ general ledger the
amounts transferred to Builders were deducted from gross income and treated, in
effect, as an expense for money going to “Builders”. The checks for payments to
Builders were described on the memo line of the general ledger as going to
“Builders”, “Builders-Principle”, “Principle-Builders”, “Builders Principle MFCU
Bank CK”, “Builders/Principle”, “To Principle”, “Form [sic] Builders”, “for
Builders/ Principle”, “To Principle Bank CK”, or “To BUILDERS on Behalf of
BANCard”. In late March or early April 2005 Mr. Carreon started to use
5
Respondent contends in his opening brief that this was check No. 1158, but
the evidence demonstrates that it was check No. 1558.
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[*10] Merchants, Inc. as the entity for his credit card service company. Bancard
Solutions dissolved on March 31, 2005.
Merchants, Inc.
On December 30, 2004, Merchants, Inc. was incorporated. Mr. Holcomb
was Merchants, Inc.’s incorporator. According to Merchants, Inc.’s statement of
information, Mr. Carreon was the chief executive officer and chief financial
officer for Merchants, Inc. Ms. Portugal served as the secretary. Mr. Carreon and
Ms. Portugal held these positions during the entire 2005 and 2006 taxable years.
Mr. Carreon and Ms. Portugal each owned 50% of Merchants, Inc. and were the
only individuals with signature authority on its accounts.
Mr. Carreon was issued a Form W-2 from Merchants, Inc. for his 2005
taxable calendar year reflecting wage income of $32,366. Merchants, Inc.
reported gross receipts of $279,352 for the 2005 calendar taxable year. For
calendar year 2005 Merchants, Inc. underreported its income by $270,000, which
is the amount Merchants, Inc. transferred to Builders. Merchants, Inc. underpaid
its Federal income tax by $89,899 for its 2005 calendar taxable year.
During 2006 Mr. Carreon had signature control of all Merchants, Inc.’s
accounts. Ms. Portugal also had signature control during this year of all the bank
accounts except Merchants, Inc.’s checking account No. 5595. Mr. Carreon was
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[*11] issued a Form W-2 for the 2006 taxable year from Merchants, Inc. reflecting
wage income of $49,134. For its 2006 calendar year Merchants, Inc.
underreported its income by $202,000, which is the amount Merchants, Inc. paid
to Builders during that year. Merchants, Inc. underpaid its Federal income tax by
$75,074 for its taxable calendar year 2006.
During its 2005 taxable calendar year Merchants, Inc. transferred $270,000
to MFCU and Builders by checks signed by Mr. Carreon. During its 2006 taxable
calendar year Merchants, Inc. transferred $202,000 to MFCU and Builders by
checks signed by Mr. Carreon. The $202,000 that went to MFCU in 2006 was
used for cashier’s checks payable to Builders. All $472,000 was not reported on
either Merchants, Inc.’s or Mr. Carreon’s Federal income tax return for the 2005
or 2006 taxable year. On Merchants, Inc.’s general ledger money going to
Builders was debited, thereby reducing income. The checks for payment to
Builders were described on Merchants, Inc.’s memo line of the general ledger as
going to “Builders”, “Builders-Principle”, “Principle-Builders”, “Builders
Principle MFCU Bank CK”, “Builders/Principle”, “To Principle”, “Form [sic]
Builders”, “For Builders/ Principle”, “To Principle Bank CK”, and “To
BUILDERS on Behalf of BANCard”. Mr. Betts prepared Merchant’s, Inc.’s
Federal income tax return for the 2006 taxable calendar year.
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[*12] Builders
Bancard Solutions and/or Merchants, Inc. transferred portions of their
income to Builders starting in 2000 and continuing through the years at issue. Mr.
Carreon maintained a very detailed QuickBooks account record of transfers going
to the Builders account. During the taxable years at issue Mr. Holcomb had
signature authority over Builders’ account.
Angel High Group
On March 14, 2000, Mr. Carreon and Ms. Portugal opened an account at
MFCU under the account name Western Hill Valley Inc. d.b.a. Angel High Group
(AHG), account no. xxxxxx405-0 (AHG 405-0 account). Mr. Carreon and Ms.
Portugal each had signature authority over the AHG 405-0 account. In the
calendar year 2005 Builders issued checks payable to the AHG 405-0 account
totaling $342,250.
