The opinion
T.C. Memo. 2003-130
UNITED STATES TAX COURT
KYL CHRISTIANS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9814-01. Filed May 5, 2003.
Ted E. Merriam and Kevin A. Planegger, for petitioner.
Richard D. D’Estrada and Frederick J. Lockhart, Jr., for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: In a statutory notice of deficiency, mailed
on May 4, 2001, respondent determined deficiencies in
petitioner’s Federal income tax and penalties for the taxable
years 1992, 1993, and 1994 as follows:
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Penalty
Year Deficiency Sec. 6663
1992 $4,831 $3,623.25
1993 12,115 9,086.25
1994 18,912 14,184.00
Petitioner contends that respondent is barred from assessing
the income tax deficiencies because the notice of deficiency was
mailed after the expiration of the 3-year period for assessment
provided for in section 6501(a).1 Respondent contends that the
period for assessment remains open under section 6501(c)(1)
because petitioner filed false and fraudulent returns for the
years in question. In the alternative, respondent contends, and
petitioner concedes, that the period for assessment remained open
for 1994 because of the substantial understatement of gross
income by more than 25 percent. In such circumstances, section
6501(e) provides for a 6-year period for assessment.
We consider here whether petitioner’s understatements for
taxable years 1992, 1993, and 1994 were due to fraud. In the
event we do not find petitioner’s understatement for taxable year
1994 was due to fraud, respondent may assess the deficiency under
section 6501(e).
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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FINDINGS OF FACT2
Petitioner resided in Loveland, Colorado, at the time his
petition was filed in this case. For taxable years 1992, 1993,
and 1994, petitioner owned and operated a construction business,
which did business under the name of K&L Exteriors Trim (K&L
Exteriors). The business of K&L Exteriors was residential
construction, in particular house framing and siding work.
Petitioner graduated from high school in 1986 and then began
employment as a construction laborer. After 1 year, petitioner
began full-time attendance at Aims Community College. Following
his first year, petitioner transferred to the University of
Northern Colorado, which he attended for 1 year.
After his second year of college, petitioner moved to
Minnesota to work for his grandfather, who owned and operated an
electric motor repair business. He worked for his grandfather
for approximately 1 year. He subsequently moved back to Colorado
and re-enrolled in the University of Northern Colorado. He
attended for two quarters and then transferred for an additional
semester to Colorado State University for an additional semester,
where he studied a specialized curriculum on construction.
Petitioner did not earn a college degree.
2
Some facts have been stipulated by the parties and are
herein incorporated by this reference.
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During his final semester at Colorado State University,
petitioner worked part time for George Moore Construction earning
between $6 and $7 per hour. Petitioner acquired first-hand
knowledge of the need for residential construction services and
believed he could earn more money by operating his own
construction business. During 1992, when petitioner was
approximately 24 years old, his father lent him approximately
$500 to $600 to start a construction business, under the name K&L
Exteriors Trim (K&L Exteriors). K&L Exteriors began with two to
three employees, and business was generated by word of mouth or
by petitioner’s contacts with other contractors at job sites.
K&L Exteriors did not maintain any inventory, and its business
consisted of providing services in the form of labor.
During 1993, petitioner organized a corporation called Four
Square Construction, Inc. (Four Square), for the sole purpose of
providing payroll services for K&L Exteriors. K&L would transfer
funds to Four Square each month, and then Four Square would
distribute the funds to the employees.
Petitioner did not have the business acumen to manage the
administrative side of the business. Petitioner managed and
performed the construction services, and he relied on his father
to manage the administrative matters, including the bookkeeping.
Petitioner trusted his father and was aware of his father’s prior
experience in administrative business matters, including his
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father’s management of petitioner’s mother’s cleaning service
business. Petitioner did not question his father and would sign,
without careful consideration, documents his father had prepared.
The administrative business services for petitioner’s and
his mother’s businesses were performed in petitioner’s parents’
home, where the books and records were maintained. Petitioner
lived with his parents in that home until sometime during 1994.
