The opinion
T.C. Memo. 2002-127
UNITED STATES TAX COURT
ZABETTI A. PAPPAS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24593-95. Filed May 23, 2002.
Zabetti A. Pappas, pro se.
Lyle B. Press and David A. Williams, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined deficiencies and
additions to tax in petitioner’s Federal income taxes as follows:
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Additions to Tax
Year Deficiency Sec. 6651(f)1 Sec. 6654(a)
1989 $21,867 $16,400 $1,478
1990 19,575 14,681 1,287
1991 3,873 2,905 224
1992 4,017 3,013 175
After concessions,2 the issues for decision are as follows:
(1) Whether amounts paid to or received by Real Services, Inc.,
during 1989 and 1990 are properly treated as petitioner’s taxable
income; (2) whether petitioner failed to report income received
in connection with an “escort” business during 1989 and 1990; (3)
whether petitioner failed to report income she received through
embezzlement and/or fraudulent loan transactions during 1989 and
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
2
In connection with the pretrial proceedings in this case,
respondent was deemed to have conceded his determinations that
petitioner had unreported income of $4,640 in 1990 as a result of
a transaction with an individual identified as Harvey K. and
unreported income of $1,500 as a result of a transaction with one
Dennis T. Additionally, on brief, respondent has conceded his
determination that petitioner had unreported income of $1,030 as
a result of a transaction with an individual identified as
Ricardo S.
The determinations in the deficiency notice included amounts
of self-employment taxes for the years in issue. Petitioner has
not specifically contested the applicability of these taxes, and
we deem that she has conceded this issue. The amount of self-
employment taxes, and the commensurate deductions for those
taxes, are to be determined in accordance with our conclusions
herein regarding petitioner’s unreported income.
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1990; (4) whether petitioner failed to report sales and rental
income she received during 1989 and 1990; (5) whether petitioner
may deduct business expenses in excess of those allowed by
respondent for 1989 and 1990; (6) whether respondent properly
reconstructed petitioner’s 1991 and 1992 taxable income through
the use of Bureau of Labor Statistics data; (7) whether
petitioner is liable for the additions to tax under section
6651(f) or, in the alternative, for the additions to tax under
section 6651(a) for the years at issue; and (8) whether
petitioner is liable for the additions to tax under section
6654(a) for the years at issue.
FINDINGS OF FACT
Petitioner Zabetti A. Pappas was a resident of New York, New
York, at the time the petition herein was filed. She did not
file Federal income tax returns for the taxable years at issue,
nor did she make estimated tax payments for those years.
1. Petitioner and Real Services, Inc.
Petitioner attended Vassar College from 1976 through
approximately 1978. Thereafter, she held a variety of jobs,
including operating a business known as “Disco Queen”. She was
known to her associates and clientele in New York as “Z” or
“Betty” or “Angel”. Petitioner was actively involved in a number
of income-producing activities. She operated a prostitution
business, in which she arranged for other women or herself to
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engage in sexual activities with individuals who paid her for
such services. The parties have referred to such arrangements as
the provision of “escort” services, and we shall do so in this
opinion. Petitioner also sold electronic equipment, lighting
equipment, theater tickets, and music tapes. She earned money
for designing apartment interiors and installing entertainment
systems; she also engaged in obtaining loans; and she dabbled in
her family’s real estate activities in Hawaii and Ohio.
Petitioner formed Real Services, Inc. (Real Services), in
New York State on September 29, 1988. Petitioner was its
president and sole shareholder. She signed a preprinted
document, filling in the blanks, which indicated that she was an
employee of Real Services. Her associate and companion, Laura
C., agreed to serve as vice president of Real Services but
performed no meaningful activities in that role. Ms. C. was
elected vice president of Real Services several months after
using that title to attest to petitioner’s employment contract.
Two individuals named Ted P. and Michael S. were business
associates of petitioner but were not actively involved in the
operation of the corporation. Real Services did not file Federal
corporation income tax returns, Federal payroll tax returns, or
New York State tax returns covering any of the years at issue.
Petitioner maintained sketchy and incomplete records for
Real Services. She did, however, have signature authority over a
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checking account at Chemical Bank in the name of Real Services.
At the request of Chemical Bank, her lawyer obtained an employer
identification number (EIN) for Real Services.
Petitioner gave the name “Real Services” for use on the
sales slips she received when she purchased electronic equipment
for resale. Instead of giving an identifying number for Real
Services, however, petitioner used her own Social Security number
when requesting exemptions from State sales tax for these
purchases.
Petitioner made deposits into the Real Services’ checking
account totaling $46,242.81 in 1989 and $73,351.08 in 1990. In
October 1989, petitioner wrote a check on this account for $500
to her brother and another for $250 to her sister as birthday
presents. The next month petitioner wrote a check on this
account for $900 to pay private school tuition for the daughter
of her companion, Laura C., and another check to pay for Ms. C.’s
contact lenses. In 1990, petitioner paid $100 for an exercise
class with a check drawn on the same account. The account was
closed in December 1990.
Petitioner also maintained two accounts at Chemical Bank in
her own name. She deposited $2,500.00 and $2,452.61 into one
such account in 1989 and 1990, respectively. Into the other
personal account, she deposited $12,711.48 in 1989 and $12,373.85
in 1990.
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During the years in issue, petitioner’s principal residence
was an apartment at 500 E. 77th Street in New York. She took
over the lease of that apartment in the early 1980s from an
individual named Joy C. but continued to use Ms. C.’s name on
documents regarding that lease. She did not use her own name or
that of Real Services. Petitioner shared the apartment with
Laura C., who occasionally used Joy C.’s name instead of her own.
After 1986, Laura C.’s infant daughter also lived in the E. 77th
Street apartment.
In July 1989, petitioner arranged to take over an apartment,
located at 320 E. 65th Street in New York, rented by another
individual named Jane M. Ms. M. was allowed to live at the E.
77th Street apartment while the apartment on E. 65th Street was
renovated. Ms. M.’s name remained on the lease for the E. 65th
Street apartment; Real Services was not identified on the lease
document.
2. Unreported Income
For petitioner’s 1989 and 1990 taxable years, respondent
determined unreported income in a number of categories. For
convenience, we discuss the issues presented in each of these
categories in the order they were presented in the deficiency
notice.
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A. Escort Income
Petitioner arranged for the provision of escort services
during 1989 and 1990 out of the two apartments noted above, as
well as an apartment on W. 58th Street in New York during the
latter year. She received cash and checks in payment for those
services. At her request, many of the checks were drawn to the
order of Real Services.
Dennis T. engaged escort services at least six times at
petitioner’s E. 77th Street apartment. Mr. T. received escort
services from Laura C. In terms of his direct dealings with
petitioner, however, he engaged only in legitimate business
activities. These included a loan to petitioner for $4,000,
which she repaid with a mixture of checks from the Real Services’
account and from her personal accounts.
A business associate of petitioner, Michael S., paid for
escort services received at either petitioner’s E. 77th or E.
65th Street apartment, approximately six times during 1989
through 1990. However, the arrangements were made by, and the
money was paid to, Laura C.
Paul G. paid petitioner $1,500 in 1989 and $500 in 1990 for
arranging escort services for him with other women. Mr. G. also
provided investment advisory services for one of the women
providing escort services to him pursuant to petitioner’s
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arrangement, but none of the amounts he paid petitioner
constituted a fee for introducing him to that woman.
Over a 10-year period that included 1989 and 1990, Jeffrey
F. paid between $5,000 and $15,000 to petitioner for procuring
escort services for his business clients. He wrote a $200 check
to cash in September 1989 that petitioner deposited into the Real
Services’ checking account. Mr. F. dealt with at least one other
escort service in addition to petitioner’s during this period.
He paid $1,500 to petitioner for escort services in 1989 and
$1,500 in 1990.
Alexander K. issued a check for $1,200 that was made out to
Real Services and dated October 12, 1989. Petitioner deposited
this check in the Real Services’ checking account. Petitioner
had in her possession Alexander K.’s business card.
Between 1989 and 1992, an individual named Richard S.
availed himself of petitioner’s escort services “maybe once a
month but not necessarily for all that period of time.” He paid
$200 per visit. Petitioner received $2,700 in 1989 and $2,700 in
1990 from Mr. S. for escort services. Mr. S. abused alcohol
during the period that he used petitioner’s escort services.
Meyer S. wrote 10 checks to cash during the first half of
1990 as payment to petitioner for escort services she arranged.
Petitioner deposited the checks into the Real Services’ checking
account. The 10 checks totaled $1,450. However, these 10 checks
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included checks totaling $460 that were dishonored, as well as
checks totaling $460 that were provided as replacements for the
dishonored checks.
A check for $200, dated June 23, 1989, was made payable to
cash by Eric K. and endorsed by Jane M. for Real Services. Jane
M. was one of the women who provided escort services to customers
pursuant to petitioner’s arrangements. The check was deposited
into the Real Services’ account.
Ronald K. paid petitioner approximately $125 per session for
escort services she arranged on 12 to 15 occasions during the
years 1989 through 1990. Additionally, in 1990, he lent
petitioner $5,000, which she repaid without interest. On two or
three occasions, however, she provided him with the escort
services of other women in appreciation for his having lent her
the money.
In the summer of 1990, Michael L. lent petitioner $4,000 in
the form of a check made out to Real Services. Two months later,
petitioner issued him a check in repayment for $4,800. The check
was dishonored, and petitioner then repaid Mr. L. by providing
escort services.
Harvey K. paid petitioner for escort services provided by
herself and by other women during 1990. He visited between three
to four times and paid petitioner $180 per visit.
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A check issued by Crihil I. for $1,300, made payable to
Jennifer R. “and/or cash” and dated November 10, 1990, was
endorsed by Jennifer R. to Real Services. On November 15, 1990,
petitioner deposited the check into one of her personal accounts
at Chemical Bank. Jennifer R. was one of the women who provided
escort services to customers pursuant to petitioner’s
arrangements.
Near the end of 1989, petitioner deposited a check for $400,
dated December 15, 1989, made payable to Real Services from
Douglas B. During 1990, petitioner deposited into her Chemical
Bank accounts two checks to cash totaling $225 from Jerrold M., a
check to cash for $200 from William C., and two checks payable to
cash totaling $140 from Takero O. These six checks were received
by petitioner as payments for escort services.
In connection with providing the escort services, petitioner
was required to pay the women who performed services for her
clientele.
On November 10, 1990, petitioner endorsed and deposited into
her account a check for $500 made payable to Real Services by Raj
International. This check constituted part of a loan to
petitioner from Parvin S. She repaid the loan later that year
with checks drawn on Real Services’ account and on her personal
account.
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B. Embezzlement Income
Michael S., who received escort services at petitioner’s
apartments during 1989 and 1990, also engaged in certain
legitimate transactions with petitioner in 1989. Petitioner
talked him into lending her $12,000 on October 10, 1989. She
explained that the loan would finance the furnishing of the
apartment on E. 65th Street. Mr. S. reviewed the expenses of
furnishing the apartment and visited the apartment to verify that
it had been furnished.
