The opinion
T.C. Memo. 2011-45
UNITED STATES TAX COURT
ENERGY RESEARCH AND GENERATION, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4936-02, 1561-04. Filed February 24, 2011.
John M. Youngquist, for petitioner.
Daniel J. Parent and Kaelyn J. Romey, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: In these consolidated cases, respondent
determined deficiencies in petitioner’s Federal income taxes,
- 2 -
additions to tax pursuant to section 6651(a)(1),1 and fraud
penalties2 pursuant to sections 6653(b) and 6663 as follows:3
Docket No. 4936-02
Fraud Penalty
Year Deficiency Sec. 6653(b)
1988 $187,030 $140,272.50
Addition to Tax Fraud Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6663(a)
1989 $355,725 $89,162.00 $266,793.75
1990 400,041 100,250.50 300,030.75
1991 870,725 217,681.25 653,043.75
1992 534,706 133,676.50 401,029.50
Fraud Penalty
Year Deficiency Sec. 6663(a)
1993 $382,865 $287,148.75
1994 178,506 133,879.50
Docket No. 1561-04
Fraud Penalty
Year Deficiency Sec. 6663(a)
1995 $457,143 $342,857.25
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
2
We use the term “fraud penalty(ies)” to include the
addition to tax under sec. 6653(b) for 1988.
3
As set forth in an amendment to answer, respondent seeks to
increase the amounts of disallowed rent expenses for tax years
1990-94. On brief respondent states that, because of
concessions, the deficiencies and penalties will not exceed the
amounts in the notices of deficiency.
- 3 -
The parties agree that the period of limitations for
assessment has expired for each of the years 1988 through 1995
(years at issue) unless the Court finds that petitioner’s returns
were false or fraudulent with the intent to evade tax. See sec.
6501(c)(1).
If we find that petitioner’s returns were fraudulent, most
of the adjustments to petitioner’s income are now agreed.
Pursuant to the parties’ stipulations and posttrial concessions
in their briefs, all but two of the adjustments to income,
deductions, and credits have been agreed. The following
schedules show the agreed adjustments:
1988
Adjustments to Taxable Income Agreed Adjustment
Gross receipts ($22,270)
Disallowed deductions:
Legal & professional fees 23,598
Research & development 24,601
Employee relations 467
Auto expenses 9,645
Life insurance expenses 2,425
Tax and license expense 311
Rents 29,400
Salaries & cost of goods sold labor 264,134
Pension plan expense 15,348
Director’s fees 24,000
Other payments -0-
Accounting method for customer deposits 86,000
Employee benefits (1,170)
Increased taxable income 456,489
- 4 -
1989
Adjustments to Taxable Income Agreed Adjustment
Gross receipts $318,507
Disallowed deductions:
Legal & professional fees 138,484
Research & development 102,222
Royalty 248,098
Employee relations 1,347
Auto expenses 10,624
Life insurance expenses 2,404
Tax and license expense 7,909
Rents 29,400
Salaries & cost of goods sold labor 118,686
Bad debts 31,675
Pension plan expense1 --
Director’s fees 24,000
Other payments -0-
Janitorial expense 5,980
Contributions -0-
Increased taxable income 1,039,336
Disallowed research & development credit $5,515
1
A $100,000 adjustment for pension plan expense is in
dispute.
1990
Adjustments to Taxable Income Agreed Adjustment
Gross receipts ($173,872)
Cost of goods sold (purchases & materials) 26,387
Disallowed deductions:
Legal & professional fees 49,652
Research & development 132,687
Royalty 193,508
Employee relations 7,139
Auto expenses 23,676
Life insurance expenses 2,480
Tax and license expense 34,147
Rents 61,308
Salaries & cost of goods sold labor 404,435
Interest expense 938
Bad debts 19,255
Pension plan expense 50,000
Director’s fees 24,000
- 5 -
Compensation of officers -0-
Other payments -0-
Materials & supplies (4,698)
Employee benefits 10,930
Janitorial expense 7,239
Repairs & maintenance 3,567
Contributions (6,000)
Dues & subscriptions (683)
Increased taxable income 866,095
Disallowed research & development credit $5,693
1991
Adjustments to Taxable Income Agreed Adjustment
Gross receipts $459,833
Cost of goods sold (purchases & materials) (1,220)
Disallowed deductions:
Legal & professional fees 55,046
Research & development 169,137
Royalty 1,764,049
Employee relations 8,418
Auto expenses 12,706
Life insurance expenses 2,458
Tax and license expense 1,799
Rents 61,308
Interest expense 8,128
Bad debts 36,053
Director’s fees 24,000
Compensation of officers -0-
Materials & supplies 9,254
Janitorial expense 6,730
Depreciation (11)
Contributions (13,200)
Dues & subscriptions (2,027)
NOL carryback from 1993 --
Increased taxable income 2,602,461
Disallowed research & development credit $7,256
1992
Adjustments to Taxable Income Agreed Adjustment
1
Gross receipts $51,017
Cost of goods sold (purchase & materials) (11,212)
Disallowed deductions:
- 6 -
Legal & professional fees 64,880
Research & development 136,045
Royalty 907,443
Employee relations 23,429
Paid to Kent Greene 7,634
Auto expenses 20,636
Life insurance expenses 2,590
Tax and license expense 21,057
Rents 80,400
Interest expense 9,051
Bad debts 84,455
Pension plan expense (2,792)
Director’s fees 36,000
Compensation of officers -0-
Other payments -0-
Materials & supplies 4,800
Employee benefits 25,446
Janitorial expense 6,760
Repairs & maintenance 15,280
Depreciation (303)
Contributions (14,400)
Salaries & wages (13,782)
Increased taxable income 1,454,434
Disallowed research & development credit $5,836
1
Respondent’s adjustment is $145,418 and petitioner has
conceded $51,017; therefore, $94,401 is in dispute.
1993
Adjustments to Taxable Income Agreed Adjustment
Gross receipts $52,597
Cost of goods sold (purchase & materials) (3,959)
Disallowed deductions:
Legal & professional fees 85,560
Research & development 118,989
Royalty 220,000
Employee relations 4,255
Paid to Kent Greene 7,032
Auto expenses 28,303
Life insurance expenses 2,646
Employee education expenses 2,599
Computer purchase -0-
Tax and license expense 24,546
Rents 105,086
Salaries & cost of goods sold labor 164,039
- 7 -
Interest expense 9,436
Bad debts 3,377
Pension plan expense 28,027
Director’s fees 36,000
Mark Benson’s medical expense -0-
Compensation of officers -0-
Employee benefits 628
Depreciation (1,435)
Contributions -0-
Dues & subscriptions (76)
Increased taxable income 887,650
1994
Adjustments to Taxable Income Agreed Adjustment
Gross receipts $1,559
Disallowed deductions:
Legal & professional fees 167,237
Research & development 106,694
Royalty 160,063
Employee relations 10,630
Auto expenses 14,723
Life insurance expenses 4,779
Employee education expenses 7,269
Tax and license expense 14,960
Rents 102,360
Salaries & cost of goods sold labor 35,561
Bad debts 9,906
Pension plan expense (56,083)
Director’s fees 36,000
Compensation of officers -0-
Materials & supplies 3,274
Employee benefits (3,310)
Maintenance & repair (359)
Travel 7,955
Depreciation (8,327)
Dues & subscriptions 4,119
Other deductions 4,106
Contributions (20,000)
Increased taxable income 603,116
1995
Adjustments to Taxable Income Agreed Adjustment
Gross receipts ($58,507)
Cost of goods sold (purchase & materials) 114,568
- 8 -
Disallowed deductions:
Legal fees 133,703
Professional fees 5,263
Royalty 260,160
Engineering studies 108,714
Employee relations 2,332
Auto expenses 8,455
Life insurance expenses 6,011
Employee education expenses 13,088
Tax and license expense 2,075
Rents 135,518
Salaries 145,620
Bad debts 11,343
Director’s fees 36,857
Compensation of officers -0-
Supplies (including R & D) 40,543
Employee benefits 30,199
Janitorial expense 584
Depreciation (10,677)
NOL deduction 131,975
Telephone expense 2,149
Business meetings 666
Contributions (19,800)
Increased taxable income 1,100,839
The issues we must decide are:
(1) Whether petitioner’s returns for the years at issue were
false or fraudulent with the intent to evade tax. If so, the
periods of limitations for assessing tax remain open and
petitioner is liable for fraud penalties pursuant to section
6653(b) for 1988 and section 6663(a) for 1989 through 1995;4
(2) whether petitioner is entitled to deduct $100,000 as a
pension plan expense in 1989;
4
Respondent alternatively asserts that petitioner is liable
for an addition to tax under sec. 6651(f) for 1994 should we not
find petitioner liable under sec. 6663(a).