When the number of documents necessary for petitioner’s business
became voluminous, petitioner’s father requested a facsimile
stamp of petitioner’s signature for use on business documents.
A business checking account was maintained for K&L
Exteriors. That account was used for payment of petitioner’s
personal and business expenses. During the period under
consideration, petitioner was provided by his father with
approximately $350 a week for living expenses. Petitioner was
aware that K&L Exteriors’ weekly receipts exceeded $350, and he
thought that the excess was being retained and/or used for
operating expenses.
Petitioner’s father also managed the preparation of
petitioner’s individual and business tax returns. Petitioner’s
father retained Doneta Layland, owner-operator of Tax
Consultants, to prepare petitioner’s tax returns. Petitioner’s
father would provide the information necessary to prepare the tax
returns to Ms. Layland. Petitioner had no contact with Ms.
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Layland, and she did not find it unusual that petitioner’s father
handled the tax matters because that type of situation occurred
with other clients.
Ms. Layland was often frustrated by the inadequate and
inaccurate tax preparation records petitioner’s father submitted
to her. For example, the cashflow statement for K&L Exteriors
for the taxable year 1993 reflected gross receipts of $160,397,
while the Forms 1099 filed by clients of the business reflected a
lesser amount ($111,516). Through communications with
petitioner’s father, Ms. Layland came to realize that the
cashflow statement figure was incorrect. Accordingly, she
reported the amount reflected on the Forms 1099. Petitioner’s
father also commingled petitioner’s personal and business
expenses, which Ms. Layland attempted to distinguish and
separate. Ms. Layland did not contact petitioner about any of
these matters. She dealt exclusively with petitioner’s father,
who resolved these matters to Ms. Layland’s satisfaction. On one
occasion, Ms. Layland questioned petitioner’s father about a loss
on petitioner’s 1993 Schedule C, Profit or Loss From Business.
Petitioner’s father responded with new figures which reflected a
small profit.
For taxable years 1993 and 1994, Ms. Layland also prepared
Four Square’s corporate returns for petitioner. Because Four
Square was incorporated solely for K&L Exteriors’ payroll
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needs, Four Square’s receipts matched its expenses, and its
corporate returns did not reflect taxable income.
Petitioner’s 1992, 1993, and 1994 income tax returns were
filed on May 4, 1993, May 16, 1994, and May 8, 1995,
respectively. The Schedules C attached to petitioner’s 1992,
1993, and 1994 income tax returns reflected taxable income of
$635, $304, and $360, respectively. All three returns were
signed by petitioner and dated April 29, 1993, May 8, 1994, and
May 3, 1995, respectively. As with other documents relating to
K&L Exteriors and Four Square, petitioner did not read or review
them before signing. At the time of signing the 1992, 1993, and
1994 returns, petitioner believed the information reported was
accurate.
Petitioner now agrees that the gross income from his
construction business was understated by $9,690, $37,204, and
$52,440 for 1992, 1993, and 1994, respectively. He also agrees
that interest income was understated by $24 and $11 for 1992 and
1993, respectively.
During August 1994, petitioner, in the process of obtaining
a personal loan, estimated his monthly income to be $3,200. At
this time, petitioner was receiving a $350 weekly check from his
father. In December 1994, petitioner sought another loan in
order to purchase a home. Petitioner knew that he had to have a
certain level of income to qualify for a home loan. In response
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to the loan officer’s questions, petitioner estimated that his
monthly income was $5,217. Petitioner signed and dated the loan
application. In mid-March 1995, petitioner entered into a
contract to purchase a home for $140,000.
The mortgage company requested petitioner’s income tax
returns from the previous 2 years. Petitioner telephoned his
father and requested copies of his income tax returns for taxable
years 1993 and 1994. Petitioner obtained copies of his income
tax returns from his father and submitted them to the mortgage
company without reviewing them. The 1993 return submitted to the
mortgage company reflected Schedule C net income of $51,297.