As security for the $12,000 loan, petitioner gave Mr. S. a
letter promising him a share of a commission she would earn on
the sale of some family property, known as Haiku Plantation,
located in Hawaii. Mr. S. looked at some documents describing
the property and discussed its value with petitioner’s sister,
who, he understood, had the majority ownership in the property.
Petitioner partially repaid Mr. S. with a series of checks
totaling $3,640 written during first half of 1990.
Mr. S. also purchased a large supply of magnetic tapes from
petitioner for $10,000, which he then donated to a school. Mr.
S. obtained these materials from petitioner because he could get
a “better rate” than elsewhere. One of his checks given in
payment to petitioner for this purchase, for $3,000, was returned
unpaid.
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Howard S. lived in the same apartment building as
petitioner. He became friendly with petitioner and, in 1989,
lent her $5,000. On August 1, 1989, she agreed to repay that
amount within 60 days. By the first quarter of 1991, petitioner
had repaid Mr. S. $1,300, which he acknowledged by initialing an
invoice to that effect. Mr. S.’s loan was made to petitioner
individually, but the repayment came in the form of Real Services
checks. On August 12, 1991, Mr. S. sued petitioner in both her
capacities; i.e., as “Zabetti Pappas, d/b/a/ Real Services
* * *”, with respect to the loan. He alleged, among other
things, that he had lent petitioner $3,750 and that “to date no
monies have been paid back”.
John K. was a friend of petitioner’s from their college days
at Vassar. Mr. K. believed petitioner possessed business acumen
and trusted her on the basis of their friendship. He sought
petitioner out in 1990, seeking a profitable return on money he
wished to invest. In March 1990, Mr. K. gave petitioner $10,000
to invest in real estate projects that she described. In August
1990, petitioner advised Mr. K. that she had an investment
opportunity that would return a profit in 30 days. On the basis
of this representation, he gave her an additional $5,000 to
invest. She returned to him only $1,750, in the form of a check
for $1,250, dated September 19, 1990, and the payment of $500 in
cash. Petitioner’s other checks to him were dishonored.
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Petitioner offered various excuses to Mr. K. for her failure to
return his money, either the $10,000 or the balance of the
$5,000, which he did not believe.
Mr. K.’s investments with petitioner were made in the form
of checks made out to Real Services, but when repayments fell
short, petitioner wrote to him, “I can start paying even more
next month * * *. I am really trying--its [sic] just that my
finances are jumbled.” Her letter made no mention of Real
Services.
On or about July 24, 1990, petitioner received $5,000 from
Jennifer R., one of the women who provided escort services to
customers pursuant to petitioner’s arrangements. Petitioner
executed a letter memorandum to record the $5,000 payment, which
stated that the money “shall be used for investment purposes” and
provided for a “guaranteed minimum return” of 25 percent
“interest” in 1 year, on July 24, 1991. On or about November 7,
1990, petitioner received an additional $10,000 from Jennifer R.
under similar circumstances. Petitioner executed another letter
memorandum, which recorded her receipt of $10,000 that was to be
used “for investment purposes” and provided for a “guaranteed
return” of 25-percent “interest”, payable within 45 days, or by
December 21, 1990. Jennifer R. died before the trial in this
case.
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C. Electronics, Introduction Fees, Theater Tickets, and
Music Tape Income
During 1989, petitioner received $10,800 from the sale of
electronics to, as well as the payment of introduction fees by,
Ted and Brian P. Petitioner also received $7,800 from the sale
of electronics to Howard S. (in addition to the $5,000 loan from
Mr. S. noted earlier). Petitioner’s cost of goods sold to Ted
and Brian P. and to Howard S. in 1989 was $5,371.
In August 1989, petitioner received $300 in the form of a
check written to her individually by David M. The check was for
the purchase of tickets to the Broadway show “Phantom of the
Opera”. Petitioner, as “Zabetti Pappas - REAL SERVICES”, had
paid $300 for these tickets. She also received $250 for tickets
to the Broadway show “M. Butterfly” for which she paid the same
amount.
On September 18, 1989, Paul H. wrote a check to Real
Services in the amount of $110, in payment for prerecorded music
tapes that had cost petitioner $12. Petitioner deposited this
check into Real Services’s checking account.
In 1990, petitioner received $3,000 for additional
electronic equipment sold to Ted and Brian P. This equipment
included some security devices for a warehouse rented by Ted P.
Petitioner’s cost for the electronic equipment totaled $2,628.
In the same year, Howard S. paid her $2,775 for additional
electronic equipment. The items petitioner sold him included a
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52-inch rear-projection television and two answering machines.
The rear-projection television cost her $2,902, including taxes
and shipping, while the answering machines cost her $210.
During 1990, petitioner also received $1,400 in cash from
Kenny T. for the sale of a video cassette recorder for $200 and a
40-inch rear-projection television for $1,200. She paid $1,400
for those items. The television was returned to the business
from which petitioner purchased it for a credit of $1,200. She
accordingly neither made nor lost money on the transactions with
Kenny T.
D. Rental Income
Petitioner arranged a lease and sublease in her own name for
the apartment on W. 58th Street. In 1990, petitioner received
$2,800 from an individual named Terri D. representing 4 months’
rent for that apartment.
3. Petitioner’s Business Expenses
During 1989, petitioner incurred rental expenses of $7,763
and an electricity expense of $302 with respect to the apartment
on E. 65th Street at which she conducted some of her escort
business.
During 1989, petitioner lived in the apartment on E. 77th
Street. She had a room in that apartment in which she conducted
office business and in which escort services were occasionally
provided.
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During 1989, petitioner incurred additional business
expenses of $825 for office expenses, printing expenses, and
travel, plus $600 for business-related telephone service. She
also incurred printing costs of $24 and miscellaneous costs paid
to contractors of $132.
During 1989, petitioner also paid a total of $3,000 in legal
and professional fees to the law firm of Saltzman & Holloran and
to Prentice-Hall Financial Services relating to the incorporation
of Real Services. She incurred additional legal expenses of
$1,000 in defense of charges that she was using the apartment on
E. 77th Street for an illegal purpose.
During 1989, petitioner, in the name of Real Services,
executed a brokerage agreement in which she undertook to sell an
estate in Hawaii. The sellers were petitioner’s sister and
another individual. Petitioner spent considerable sums in
improving and marketing the property. The property had been
recorded as belonging to their deceased father and another
individual. The efforts to sell the property were unsuccessful,
and it was foreclosed upon in 1991.
Petitioner incurred rental expenses of $3,600 and utility
expenses of $223 in 1990 for the apartment on W. 58th Street
which, in that year, was used in her escort business and was also
subleased for 4 months.
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Petitioner continued to rent the apartment on E. 65th Street
for business purposes during 1990. She incurred rental expenses
of $13,983 and a utility charge of $790 in that year with respect
to that apartment.
During 1990, petitioner continued to live in the apartment
on E. 77th Street.
Petitioner incurred $100 for messenger expenses in 1990 and
$126.60 in shipping and mailing expenses. She incurred business
expenses of $600 for telephone service in that year. She also
paid monthly services charges totaling $220 during 1990 on the
Real Services’ checking account. In the same year she paid legal
fees of $1,650 in defending against charges that she was using
the apartment on E. 77th Street for an illegal purpose. She paid
an additional $400 to an attorney in connection with obtaining a
lease.
In 1990, petitioner also paid $150 to her brother for
appraisal fees concerning some property inherited from their
father.
4. Petitioner’s Interest Expenses
Petitioner frequently borrowed money. In addition to the
instances already cited, Tammy M., one of the women who provided
escort services to customers pursuant to petitioner’s
arrangements, lent petitioner $6,000 in 1990. Petitioner wrote
checks in repayment totaling at least $6,070. Many of
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petitioner’s repayment checks bounced, however, or were
reinvested, on the basis of petitioner’s representation that she
would invest this money in real estate on behalf of Tammy M.
Tammy M. recovered the amount of her loan to petitioner, but she
received no more than that.
In another transaction in early 1990, petitioner received
$2,500 from Vania W. Petitioner executed a letter memorandum
dated February 3, 1990, acknowledging her receipt of $2,500 from
Vania W., which she promised to invest and to repay in 30 days
with $1,000 interest. Petitioner subsequently wrote two checks
in March 1990 totaling $2,650 on a Real Services’ account, made
payable to herself or to cash. Although the memorandum line on
the checks indicated that they were executed as a “return” or
“replacement” for Ms. W., each check was endorsed only by
petitioner herself.
In the summer of 1990, petitioner borrowed $2,500 from a
tennis-playing partner named Phillip B.; he charged her no
interest on the loan. She made substantial repayments a few
months later.
5. Petitioner’s 1991 and 1992 Taxable Years
For the last two years in issue, 1991 and 1992, respondent
determined petitioner’s unreported income by applying cost-of-
living survey information published by the Bureau of Labor
Statistics (BLS). Respondent used BLS tables that classify the
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cost of living for specific years according to such factors as
age, size of consumer unit, occupation and location in the
greater New York area to determine that petitioner had a cost of
living-–and, hence, net income-–of $16,766 for 1991 and $17,461
for 1992.
OPINION
The Commissioner’s determinations in the notice of
deficiency are presumed correct, and petitioner bears the burden
of proving that the determinations are in error.3 See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
We note at the outset that petitioner has no credibility
with respect to the matters on which she testified. Her
testimony was shown on repeated occasions to be false, indicating
to us that she did not consider herself under any particular
obligation to testify truthfully in these proceedings. For
example, she denied absolutely that she, either in a personal or
corporate capacity, received any money for providing escort
services, although many of the 17 individuals identified in
respondent’s notice of deficiency testified credibly that they
paid her for such services. Also, petitioner first denied any
detailed knowledge regarding an eviction proceeding for an
3
Sec. 7491 does not apply to this case because the
examination commenced prior to July 22, 1998, the effective date
of that section. See Internal Revenue Service Restructuring and
Reform Act of 1998, Pub. L. 105-206, sec. 3001(c)(1), 112 Stat.
726.
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apartment she had rented, and then revealed a familiarity with
minute details regarding the proceeding when cross-examining
witnesses. In addition, on at least one occasion petitioner
sought to have a document admitted into evidence that she had
falsified. A witness testified credibly that petitioner provided
him with a written statement that contained a material
misstatement. He corrected the document and then signed it.
Petitioner then substituted a page of that document which failed
to reflect his correction before she submitted the document to
this Court. We accordingly give credence to petitioner’s
testimony and proffered documentary evidence only where we are
convinced by independent corroborating evidence of their veracity
or authenticity.
I. Whether Amounts Paid to or Received by Real Services Are
Properly Treated as Petitioner’s Taxable Income
The first issue to be addressed concerns the identity of the
taxpayer. Petitioner contends that she, individually, is not
liable for the taxes at issue; instead, she argues, the
corporation Real Services is liable for any taxes that may be
owing, because Real Services received the unreported income that
respondent has attributed to petitioner in his determination.