- 9 -
(3) whether petitioner understated its gross receipts by
$94,401 in 1992; and
(4) whether petitioner is liable for an addition to tax
pursuant to section 6651(a)(1) for 1989 through 1992.
FINDINGS OF FACT
Even though most of the adjustments to petitioner’s taxable
income have been agreed, it is necessary to make fact findings
regarding many of those adjustments because the factual basis for
those adjustments is also the factual basis for respondent’s
allegations of fraud. Some of the facts have been stipulated and
are so found. The stipulation of facts, the first and second
supplemental stipulations of facts, and the stipulation of
settled issues are incorporated herein by this reference.5 At
the time the petitions were filed, petitioner’s principal place
of business was in California.
Background
Petitioner is a corporation incorporated in California in
1967 by Glendon M. Benson (Glendon), his wife, Janet Benson
5
In Benson v. Commissioner, T.C. Memo. 2004-272,
supplemented by T.C. Memo. 2006-55, affd. 560 F.3d 1133 (9th Cir.
2009), in which Burton O. Benson (Burton) was a petitioner, we
made certain findings that the parties agree apply in this case.
- 10 -
(Janet), and Burton O. Benson (Burton),6 Glendon’s younger
brother.
Petitioner is the only company in the world that
manufactures various forms of foam metal and foam metal baffles.7
Duane Walz and Glendon invented the process known as foam metal,
which Glendon then developed into a product. Mr. Walz was given
sole credit as the inventor of the patent and, on March 23, 1976,
he assigned his patent rights to petitioner.
In the mid-1980s a dispute arose between Burton and Glendon
over the operation and ownership of petitioner. On April 4,
1985, Burton and his wife, Elizabeth, filed suit against Glendon,
Janet, and petitioner. In October 1985 Burton and Glendon
executed an agreement delineating their respective
responsibilities concerning contracts with two of petitioner’s
major clients, Hercules Aerospace Co., Inc. (Hercules),8 and Gas
Research Institute (GRI). Under the agreement, Burton was
6
Burton has a degree in mechanical engineering from the
University of Minnesota. He and his wife, Elizabeth Benson
(Elizabeth), have three sons: Eric, Mark, and Brad. Esther V.
Benson (Esther) was the mother of Burton and Glendon. Burton
served 9 years as an officer in the U.S. Navy and 23 years as an
officer in the U.S. Naval Reserve, retiring with the rank of Rear
Admiral.
7
Foam metal baffles are used in the U.S. Navy’s fleet of
ballistic missiles.
8
Hercules Aerospace Co., Inc., and all predecessors and
successors in interest will be referred to throughout this
opinion as Hercules.
- 11 -
granted all rights to and responsibility for contracts with
Hercules,9 and Glendon was granted all rights to and
responsibility for contracts with GRI.
In May 1986 Burton and Glendon initiated binding
arbitration. On July 9, 1986, the arbitration panel issued an
interim decision. In October 1986 Burton and Glendon entered
into an agreement to adjourn the arbitration proceedings,
choosing to mediate the dispute with the aid of Winston E. Miller
(WEM) as mediator. On June 28, 1987, during the course of
mediation, Burton and Glendon entered into an agreement entitled
“Memorandum Re: Unbundling of ERG (June 24, 1987)”. The
unbundling agreement provided terms for petitioner to purchase
Glendon’s interest (stock) in petitioner with the result that
Burton becomes the sole owner of petitioner. Burton and Glendon
subsequently executed a document entitled “Supplemental
Memorandum Re: Unbundling of ERG (December 4, 1987)”. On
December 5, 1987, Burton and Glendon executed a document entitled
“Memorandum Re: Other Commitments made to WEM”.10
In July 1987 Glendon started Aker Industries (Aker) in
Oakland, California. Aker performs research and development
9
During the years at issue petitioner produced for Hercules
the First Stage Baffle for the Trident II D-5 U.S. Navy Fleet
Ballistic Missile Program.
10
Except as noted to the contrary, we refer to the documents
executed by Burton and Glendon during mediation collectively as
the unbundling agreement.
- 12 -
contracts. During the years at issue neither Glendon nor Aker
performed research or development for petitioner. Burton is not,
and never has been, an owner, shareholder, employee, director, or
officer of Aker.
Neither petitioner nor Burton paid Glendon for his interest
in petitioner, and the brothers continued to fight over what, if
anything, was due to Glendon. On March 23, 1993, Glendon and
Janet filed a motion asking a California court to enforce the
unbundling agreement as a settlement agreement. In response to a
1994 petition filed by Burton, the court ordered the parties to
recommence arbitration. In 1994 arbitration proceedings
recommenced. On June 7, 1995, a second interim arbitration
decision was issued and, on November 8, 1996, a third interim
arbitration decision was issued.
On March 5, 1999, a final arbitration decision was issued.
The final arbitration decision comprehensively decided the issues
between Burton and Glendon. The arbitrators held that Burton
became the 100-percent owner of petitioner on July 1, 1987, and
found, inter alia, that
During the period from and after July 1, 1987,
* * * [Burton]/* * * [petitioner]/* * * [New Process
Industries, Inc.,] was extremely successful * * *. As
a result, in the period from 1988 through 1996, * * *
[Burton] and his family obtained in excess of
$6,500,000 in salaries, director’s fees and cash
distributions from * * * [petitioner]/* * * [New
Process Industries, Inc.].
- 13 -
* * * from and after July 1, 1987, * * * [Burton]
had total control over both * * * [petitioner] and
* * * [New Process Industries, Inc.] * * *.
The arbitrators also found that Burton owed Glendon a gross
amount of $3,119,475 for Glendon’s interest in petitioner. The
arbitrators awarded property (the Lowell plant) at 952 57th
Street, Oakland, California, to Glendon/Aker, for which Burton
received a credit of $185,500. Additionally, the arbitrators
found that Glendon/Aker should have paid New Process Industries,
Inc. (NPI),11 rent for the Lowell plant at $2,000 per month from
July 1, 1987, to December 31, 1994, and $2,500 thereafter.