On April 24, 2006, Mr. Carreon opened an account at MFCU under the
account name Western Hill Valley Inc. d.b.a. AHG, account no. xxxxxx 568-1
(AHG 568-1 account). Mr. Carreon had sole signature authority over the AHG
568-1 account. During the calendar year 2006 Builders paid $197,700 to the AHG
568-1 account. During the years at issue the AHG 568-1 account issued checks
under the name “Angel High Group, David Carreon”. During the taxable calendar
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[*13] year 2006 Mr. Carreon paid personal expenses using funds deposited into
the AHG 568-1 account. Mr. Carreon and Ms. Portugal did not report as Federal
taxable income any of the amounts deposited in either the AHG 405-0 or AHG
568-1 account during the calendar years 2005 and 2006.
Boot Peak Hill
During 2006 Builders issued checks to Helping Hand, Jubilee, and
Brother’s Keeper totaling $55,200 which were deposited into the Boot Peak Hill
(Boot) checking account No. xxxxx-x3252 (Boot 3252 account). Mr. Carreon had
signature authority on the Boot 3252 account during the taxable years at issue.
Mr. Carreon endorsed and deposited checks into the Boot 3252 account during the
year 2006. During 2006 checks from the Boot 3252 account were issued under the
name “Boot Peak Hills, David Carreon”. Petitioners did not report as Federal
taxable income any of the money transferred into the Boot 3252 account.
Funds in the AHG 405-0, AHG 568-1, and Boot 3252 accounts were used
by Mr. Carreon and Ms. Portugal to pay some of their personal expenses during
the calendar year 2006. There were no QuickBooks account entries set up for
transfers going from Builders into the AHG or Boot accounts. Checks issued from
the Builders accounts displayed the names “Agape”, “Jubilee”, and “Helping
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[*14] Hand”, and were deposited into either the AHG or the Boot accounts. The
checks issued from Builders were signed by Mr. Holcomb.
Rental Property
Mr. Carreon and Ms. Portugal received rental income of $9,300 from jointly
held property during the 2005 taxable year. Mr. Carreon deposited $9,300 into the
AHG 405-0 account. Mr. Carreon and Ms. Portugal did not report the $9,300 as
income on their joint Federal income tax return for the calendar year 2005.
In the 2006 calendar taxable year, Mr. Carreon and Ms. Portugal received
rental income of $31,850 from their jointly held property. Mr. Carreon deposited
$15,700 and $16,1006 into the AHG 405-0 and Boot 3252 accounts, respectively.
Neither Mr. Carreon nor Ms. Portugal reported any of this rental income on his or
her 2006 Federal income tax return.
Mr. Carreon’s Reliance on Mr. Holcomb and Mr. Betts
Mr. Betts helped maintain the QuickBooks file on a monthly basis and
reconciled Mr. Carreon’s, Bancard Solutions’, and Merchants, Inc.’s bank
accounts every month. Mr. Betts testified that to his then-current knowledge Mr.
Carreon provided records sufficient to determine his tax liability. Mr. Betts also
6
The parties did not indicate nor does the record reveal where the remaining
$50 of rental income was transferred to.
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[*15] testified that to his knowledge all of the tax returns he prepared using the
“agent-principal” relationship were correct. Mr. Holcomb had discussed this
“agent-principal” relationship with Mr. Betts, Mr. Carreon, and Ms. Portugal and
had assured them about its validity. Mr. Carreon relied on Mr. Betts and Mr.
Holcomb in his determination and review for accuracy of his Federal income tax
returns for himself and for his businesses.
Procedural History
On July 12, 2011, notices of deficiency were issued to Mr. Carreon and Ms.
Portugal for the 2005 taxable calendar year; to Mr. Carreon for the 2006 taxable
calendar year; to Bancard Solutions for the taxable fiscal year ending July 31,
2005; and to Merchants, Inc. for the 2005 and 2006 taxable calendar years.7 Mr.
Carreon has agreed to his Federal income taxation, for 2005 and 2006, of all the
constructive dividend amounts, consisting of the money deposited to Builders
from Merchants, Inc. during 2005 and 2006. Merchants, Inc. has agreed to pay
taxes on the full amount that was deposited into the “Builders” account from
Merchants, Inc.