Taxpayers have the right to shape business transactions in a
manner that minimizes the incidence of taxation. Gregory v.
Helvering, 293 U.S. 465, 469 (1935). In this regard, a corporate
entity is deemed to exist as a separate taxpayer if it is
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organized to carry on a business activity or if, in fact, it has
carried on such activity. Moline Props., Inc. v. Commissioner,
319 U.S. 436 (1943). However, “in matters relating to the
revenue, the corporate form may be disregarded where it is a sham
or unreal. In such situations, the form is a bald and
mischievous fiction.” Id. at 439. In the latter situation, the
Government may not be required to acquiesce in the taxpayer’s
election of that form for doing business which is most
advantageous to him. The Government may look at actualities and
upon determination that the form employed for doing business or
carrying out the challenged tax event is unreal or a sham may
sustain or disregard the effect of the fiction as best serves the
purposes of the tax statute. See Higgins v. Smith, 308 U.S. 473,
477 (1940).
Here, if Real Services operated merely as a sham or the
alter ego of petitioner, its incorporation would have no impact
on her Federal income tax liabilities. See G.M. Leasing Corp. v.
United States, 429 U.S. 338, 350-351 (1977). The question before
us, then, is whether Real Services “conducted the kind and amount
of business activities to be a taxable entity.” Kimbrell v.
Commissioner, 371 F.2d 897, 902 (5th Cir. 1967), affg. T.C. Memo.
1965-115.
In this case, “Adopting a reasonable meaning of the Moline
Properties’ guiding phrase,” id., we hold that Real Services did
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not conduct sufficient business activities to be recognized for
Federal income tax purposes.
Petitioner’s activities with respect to Real Services reveal
many characteristics of an alter ego, such as:
“the intermingling of corporate and personal funds,
undercapitalization of the corporation, failure to
observe corporate formalities such as the maintenance
of separate books and records, failure to pay
dividends, insolvency at the time of a transaction,
siphoning off of funds by the dominant shareholder, and
the inactivity of other officers and directors.”
[LiButti v. United States, 107 F.3d 110, 119 (2d Cir.
1997) (quoting Bridgestone/Firestone, Inc. v. Recovery
Credit Servs., Inc., 98 F.3d 13, 18 (2d Cir. 1996)).]
Petitioner observed no meaningful distinction between her
personal funds and those of her corporation. Although petitioner
opened bank accounts in the name of Real Services, she siphoned
funds from that account for personal expenses and gifts. On the
other hand, petitioner wrote checks in her own name for
transactions that she now alleges were those of Real Services.
The record also reveals a number of checks made out to Real
Services from petitioner’s escort service clients, but the
evidence suggests that, in naming the payee, the clientele were
only following petitioner’s wishes.
There is no indication that Real Services was ever properly
capitalized; to the contrary, it often appeared to be insolvent.
Individuals such as John K. and Tammy M., who had made loans to
petitioner operating as Real Services, reported that checks they
received in repayment often were dishonored.
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Petitioner consistently ignored corporate formalities.
After the organizational meeting for Real Services, there is no
indication of another meeting of a board of directors. Real
Services maintained no office separate from petitioner’s personal
address, and petitioner was its only purported employee. There
is no evidence that Real Services furnished to outside parties
any papers relating to petitioner’s employment, such as tax
withholding forms or other payroll records. There are no
meaningful corporate records; petitioner produced only three
handwritten documents as records of the corporation–-one
indicating the costs of furnishing the E. 65th Street apartment
and the other two listing startup costs. Even petitioner’s
employment contract is suspect; it is a fill-in-the-blanks form
that contains many blanks and was executed several months before
the date that the hiring officer, petitioner’s companion Laura
C., allegedly assumed office. We reject petitioner’s contention
that other corporate records were stolen; we find it much more
likely that such records never existed. There is no history of
the declaration or payment of dividends.
No other individuals were active as officers or directors of
Real Services. Petitioner exaggerated the roles played by two
individuals named Ted P. and Michael S. in the operation of the
corporation. Petitioner, in fact, altered a document in which
Mr. P.’s son Brian had indicated to her that his father was not
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an officer of Real Services. Moreover, Mr. S. testified that he
was not involved in the directorship or management of Real
Services. Although Laura C. provided some testimonial support to
petitioner’s claims of corporate meetings and elections, we
believe that her testimony was coached and does not accurately
represent actual events.
There is no evidence of any business extending credit to
Real Services; for example, its name did not appear on any of the
documents used for its alleged leasing of real properties.
Indeed, the contrary appears to be true: on the E. 65th Street
apartment, the name of the lessee was Jane M., not Real Services,
and on the E. 77th Street apartment, the name was that of Joy C.,
not Real Services. Similarly, the lease for the W. 58th Street
apartment does not indicate that the lessor-sublessee was Real
Services.
Real Services’ alleged dealings in the Hawaii real property
are similarly suspect. These arrangements were made with
petitioner’s family members. Once again, many of the documents
executed in these transactions bear only petitioner’s name, and
not that of Real Services.
In sum, there is no evidence that Real Services engaged in
business as a separate entity. Petitioner cites clauses
typically used in preprinted forms for incorporating business
entities. The use of such clauses for Real Services, however,
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falls short of showing actual business activity by the
corporation. Nor is such activity reflected in petitioner’s
practice of having salespeople and customers use the name “Real
Services” when they executed sales slips and checks to
petitioner. The fact remains that no one who dealt with
petitioner did so with any reliance upon the business probity or
solvency of Real Services. To the extent that anyone acquiesced
in petitioner’s employment of the name “Real Services”, they did
so with the understanding that they were doing business with her,
and not with a corporation.4
We conclude that Real Services functioned merely as an alter
ego of petitioner and is therefore a sham corporation. As a
result, we disregard the existence of Real Services for purposes
of Federal taxation; the income at issue is properly taxed to
petitioner individually.
II. Whether Petitioner Had Unreported Income From an Escort
Business in 1989 and 1990
Petitioner operated an escort business as previously
described during 1989 and 1990. Although she denies involvement
with the escort business, and with the receipt of income from
4
In this regard, petitioner argues that the dealings of
Real Services involved making payments to a puppeteer. In
support she cites an exhibit that was not introduced into
evidence. She has made similar citations throughout her briefs.
These documents are not part of the record and have not been
considered in making our decision herein. Rule 143; see
Eickmeyer v. Commissioner, 66 T.C. 109, 110 n.3 (1976).
- 26 -
that business, the evidence to the contrary provided by her
clientele is overwhelming. That evidence nonetheless falls short
of providing us with a firm basis upon which to calculate her
income from those activities. Perhaps unsurprisingly, few of the
witnesses have been entirely forthcoming, leaving us with an
unsatisfactory record.
Respondent has used the specific item method of
reconstructing petitioner’s income for 1989 and 1990. This
method depends upon proof of specific items of income that were
omitted from the taxpayer’s return. In Estate of Beck v.
Commissioner, 56 T.C. 297, 353 (1971), the Court stated: “the
‘specific item’ method of proof * * * simply consists of evidence
of particular or specific amounts of taxable income received by
the taxpayer during a particular tax period, with evidence that
the taxpayer did not include such amounts in his tax return”.
See also United States v. Merrick, 464 F.2d 1087, 1092 (10th Cir.
1972). In most instances, petitioner has presented evidence
disputing the specific amounts or taxability of the items in
question. We have used our best judgment on the basis of the
record before us to arrive at the amounts of income involved.
Respondent determined that petitioner had unreported escort
income of $3,600 in 1989 and $3,600 in 1990 from an individual
named Dennis T. Dennis T. testified, however, that he had only
legitimate business dealings with petitioner. He conceded that
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he engaged escort services at least six times at petitioner’s E.
77th Street apartment. The services were provided by women other
than petitioner. Dennis T. recalled the name used by
petitioner’s companion Laura C. and conceded receiving escort
services from her. There are no checks or other documentary
evidence connecting petitioner to any amounts Dennis T. may have
paid for escort services received at the E. 77th Street
apartment, where Ms. C. also resided. Although the evidence
demonstrates a business relationship between petitioner and
Dennis T., it fails to connect her with any of the money he paid
for escort services. We accordingly do not sustain the
determination.
Respondent determined that petitioner had unreported escort
income of $945 in 1989 and $945 in 1990 from an individual named
Michael S. Although Michael S. was a business associate of
petitioner’s and admitted paying for escort services at one of
petitioner’s apartments, the arrangements were made by, and the
money was paid to, Laura C., not to petitioner. The payments for
escort services by Michael S. have not been connected to
petitioner, and we accordingly do not sustain the determination.
Respondent determined that petitioner had unreported escort
income of $1,500 in 1989 and $750 in 1990 from an individual
named Paul G. Mr. G. testified that he paid between $1,500 and
$2,000 to petitioner for escort services during the period of
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their relationship, which he estimated to be approximately 2
years. His testimony and the documentary evidence support the
conclusion that he paid most of this amount in 1989, but that the
relationship continued into 1990. On the basis of his testimony,
we find that petitioner received $1,500 from Mr. G. in 1989 and
another $500 in 1990. We accordingly sustain all of respondent’s
determination except to the extent of $250 in 1990.
Respondent determined that petitioner had unreported escort
income of $10,500 in 1989 and $3,900 in 1990 from an individual
named Jeffrey F. The evidence adduced in connection with this
determination conflicts to some extent with the specific items of
income determined by respondent. Mr. F. recognized the name Real
Services as the payee of checks he used to acquire escort
services for his clients. The record contains one check from him
for $200 that petitioner deposited. Mr. F. also testified that
he paid between $5,000 and $15,000 to a woman named “Angel”, one
of petitioner’s nicknames, for escort services for his clients.
However, Mr. F. testified that these payments took place over a
10-year period during which he also used at least one other
escort service for his clients. Mr. F. was unable to identify
petitioner at trial, or to recall the amount he paid petitioner
during the years at issue. We conclude that the evidence
establishes that Mr. F. paid petitioner $1,500 in 1989 and $1,500
- 29 -
in 1990. We accordingly sustain respondent’s determination to
that extent.
Respondent determined that petitioner had unreported escort
income of $1,400 in 1989 and $200 in 1990 from an individual
named Alexander K. The evidence with respect to these specific
items consists of Mr. K.’s check for $1,200 made out to Real
Services, dated October 12, 1989, which petitioner deposited into
the Real Services’ account; petitioner’s possession of Mr. K.’s
business card; Mr. K.’s testimony that he did not purchase escort
services from petitioner in 1989 or 1990, but that he entered
only the amount on the check and signed it; and petitioner’s
claim that the check was in payment for space for an office
party. Petitioner’s claim is uncorroborated; the amount is
improbable for the use of residential apartment space for a
party; and she is otherwise not credible. Given the other proof
of petitioner’s extensive dealings in providing escort services
in 1989, we find that the $1,200 payment in October 1989 was for
escort services. There is no other evidence that petitioner had
the specific items of income determined by respondent or which
connects petitioner to any payments from Mr. K. for any goods or
services. We accordingly sustain respondent’s determination only
to the extent that petitioner had unreported escort income of
$1,200 in 1989.