Accordingly, Burton was credited with $420,650 for the rent
payments plus interest. The final arbitration decision awarded
Glendon a net $2,412,172 after credits and deductions.
11
New Process Industries, Inc. (NPI), was a family-owned S
corporation, incorporated in Minnesota. On its respective 1988
through 1995 tax returns, the Benson family’s percentage of
ownership of NPI was reported as follows:
Year and Percentage Ownership
Individual 1988 1989 1990 1991 1992 1993 1994 1995
Burton 66.7 66.7 66.7 66.7 50.0 66.7 50.0 50.0
Esther 33.3 33.3 33.3 33.3 50.0 –- –- –-
Eric –- –- –- –- –- 11.1 16.7 16.7
Mark –- –- –- –- –- 11.1 16.7 16.7
Brad –- –- –- –- –- 11.1 16.7 16.7
Burton exercised almost sole control over management and
operations of NPI.
- 14 -
During the years at issue Burton was petitioner’s president
and director.12 Burton alone exercised almost sole control over
petitioner’s management and operations. On each of petitioner’s
1988 through 1994 Forms 1120, U.S. Corporation Income Tax Return
(tax returns), Burton is listed on Schedule E, Compensation of
Officers, as owning 100 percent of petitioner’s common stock. On
petitioner’s 1995 Schedule E, Burton is listed as owning 28
percent of petitioner’s common stock and Elizabeth, Eric B.
Benson (Eric), and Mark D. Benson (Mark), Burton and Elizabeth’s
sons, are listed as each owning 24 percent.
Tax Return Preparation
Tax Return Preparers
G.A. “Al” Piepho (Mr. Piepho) performed all of petitioner’s
bookkeeping and accounting up until his death on October 1, 1989.
Mr. Piepho prepared petitioner’s 1987 tax return, which was filed
on May 23, 1989. Burton worked directly with Mr. Piepho and
provided him the records from which he was to prepare
petitioner’s tax returns.
Edward J. Bradac, C.P.A. (Mr. Bradac), purchased Mr.
Piepho’s accounting business. For tax years 1988 through 1993,
Mr. Bradac prepared petitioner’s tax returns. In 1995 Mr. Bradac
12
Burton joined petitioner in 1969 in the capacity of vice
president. Before working for petitioner, Burton was an
assistant program manager at Westinghouse, where it was his
responsibility to check and ensure that the accounting was being
done correctly.
- 15 -
became associated with Armstrong, Gilmour & Associates
(Armstrong) and prepared petitioner’s 1994 tax return.
Petitioner’s 1995 tax return was prepared by Jill Toibin, C.P.A.
(Ms. Toibin), who was Mr. Bradac’s manager at Armstrong.
Books and Records
Burton supervised petitioner’s general bookkeeping, accounts
receivable, accounts payable, sales, and purchases. Petitioner
kept sales, invoice, and check registers. The sales, invoice,
and check registers were not provided to Mr. Bradac or Ms. Toibin
for the preparation of petitioner’s 1988 through 1995 tax
returns. Instead, Burton prepared summary/data sheets from the
information in the registers and provided the summary/data sheets
to the return preparer.
Burton understood income taxes, and he frequently asked
petitioner’s accountants tax questions or discussed tax planning
or tax return preparation. Burton responded to any questions the
return preparers had about any of the entries on the summary/data
sheets. However, Burton’s responses generally did not include
providing the return preparers with any of the underlying
documentation used in preparing the summary/data sheets.
Filing the Tax Returns
Most of petitioner’s tax returns for the years at issue were
not timely prepared or filed. The dates on which Burton first
provided the summary/data sheets to petitioner’s return preparers
- 16 -
and the dates on which petitioner’s returns were filed are as
follows:
Summary Provided
Year to Preparer Return Filed
1988 7/94 8/1/94
1989 8/1/94 8/8/94
1990 8/27/94 11/20/94
1991 1/26/95 7/16/95
1992 2/9/95 7/16/95
1993 9/13/94 9/18/94
1994 9/15/95 9/15/95
1995 9/4/96 9/16/96
Respondent’s Initial Examination
Respondent sent to petitioner a letter dated June 9, 1991,
inquiring as to petitioner’s unfiled 1988 tax return. On August
23, 1995, respondent’s revenue agent contacted petitioner’s
president, Burton, by telephone regarding petitioner’s 1993 tax
return. On January 8, 1996, petitioner’s case was assigned to
respondent’s revenue agent Theresa Martin (Revenue Agent Martin).
The initial appointment was rescheduled several times.
On May 8, 1996, Revenue Agent Martin met with Burton and Mr.
Bradac at Mr. Bradac’s office and reviewed information and
documents. At this meeting Revenue Agent Martin was provided
schedules of expenses for 1993 and copies of invoices for
“royalties”, “research and development”, and “engineering
services”. The examination was subsequently expanded to include
the other years at issue. During the examination petitioner did
not provide respondent with copies of its invoice or check
- 17 -
registers for 1988 through 1995. Petitioner first provided the
invoice and check registers for 1988 through 1995 to respondent
in February and March 2008.
During the examination Revenue Agent Martin requested the
corporate minutes and was told that there were no corporate
minutes. At trial petitioner offered into evidence documents
which petitioner’s president testified were contemporaneously
kept corporate minutes.
Gross Receipts
Respondent conducted a bank deposits analysis to determine
whether petitioner correctly reported its gross receipts. The
parties agree to the bank deposits analysis, except for the
inclusion of a $94,401 deposit on March 27, 1992, into
petitioner’s Merrill Lynch account #XXX-X7888. For tax years
1989, 1991, 1993, and 1994 petitioner understated its gross
receipts by $318,507, $459,833, $52,606, and $1,559,
respectively. Petitioner also understated its gross receipts by
at least $51,017 in 1992. Petitioner overstated its gross
receipts or sales by $22,270, $173,872, and $58,507 in 1988,
1990, and 1995, respectively. Thus, for the 8 consecutive years
at issue in this case, petitioner understated its gross receipts
or sales by at least $628,873 ($883,522 in understatements less
$254,649 in overstatements). Gross receipts reported on
- 18 -
petitioner’s tax returns were based on the summary/data sheets
prepared by Burton and given to the return preparers.
Rent
During the years at issue NPI owned the Lowell plant and
property at 900-960-962-964 Stanford Avenue, Oakland, California
(the Stanford plant). Petitioner deducted the rent payments it
made to NPI for both the Lowell plant and the Stanford plant on
its tax returns as follows: $91,308 in 1988; $91,308 in 1989;
$127,308 in 1990; $127,308 in 1991; $146,400 in 1992; $171,086 in
1993; $168,360 in 1994; and $201,518 in 1995. Petitioner
conducted its foam metal and manufacturing operations from the
Stanford plant before and after July 1, 1987. For years 1988 and
1989, petitioner paid $5,159 per month to NPI for the use of the
Stanford plant. The monthly rent expense remained unchanged
until August 15, 1990, when petitioner paid $26,159 to NPI. For
the remaining 4 months of 1990, petitioner made rent payments of
$8,159, $8,159, $14,159, and $8,159, respectively. In 1993 and
1994 petitioner paid to NPI $9,380 and $10,787 per month,
respectively. Petitioner made 1 monthly payment of $10,787 and
11 monthly payments of $12,405 to NPI for tax year 1995.