7
A Tax Court petition was also filed by Ms. Portugal for her 2005 calendar
taxable year at docket No. 22063-11, but at the request of these parties that case
was severed from these consolidated cases by order of this Court dated December
10, 2012.
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[*16] OPINION
I. Section 6663 Fraud Penalty
In any case involving the issue of fraud with intent to evade tax, the
Commissioner bears the burden of proof as to that issue. Sec. 7454(a). That
burden of proof must be carried by “clear and convincing evidence”. Rule 142(b).
Section 6663(a) imposes a penalty of “an amount equal to 75 percent of the
portion of the underpayment which is attributable to fraud.” Section 6663(b)
specifies that if “any portion of an underpayment is attributable to fraud, the entire
underpayment shall be treated as attributable to fraud, except” to the extent “the
taxpayer establishes (by a preponderance of the evidence) [that some part] is not
attributable to fraud.” Id.
Respondent must prove, for each year, by clear and convincing evidence
that (1) petitioners underpaid their tax for that year, and (2) that some part of that
underpayment for that year was due to fraud. See Parks v. Commissioner, 94 T.C.
654, 660-661 (1990); Hebrank v. Commissioner, 81 T.C. 640, 642 (1983).
A. Underpayment of Tax
The first prong of the fraud test mandates that the Commissioner prove the
existence of an underpayment of tax for the year. In doing so, the Commissioner
may not simply rely on the taxpayer’s failure to prove error in the deficiency
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[*17] determination. DiLeo v. Commissioner, 96 T.C. 858, 873 (1991), aff’d, 959
F.2d 16 (2d Cir. 1992); Otsuki v. Commissioner, 53 T.C. 96, 106 (1969).
Petitioners and respondent have stipulated unreported income and gross receipts
that result in underpayments of tax liabilities for the 2005 and 2006 taxable years.
Accordingly, the Court concludes respondent has proven underpayments of tax by
clear and convincing evidence. Consequently, respondent has proved the first
prong of the fraud test for both the 2005 and 2006 taxable years for each
petitioner.
B. Fraudulent Intent
To satisfy the second prong of the fraud test, the Commissioner must show
that a portion of the underpayment is attributable to fraud. The determination of
whether civil fraud exists “is a question of fact to be resolved upon consideration
of the entire record.” See Parks v. Commissioner, 94 T.C. at 660. Fraud for that
purpose is defined as intentional wrongdoing, with the specific purpose of
avoiding a tax believed to be owed. E.g., DiLeo v. Commissioner, 96 T.C. at 874.
Although no single factor may necessarily be sufficient to establish fraud, the
existence of several indicia may be persuasive circumstantial evidence of fraud.
Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), aff’g T.C. Memo.
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[*18] 1982-603. Mere suspicion, however, is not enough. E.g., Katz v.
Commissioner, 90 T.C. 1130, 1144 (1988).
As direct proof of a taxpayer’s intent is seldom available, fraud may be
established by circumstantial evidence and reasonable inference drawn from the
record. Stoltzfus v. United States, 398 F.2d 1002, 1005 (3d Cir. 1968); DiLeo v.
Commissioner, 96 T.C. at 874. Courts have developed a nonexclusive list of
badges of fraud useful in determining whether there is circumstantial evidence of
fraudulent intent. Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
Among the badges of fraud that can be gathered from the caselaw of the Court of
Appeals for the Ninth Circuit (the Court to which these cases are appealable
absent a stipulation by the parties to the contrary) are the following: (1)
understatement of income, (2) inadequate maintenance of records, (3) failure to
file tax returns, (4) offering implausible or inconsistent explanations of behavior,
(5) concealment of income or assets, and (6) failure to cooperate with tax
authorities. See Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.
1986), aff’g T.C. Memo. 1984-601.
Other factors looked at by courts include: engaging in illegal activities;
dealing in cash; failure to make estimated payments; offering false or incredible
testimony; and filing false documents. See Niedringhaus v. Commissioner, 99
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[*19] T.C. at 211; Parks v. Commissioner, 94 T.C. at 664-665. Additionally the
taxpayer’s background, level of education, and prior history of filing proper
returns are relevant. See Niedringhaus v. Commissioner, 99 T.C. at 202.