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Respondent determined that petitioner had unreported escort
income of $2,700 in 1989 and $2,700 in 1990 from an individual
named Richard S. Mr. S. testified that, between 1989 and 1992,
he utilized petitioner’s services “maybe once a month but not
necessarily for all that period of time” and paid $200 per visit.
Petitioner has failed to provide sufficient credible evidence
that Mr. S. paid her less than the amounts determined for the
years in issue. We accordingly sustain respondent’s
determination.
Respondent determined that petitioner had unreported escort
income of $2,350 in 1990 from an individual named Meyer S. Mr.
S. wrote 10 checks to cash during the first half of 1990 for
escort services arranged by petitioner.5 Petitioner deposited
the checks into the Real Services’ account. The 10 checks
totaled $1,450. The $1,450 in Meyer S.’s checks in the record
included $460 in checks that were dishonored, as well as $460 in
checks that replaced the dishonored checks. Thus, the documented
amount that Mr. S. paid petitioner for escort services in 1990 is
$990 ($1,450 less $460). We therefore hold that petitioner
received $990 as payment for the escort services she arranged for
5
Although Mr. S. testified that the checks were payment for
the use of petitioner’s apartment to work on clothing designs,
his testimony was highly implausible in the circumstances and not
worthy of belief. We find that Mr. S. testified falsely in view
of an obvious motive to avoid admitting to the purchase of escort
services.
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Mr. S. in 1990, and sustain respondent’s determination only to
that extent.
Respondent determined that petitioner had unreported escort
income of $200 in 1989 from an individual named Eric K. A check
in the amount of $200, dated June 23, 1989, was made payable to
cash, written by Eric K., and endorsed by Jane M., who provided
escort services to customers pursuant to petitioner’s
arrangements. In these circumstances, and because the check was
deposited into the Real Services’ account controlled by
petitioner, we sustain respondent’s determination.
Respondent determined that petitioner had unreported escort
income of $875 in 1989 and $875 in 1990 from Ronald K.
Respondent’s figures reflect seven escort sessions per year at
$125 per session. Mr. K. testified on cross-examination,
consistently with respondent’s determination, that he received
escort services arranged by petitioner on 12 to 15 occasions
during the 2-year period 1989 through 1990. He also testified
that he paid approximately $125 per occasion. Petitioner’s
contention that she paid $875 of this amount in 1990 to furnish
mud wrestlers at an event sponsored by Mr. K. was contradicted by
him, and we do not accept it. Accordingly, we sustain
respondent’s determination.
Respondent determined that petitioner had unreported escort
income of $6,000 in 1989 and $6,000 in 1990 from an individual
- 32 -
named Michael L. Mr. L. testified to paying substantial sums for
escort services in 1989 and 1990 that were provided in
petitioner’s E. 77th Street apartment. He could not, however,
identify petitioner in person, and he was uncertain whether a
person he knew as “Angel” was the person depicted in a photograph
of petitioner taken close to the years in issue. He described
the “Angel” with whom he had dealings as a person who bears
little resemblance to petitioner. The record before us fails to
provide an adequate basis for finding that petitioner, rather
than some of her associates, received unreported income in the
form of direct payment for escort services from Mr. L. during the
years at issue. The evidence nevertheless supports a finding
that petitioner received $4,000 in escort income from Mr. L., and
that she received this amount in 1990. In the summer of 1990,
Mr. L. lent $4,000 to “Real Services Corp.” Two months later,
petitioner signed and issued a check, presumably in repayment,
for $4,800. The check was dishonored, and Mr. L. acknowledged
that his loan was “most probably” repaid in the form of escort
services. Although Mr. L. did not pay petitioner directly for
escort services, petitioner’s signature on the invalid check
nevertheless connects her to the receipt of $4,000 in 1990 in
exchange for which Mr. L. received such services. We accordingly
sustain respondent’s determination only to the extent of $4,000
of unreported escort income in 1990.
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Respondent determined that petitioner had unreported escort
income of $540 in 1990 from an individual named Harvey K. Mr.
K.’s testimony supports the determination in full, in that he
recalled paying petitioner for escort services on three or four
occasions in 1990, estimated the cost at between $100 and $200,
and acknowledged a check paid in one instance in 1990 for $180.
Respondent’s determination of $540 is three times this figure.
We do not accept petitioner’s contention that she and Mr. K. were
having an affair and that any escort-related activities involved
were independent of his giving her money. We accordingly sustain
respondent’s determination.
Respondent determined that petitioner had unreported escort
income of $1,300 in 1990 from an individual named Crihil I. A
check for $1,300 issued by Mr. I. on November 10, 1990 to
Jennifer R. and/or cash was endorsed by Jennifer R. to Real
Services and deposited by petitioner into one of her personal
bank accounts on November 15, 1990. Mr. I. did not testify and
Ms. R. is deceased.
Jennifer R. was one of the women who provided escort
services to customers pursuant to petitioner’s arrangements
during the years in issue. In these circumstances, and in light
of the other proof that petitioner was regularly engaged in the
provision of escort services in 1990, we conclude that this check
was for escort services arranged by petitioner. We reject
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petitioner’s contention that this $1,300 was a loan to her (or
Real Services) from Jennifer R. On the basis of the record in
this case as a whole, we do not believe that all of this money
belonged to Jennifer R. so that she could “lend” it to
petitioner. The credible testimony of other witnesses
establishes that single payments of this magnitude were sometimes
made for escort services arranged by petitioner when the occasion
was a “party” involving several customers. We infer that this
$1,300 payment was for escort services in addition to those
provided by Jennifer R. personally. In addition, the record as a
whole also establishes that when petitioner arranged for other
women to provide escort services, she did not do so for free.
Therefore, we believe that the check signed over to petitioner by
Jennifer R. included petitioner’s “brokerage” fee for the
transaction she had arranged. In sum, we are satisfied that the
evidence supports, and petitioner has demonstrated no error in,
respondent’s determination. We accordingly sustain it.
Respondent determined that petitioner had unreported escort
income of $1,200 in 1989 and $1,200 in 1990 from an individual
named Douglas B.; $1,440 in 1989 and $1,680 in 1990 from an
individual named Jerrold M.; $1,050 in 1989 and $1,050 in 1990
from an individual named William C.; and $400 in 1989 and $600 in
1990 from an individual named Takero O.
- 35 -
In 1989, petitioner deposited a check payable to Real
Services from Douglas B. for $400. During 1990, petitioner
deposited into her Chemical Bank accounts two checks to cash
totaling $225 from Jerrold M., a check to cash for $200 from
William C., and two checks payable to cash totaling $140 from
Takero O. Petitioner claims that the $400 check from Douglas B.
represents repayment of a loan. She argues that she got two
checks from Jerrold M. for helping him to find his girlfriend.
She claims not to know William C. and that she got his $200 check
from a third party for room rental. She says the two checks
totaling $140 from Takero O., plus $10 cash, were payment for
tickets to a Broadway show. We do not accept her self-serving
testimony. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
To the contrary, in light of the other substantial evidence that
petitioner was in the business of providing escort services for
compensation during 1989 and 1990, her deposit of checks made out
to Real Services or to cash from Douglas B., Jerrold M., William
C., and Takero O. is sufficient, we conclude, to support the
finding that these six checks were payments to her for the
provision of escort services. On the other hand, these
individuals did not testify, and there is no evidence in the
record that petitioner had any specific items of income from
these individuals beyond the amounts evidenced by the checks. We
accordingly hold that petitioner had unreported escort income in
- 36 -
1989 of $400 from Douglas B.; and in 1990 of $225 from Jerrold
M., $200 from William C., and $140 from Takero O., but we do not
otherwise sustain respondent’s determinations with respect to
these individuals.
Respondent determined that petitioner had unreported escort
income of $500 from Raj International in 1990. Although
petitioner endorsed and deposited into her account a $500 check
in November 1990 made payable to Real Services by Raj
International, we have found that this amount was a loan to
petitioner which she repaid later that year with funds drawn on
Real Services’ and her personal accounts. Accordingly,
respondent’s determination with respect to Raj International is
not sustained.
III. Whether Petitioner Had Unreported Income From Fraudulent
Loan and Investment Transactions
Respondent determined that petitioner received embezzlement
income in several instances during 1989 and 1990 by taking money,
as “investments” or “loans”, from friends and associates without
any intention of repayment. See, e.g., James v. United States,
366 U.S. 213, 219 (1961) (“wrongful appropriations” constitute
income if acquired with no intent to repay); United States v.
Rochelle, 384 F.2d 748, 751-752 (5th Cir. 1967) (fraudulent loans
are “wrongful appropriations” within the meaning of James v.
United States, supra). We consider each determination
separately.
- 37 -
Respondent determined that petitioner received embezzlement
income of $18,500 from Michael S. in 1989. In pretrial
pleadings, respondent asserted that the $18,500 determination
consisted of: (i) $12,000 from petitioner’s sale to Michael S. of
a fictitious interest in certain real property in Hawaii; and
(ii) $10,000 from a fraudulent loan transaction involving Michael
S., of which petitioner had repaid $3,500.
Respondent now concedes that the $12,000 fictitious sale of
property was in fact a loan of $12,000 by Mr. S. to petitioner,
secured by an interest in any commission that petitioner might
receive on the sale of the Hawaii property.6 The evidence
adduced at trial establishes that petitioner partially repaid
this loan in a series of checks totaling $3,640 that were given
to Mr. S. during the first half of 1990.
On brief, respondent argues that the $12,000 loan was income
to petitioner in 1989, the year of its receipt, because she did
not intend to repay this amount to Michael S. Petitioner,
however, repaid $3,640 of the loan in 1990. We conclude that
this repayment evidences an intent to repay at the time she
obtained the loan, and that this intent continued at least
through some portion of 1990. Although respondent has modified
his theory to some extent in response to the evidence at trial,
6
Respondent seeks findings of fact to that effect in his
posttrial brief.
- 38 -
he has not asserted in the alternative that petitioner received
income in 1990 as a result of this loan transaction. On this
record, we are persuaded that petitioner has shown error in
respondent’s determination that she had $12,000 in income in 1989
as a result of the payment from Michael S. in that amount.
Accordingly, the determination is not sustained.
With respect to the second element of respondent’s original
$18,500 determination, namely, the $10,000 fraudulent loan
transaction, petitioner claims that this amount represents the
proceeds from a sale of magnetic tapes from which she realized no
gain. At trial, Mr. S. corroborated petitioner’s claim by
testifying that he paid her $10,000 for magnetic tapes which he
then donated to a school.