The 1989 unbundling agreement provided that the Stanford
plant would be leased for a term of 8 years at “$5,000 (or $5,500
per month)”. The maximum monthly lease amount listed in the
unbundling agreement reflected the product of an arm’s-length
- 19 -
negotiation. The rent petitioner paid for the Stanford plant in
excess of $5,500 per month was a constructive dividend to Burton
that petitioner was not entitled to deduct.
The Lowell plant was used by Glendon and Aker. In the
unbundling agreement Glendon and Burton agreed to enter into an
8-year lease with respect to the Lowell plant, which was to
provide that Glendon would pay $2,000 per month to NPI. In 1988
a confirming commercial lease was prepared but not executed.
This lease agreement was for a term of 8 years to commence in
March 1988 and provided that Aker pay rent of $2,000 per month.
During the years at issue neither Glendon nor Aker paid rent to
NPI for the use of the Lowell plant. Instead, petitioner paid
rent to NPI on behalf of Glendon/Aker.
Petitioner had no contractual obligation to pay rent to NPI
for Glendon’s/Aker’s use of the Lowell plant. It was Aker’s
responsibility to pay NPI for the use of the Lowell plant, which
Glendon ultimately paid by virtue of the final arbitration
decision. The rent petitioner paid to NPI was a constructive
dividend to Burton that petitioner was not entitled to deduct.
Legal and Professional Fees
During the years at issue petitioner deducted legal and
professional fees that were properly disallowed as deductions.
Among these deductions was a $96,749 legal fee paid to
Michael B. Carroll (Mr. Carroll) for advice and services as an
- 20 -
advocate for Burton concerning ownership and control of
petitioner and NPI. Mr. Carroll’s representation involved a
personal and noncorporate matter between Glendon and Burton. On
May 19, 1989, petitioner issued a $96,749 check to Burton, and
Burton deposited the check. On or about May 23, 1989, Burton
purchased a $97,467.21 cashier’s check made payable to Mr.
Carroll. On its 1989 tax return, petitioner claimed a $96,749
deduction for legal fees paid to Mr. Carroll. Burton also
claimed the $96,749 as a deduction in computing his 1989 Federal
income tax liability. The $96,749 petitioner paid was a
constructive dividend to Burton that petitioner was not entitled
to deduct.
Royalties and Engineering Services
During the years 1988, 1993, and 1994 petitioner transferred
significant amounts of money to NPI as follows:
Date Transferred Amount
12/30/88 $180,000
4/15/93 750,000
4/15/93 190,000
4/20/93 2,060,000
12/30/93 600,000
4/15/94 129,414
6/17/94 30,649
Total 3,940,063
Burton’s goal was to limit petitioner’s reported profits.
The plan to achieve this goal was put in place in 1993 and Burton
caused petitioner to transfer most of the money in 1993.
- 21 -
Burton’s goal was to have petitioner show a paper profit of
approximately $75,000 per year.
On its 1989 through 1995 tax returns, petitioner claimed
deductions for royalties expense and engineering services as
follows:
Year Amount Classification
1
1989 $252,679 Royalty expense
1990 193,508 Royalty expense
1991 1,764,049 Royalty expense
1992 907,443 Royalty expense
1993 220,000 Royalty expense
1994 160,063 Royalty expense
1995 260,160 Royalty expense
1995 108,714 Engineering services
Total 3,866,616
1
In the notice of deficiency for 1989, respondent
disallowed $248,098 of the claimed $252,679 as a
royalty expense. As previously noted the parties now
agree to respondent’s adjustment.
Since most of petitioner’s payments to NPI were made after
the claimed royalties were supposedly earned the deductions on
petitioner’s tax returns have little, if any, correlation to when
the funds were transferred to NPI.
The royalty deductions were based on a purported licensing
agreement between petitioner and NPI. The purported licensing
agreement to pay royalties to NPI was merely a tax planning tool,
completely lacking in economic substance. Burton, however, told
Mr. Bradac that the purported licensing agreement was legally
enforceable.
- 22 -
During the years at issue there was no written agreement
between petitioner and NPI relating to engineering, design, or
management services, and NPI did not perform any engineering work
for petitioner or provide any services to petitioner. NPI did
not treat anyone as an employee, did not issue any Forms 1099,
and did not file any Forms 941, Employer’s Quarterly Federal Tax
Return. The label “engineering services” was created to achieve
Burton’s goal of having petitioner show profits of approximately
$75,000.
At a May 8, 1996, meeting, petitioner provided Revenue Agent
Martin with royalty invoices and engineering services invoices in
support of its claim that during 1993 it paid $224,023 to NPI as
royalties and $220,000 as engineering services. These invoices
were on NPI letterhead, addressed to petitioner, showed amount
“due”, and were dated and stamped as “RECEIVED” in 1993. The NPI
letterhead shows NPI’s address in Minneapolis, Minnesota. Burton
created and backdated these royalty and engineering services
invoices shortly before the May 8, 1996, meeting. Burton did not
inform Revenue Agent Martin that he created the royalty and
engineering invoices in preparation for his meeting with her.
Mr. Bradac first saw the royalty and engineering services
invoices on May 8, 1996, shortly before they were provided to
Revenue Agent Martin. Burton did not inform Mr. Bradac that he
- 23 -
had just created the invoices for the meeting with Revenue Agent
Martin.
In February 1998 Burton told respondent’s agents that he
always computed the royalties each month and he always made the
invoice each month for royalties and then gave it to his
secretary. However, the only year for which petitioner provided
the examining agent invoices for royalties or engineering
services was 1993. In late 1999 or early 2000 Burton finally
acknowledged to respondent’s agents that the NPI invoices that he
had provided were created in 1996 and backdated to 1993.
The purported royalty and engineering services payments that
petitioner transferred to NPI were used for Burton’s and his
family’s economic benefit and constituted constructive dividends
to Burton in the year of transfer. Petitioner was not entitled
to any of the claimed deductions for royalty and engineering
services purportedly provided by NPI.
Payments to Cox Construction and to Kent Greene
In 1992 Burton and Cox Construction entered into a contract
to remodel a recreation room in Burton’s residence. The contract
provided, inter alia, that “Mr. Benson may furnish a maintenance
man from his plant to help with the framing.” Burton provided
petitioner’s maintenance man, Kent Greene (Mr. Greene), to assist
in the remodel of his residence. On its 1992 tax return
petitioner improperly deducted a $15,280 “repair and maintenance
- 24 -
expense” that it paid to Cox Construction. On its 1992 and 1993
tax returns petitioner improperly deducted salaries and labor
expenses of $7,634 and $7,032, respectively, which it paid to Mr.
Greene.
Employee Education Expense
On its 1993 and 1994 tax returns, petitioner improperly
deducted employee education expenses of $2,599 and $7,269,
respectively, for payments made to Oregon State University,
Corvallis, Oregon (OSU). On its 1995 tax return, petitioner
deducted employee education expenses of $13,334. Petitioner’s
1995 ledger reflects payments made as follows:
Date Paid Check Payee Amount
1/9/95 25588 OSU $3,129
3/25/95 25840 Linn-Benton College 128
Albany, Oregon
4/24/95 25886 OSU 200
4/25/95 25921 OSU 2,812
10/1/95 26345 OSU 3,422
10/4/95 26349 OSU 3,397
Subtotal 13,088
Burt Hutchinson 73
Drexel University 135
Don Holleran 38
1
Total 13,334
1
Of the amount claimed in 1995, respondent allowed
$246 of employee education expense for the payments to
Burt Hutchinson, Drexel University, and Don Holleran.