This return differed in the amount of income from the one filed
with the Internal Revenue Service. There were also differences
in petitioner’s signatures. The date reflected on the return
provided to the mortgage company was April 15, 1994, and was not
in petitioner’s handwriting.
The 1994 income tax return submitted to the mortgage company
reflected Schedule C net income of $50,685, an amount different
from that reported to respondent. These returns also contained
differences in petitioner’s signatures. The date reflected on
the 1994 return provided to the mortgage company was February 2,
1995, and was in petitioner’s handwriting.
Petitioner did not read any of the loan documents relating
to the purchase of the home. Instead, the loan officer explained
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the documents, and then petitioner signed them. The closing date
for petitioner’s home purchase was July 28, 1995. On that date,
petitioner signed a Universal Residential Loan Application, which
reflected that his monthly income was $4,137. Petitioner
believed this figure was derived from his income tax returns.
In the course of an examination of another taxpayer
regarding employee wage deductions, respondent began an
examination of petitioner’s returns. For taxable year 1991,
petitioner admitted to respondent’s agent that he did not report
approximately $2,000 in wages he had received for part-time
construction work.
Respondent’s examining agent referred petitioner’s tax
examination to the Criminal Investigation Division. In the
course of the investigation, respondent’s special agent
(1) interviewed contractors to determine whether K&L had reported
all of its income through a specific item analysis, (2)
interviewed Ms. Layland regarding the preparation of petitioner’s
income tax returns, and (3) sought out other potential sources of
income. In so doing, the special agent discovered: (1)
Petitioner’s mortgage applications, (2) that petitioner’s father
had sole contact with Ms. Layland, (3) that petitioner timely
filed his income tax returns, (4) that petitioner’s return for
1992 did not include income received from a contractor, (5) that
petitioner’s return did not include $11 of interest income, (6)
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that petitioner did not deal in cash, (7) that K&L Exteriors was
one of the least sophisticated operations he had seen, (8) that
petitioner paid approximately $90 in self-employment tax for
taxable year 1992 and a minimal amount of income tax, and (9)
that petitioner reported no income tax or self-employment tax
liability for taxable years 1993 and 1994.
The special agent did not discover evidence showing an
overstatement of expense deductions or illegal activities or that
Four Square was used for any improper purposes. At the
conclusion of the criminal investigation, the special agent
recommended criminal prosecution of petitioner and petitioner’s
father for taxable years 1993 and 1994. The record does not
reflect the disposition of these matters.
OPINION
The parties have narrowed the focus of this case.
Petitioner agrees that there was unreported income and, hence,
underpayments of tax for 1992, 1993, and 1994. However, the 3-
year period for assessment, provided for in section 6501(a), had
expired with respect to all 3 taxable years at the time
respondent mailed the notice of deficiency to petitioner.
Respondent, in his answer, affirmatively alleged that the
understatement of tax for each of the 3 years is due to fraud
and, therefore, that the period for assessment remained open at
the time the notice was mailed. See sec. 6501(c)(1).
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Accordingly, the initial and principal question we consider is
whether “any portion of * * * [the underpayments] is attributable
to fraud”. Sec. 6663(b).
I. Whether Petitioner Filed Fraudulent 1992, 1993, or 1994
Income Tax Returns
For purposes of defining fraud, it is important to note that
the definitions of fraud in sections 6663 and 6501 have been held
to be interchangeable. Rhone-Poulenc Surfactants v.
Commissioner, 114 T.C. 533, 548 (2000) (and cases cited therein);
Murphy v. Commissioner, T.C. Memo. 1995-76. Fraud is an
intentional wrongdoing on the part of the taxpayer with the
specific purpose to evade a tax believed to be owing. McGee v.
Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th
Cir. 1975); Terrell Equip. Co. v. Commissioner, T.C. Memo. 2002-
58. The Commissioner bears the burden of proving fraud by clear
and convincing evidence. Sec. 7454(a); Rule 142(b); Zell v.