On brief, respondent now argues that the $10,000, even if
paid for tapes provided by petitioner, was nevertheless income to
petitioner. Respondent’s propounding of the theory that the
$10,000 from Mr. S. was sales income, and not income from a
fraudulent loan transaction, is, at a minimum, “new matter”
within the meaning of Rule 142(a). Respondent’s adoption of this
theory (without making an allowance for cost of goods sold) is a
new theory which, if we considered it, would prejudice
petitioner. Its tardy assertion would deprive petitioner of an
adequate opportunity to acquire the requisite evidence of her
cost of goods sold. See Sundstrand Corp. v. Commissioner, 96
- 39 -
T.C. 226, 347 (1991). Moreover, under Rule 142(a), respondent
would bear the burden of proof as to the issue whether the
$10,000 is sales income. Even if we permitted respondent to
raise this new theory, he would not prevail upon it because he
cannot carry his burden. The record shows that Mr. S. ordered
tapes from petitioner because he could get a “better rate” than
elsewhere. He wrote her checks totaling $10,000. One of those
checks, for $3,000, was returned unpaid. We believe that, if
petitioner provided a better rate than other sellers, her loss of
$3,000 on the sale likely prevented her from earning any profit
on the transactions. In any event, respondent has not shown
otherwise. We accordingly do not sustain any portion of
respondent’s determination that petitioner had $18,500 in
unreported income from Mr. S. in 1989.
Respondent determined that petitioner had unreported income
of $5,000 in 1989 from a loan transaction with an individual
named Howard S. On brief, respondent argues that this was a
“fraudulent” loan transaction in that petitioner had no intention
of repaying, making the original loan amount income to her in
1989.
We have found that Howard S. lent petitioner $5,000 in 1989
and that by the first quarter of 1991 she had repaid him $1,300.
Mr. S. acknowledged as much in early 1991 in an invoice that he
admits initialing. He subsequently sued petitioner in August
- 40 -
1991 with respect to the loan, seeking $3,750, which further
confirms that significant repayment had been made.7 Respondent
makes no effort on brief to explain how petitioner lacked intent
to repay this loan when she in fact repaid approximately 25
percent. His determination is not sustained.
Respondent determined that petitioner had unreported
embezzlement income of $5,000 in 1989 from an individual named
Jane M. Although the evidence establishes that Jane M. was an
associate of petitioner’s, petitioner has denied receiving this
amount from Jane M. Respondent has not introduced evidence to
rebut this assertion, nor has he contested petitioner’s denial on
brief. We conclude that respondent has abandoned this issue, see
Julicher v. Commissioner, T.C. Memo. 2002-55; Zidar v.
Commissioner, T.C. Memo. 2001-200 (citing Bradley v.
Commissioner, 100 T.C. 367, 370 (1993)), and the determination is
accordingly not sustained.
Respondent determined that petitioner had unreported
embezzlement income of $13,250 from an individual named John K.
Respondent clarified in his answer that the determination was
7
Mr. S. subsequently made at least two statements to the
IRS in connection with these proceedings that were inconsistent
with these findings (and with each other), to the general effect
that none of the $5,000 had been repaid. We are convinced,
however, that Mr. S. would not have sued in 1991 for less than he
thought he was owed. Further, when confronted at trial with the
invoice documenting partial repayment, Mr. S. acknowledged his
initials on the document.
- 41 -
based upon petitioner’s having received $15,000 from John K. in
1990 to invest on his behalf and having only repaid him $1,750.
John K. was a college friend of petitioner’s. Mr. K.
testified credibly that he turned over $10,000 to petitioner in
March 1990, based upon petitioner’s representation that she could
earn him a 25 percent return in 1 year. He believed that
petitioner was a savvy businesswoman and trusted her on the basis
of their friendship; he accordingly did not investigate her
claims or plans with any rigor, although he recalled that she
represented that the money would be invested in a real estate
project in the Midwest. Several months later, in August 1990,
petitioner advised Mr. K. that she had an investment opportunity
that would give him a profit in 30 days. Mr. K. gave petitioner
an additional $5,000 on her representation of a 30-day turnaround
for that investment. According to his testimony, when the $5,000
was not returned as promised, Mr. K. first suspected that
petitioner had taken advantage of their friendship and
“hoodwinked” him; he became convinced of that fact when neither
the $10,000 nor $5,000 was returned, and petitioner made excuses
that he did not believe.
Petitioner contends that these amounts are not income to her
because she genuinely tried and intended to repay Mr. K. These
amounts were not bona fide loans, however; the money was given on
the representation that it would be invested on Mr. K.’s behalf.
- 42 -
Petitioner’s explanations of how the money was invested are
vague, uncorroborated, and/or contradicted by Mr. K.’s credible
testimony. On the basis of the evidence in the record, we are
convinced that petitioner exploited Mr. K.’s trust in her to
obtain the funds in issue, and then did not invest them as she
had represented. As a result, she exercised sufficient dominion
and control over the $13,250 she did not repay to render that
amount taxable to her in 1990. See James v. United States, 366
U.S. at 219 (proceeds over which taxpayer wrongly assumes “actual
command” taxable to him); United States v. Rochelle, 384 F.2d 748
(5th Cir. 1967); O’Sheeran v. Commissioner, T.C. Memo. 1983-702;
see also United States v. Rosenthal, 454 F.2d 1252, 1254 (2d Cir.
1972). We accordingly sustain respondent’s determination.
Respondent determined that petitioner had unreported
embezzlement income of $15,000 in 1990 from an individual named
Jennifer R. Respondent now asserts that petitioner had $17,700
of such income in that year.
Jennifer R. was one of the women who provided escort
services to customers pursuant to petitioner’s arrangements. Ms.
R. died before trial, and the evidence that has been offered with
respect to this item consists of the notes of one of respondent’s
agents concerning an interview he conducted with Ms. R. before
her death, two letter memoranda documenting payments from Ms. R.
to petitioner, and petitioner’s testimony.
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We turn first to the interview notes. Although respondent’s
original determination in the deficiency notice was that
petitioner had 1990 embezzlement income from Ms. R. of $15,000,
respondent now contends on brief that the amount is $20,000, less
a repayment of $2,300, or $17,700.8 Respondent bases his
assertion of an increased amount and the partial repayment on the
agent’s notes. We pass over the question whether the increased
deficiency respondent asserts has been properly raised in this
case, because we agree with petitioner that the agent’s notes,
which are the only basis for asserting the increased deficiency,
are inadmissible hearsay.
Respondent argues that the notes qualify for the exception
to the hearsay rule provided in Federal Rules of Evidence
804(b)(3). Respondent maintains that the notes embody a
statement against Ms. R.’s penal interest, because they reflect
Ms. R.’s statement that she earned money as a prostitute.
Respondent, however, does not seek the admission of the notes as
proof of Ms. R.’s illegal profession; respondent seeks their
admission to prove petitioner’s receipt of a net $17,700 in
embezzlement income from her. It is settled that a statement
against interest will not operate as an exception to the hearsay
8
Although respondent on brief repeatedly states the balance
of $20,000 less $2,300 as $17,800, we deem respondent to have
taken the position that petitioner had unreported embezzlement
income from Jennifer R. of $17,700.
- 44 -
rule when the statement sought to be introduced is only
collateral to the statement against the declarant’s interest.
Williamson v. United States, 512 U.S. 594, 599-600 (1994). Such
is the case with the statement respondent seeks to introduce. We
accordingly decline to consider respondent’s allegation that
petitioner had embezzlement income in an increased amount of
$17,700 from Ms. R. The sole basis for the allegation is
inadmissible hearsay.9
With respect to respondent’s original determination that
petitioner had embezzlement income of $15,000 from Ms. R. in
1990, the two letter memoranda executed by petitioner establish
to our satisfaction that petitioner received $5,000 and $10,000
from Jennifer R. in July and November 1990, respectively. In
these memoranda, petitioner acknowledges receipt of the foregoing
amounts, promises to invest the money, and guarantees a “minimum
return” or “return” of 25 percent in 1 year (in one instance) or
45 days (in the other). We are struck by the similarity of these
arrangements with those that petitioner foisted upon John K.
That is, in the same year, with respect to both John K. and
Jennifer R., petitioner first obtained a substantial sum
9
Respondent also concedes on brief that the revenue agent’s
notes provide the sole basis for his determination that
petitioner had unreported income of $2,600 in 1990 from the sale
of electronics to Jennifer R. Because the notes are likewise
inadmissible hearsay with respect to this transaction, there is
no competent evidence that petitioner had this specific item of
income, and we accordingly do not sustain the determination.
- 45 -
promising to return it in 1 year with a guaranteed return, and
then went back to each individual several months later and
persuaded him or her to part with another substantial sum by
promising a quick return in 30 or 45 days. We draw the inference
that petitioner engineered a scheme with Jennifer R. that was
similar to the scheme to which John K. testified.
Unlike the situation with John K., Jennifer R. was deceased
at the time of trial and unable to give testimony from which we
might determine whether her payments to petitioner were loans or
entrustments of funds to invest. Regardless of which
characterization is more accurate, we are satisfied that
petitioner is taxable on the amounts Ms. R. turned over to her in
1990. We decline to accept petitioner’s self-serving testimony
regarding her dealings with Ms. R. Absent petitioner’s
testimony, there is no evidence that petitioner repaid the
amounts at issue when due or ever,10 and Ms. R. is now deceased.
10
To support her claim that she made repayment to Jennifer
R., petitioner offered into evidence two deposit slips dated in
January 1991 evidencing deposits totaling $2,771 into an account
in the name of Jennson Co. The exhibits were not admitted
because their relevance to Jennifer R. was not established. As
part of her posttrial brief, petitioner submitted a copy of a
business certificate indicating that Jennifer R. was conducting
business under the name Jennson Co. Even if the foregoing
exhibits were admitted, however, they would not establish
repayment because there is no proof that petitioner made the
deposits or, even if petitioner made them, that the deposits
represented repayments with respect to the $15,000 in issue-–as
opposed to, e.g., payments to Jennifer R. for rendering escort
services pursuant to petitioner’s arrangements.
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There is likewise no evidence that the funds were invested as
petitioner represented to Ms. R. in the letter memoranda. Based
on the record as a whole, we are satisfied that petitioner has
failed to demonstrate error in respondent’s determination that
she had $15,000 in unreported income in 1990 as a result of
payments to her from Jennifer R. in that amount; we accordingly
sustain the determination. See James v. United States, 366 U.S.
213 (1961); United States v. Rosenthal, 454 F.2d 1252 (2d Cir.
1972); United States v. Rochelle, 384 F.2d 748 (5th Cir. 1967).
IV. Whether Petitioner Had Unreported Income From Sales and
Rentals During 1989 and 1990
Respondent determined, also using the specific item method,
that petitioner had unreported income from certain sales and
rental activity during 1989 and 1990.
A. 1989 Sales of Electronics, Theater Tickets, and Music
Tapes
Respondent determined that petitioner had unreported income
from the sale of electronics of $10,500 from individuals named
Brian and Ted P. and $8,200 from an individual named Howard S.
Petitioner does not dispute receipt of these amounts,11 except
for $400 of the $8,200 received from Howard S. We agree with
11
Although respondent originally determined that petitioner
had unreported income in 1989 of $10,500 from electronics sales
to Brian P., the parties subsequently stipulated that the amount
received from Brian (and Ted) P. from the sale of electronics and
certain introductory fees was $10,800 in 1989.