The payments made to OSU were for college tuition, fees, and
books for Burton’s son Eric during 1993, 1994, and for Burton’s
sons Eric and Mark in 1995.
- 25 -
Petitioner produced letters dated June 12, 1993, and June
12, 1995, indicating that Eric and Mark, respectively, were
selected from a vast field of applicants for the “ERG Management
Training Program”; however, neither Eric nor Mark was selected
from a “vast field” of applicants for the scholarship. In fact,
petitioner’s awarding of “scholarships” coincided with Burton’s
three sons’ turning 18 or 19 years old and starting college.
Neither Eric nor Mark received a salary from petitioner before
receiving the purported scholarship from petitioner.
Automobile and Truck Deductions
During the years at issue petitioner improperly deducted
automobile and truck expenses, including Department of Motor
Vehicle fees, insurance, gasoline, and repairs for automobiles
used by Burton’s family (the Bensons). The Bensons were
authorized signators on a First Interstate checking account,
which was used exclusively to pay for gasoline purchases through
Interlink bank debit card(s) linked to that account. Petitioner
paid and deducted $1,853 in 1990, $3,327.85 in 1991, $3,995.08 in
1992, $4,194.09 in 1993, $4,383.16 in 1994, and $3,875.32 in 1995
for gasoline purchases. On its respective 1990 and 1993 tax
returns, petitioner improperly deducted the purchase of a $15,000
Jeep for Eric, and a $13,500 Ford Bronco for Mark.
Burton provided Mr. Bradac with the amounts of petitioner’s
automobile expenses for 1988 through 1993. When Mr. Bradac
- 26 -
questioned Burton as to how the automobile expenses were
calculated and what they represented, Burton responded: “LEAVE
AS IS.” When Mr. Bradac prepared petitioner’s 1988 through 1993
tax returns, he did not know that petitioner had purchased the
vehicles for Eric and Mark.
Director’s Fees
During 1988 through 1995 petitioner improperly deducted
payments it made to Elizabeth, Esther, Eric, and Mark as
director’s fees. Petitioner did not file a Form 1099 (or other
information return) with respondent reporting that it paid
director’s fees to Elizabeth, Esther, Eric, or Mark. During the
years at issue, petitioner made the following payments, which it
deducted as director’s fees:
Individual 1988 1989 1990 1991 1992 1993 1994 1995
Elizabeth -0- $3,000 $12,000 $12,000 $12,000 $12,000 $12,000 $16,260
Esther -0- 3,000 12,000 12,000 12,000 12,000 9,000 --
Eric -- -- -- -- 6,000 12,000 12,000 12,000
Mark -- -- -- -- -- -- 5,000 12,000
Petitioner concedes that it is not entitled to deduct the
director’s fees claimed on its 1988 through 1995 tax returns.
This is another instance where Burton had petitioner pay and
improperly deduct personal expenditures.
Life Insurance
In 1969 Burton applied for a $100,000 life insurance policy
with Massachusetts Mutual Life Insurance Co. (MassMutual).
MassMutual issued policy number XXX6416 to Burton, the insured
- 27 -
and owner of the policy, and during the years at issue his wife
Elizabeth was the primary beneficiary. For each of the years at
issue, petitioner paid and claimed a deduction for payments made
to MassMutual for a policy on Burton’s life. In a memorandum
sent to Burton, dated September 14, 1995, Mr. Bradac asked:
“What is included in insurance. Life insurance is not
deductible.” In a handwritten note Burton responded that there
was “NO LIFE”.
In May 1996 Revenue Agent Martin asked Burton who the
beneficiary of the life insurance policy was. On October 7,
1996, petitioner’s representative provided Revenue Agent Martin
with a letter dated October 2, 1996, on petitioner’s letterhead
addressed to MassMutual, which indicated that in a telephone
conversation between Burton and a customer service representative
it had been confirmed that petitioner was the beneficiary of the
life insurance policy. On December 16, 1996, respondent’s
examining agent was given a letter dated December 2, 1996, from
MassMutual indicating that petitioner was the current beneficiary
of the life insurance policy; the letter did not indicate who the
beneficiary was during the years at issue. On February 18, 1997,
Revenue Agent Martin issued a summons to MassMutual and on March
11, 1997, MassMutual produced numerous documents including a copy
of a “Change of Beneficiary with Proceeds Paid in One Sum” dated
October 25, 1996, wherein Burton had changed the beneficiary of
- 28 -
the life insurance policy to petitioner effective November 1,
1996. During the examination process, neither Burton nor any
other of petitioner’s representatives disclosed to respondent’s
agents that petitioner was not the primary beneficiary of the
MassMutual life insurance policy during the years at issue.
1994 Travel Expenses
Burton’s mother Esther passed away September 3, 1994, and
funeral services were held in Minnesota. On or about October 4,
1994, petitioner paid $833.06 for travel expenses incurred on
behalf of Pastor Leroy M. Nelson, Burton’s cousin. Pastor Nelson
presided over Esther’s funeral services.
During 1994 Eric attended college at OSU, in Corvallis,
Oregon. On or about February 9, 1994, Burton signed a travel
expense report indicating that he spent $286.95 on behalf of
petitioner for travel to Corvallis, Oregon. In 1994 charges were
made to a credit card issued for petitioner’s BankAmericard
account as follows:
Date Description Amount
2/5/94 Grand Manor Inn #35 $223.82
Corvallis, OR
2/3-6/94 Hertz/fuel/parking 105.70
5/10/94 Hertz Rent-A-Car, 91.61
St. Paul, MN
5/10/94 Radisson Hotels, 227.32
Minneapolis, MN
5/13/94 Ramada Inns 342.17
Falls Church, VA
5/13/94 Hertz Rent-A-Car 137.46
Washington, D.C.
- 29 -
9/10/94 Lowell Inn 1,542.79
Lake Elmo, MN
9/11/94 Super America 4454 9.23
Bloomington, MN
9/11/94 Hertz Rent-A-Car 89.90
St. Paul, MN
Total 2,770.00
On its 1994 tax return, petitioner improperly claimed
deductions for these travel expenses, which petitioner now agrees
are not deductible.
Property Taxes
In June 1990 petitioner purchased real property in Orinda,
California (Orinda property), for $335,000.13 Title to the
Orinda property was put in the name of “Burton O. Benson,
Trustee” of petitioner’s retirement trust. Petitioner’s
retirement trust neither paid for the purchase nor reflected the
Orinda property as an asset on any tax return or financial
statement.
Petitioner’s purchase of the Orinda property occurred at
approximately the same time that Burton and Elizabeth purchased
a vacant lot between their home and the Orinda property. With
petitioner’s purchase of the Orinda property, Burton and
Elizabeth had effectively acquired a large, uninterrupted piece
of land behind and abutting their residence. On October 28,
1997, Burton, acting as trustee of petitioner’s retirement trust,
13
The price paid inclusive of fees and taxes was
$336,410.72.