Commissioner, 763 F.2d 1139, 1142-1143 (10th Cir. 1985), affg.
T.C. Memo. 1984-152; Terrell Equip. Co. v. Commissioner, supra.
To satisfy his burden, the Commissioner must show that (1)
an underpayment exists; and (2) the taxpayer intended to evade
taxes known to be owing by conduct intended to conceal, mislead,
or otherwise prevent the collection of taxes. Parks v.
Commissioner, 94 T.C. 654 692 (1970). The existence of fraud is
a question of fact to be resolved from the entire record. DiLeo
v. Commissioner, 96 T.C. 858, 874 (1991), affd. 959 F.2d 16 (2d
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Cir. 1992). Because direct proof of a taxpayer’s intent is
rarely available, fraud may be proven by circumstantial evidence,
and reasonable inferences may be drawn from the relevant facts.
Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v.
Commissioner, 79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th
Cir. 1984). Mere suspicion, however, does not prove fraud. Katz
v. Commissioner, 90 T.C. 1130, 1144 (1988).
Courts have developed a nonexclusive list of so-called
badges of fraud which demonstrate fraudulent intent:
(1) Understating income, (2) maintaining inadequate records, (3)
providing implausible or inconsistent explanations of behavior,
(4) concealing income or assets, (5) failing to cooperate with
taxing authorities, (6) engaging in illegal activities, (7)
engaging in a pattern of behavior which indicates an intent to
mislead, (8) testifying with a lack of credibility, (9) filing
false documents, (10) failing to file tax returns, and (11)
dealing in cash. Bradford v. Commissioner, 796 F.2d 303, 307-308
(9th Cir. 1986), affg. T.C. Memo. 1984-601; Recklitis v.
Commissioner, 91 T.C. 874 (1988); Middleton v. Commissioner, T.C.
Memo. 2002-164. The sophistication, education, and intelligence
of the taxpayer are relevant in determining fraudulent intent.
Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
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A. In General
The record in this case reflects a general pattern of
dereliction, but not one of deceit and fraud. There can be no
doubt that petitioner’s reliance upon his father was misplaced
and in no way relieved petitioner of his obligation to correctly
report his tax liability. Petitioner may not avoid his duty to
accurately report by placing the responsibility on an agent. See
United States v. Boyle, 469 U.S. 241, 250-251 (1985). There is
ample evidence, as observed by his return preparer, that
petitioner’s tax records were inaccurate and inadequate and
commingled personal and business items. Petitioner knew that his
earnings exceeded the $350 received weekly from his father for
personal expenses. But petitioner was not aware of the
particulars of his tax reporting, including the amount of income
reported on his Federal income tax returns. In spite of his
laxity and inattention to the administration of his business,
petitioner did not intend to evade tax by conduct intended to
conceal, mislead, or prevent the collection of tax.
Petitioner’s forte was in the operational side of his
construction business. He was young and inexperienced regarding
the administrative necessities of his business. As a result,
petitioner relied exclusively on his father to look after the
administrative matters, including tax reporting. Petitioner
perfunctorily signed documents, including tax returns, that his
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father prepared and placed before him for signature.
Additionally, there has been no showing that petitioner
collaborated or colluded with his father to defraud the
Government. Respondent has not shown, on this record, that
petitioner attempted to defraud. We have reached this conclusion
after considering the specific criteria for fraud and whether the
“badges of fraud” existed in this case.
Fraud may be proven by circumstantial evidence and
reasonable inferences drawn from the facts. Spies v. United
States, supra. A taxpayer’s course of conduct or a pattern of
conduct may establish, by inference, the intent to conceal or
mislead. Id. at 499; Otsuki v. Commissioner, 53 T.C. 96, 105-106
(1969). Respondent contends that the 3-year pattern of
underreporting income is evidence from which we should infer
petitioner’s intent to conceal or mislead. It has been held that
a pattern of underreporting of income over an extended period may
be indicative of fraud, but the mere failure to report is not
sufficient to establish fraud. Petzoldt v. Commissioner, 92 T.C.