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petitioner regarding this $400 and do not sustain that portion of
respondent’s determination.12
Respondent conceded at trial that petitioner is entitled to
a cost-of-goods-sold allowance with respect to the foregoing
sales of $1,360.13 We conclude that petitioner has produced
documentary evidence and testimony which establish that she may
increase her cost-of-goods-sold allowance by an additional
$4,011, for a total of $5,371, with respect to goods sold to
those individuals.
The difference between the $18,300 petitioner demonstrably
received from the P.’s and from Mr. S. in exchange for
electronics merchandise provided to them and the $5,371 we have
concluded petitioner paid for those goods is surprisingly large
and reflects substantial unreported income. In making our
allowance for the cost of goods sold to the P.’s and to Mr. S.,
we have resolved doubts in favor of petitioner, even to the
12
Petitioner objected to respondent’s “specific item”
evidence for $400 of the amount received from Howard S. because
the check documenting this amount states clearly that it is for a
“ticket purchase”, whereas respondent’s determination, answer,
and pretrial memorandum all took the position that the foregoing
amount was for electronics. We advised respondent’s counsel
prior to trial that if the $400 check was intended to prove
receipt of income by petitioner from the sale of tickets,
respondent would be required to amend his pleadings. Respondent
sought no leave to amend, and we accordingly treat the $400
specific item of income from Howard S. as abandoned.
13
Although respondent contends on brief that the total
conceded is $890, he clearly conceded an additional $470 at trial
with respect to Howard S., for a total of $1,360.
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extent of accepting her reasonably based estimated cost of a
speaker system and a receiver. She has claimed no larger costs
than we have found, and, in any event, the record does not
support our allowing her more. Although we suspect that the
actual cost of goods sold was higher, we cannot make that
estimate absent a demonstration “that at least the amount allowed
in the estimate was in fact spent or incurred for the stated
purpose. Until the trier [of fact] has that assurance from the
record, relief to the taxpayer would be unguided largesse.”
Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); see
Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).
Based on the foregoing, we hold that petitioner had
unreported sales income from Brian and Ted P. and Howard S. in
1989 of $12,929 (i.e., $18,300 gross receipts less $5,371 in
costs of goods sold).
Respondent determined that petitioner had unreported income
of $300 in 1989 from the sale of tickets and tapes to an
individual named David M. In August of 1989, David M. wrote a
check to petitioner individually for $300 for the purchase of
tickets to the Broadway show “Phantom of the Opera”. Petitioner,
however, has provided a receipt showing that she paid $300 for
those tickets. She accordingly has no unreported income from the
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transaction with Mr. M., and respondent’s determination is not
sustained.14
Respondent determined that petitioner had unreported income
of $110 in 1989 from the sale of tickets and tapes to an
individual named Paul H. In September of 1989, Paul H. wrote a
check to Real Services in the amount of $110, in payment for
prerecorded music tapes. Petitioner deposited this check into
Real Services’ checking account. Respondent concedes that
petitioner is entitled to a cost-of-goods-sold allowance of $12
with respect to these tapes. We accordingly find that petitioner
had unreported income of $98 in 1989 from this transaction and
sustain respondent’s determination to that extent.
B. 1990 Sales of Electronics and Rental Income
Respondent determined that petitioner had unreported income
of $3,000 in 1990 from the sale of additional electronic
equipment to Ted and Brian P. Brian P. confirmed this amount at
trial. From numerous receipts, petitioner has identified the
items that she purchased and resold to Ted and Brian P. The
receipts indicate that her cost for this electronic equipment
14
Petitioner claims an additional $250 exclusion from
income, relying upon documentary evidence that she paid that
amount for tickets to the Broadway show “M. Butterfly”. The case
of Mr. M. indicates, however, that petitioner charged her
customers what she paid for Broadway tickets. There is no basis
to assume otherwise in the case of the tickets for “M.
Butterfly”. Absent some proof to the contrary, we believe that
petitioner received full payment for those tickets, offsetting
the amount she used to buy them. There is thus no taxable event.
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totaled $2,628.15 Accordingly, we conclude that petitioner is
entitled to a cost-of-goods-sold allowance of $2,628 with respect
to the $3,000 in sales to Ted and Brian P. and sustain
respondent’s determination only to the extent of $372.
Respondent determined that petitioner had unreported income
of $2,775 in 1990 from the sale of additional electronic
equipment to Howard S. Howard S. paid petitioner $2,775 for
electronic equipment in that year. Petitioner sold him a 52-inch
rear-projection television and two answering machines. The rear-
projection television cost $2,902, including taxes and shipping,
while the answering machines cost her $210.16 As petitioner has
shown that she had product costs for goods transferred to Mr. S.
in 1990 that exceed the amount that respondent determined was
paid to her by Mr. S., we conclude that petitioner has
demonstrated error in respondent’s determination and do not
sustain it.
15
Petitioner’s brief overstates by $100 the cost of
equipment purchased on Feb. 22, 1990, and resold to Ted and Brian
P.
16
Mr. S.’s complaint in his previously noted lawsuit
against petitioner states that he never received the projection
television set. His later affidavit states, however, that he
received the set, but that it was in defective condition and he
never received a replacement. Petitioner has submitted evidence
of the purchase of the set, its delivery to Mr. S., and two
service calls to repair the set. On this record, we conclude
that Howard S. paid for and received a 52-inch rear-projection
television.
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Respondent determined that petitioner had unreported income
of $1,400 in 1990 from the sale of electronics to an individual
named Kenny T. We find, however, that she neither made nor lost
money on these sales. She sold Mr. T. a video cassette recorder
and a television for the same amount she was required to pay her
supplier for these items. Although the television was returned
to the supplier for a credit equal to what petitioner (and Mr.
T.) had paid, there is no evidence or suggestion that petitioner
retained the $1,200 that Mr. T. had paid her. We accordingly do
not sustain the determination.
Petitioner also paid $1,147 for items that she asserts she
provided to Jennifer R. in repayment of a loan in 1990. Although
petitioner has presented receipts showing her purchases in these
amounts, we have only her self-serving testimony that these items
were delivered to Ms. R., and Ms. R. is deceased.
Respondent determined that petitioner had unreported income
of $2,800 in 1990 from the rental of an apartment to an
individual named Terri D. Petitioner concedes receiving $2,800
in 1990 for the short-term rental of the apartment on W. 58th
Street but asserts that it was paid to Real Services and is not
income to her individually. Because we have elsewhere concluded
that Real Services should be disregarded for tax purposes, we
hold that the $2,800 is taxable income to petitioner and sustain
respondent’s determination.
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V. Whether Petitioner May Deduct Business Expenses in Excess of
Those Allowed by Respondent
A. Business Expenses in 1989
Petitioner maintains that, if we find that she was engaged
in providing escort services, respondent has failed to allow her
a sufficient deduction for the amounts she was required to pay to
the women she arranged to engage in those services. Petitioner
strenuously denies that she was engaged in providing escort
services. Nevertheless, she argues in the alternative that if we
find she was engaged in such a business, we should allow her to
deduct 50 to 60 percent of the gross receipts in recognition of
the fact that she was required to pay the women who actually
rendered the services.
Under certain circumstances, where a taxpayer establishes
his entitlement to a deduction, but does not establish the amount
of the deduction, we are permitted to estimate the amount
allowable. Cohan v. Commissioner, supra. In so doing, we bear
heavily against the taxpayer, who is responsible for the
uncertainty. Id. at 543-544. In this case, respondent has
allowed a deduction equal to 31.64 percent of the amount
determined as escort income in 1989 as specific expenses of
petitioner’s escort business. Petitioner has failed to establish
that she is entitled to larger deductions than those allowed by
respondent. We therefore hold that she may deduct, as business
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expenses, 31.64 percent of the amounts that we have held were
unreported escort income for 1989.
Petitioner asserts and respondent concedes that during 1989
petitioner incurred rental expenses of $7,763 and an electricity
expense of $302 with respect to the apartment on E. 65th Street,
at which petitioner’s escort business was conducted. We hold
that she is entitled to deduct these amounts as business expenses
in 1989.
During 1989, petitioner lived in the apartment at E. 77th
Street. She had a room in that apartment in which she conducted
office business and in which, to some extent, escort services
were provided. She now claims one-third of the rentals paid for
that apartment during 1989 as a home office deduction.
In general, a taxpayer is not entitled to deduct any
expenses related to the use of a dwelling unit used by the
taxpayer as a residence during the taxable year. See sec. 280A.
The statute provides an exception to this general rule, however,
if the expenses are allocable to a portion of the dwelling which
is used exclusively on a regular basis as the principal place of
business for the taxpayer’s trade or business. Petitioner’s
claims that the room was used exclusively for business purposes
and that it was her principal place of business rest entirely on
her own testimony which, as we have concluded elsewhere, should
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not be given any credence. Accordingly, we hold that she is not
entitled to the claimed home office deduction for 1989.17
Respondent has conceded that during 1989 petitioner incurred
deductible business expenses of $825 for office expenses, bank
charges, printing expenses, and travel. Petitioner has claimed
that she is entitled to deduct other expenses in addition to
those conceded by respondent. She has borne her burden of
proving that she is entitled to deduct additional printing costs
of $24 and miscellaneous costs paid to contractors of $132.
Petitioner further claims a deduction of $5,220 in 1989 for
telephone service. She claims that she maintained one personal
telephone line and two business lines, located in two of her
apartments, and seeks deductions with respect to the claimed
business lines.18 She has offered as proof cancelled checks and
receipts from the telephone company. We are not convinced that
she made payments in the amounts claimed. The records proffered
for each of the claimed business telephone lines contain
cancelled checks that are duplicates of those submitted in
17
Petitioner also claims a deduction of 3 months’ rent in
the summer of 1989 when she allegedly provided a home to Jane M.
in order to move Ms. M. out of the apartment on E. 65th Street.
Petitioner has not established that this was legitimately a trade
or business expense, and accordingly we do not allow the claimed
deduction.
18
Sec. 262(b) provides that, in the case of individuals,
charges for basic local telephone service with respect to the
first telephone line provided to a residence are nondeductible
personal expenses.
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support of deductions for the other line. Moreover, the records
do not distinguish whether the telephone charges were for local
or long distance service.
The magnitude of the telephone expenses petitioner seeks to
deduct suggests to us that significant long-distance charges are
included in the figure. The documentation proferred by
petitioner generally does not indicate what portion of the
charges was for long-distance, nor has she proven a business
purpose for significant long-distance charges. However, we are
persuaded that petitioner’s escort business almost certainly
involved the use of local telephone service to arrange
appointments. In these circumstances, we allow a deduction of
$600 for local telephone expenses at the locations where she
conducted her escort business during 1989. See Cohan v.
Commissioner, supra.