- 30 -
deeded the Orinda property to Burton and Elizabeth, as husband
and wife. The deed shows no consideration for the transfer of
property and, in a handwritten note, describes the transfer as a
“Gift to spouse”.
Petitioner’s payment in 1990 for the acquisition of the
Orinda property and petitioner’s payment of property taxes on the
Orinda property were constructive dividends to Burton. On its
tax returns, petitioner improperly deducted property taxes paid
on the Orinda property as follows: $4,363 in 1991; $3,796 in
1992; $3,879 in 1993; $8,196 in 1994; and $2,075 in 1995.
Research and Development Expenses and Credits
On or about March 9, 1989, petitioner opened Money Fund
account No. XXXXXXX9082 with Franklin Funds under the name of
“R & D Division, ERG Inc.” and used petitioner’s tax
identification number, 94-XXXX686. From 1989 through 1995 Burton
was the only person who had signature authorization over the
account.
From March 1989 through January 1995 Burton wrote checks
made payable to “R & D Division, ERG, Inc.”; “Aker Industries,
Inc.–-R & D Division”; “Aker Industries R & D Division”; or
“R & D Division, Aker Industries, Inc.” These checks were
written on petitioner’s Bank of America account, and deposited
into petitioner’s Franklin Funds “R & D Division, ERG Inc.”
account. Burton handwrote the endorsement “Aker Industries” on
- 31 -
the back of each check made payable to Aker Industries which was
deposited into the Franklin “R & D Division ERC Inc.” account.
Between 1989 and 1995 over $700,000 was accumulated in the
Franklin Funds “R & D Division, ERG Inc.” account in the above
described manner.
During the years at issue neither Aker nor Glendon provided
any research and development services for petitioner and did not
issue invoices to petitioner. Glendon had no knowledge of the
Franklin Funds account.
On its tax returns for 1988 through 1994, petitioner
improperly deducted research and development expenses of $24,601
in 1988; $102,222 in 1989; $132,687 in 1990; $169,137 in 1991;
136,045 in 1992; 118,989 in 1993; and $106,694 in 1994.
Petitioner also deposited a $3,865 check made payable to “R & D
Division, Aker Industries Inc.” into the Franklin Funds “R & D
Division, ERG Inc.” account and improperly claimed a deduction
for it as part of a supplies expense on its 1995 tax return.
In a confirmation letter dated July 11, 1995, sent to Burton
regarding the preparation of petitioner’s 1988 through 1993 tax
returns, Mr. Bradac wrote, in pertinent part:
Research and Development expenses: The research and
development expense shown on your summary is for
qualified research costs. Qualified research is
limited to scientific experimentation or engineering
activities designed to aid in the development of a new
or improved product, process, technique, formula,
invention or computer software program held for sale,
- 32 -
lease, or license, or used by you in a trade or
business. All research was conducted in the state of
California.
Mr. Bradac was not aware of the fact that neither Aker nor
Glendon had provided any services to petitioner and was unaware
of petitioner’s Franklin Funds “R & D Division ERG Inc.” account
until after the examination of petitioner’s 1993 tax year had
begun.
At the May 8, 1996, meeting with Revenue Agent Martin,
Burton provided her with research and development invoices for
tax year 1993. These research and development invoices are on
Aker letterhead and were provided to agent Martin to support that
the research and development deductions claimed on petitioner’s
1993 tax return were for expenses paid to Aker. The research and
development invoices are dated and stamped as “RECEIVED” by
petitioner in 1993. Burton created these research and
development invoices shortly before the May 8, 1996, meeting to
substantiate the improper deductions. Mr. Bradac saw the
fabricated research and development invoices for the first time
approximately 5 minutes before the initial meeting with Revenue
Agent Martin on May 8, 1996.
Petitioner also improperly claimed research and development
credits as follows: $5,515 in 1989, $5,693 in 1990, $7,256 in
1991, and $5,836 in 1992. While preparing petitioner’s tax
returns, Mr. Bradac informed Burton of the requirements to
- 33 -
qualify for the research and development credit. Nevertheless,
Burton told Mr. Bradac that petitioner’s purported research and
development payments qualified for the research and development
credit. On August 2 and November 11, 1994, Burton sent (via
facsimile) memorandums to Mr. Bradac to inform him not to forget
the research and development tax credit.
Concealed Bank Accounts/Checks
In an information document request (IDR) dated August 23,
1995, respondent requested “Bank statements, reconciliations and
cancelled checks for all corporate accounts for the period
beginning December 1, 1992 and ending January 31, 1994.” On May
8, 1996, petitioner provided bank statements and canceled checks
for petitioner’s accounts at Bank of America and Merrill Lynch
but did not disclose or provide statements for its accounts with
Franklin Funds.
In an IDR dated August 19, 1996, respondent requested “Bank
statements, reconciliations and cancelled checks for all
corporate accounts for the period beginning January 1994 and
ending January 1995.” On October 7, 1996, petitioner provided
bank statements and most canceled checks for petitioner’s
accounts at Bank of America and Merrill Lynch but did not
disclose or provide statements for its accounts with Franklin
Funds.
- 34 -
In an IDR dated October 10, 1996, respondent requested 18
missing checks as follows: “Cancelled checks shown on bank
statements for Bank of America account XXX-X8267 but not included
with the statements on 10-07-96”. On December 16, 1996,
petitioner provided respondent with 12 checks made payable to
“R & D Division, Aker Industries, Inc.”
In December 1996 respondent requested bank statements and
canceled checks for the period 1988 through 1992. On January 29,
1997, petitioner provided statements and most canceled checks for
petitioner’s accounts at Bank of America and Merrill Lynch but
did not disclose or provide statements for its accounts with
Franklin Funds.
After comparing canceled checks to the Bank of America
statements, Revenue Agent Martin determined that 12 canceled
checks were missing for 1989. Respondent issued summonses to
Bank of America and to Merrill Lynch requesting petitioner’s bank
records for the years at issue. Bank of America and Merrill
Lynch complied with the summonses to the extent that records
existed. Bank of America provided copies of the 12 missing
checks for 1989. Eleven of the checks were made payable to Aker
and one $33,328 check was made payable to “cash”.
On February 6, 1997, respondent issued two summonses to
Franklin Funds. One summons was in the matter of “Energy
Research and Generation, Inc.”, and the other summons was in the
- 35 -
matter of “R & D Division E.R.G. Aker Industries, Inc. Trust”.
The Franklin Funds legal department received the summonses, and
they were forwarded to a loss prevention specialist who began
retrieving the documents. On February 19, 1997, Burton called
Franklin Funds and indicated that he thought the accounts did not
fall within the scope of the summons. On February 21, 1997,
Franklin Funds issued a “Certificate of No Records” which stated
that “no records exist pertaining to securities in the name of or
for the benefit of Energy Research and Generation, Inc. under tax
identification number 94-XXXX686.” On February 27, 1997,
respondent issued a summons to Franklin Funds requesting the
signature card for the account in which the checks made payable
to “R & D Division Aker Industries” had been deposited. On or
about March 10, 1997, Franklin Funds provided the account
application to respondent. The account application was signed by
Burton as president of petitioner and the tax identification
number on the account was petitioner’s.
On April 14, 1997, respondent issued additional summonses to
Franklin Funds, which, in turn, provided copies of account
statements and deposited items. When Revenue Agent Martin
received the Franklin Funds account information she learned for
the first time that the account--where the checks payable to
“R & D Division, Aker Industries” were deposited--was owned by
petitioner, was under petitioner’s tax identification number, and
- 36 -
Burton, as petitioner’s president, was the only individual with
signature authority over the account.