C. Second Prong of Fraud Test as Applied to Mr. Carreon
1. Understatement of Income
This Court has held that consistent understatements of income in substantial
amounts over a number of years by knowledgeable taxpayers, standing alone, may
be considered persuasive evidence of fraud. See Otsuki v. Commissioner, 53 T.C.
at 108. Mr. Carreon conceded that he underreported income for the 2005 and
2006 tax years by $355,000 and $101,000, respectively. However, the reason for
the underreporting was Mr. Carreon’s reliance on the validity of the “agent-
principal” relationship. See Alexander v. Commissioner, T.C. Memo. 2013-203,
at *44. Mr. Carreon was assured by Mr. Holcomb and to a certain extent by his
own C.P.A. Mr. Betts of the validity of the “agent-principal” relationship.8 While
Mr. Carreon’s reliance on Mr. Holcomb may not have been reasonable, his
reliance was not fraudulent. See id. (holding that relying on a promoter will not
8
Mr. Betts testified that he had previously used the “agent-principal”
relationship when he performed accounting services for travel agents. The travel
agents would collect the money from ticket fees and then transfer most of it to the
airline, which would make the transferred portion deductible to the travel agents.
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[*20] satisfy the reasonable cause defense for section 6664; however, reliance on a
promoter can negate fraudulent intent for purposes of section 6663). Accordingly,
this factor weighs slightly against a finding of civil fraud.
2. Inadequate Maintenance of Records
The failure to maintain adequate business records supports a finding of
fraud. See Lollis v. Commissioner, 595 F.2d 1189, 1192 (9th Cir. 1979), aff’g
T.C. Memo. 1976-15; Estate of Mazzoni v. Commissioner, 451 F.2d 197, 202 (3d
Cir. 1971), aff’g T.C. Memo. 1970-37, supplemented by T.C. Memo. 1970-144.
A taxpayer is required to keep records and statements sufficient to determine
whether the taxpayer is liable for tax. Sec. 6001; sec. 1.6001-1, Income Tax Regs.
Mr. Carreon maintained an extensive QuickBooks file showing where his
personal account, Bancard Solutions’, and Merchants, Inc.’s checks and credit
card transactions were being sent. The QuickBooks file was maintained to show
not only where the money was going, but also the type of expense. This file was
maintained by Mr. Carreon or Ms. Portugal throughout the years at issue. The
QuickBooks accounts contained profit and loss statements, general ledgers, and
balance sheets for petitioners.
Mr. Carreon followed detailed instructions from Mr. Holcomb on how to
maintain the QuickBooks account, which did not include keeping any records or
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[*21] books on the AHG or Boot bank accounts. Because of the failure to record
and provide AHG or Boot bank accounts information to the Commissioner, we
conclude Mr. Carreon did not clearly maintain a complete set of books. Therefore,
this factor weighs slightly in favor of a finding of civil fraud.
3. Mr. Carreon’s Tax Returns
Failure to file tax returns is a badge of fraud. See Niedringhaus v.
Commissioner, 99 T.C. at 211-212. Mr. Carreon filed tax returns for the years at
issue albeit up to six days late. Therefore, this factors weighs against a finding of
civil fraud.
4. Plausible or Consistent Explanations of Behavior
Implausible or inconsistent explanations of a taxpayer’s behavior can
constitute circumstantial evidence of fraudulent intent. See Bradford v.
Commissioner, 796 F.2d at 307. Mr. Carreon noted on the general ledger and
other documents that the money transferred to Builders was going to the principal.
It is apparent from the record that Mr. Carreon continually was under the
impression that he was using an “agent-principal” relationship.
We are, however, suspicious of Mr. Carreon’s failure to prepare any record
for AHG or Boot, the use of checks with charitable-sounding names, and the too-
good-to-be-true tax result obtained; but suspicious circumstances alone do not
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[*22] sustain a finding of fraud. See Katz v. Commissioner, 90 T.C. at 1144;
Holmes v. Commissioner, T.C. Memo. 2012-251, at *34. While mere suspicion
would generally weigh against a determination of “good faith” under section
6664(c)(1), we are mindful that respondent must prove the elements of fraud by
clear and convincing evidence, and absent persuasive evidence, we do not find
that Mr. Carreon fraudulently failed to maintained adequate records.
Accordingly, this factor weighs against a finding of civil fraud.