The deduction of other claimed expenses for 1989 requires
closer examination. The allowance of travel and entertainment
business deductions described in section 274 are subject to
strict rules of substantiation. Section 274(d) provides that,
unless the taxpayer complies with these rules, no deductions
shall be allowed with respect to “any traveling expense
(including meals and lodging away from home),” or “for any item
with respect to an activity which is of a type generally
considered to constitute entertainment”. The rules require the
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taxpayer to substantiate by adequate records or by sufficient
evidence to corroborate the taxpayer’s own testimony: (a) The
amount of the expenditure, (b) the time and place of the
expenditure, (c) the business purpose of the expenditure, and (d)
the business relationship to the taxpayer of the person being
entertained.
For 1989, petitioner claims a business expense deduction of
$180 for the cost of meals billed through the Vassar Club.
Inconsistencies between the handwritten and printed receipts from
the Vassar Club, however, prevent us from finding that she has
adequately substantiated the business meal deductions claimed.
Nor has she adequately demonstrated the business purposes of
claimed travel expenses totaling $343 for separate trips in 1989
to Florida and to Washington, D.C.
Petitioner also claims deductions in 1989 for $3,000 in
legal and professional fees paid to the law firm of Saltzman &
Holloran and to the Prentice-Hall Financial Service relating to
the incorporation of Real Services. She also seeks to deduct the
filing fees charged for such incorporation. Assuming arguendo
that the claimed expenses of incorporating a corporation found to
be a sham for tax purposes have a business purpose, these
expenses would nevertheless not be deductible in 1989;19 these
19
Organizational expenses incurred and paid by a
corporation can be amortized at its election over a 60-month
(continued...)
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costs, which petitioner incurred in connection with the
acquisition of a capital asset-–that is, the stock of Real
Services--are capital in nature and not currently deductible.
See Woodward v. Commissioner, 397 U.S. 572, 575 (1970);
Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 781 (2d
Cir. 1973), revg. on other grounds and remanding T.C. Memo. 1972-
43; Lychuk v. Commissioner, 116 T.C. 374, 389 (2001).
The situation is different, however, with respect to the
other $1,000 in legal fees claimed by petitioner. Those fees,
incurred by petitioner against charges that she was using the
apartment on E. 77th Street for an illegal purpose, were incurred
in connection with the preservation of the income-producing
activities associated with her escort business and are
deductible. See Johnson v. Commissioner, 72 T.C. 340, 348
(1979).
Petitioner also maintains that she entered into a real
estate brokerage agreement with her sister and another
individual, who were owners of some valuable real estate in
Hawaii. She argues that this arrangement resulted in her making
deductible expenditures during either 1989 or 1990.20 Even if we
accept petitioner’s contention that she had a valid broker’s
19
(...continued)
period beginning when its business commences. Sec. 248.
20
Although petitioner contends that the expenditures were
incurred in 1989, she claims deductions for them in 1990.
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agreement to sell the property, and, further, that she spent
substantial sums in preparing the property for sale, she has
failed to demonstrate that she is entitled to deduct any of the
claimed expenditures in either 1989 or 1990. Deductions are a
matter of legislative grace, and a taxpayer claiming a deduction
bears the burden of clearly showing that the terms of the
applicable statute have been satisfied. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992); Holmes v. United States, 85
F.3d 956 (2d Cir. 1996); Stark v. Commissioner, T.C. Memo.
1999-1.
Petitioner initially claims that she may deduct these
expenditures as business expenses under section 162 or as
expenses for the production of income under section 212. Here,
however, the details concerning the property in Hawaii and its
disposition are too vague and contradictory to support such
deductions. For example, there is evidence that, in May of 1990,
petitioner’s sister in Hawaii sent petitioner $1500 in the form
of credit from a bank in Hawaii. On brief, petitioner maintains
that she received this $1,500 "back in regard to expenses paid."
This suggests that the amounts petitioner expended upon the
property in 1989 were loans or advances to her sister, rather
than expenses of her own. She has not demonstrated otherwise,
and we hold that she is not entitled to deduct the claimed
expenditures under either section 162 or 212 in 1989 or 1990.
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Petitioner alternatively claims a deductible loss in 1990
based upon her ultimate failure to recover these expenditures.
She explains that when the property did not sell, it was
foreclosed upon. Section 165(a) allows a deduction for "any loss
sustained during the taxable year and not compensated for by
insurance or otherwise." To be claimed as a deduction, a loss
must be evidenced by a closed or completed transaction. United
States v. S.S. White Dental Manufacturing Co., 274 U.S. 398, 401
(1927); Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 807
(1974), affd. 521 F.2d 786 (4th Cir. 1975); sec. 1.165-1(b),
Income Tax Regs. If the taxpayer has a claim for reimbursement
of a loss and there is a reasonable prospect of recovery, the
loss is not deductible until it can be ascertained with
reasonable certainty whether or not the reimbursement will be
received. Ramsay Scarlett & Co. v. Commissioner, supra; Julicher
v. Commissioner, T.C. Memo. 2002-55; sec. 1.165-1(d)(2)(i) and
(3), Income Tax Regs. The evidence before us, although far from
clear, indicates petitioner was being repaid some amounts of
these expenditures in 1990, the year for which she claims the
loss, and, further, that the foreclosure did not take place until
1991, 1 year later than the year for which she claims the loss.
The return of $1,500 of her expenditures in 1990 suggests that
she had a reasonable prospect of recovery for the claimed loss in
the year for which the deduction is claimed; petitioner has not
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proven otherwise. Alternatively, the fact that foreclosure did
not occur until 1991 indicates that there was no closed or
completed transaction in 1990. Accordingly, we hold that
petitioner has failed to demonstrate that she is entitled to
deductions from income tax with respect to the property in
Hawaii.
B. Business Expenses in 1990
Petitioner also claims a deduction in 1990 for the amounts
she was required to pay the women who provided escort services
pursuant to her arrangements, equal to 50 to 60 percent of gross
receipts. Respondent has allowed a deduction equal to 27.04
percent of the amount determined as escort income in 1990 as
specific expenses of petitioner’s escort business. On the same
basis as our conclusions for 1989, we find that petitioner has
failed to establish that she is entitled to larger deductions
than those allowed by respondent. We therefore hold that
petitioner may deduct 27.04 percent of the amounts we have held
were unreported escort income for 1990.
Petitioner also claims as deductions $220 allegedly paid to
third-party contractors in 1990. The record, however, fails to
provide sufficient substantiation for us to permit this
deduction.
Petitioner asserts, and respondent concedes, that petitioner
is entitled to a deduction for rent of $3,600 and utility
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expenses of $223 in 1990 with respect to the apartment on W. 58th
Street.
Petitioner continued to rent the apartment on E. 65th Street
for business purposes during 1990. She asserts, and respondent
concedes, that she is entitled to a deduction for rent of $13,983
and utility expenses of $790 in 1990 with respect to the
apartment on E. 65th Street.
In 1990, petitioner continued to live in the apartment on E.
77th Street. As was the case for 1989, however, we do not accept
her uncorroborated testimony regarding exclusive business use of
the furniture or any portion of the space. She has thus failed
to demonstrate that she is entitled to any business-related
deductions for 1990 rental costs of this property. Petitioner
has also failed to prove to our satisfaction that $857 of
furniture she claims to have purchased in 1990 was used in her
trade or business and thus could be deducted as a business
expense or in the form of depreciation deductions. See secs.
162(a), 167(a).
Respondent has allowed petitioner $100 for messenger
expenses in 1990 and an additional $114 in shipping and mailing
expenses. Petitioner has satisfied us that she is entitled to
claim an additional $12.60 in mailing expenses, but she has not
provided substantiation for an additional claimed $114.75 for
such expenses.
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Respondent has also conceded that petitioner may claim, as
business expenses, monthly bank service charges totaling $220 in
1990 on Real Services’ checking account. She claims that she
should be allowed to deduct additional service charges imposed on
her personal account, but she has failed to substantiate to our
satisfaction either the amount of these claimed expenses or their
business purpose. Petitioner has also failed to meet the
substantiation requirements of section 274 with respect to a
claimed traveling expense deduction in 1990 of $92.
Petitioner further claims a deduction of $4,064.10 for
telephone service in 1990. As was the case for 1989, her
documentary evidence is duplicative and unclear, and there is
generally no basis to distinguish between local and long-distance
charges. We are persuaded, however, that local telephone service
was utilized by petitioner to conduct her escort business. Again
exercising our discretion under the Cohan rule, we hold that she
may deduct $600 in 1990 for local telephone expenses at the
locations where she conducted her escort business in that year.
Petitioner may deduct additional legal fees of $1,650,
incurred in 1990 by her in defense against charges that she was
using the apartment on E. 77th Street for an illegal purpose,
because they were incurred in connection with the preservation of
her income-producing activities and are deductible. See Johnson
v. Commissioner, 72 T.C. at 348. Similarly, she has demonstrated
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that the amount of $400, paid to an attorney in connection with
obtaining a lease for the W. 58th Street apartment, is properly
deductible, because, as we have found above, she used that
apartment for income-producing purposes.
Petitioner’s testimony and the introduction of a cancelled
check indicates that she paid her brother $150 in 1990 for
appraisal fees concerning some property in Ohio that was
inherited from their father. Petitioner argues that she, as Real
Services, might have been interested in selling the property at a
profit and is therefore entitled to deduct this $150. As was the
case with the 1989 Hawaiian property expenditures, however,
petitioner has failed to show that the $150 qualifies as a
deduction. She testified that, when the property was sold, “Real
Services was returned $175 in regard to this loan”. It thus
appears that her check for $150, rather than being a deductible
expense, was a loan or advance to her brother.
C. Interest Deductions in 1990
Petitioner borrowed money from a number of people in 1990
and now claims that she should be allowed to deduct the interest
she paid to her lenders. Petitioner, however, has failed to
establish that she actually paid such interest. As noted above,
she borrowed $4,000 from Michael L. and, a few months later,
wrote him a check in repayment of $4,800. But the repayment
check was dishonored, and Mr. L. acknowledged that his loan was
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“most probably” repaid in the form of escort services. We held
that petitioner derived $4,000 in escort income from this
transaction. This evidence does not demonstrate that petitioner
is entitled to an interest deduction.
Petitioner also claims a deduction for interest paid to
Vania W., as a result of a $2,500 “loan” made to her by Ms. W.
“for investment purposes” in February 1990. However, the
documents petitioner offered in support of the claimed interest
payments are not competent evidence for this purpose,21 and Ms.
W. did not testify. Petitioner has failed to prove the amount of
any repayment to Ms. W. that may have occurred, or the amount of
principal repayment versus interest.
Petitioner claims a $200 interest deduction with respect to
a loan from Phillip B., but undercuts that claim with other
testimony to the effect that this loan was to be one with “no
interest”. She additionally claims that, if we find that she was
in the escort business, she is entitled to an interest deduction
of $875 for escort services provided to Ronald K. His testimony,
however, is that she provided the services (less frequently than
she now claims) only as a favor. Once again, this testimony
fails to support a finding that petitioner incurred a deductible
21
Ms. W.’s written statements regarding repayment were
excluded as hearsay, and the checks that petitioner claims
reflect repayment to Ms. W. were made out to petitioner herself
or cash.