Revenue Agent Martin also learned for the first time that
petitioner maintained a second account with Franklin Funds, the
ERG-Recreation Fund. During the years at issue Burton was the
only person with signature authorization over the ERG-Recreation
Fund.
During the years at issue $87,102 was deposited into the
ERG-Recreation Fund account. Checks written on the ERG-
Recreation Fund account were often for the benefit of Burton and
his family and were constructive dividends to Burton.
OPINION
A. The Statute of Limitations
The parties agree that the periods for assessing tax for the
years at issue have expired unless petitioner’s returns were
fraudulent. Generally, the Commissioner must assess any tax
within 3 years after a return is filed. See sec. 6501(a). An
exception to the “3-year rule” is provided in section 6501(c).
Section 6501(c), in pertinent part, provides:
SEC. 6501(c). Exceptions.--
(1) 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.
- 37 -
Fraud is defined as an intentional wrongdoing on the part of
the taxpayer designed to evade tax believed to be owing. Neely
v. Commissioner, 116 T.C. 79, 86 (2001) (citing Edelson v.
Commissioner, 829 F.2d 828, 833 (9th Cir. 1987), affg. T.C. Memo.
1986-223, and McGee v. Commissioner, 61 T.C. 249, 256 (1973),
affd. 519 F.2d 1121 (5th Cir. 1975)). 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
Cir. 1992).
A corporation acts through its officers, and corporate fraud
necessarily depends upon the fraudulent intent of a corporate
officer. DiLeo v. Commissioner, supra at 875 (citing Auerbach
Shoe Co. v. Commissioner, 216 F.2d 693 (1st Cir. 1954), affg. 21
T.C. 191 (1953), Currier v. United States, 166 F.2d 346 (1st Cir.
1948), and Federbush v. Commissioner, 34 T.C. 740, 749 (1960),
affd. 325 F.2d 1 (2d Cir. 1963)).
Respondent bears the burden of proving fraud by clear and
convincing evidence. See sec. 7454(a); Rule 142(b); DiLeo v.
Commissioner, supra at 873. Respondent must establish both that
(1) petitioner has underpaid its taxes for each year; and (2)
some part of the underpayment is due to fraud. DiLeo v.
Commissioner, supra at 873 (citing Hebrank v. Commissioner, 81
T.C. 640, 642 (1983)).
- 38 -
The undisputed facts show that petitioner substantially
underpaid its taxes for each of the years at issue, and we find
that respondent has met his burden of proof with respect to the
first prong of the fraud test. We must now decide whether
petitioner filed its tax returns with the specific willful intent
to evade taxes.
Any conduct, the likely effect of which would be to mislead,
conceal, or otherwise prevent the collection of taxes may
establish an affirmative act of evasion. See DiLeo v.
Commissioner, supra at 874; see also Spies v. United States, 317
U.S. 492, 499 (1943). The taxpayer’s entire course of conduct
can be indicative of fraud. DiLeo v. Commissioner, supra at 874.
Because fraudulent intent is rarely established by direct
evidence, fraud may be inferred from various kinds of
circumstantial evidence. Bradford v. Commissioner, 796 F.2d 303,
307 (9th Cir. 1986), affg. T.C. Memo. 1984-601. Circumstantial
evidence tending to indicate that an underpayment of tax is due
to fraud has often been referred to as “indicia of fraud” and
generally includes: (1) Understatement of income; (2) inadequate
records; (3) failure to file tax returns; (4) implausible or
inconsistent explanations of behavior; (5) concealing assets; and
(6) failure to cooperate with tax authorities. Id. Although no
single factor is necessarily sufficient to establish fraud, the
existence of several of these indicia is persuasive
- 39 -
circumstantial evidence of fraud. Petzoldt v. Commissioner, 92
T.C. 661, 700 (1989).
1. Understatement of Income
The evidence clearly establishes that petitioner
substantially understated its taxable income in each of the years
at issue. The understatements of income are the result of both
understated gross receipts and overstated costs of goods sold and
expenses.
Gross receipts reported on petitioner’s tax returns were
based on summary/data sheets prepared by Burton and given to the
return preparers. The underlying corporate records were not
provided to the return preparers. In the light of respondent’s
bank deposits analysis, petitioner now concedes that its gross
receipts were understated in tax years 1989, 1991, 1992, 1993,
and 1994, with the exception of a $94,401 deposit in 1992. The
bank deposits method of reconstruction has long been sanctioned
by the courts. Clayton v. Commissioner, 102 T.C. 632, 645
(1994); Estate of Mason v. Commissioner, 64 T.C. 651, 657 (1975),
affd. 566 F.2d 2 (6th Cir. 1977). For the 8 years at issue
petitioner understated its gross receipts by at least $628,000.
Petitioner has offered no explanation for these understatements
of gross receipts.
The evidence also shows that petitioner claimed substantial
improper deductions in each of the years at issue. For the 8
- 40 -
years at issue petitioner has agreed to the disallowance of at
least $8.5 million in improperly deducted expenses. The most
egregious of the improper deductions were for the fabricated
research and development expenses and the fabricated royalty and
engineering services expenses paid to NPI.
The research and development expenses were allegedly paid to
Aker but were actually deposited into an undisclosed bank account
controlled by petitioner and its principal officer, who knew that
Aker never performed any research and development services for
petitioner during the years at issue. These phony research and
development deductions exceed $790,000 during the years at issue.
The fabricated royalty and engineering services expenses
were paid to NPI, which was a separate entity controlled by
Burton. The purported royalties and engineering services were
fabrications intended to reduce petitioner’s reported income to a
range that was acceptable to petitioner’s principal officer, who
was also the personal beneficiary of the payments to NPI. These
transfers and improper deductions were as follows:
Year Amount Transferred Amount Deducted
1989 $180,000 $248,098
1990 -- 193,508
1991 -- 1,764,049
1992 -- 907,443
1993 3,600,000 220,000
1994 160,063 160,063
1995 -- 368,874
Total 3,940,063 3,862,035
- 41 -
We will not repeat the previously stated facts regarding the
other improper deductions. Suffice it to say that we find that
they represent a pattern demonstrating a consistent and
deliberate attempt to understate petitioner’s correct tax
liabilities.
Consistent and substantial understatements of income over
several years are highly persuasive evidence of intent to defraud
the Government, particularly when combined with other indicia of
fraud. See Baisden v. Commissioner, T.C. Memo. 2008-215. To
this effect the Court of Appeals for the Ninth Circuit has
stated: “repeated understatements in successive years when
coupled with other circumstances showing an intent to conceal or
misstate taxable income present a basis on which the Tax Court
may properly infer fraud.” Furnish v. Commissioner, 262 F.2d
727, 728-729 (9th Cir. 1958), affg. in part and remanding in part
Funk v. Commissioner, 29 T.C. 279 (1957). Accordingly, we find
petitioner’s consistent understatements of income to be clear and
convincing evidence of an intent to evade tax known to be owing.
2. Inadequate Records/Failure To Provide the Tax Return
Preparers With Accurate Information
Petitioner’s records consisted of sales, invoice, and check
registers. However, petitioner did not provide these registers
to the return preparers for their use in the preparation of
petitioner’s tax returns. Rather, Burton instructed Mr. Bradac
and Ms. Toibin to use the summary/data sheets he had prepared.