661, 700 (1989) (and cases cited thereat).
Petitioner concedes that his income was underreported for
the 3 years. Petitioner, however, contends that he relied
(reasonably or unreasonably) upon his father and that he was
without sufficient knowledge to be culpable and/or that he did
not formulate a specific intent to evade tax, conceal, or
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defraud. We have carefully considered the evidence, including
petitioner’s testimony, which we found credible. We hold that
the under reporting here does not, when considered in light of
the record in its totality, show or raise an inference that
petitioner intended to conceal or mislead.
We find the circumstances here to be somewhat unusual. The
combination of petitioner’s inexperience, immaturity, and
reliance on his father make his position plausible. It must be
noted that the three Federal income tax returns under
consideration represent some of the first ones that petitioner
filed, and he continued to live with his parents throughout most
of the period under consideration. In addition, this was
petitioner’s first self-employment business experience.
The Commissioner has relied upon taxpayers’ understatements
of income to circumstantially show fraudulent intent and has been
successful in numerous fraud penalty cases where such
understatements were coupled with other badges of fraud. In a
few cases, however, the Commissioner has failed to establish a
link between understatements and fraudulent intent. In Rao v.
Commissioner, T.C. Memo. 1996-500, the fraud penalty was not
sustained even though the taxpayer, a doctor, had substantial and
consistent understatements of gross income. In that case, the
taxpayer relied on his accountant, in the same manner as
petitioner has relied on his father. In another case, involving
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a doctor whose income was consistently and substantially
understated, the taxpayer’s reliance on his accountant was a
factor in the Court’s holding that the Commissioner failed to
clearly and convincingly prove fraud. Zipp v. Commissioner, T.C.
Memo. 1998-371.
B. Whether There Was a Pattern of Behavior Which Indicates
an Intent To Mislead
Respondent points out that petitioner, in the process of
applying for loans, provided monthly income figures to lenders
that reflected that he knew that he was underreporting his
income. During 1994, petitioner sought a $5,100 personal loan,
and he estimated that his monthly income was $3,200. A few
months later petitioner began the process of purchasing a home,
and in documents submitted to secure a $140,000 mortgage loan, he
estimated that his monthly income was $5,217 on one occasion and
$4,137 on another.
When the home loan was being finalized, the mortgage company
requested copies of petitioner’s 2 prior years’ Federal income
tax returns. Petitioner obtained the copies of the returns from
his father and provided them to the mortgage company. Unlike the
returns filed with respondent, which reported insignificant
amounts of net income from the construction business, the copies
supplied to the mortgage company reflected annual net income in
the low $50,000's. In addition, there were some discrepancies
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with respect to the signatures on the returns supplied to the
mortgage company.
Respondent argues that these circumstances indicate
petitioner’s knowledge that the income reported to the Government
was understated. Petitioner does not deny that there were
discrepancies and that the amounts reported to respondent
differed from the amounts contained in the return documents
provided to the mortgage company. Petitioner, consistent with
his approach to business documents and procedures, was not
cognizant of the contents of the returns presented to the various
recipients or of the taxable income that was being earned from
his business activity. Petitioner did not have working knowledge
of the administrative side of his business and followed his
father’s guidance on those aspects of his business.
There has been no evidence, circumstantial or otherwise,
that would lead us to find that petitioner was aware of the
discrepancies or that he colluded with his father in an attempt
to deceive the Government or the mortgage company. Even if
petitioner’s father intended to conceal, deceive, and defraud,
such a finding would not automatically be imputed to petitioner.