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interest expense. Finally, the testimony of Tammy M., one of the
women who provided escort services to customers pursuant to
petitioner’s arrangements, fails to establish that petitioner
paid interest with respect to any loan from Ms. M. Ms. M. lent
petitioner $6,000, and respondent concedes that petitioner wrote
checks in repayment totaling at least $6,070. Ms. M. testified,
however, that many of petitioner’s repayment checks were
dishonored. She also testified that, while she may have
recovered the amount of her loan to petitioner, she received no
more than that. We thus cannot find that petitioner has
established her entitlement to a deduction for interest from her
dealings with Ms. M.22
VI. Whether Petitioner Has Unreported Income in 1991 and 1992
For the last 2 years in issue, 1991 and 1992, respondent
determined that petitioner had unreported income by
reconstructing her income using cost-of-living survey information
published by the Bureau of Labor Statistics (BLS). Respondent
employed this data to determine that petitioner had a cost of
22
In addition to claiming deductions for interest,
petitioner also claims deductions for the repayment of principal
in various instances. There is no legal basis for her to deduct
repayments of principal per se. Our findings of unreported
income to petitioner from embezzlement, however, have excluded
amounts she repaid. Petitioner has thus received the benefit of
her repayments for tax purposes where appropriate. See Collins
v. Commissioner, 3 F.3d 625 (2d Cir. 1993), affg. T.C. Memo.
1992-478.
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living-–and, hence, net income-–of $16,766 for 1991 and $17,461
for 1992.
We have approved the Commissioner’s use of cost of living
statistics, such as BLS survey statistics, to reconstruct the
amount of a taxpayer’s income. We explained in Giddio v.
Commissioner, 54 T.C. 1530, 1533 (1970):
Where * * * there is evidence of taxable income but no
information can be acquired to ascertain the amount of
such income, we do not think it is arbitrary for the
Commissioner to determine that the taxpayer had income
at least equal to the normal cost of supporting his
family. [Citation omitted.]
As noted earlier, respondent’s determinations are
presumptively correct. Rule 142(a). In cases involving the
Commissioner’s determination of unreported income, however, the
presumption of correctness may not attach if the notice of
deficiency is unsupported by any evidence. Schaffer v.
Commissioner, 779 F.2d 849, 858 (2d Cir. 1985), affg. in part and
remanding in part Mandina v. Commissioner, T.C. Memo. 1982-34.
Thus, in unreported income cases, imposition of the burden of
proof upon the petitioner requires that the “record must at least
link the taxpayer with some tax-generating acts”. Llorente v.
Commissioner, 649 F.2d 152, 156 (2d Cir. 1981), affg. in part and
revg. and remanding in part 74 T.C. 260 (1980). In the absence
of evidence linking the taxpayer with such acts, a notice of
deficiency will be found arbitrary, insofar as it covers periods
for which there is no evidence of direct involvement. Id.
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In this case, petitioner disputes respondent’s determination
of unreported income for 1991 and 1992, claiming that there is no
reliable evidence that she earned taxable income in those years.
To the contrary, she maintains, after 1990 she abandoned her
business activities and moved in with family members who
supported her.
Evidence linking petitioner to taxable income for 1991 and
1992 is no more than tenuous. Revenue Agent Schnorbus, who
examined petitioner’s tax liability for the years in issue,
testified that the majority of the parties he interviewed told
him that they did not have dealings with petitioner in 1991 or
1992. Agent Schnorbus was not aware of any bank accounts which
reflected that petitioner earned income or had a business in 1991
or 1992.
Agent Schnorbus indicated that he believed that two of
petitioner’s associates, Jeffrey F. and Richard S., had told him
that they had engaged in business activities with petitioner
during 1991 and 1992. Agent Schnorbus conceded, however, that
neither had provided canceled checks nor other documents showing
that there were any such dealings in those 2 years. Moreover,
although respondent introduced notes of an interview that Agent
Schnorbus had conducted with Mr. F., those notes make no
reference to petitioner’s receipt of income for 1991 or 1992.
Finally, Agent Schnorbus stated that although he had made notes
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of the interview with Mr. S., those notes had been lost before trial.
Both Mr. F. and Mr. S. testified at trial. Mr. F. stated
that he referred business clients to an “Angel” for escort
services “probably sometime between–-sometime between ‘82 and
‘92.” He later added, “somewhere in around there.” He did
business with the escort service for “6 or 7 years.” At trial,
however, Mr. F. failed to identify petitioner as the “Angel” to
whom he sent his clients. On cross-examination, petitioner asked
Mr. F. if he could have stopped using the escort services prior
to 1989. He replied: “It’s possible. I don’t think so, but
it’s possible.”
Similarly, at trial, respondent’s counsel asked Mr. S.:
“Did you engage in any business transactions with Ms. Pappas
during the years 1989 through 1992, sir?” Mr. S. replied: “Yes,
I did.” He identified the nature of those business transactions
as “sexual favors”. When asked specifically about 1989, however,
Mr. S. replied: “I can’t guarantee that it was 1989. I just
* * * don’t remember back that far.” On cross-examination,
petitioner asked Mr. S. whether the events in his narration to
the IRS could have occurred prior to 1989. He replied: “It’s
possible.” She also asked “So in fact all of this activity could
have occurred prior to 1989?” Mr. S. replied: “Could have.”
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Mr. S.’s testimony also establishes that he abused alcohol during
the periods in which he engaged in transactions with petitioner.
In the final analysis, the record in this case shows that
the examining agent believed that two individuals had informed
him of business dealings with petitioner in 1991 and 1992,
although the majority of his contacts did not support that
contention. There are no checks or other contemporaneous
documentation in the record connecting petitioner to the receipt
of taxable income in those years. The two individuals who
provided the basis for respondent’s assertion of income in those
years both conceded at trial that it is possible that their
business with petitioner had taken place at other times. The
evidence thus only shows that petitioner possibly engaged in an
income-generating activity in 1991 and 1992, not that she
actually did so. The notice of deficiency therefore lacks the
evidentiary support needed to sustain the determination of income
based upon BLS data for 1991 and 1992. Respondent’s
determinations for those 2 years are therefore not sustained.
VII. Whether Petitioner Is Liable for the Addition to Tax Under
Section 6651(f) or, in the Alternative, for the Addition to Tax
Under Section 6651(a), for the Years in Issue
Sections 6011 and 6012 require every individual who has
gross income in excess of certain amounts for a taxable year to
file an income tax return. Section 6651(a)(1) provides for an
addition to tax for failure to file a timely return. The
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addition to tax is equal to 5 percent of the amount required to
be shown as tax on the return, with an additional 5 percent for
each additional month or fraction thereof during which such
failure continues, not exceeding 25 percent in the aggregate.
If, however, the failure to file any return is fraudulent, then
the addition to tax is equal to 15 percent of the amount required
to be shown as tax on the return, with an additional 15 percent
for each additional month or fraction thereof during which such
failure continues, not exceeding 75 percent in the aggregate.
Sec. 6651(f). Respondent has determined that petitioner’s
failure to file for the years in issue was fraudulent.
The Commissioner must prove fraud by clear and convincing
evidence. See sec. 7454(a); Rule 142(b); Clayton v.
Commissioner, 102 T.C. 632, 646 (1994). In determining whether
petitioner’s failure to file was fraudulent within the meaning of
section 6651(f), we consider the same elements that are relevant
in imposing the penalty for underpayment of tax due to fraud
under section 6663. Clayton v. Commissioner, supra at 653.
Establishing fraud requires proof that the taxpayer “acted
with an intent to evade paying taxes” and may be proved by
circumstantial evidence. Douge v. Commissioner, 899 F.2d 164,
168 (2d Cir. 1990), affg. in part and revg. in part and remanding
an order of this Court dated June 6, 1988. “Such evidence may
include (1) consistent and substantial understatement of income,
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(2) failure to maintain adequate records, (3) failure to
cooperate with an IRS investigation, (4) inconsistent or
implausible explanations of behavior and (5) awareness of the
obligation to file returns, report income and pay taxes.” Id.
An application of these criteria to petitioner’s situation
demonstrates convincingly that in failing to file tax returns for
1989 and 1990 she intended to evade paying taxes and therefore
committed fraud. We have found that she received, and knew she
had received, gross income sufficient to require filing returns
for 1989 and 1990. Petitioner has consistently and substantially
understated her income. Part of her defense in this case has
been her claim that Real Services, rather than herself, was the
recipient of the income at issue. However, no corporate income
tax returns were filed on behalf of Real Services. She had not
maintained adequate records; the three pages of handwritten notes
and a cluster of receipts are inadequate under any definition.
Petitioner has contended that most of her business records were
stolen, but we do not believe her. She has not cooperated with
the Internal Revenue Service investigation; instead, petitioner
has manifested a persistent pattern of obstruction,
confrontation, and inattention with respect to respondent’s
attempts to determine the correct amount of her taxable income
for the years in issue. She has been equally persistent in
advancing implausible explanations for her failure to report her
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income and to pay taxes thereon. Her excuses include the
improbable contention that her now-deceased attorney informed her
that she was not required to file personal or corporate tax
returns, her tales of theft of records, and her steadfast denials
that she earned any income from an escort business. She also
altered a document in a material respect that she sought to
introduce as evidence in this case. These dubious claims and
actions are the kinds of implausible or deceitful representations
that serve as circumstantial evidence of fraud. Finally,
petitioner’s actions in these proceedings reveal that she is
intelligent, shrewd, and experienced in financial matters. Her
efforts to interpose a sham corporate entity between herself and
her tax obligations confirm this view. We conclude that she was
aware of her obligation to file tax returns and pay tax for 1989
and 1990, and that her failure to do so was a willful attempt to
evade those responsibilities, which is fraudulent within the
meaning of section 6651(f).23
For the taxable years 1991 and 1992, however, it has not
been established that petitioner had sufficient gross income to
require the filing of income tax returns. It follows that she is
not liable for any addition to tax under section 6651 for those
years.
23
Because we conclude that petitioner’s failure to file in
1989 and 1990 was fraudulent, we need not address respondent’s
alternative determinations under sec. 6651(a).
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VIII. Whether Petitioner Is Liable for the Addition to Tax Under
Section 6654(a) for the Years at Issue
Respondent also determined additions to tax for 1989 through
1992 under section 6654 arising from an underpayment of estimated
taxes. This addition to tax is mandatory absent a showing by
petitioner that one of the specified statutory exceptions
applies. See Clayton v. Commissioner, supra (citing Grosshandler
v. Commissioner, 75 T.C. 1, 20-21 (1980)). Petitioner has made
no such showing for her 1989 and 1990 taxable years, and we
therefore sustain the additions to tax provided in section 6654
for those years. Section 6654(e) provides, however, that no
addition to tax for underpaid estimated taxes shall be imposed if
the tax “is less than $500.” We have found that petitioner is
not liable for income tax for the years 1991 and 1992.
Accordingly, the determination of additions to tax under section
6654 for those 2 years is not sustained.
In view of the foregoing,
Decision will be entered
under Rule 155.