5. Concealment of Income or Assets
An intent to evade tax may be inferred from concealment of assets or
covering up sources of income. See Edelson v. Commissioner, 829 F.2d 828, 832
(1987), aff’g T.C. Memo. 1986-223. Mr. Carreon kept a general ledger with all
the payments from Bancard Solutions and Merchants, Inc. to Builders; however,
there was no information provided about any of the transactions after the income
went to Builders and then into other accounts. Most of this money went into
accounts controlled by Mr. Carreon, which Mr. Carreon ultimately used for
personal expenses. Builders’ accounts information was never disclosed to Mr.
Betts, nor was it fully accounted for or ever included in petitioners’ income tax
returns. Therefore, this factor weighs in favor of a finding of civil fraud.
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[*23] 6. Cooperation With Taxing Authorities
A taxpayer’s failure to cooperate with revenue agents during an
investigation is a badge of fraud. See Grosshandler v. Commissioner, 75 T.C. 1,
20 (1980). After the first meeting at Mr. Carreon’s residence, which lasted almost
the entire day, Mr. Peters, a revenue agent, described Mr. Carreon as “pleasant”.
In response to part of the revenue agent’s initial request for documents, Mr.
Carreon provided the general ledgers and other requested or sought information.
In fact Mr. Carreon voluntarily extended the period of limitation to allow the audit
to continue.
Mr. Carreon, however, was not helpful in establishing the links between
Builders and the AHG 405-0 account, the AHG 568-1 account, and the Boot 3252
account. The revenue agent requested documents about these transfers and never
received them from Mr. Carreon. Mr. Carreon did provide other information
requested and went in person to meet with the revenue agent. Accordingly, this
factor is neutral.
7. Mr. Carreon’s Engaging in Legal Activities
There is no evidence that Mr. Carreon was performing any outside unlawful
activities. Accordingly, this factor weighs against a finding of civil fraud.
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[*24] 8. Mr. Carreon Did Not Make Cash Transfers.
Dealing in cash to prevent scrutiny of a taxpayer’s finances is a badge of
fraud. See Bradford v. Commissioner, 796 F.2d at 307-308. Further, if a taxpayer
deals in cash while attempting to conceal a transaction or avoid reporting the
transaction, that conduct may be indicative of fraud. See Valbrun v.
Commissioner, T.C. Memo. 2004-242, slip op. at 8-9.
Mr. Betts had testified that Bancard Solutions and Merchants, Inc. never
dealt in cash. Mr. Carreon primarily used checks and credit cards in order to make
payments. Mr. Carreon on occasion made large transfers using cashier’s checks
from Bancard Solutions and Merchants, Inc. to Builders. This Court has on
occasion held that the use of cashier’s checks can be a badge of fraud. See
Hamilton v. Commissioner, T.C. Memo. 2004-66, slip op. at 6. In Hamilton, the
taxpayer used cashier’s checks made out to himself and did not keep an accurate
record of where the cashier’s checks were going. See id. In the instant case, Mr.
Carreon made the cashier’s checks payable to Builders, and the general ledgers
had the funds going to Builders. Therefore, Mr. Carreon did not use the cashier’s
checks to conceal the money transfers. Accordingly, this factor weighs against a
finding of civil fraud.
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[*25] 9. No False Documents Filed
Filing a document intending to conceal, mislead, or prevent the collection of
tax is an indicium of civil fraud. See Edelson v. Commissioner, 829 F.2d at 832.
Specifically, filing a false document with the IRS is an affirmative act of
misrepresentation that may justify the fraud penalty. See Zell v. Commissioner,
763 F.2d 1139, 1146 (10th Cir. 1985) (holding false withholding certificates were
evidence of fraud), aff’g T.C. Memo. 1984-152.
Respondent does not allege that Mr. Carreon filed any false documents with
the IRS. A fictitious business name was registered for Merchants, Inc. with the
State of California, but respondent did not allege that this had any bearing on Mr.
Carreon’s income tax. Mr. Carreon did file incorrect and thereby false returns
when he did not report or disclose that Builders paid his personal expenses.
Accordingly, this factor weighs in favor of a finding of civil fraud.
10. No False or Incredible Testimony
Mr. Carreon asserts when he filled out the relevant tax returns he believed
that the “agent-principal” relationship described and explained by Mr. Holcomb
and accepted as viable by Mr. Betts was a legal relationship that justified his tax
reporting position although the Builders payments of some of his expenses were
not included, or fully disclosed to Mr. Betts. Further, Mr. Carreon’s course of
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[*26] conduct gives credence to his belief. Respondent has failed to convincingly
rebut Mr. Carreon’s assertion and has failed to show the requisite specific
fraudulent intent. Accordingly, this factor weighs heavily against a finding of
civil fraud.