Respondent, relying on United States v. Bornfield, 145 F.3d
1123, 1129 (10th Cir. 1998), contends that petitioner cannot, by
burying his head in the sand, avoid blame for any deception by
his father. Bornfield, a criminal case, involved a “deliberate
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ignorance instruction” to a jury. It was held that such an
instruction “is appropriate if the defendant denies knowledge of
an operative fact and the evidence demonstrates or creates the
inference that the defendant deliberately avoided actual
knowledge of that fact.” Id. (citing United States v. Lee, 54
F.3d 1534, 1538 (10th Cir. 1995)). As we have found, petitioner
did not collude with his father or deliberately avoid knowledge
to avoid culpability. Accordingly, United States v. Bornfield,
supra, is not analogous to our circumstances.
In conjunction with that approach, respondent also argues
that petitioner’s father’s actions should be imputed to
petitioner. Respondent’s position derives from joint and several
liability cases. In those cases, both spouses by the filing of a
joint return were liable for any fraud penalty, irrespective of
which spouse intended to evade the tax. We note that the cases
respondent relies on are dated and have been superseded by
statute. See, e.g., sec. 6663(c).
More importantly, the cases relied upon by respondent
involve situations where one spouse was found to have
intentionally evaded tax. There has been no showing by clear and
convincing evidence that petitioner’s father intended to file a
fraudulent return on his son’s behalf. Accordingly, there is no
need to consider whether the concept of joint and several
liability would apply in this case.
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C. Remaining Badges of Fraud
Petitioner points out that factually, respondent’s case
rests on the understatements and the information provided to
lenders. There has been no showing or allegation that petitioner
(1) knowingly concealed income or assets, (2) failed to cooperate
with respondent, (3)engaged in illegal activities, (4) attempted
to mislead, (5) dealt in cash, (6) lacked credibility, or (7)
knowingly filed false documents.
On this record we conclude and hold that respondent has
failed to prove by clear and convincing evidence that petitioner
intended to evade taxes known to be owing by conduct intended to
conceal, mislead, or otherwise prevent the collection of taxes.
Accordingly, the exception for fraud did not serve to keep the
assessment period for 1992, 1993, or 1994 open under section
6501(c).
II. Respondent’s Alternative Argument Concerning Section
6501(c)(1)
Respondent also argues that, for purposes of indefinitely
extending the period for assessment under section 6501(c)(1),
petitioner’s state of mind is irrelevant. Section 6501(c)(1)
provides for an exception to the 3-year period for assessment of
section 6501(a), as follows:
False Return. In the case of a false or
fraudulent return with the intent to evade
tax, the tax may be assessed, or a proceeding
in court for collection of such tax may be
begun without assessment, at any time.
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Respondent argues that the statute requires only an “intent to
evade tax.” Under respondent’s position the intent to evade may
be imputed to the taxpayer from a third person. In the setting
of this case, respondent would have us impute to petitioner any
intent to evade tax that petitioner’s father may have had. Under
respondent’s interpretation, the period for assessment would
remain open indefinitely in a situation where, as here, a
taxpayer is found not to have intended to evade tax, but some
third person involved in the reporting of income did so intend.
Assuming arguendo that respondent’s interpretation of
section 6501(c)(1) is correct, for respondent to be successful in
this case, he first would have to establish the factual predicate
that petitioner’s tax preparer/father had an “intent to evade
tax”. With respect to extending the period for assessment,
respondent bears the burden of proof. Mecom v. Commissioner, 101
T.C. 374 (1993), affd. without published opinion 40 F.3d 385 (5th
Cir. 1994). We have found that respondent has not shown by clear
and convincing evidence that petitioner intended to evade tax
when he signed the returns in question. We have also found that
respondent has not shown that petitioner’s father/return preparer
intended to evade tax. Therefore, the question of whether
respondent’s interpretation of section 6501(c)(1) is correct is
rendered moot.
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Accordingly, the period for assessment for 1992, 1993, or
1994 did not remain open under the provisions of section
6501(c)(1). Because of petitioner’s concession that the 1994
assessment period was open under section 6501(e), petitioner
remains liable for an income tax deficiency based on the agreed
underpayment for his 1994 tax year.
To reflect the foregoing,
Decision will be entered
under Rule 155.