Summary of Badges
The Court concludes three factors weigh in favor of civil fraud, one factor is
neutral, and six factors weigh against civil fraud as applied to Mr. Carreon.
Additionally, Mr. Carreon placed a great deal of reliance on his C.P.A. Mr. Betts
and believed the agent-principal relationship complied with Federal tax law. Mr.
Carreon does not possess the education or experience in tax law that would allow
him to know that he should have reported the additional income. Even though the
reliance on Mr. Betts and Mr. Holcomb was misplaced and three badges of fraud
exist, respondent has not carried his substantial burden of proving by clear and
convincing evidence that Mr. Carreon committed fraud.
Accordingly, the Court concludes that respondent has failed to prove the
second prong of the fraud test with respect to Mr. Carreon for the years 2005 and
2006.
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[*27] D. Second Prong of Fraud Test as Applied to Bancard Solutions and
Merchants, Inc.
Respondent contends Bancard Solutions and Merchants, Inc. are liable for
the civil fraud penalty. Fraud must be proven by independent evidence of
fraudulent intent. Toussaint v. Commissioner, 743 F. 2d 309, 312 (5th Cir. 1984),
aff’g T.C. Memo. 1984-25. Therefore, the finding that Mr. Carreon is not liable
for fraud is a separate and distinct finding.
Bancard Solutions and Merchants, Inc. conceded that they underreported
their income for the years in issue. Merchants, Inc. conceded that it underreported
gross receipts for the taxable years 2005 and 2006 by $270,000 and $202,000,
respectively. Bancard Solutions conceded that it failed to report gross receipts of
$215,000 for the taxable year ending July 31, 2005. However, the reason for the
underreporting was its management’s reliance on the validity of the agent-
principal relationship. Mr. Carreon and Ms. Portugal were assured by Mr.
Holcomb and their C.P.A. Mr. Betts of the validity of this relationship. While Mr.
Carreon and Ms. Portugal’s reliance on Mr. Holcomb may not have been
reasonable, their reliance was not fraudulent. See Alexander v. Commissioner, at
*44, *50. Accordingly, this factor weighs slightly against a finding of civil fraud.
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[*28] Bancard Solutions and Merchants, Inc. kept extensive QuickBooks
accounts. Mr. Betts, petitioners’ C.P.A., would help maintain the QuickBooks file
on a monthly basis and reconciled Bancard Solutions’ and Merchants, Inc.’s bank
accounts every month for petitioners. However, neither Bancard Solutions nor
Merchants, Inc. kept details on why payments going to Builders were deductible;
and those payments to Builders sometimes were used to pay their owners’ personal
expenses. Therefore, this factors weighs in favor of civil fraud.
Bancard Solutions and Merchants, Inc. filed all their tax returns for the
years at issue. Therefore, this factor weighs against fraud. Respondent does not
allege that Bancard Solutions or Merchants, Inc. was engaged in any illegal
activities. Therefore, this factor weighs against a finding of civil fraud.
Respondent does not allege that Bancard Solutions or Merchants, Inc. filed any
false documents with the IRS. Therefore, this factor also weighs against a finding
of civil fraud.
The Court concludes that respondent has again failed to carry his burden of
establishing by clear and convincing evidence the second prong of the fraud test
for the years 2005 and 2006 as applied to Bancard Solutions and Merchants, Inc.
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[*29] II. Conclusion
On the basis of the record as a whole and particularly in light of the advice
provided to petitioners by Mr. Holcomb and most importantly by their C.P.A. Mr.
Betts, who testified at the trial and whose testimony was credible, the Court rejects
respondent’s determination of the section 6663 civil fraud penalty as to any of
petitioners. Mr. Betts testified at the trial, and the Court found his testimony
credible even though, as to the tax law as applied to the “agent-principal
relationship,” incorrect and naive. See generally United States v. Boyle, 469 U.S.
241, 250-251 (1985). Petitioners’ decision to engage in the transaction at issue
here was the result of misguided reliance on their advisers and not their intent to
fraudulently evade tax.
To reflect the foregoing,
Decisions will be entered under
Rule 155.