- 42 -
The total sales amounts Burton provided for 1988 through 1993 do
not match the sales amounts recorded in petitioner’s sales
registers.
At the time petitioner’s 1988 through 1995 tax returns were
prepared, Mr. Bradac was unaware of the existence of the Franklin
Funds “R & D Division, ERG Inc.” account and that the alleged
research and development expenditures had been deposited into
that account. Burton intentionally misled the tax return
preparer by insisting that petitioner’s payments to Aker
qualified as research and development expenditures even though
Mr. Bradac had told him the requirements for research and
development deductions and credits.
Burton told the return preparer that the so-called royalty
payments to NPI were made pursuant to a legal obligation when in
fact the purported licensing agreement was nothing but a sham
whose purpose was to reduce petitioner’s taxable income. Burton
also told Mr. Bradac that petitioner’s insurance expenses did not
include life insurance when Mr. Bradac asked whether the
insurance expense included any life insurance. He also insisted
that Mr. Bradac “LEAVE AS IS” the automobile expenses on
petitioner’s 1990 and 1993 tax returns after Mr. Bradac had
inquired as to the substance of the expenses.
Burton’s failure to keep and provide adequate records and
his obfuscatory behavior--when questioned by Mr. Bradac regarding
- 43 -
claimed expenses--is evidence of petitioner’s intent to evade
taxes known to be owing by concealing corporate information and
records and failing to provide this information to its tax return
preparer. See Federbush v. Commissioner, 34 T.C. at 749-750.
3. Failure To File Tax Returns
Petitioner filed untimely tax returns for 1988, 1989, 1990,
1991, and 1992 indicating a disregard of its legal obligation to
pay tax.
4. Implausible or Inconsistent Explanations of Behavior
a. Royalty and Engineering Services Invoices
At the meeting with the Internal Revenue Service (IRS) on
May 8, 1996, Burton provided Revenue Agent Martin with recently
fabricated royalty and engineering services invoices to support
hundreds of thousands of dollars in alleged deductible expenses.
The invoices were written on NPI letterhead and were respectively
dated at the end of each calendar month in 1993. Burton had
actually created and backdated the invoices shortly before the
May 8, 1996, meeting but did not inform either Mr. Bradac or
Revenue Agent Martin that these invoices had just been created.
Burton’s conduct was deceptive with the specific purpose of
misleading respondent with respect to the legitimacy of the
alleged royalty and engineering services expenses.
- 44 -
b. Research and Development Invoices
At the May 8, 1996, meeting Burton also provided Revenue
Agent Martin with research and development invoices. The
research and development invoices were written on Aker’s
letterhead and were provided to Revenue Agent Martin as support
for the research and development deductions claimed on
petitioner’s 1993 tax return. Neither Aker nor Glendon had
performed any research and development for petitioner. Burton
had created and backdated the research and development invoices
shortly before the May 8, 1996, meeting. Again, Burton did not
disclose to Revenue Agent Martin that he had fabricated the
research and development invoices shortly before the meeting.
This was a deliberate attempt to mislead respondent.
5. Concealing Assets
During the examination of petitioner’s tax returns
respondent’s agents issued several IDRs, requesting that
petitioner provide records of all of its bank accounts. Although
petitioner provided information regarding accounts at Bank of
America and Merrill Lynch, no information was disclosed regarding
the Franklin Funds “R & D Division, ERG Inc.” account. When
Revenue Agent Martin expanded the examination to include tax year
1994, she discovered that copies of several of the Bank of
America canceled checks were missing. After inquiring further,
Revenue Agent Martin determined that most of the missing checks
- 45 -
were payable to Aker and deposited into the Franklin Funds “R & D
Division, ERG Inc.” account.
In order to acquire information regarding the ownership of
the Franklin Funds account, on February 6, 1997, respondent
issued two summonses to Franklin Funds. When Burton learned of
the summonses, he contacted Franklin Funds in an attempt to
persuade it that the summonses did not pertain to petitioner’s
accounts. As a result, Franklin Funds indicated to the IRS that
no records existed; but after issuing additional summonses to
Franklin Funds, Revenue Agent Martin was able to determine that
petitioner was the owner of the Franklin Funds “R & D Division,
ERG Inc.” account. Between 1988 and 1995 petitioner accumulated
more than $700,000 in the Franklin Funds “R & D Division, ERG
Inc.” account.
6. Failure To Cooperate With Tax Authorities
Petitioner consistently failed to provide complete and
accurate information to Revenue Agent Martin, and some of the
information was false with the intent to mislead her.
7. Conclusion
Respondent has clearly and convincingly established that
petitioner filed its 1988 through 1995 tax returns intending to
conceal, mislead, or otherwise prevent the collection of tax.
Accordingly, we hold that the requirements for the exception in
section 6501(c)(1) to the 3-year period of limitations are met
- 46 -
and, therefore, each of the years at issue is open for
assessment.
Before the trial in these cases petitioner moved for summary
judgment on the fraud issue on the basis of our finding in Benson
v. Commissioner, T.C. Memo. 2004-272 (Benson I), supplemented by
T.C. Memo. 2006-55, affd. 560 F.3d 1133 (9th Cir. 2009). In
Benson I we found that, even though there was evidence that could
be considered indicia of fraud, respondent had failed to carry
his burden of proving by clear and convincing evidence that
Burton’s individual returns were fraudulent with intent to evade
tax. In the instant proceedings we denied petitioner’s motion
for summary judgment on the obvious grounds that petitioner and
Burton are separate taxpayers and the issue of whether
petitioner’s tax returns were fraudulent was neither presented
nor decided in Benson I. And while the parties agree that some
of the fact findings in Benson I should be followed in the
instant case, a separate trial was held in petitioner’s case
wherein additional evidence was presented to prove that
petitioner’s returns were fraudulent. We also note that some of
the evidence of fraud regarding petitioner’s returns was excluded
from evidence in the Benson I trial pursuant to Burton’s
attorney’s objection.14
14
In Benson v. Commissioner, T.C. Memo. 2004-272 (Benson I),
we expressed some concern about whether the return preparers
(continued...)
- 47 -
B. Fraud Penalties
The determination of fraud for purposes of section
6501(c)(1) is the same as the determination of fraud for purposes
of the fraud penalty under section 6663. Neely v. Commissioner,
116 T.C. at 85; Rhone-Poulenc Surfactants & Specialties, L.P. v.
Commissioner, 114 T.C. 533, 548 (2000). Since we have already
found that petitioner filed a fraudulent return under section
6501(c) for each of the years at issue, it follows that
petitioner is also liable for the fraud penalty pursuant to
section 6653(b) for tax year 1988 and section 6663 for tax years
1989 through 1995.
Common to both the old section 6653(b) and the newer section
6663 is the provision that when the Commissioner has established
that any portion of the underpayment is due to fraud, the entire
14
(...continued)
might have shared responsibility for some of the inaccuracies
regarding the improper reporting of transactions between
petitioner and NPI, even though Burton was also responsible for
misrepresenting the true nature of those transactions. The
records in the instant cases contain additional evidence, not
presented in Benson I, regarding other similar inaccuracies and
misrepresentations for which Burton is solely responsible. For
example, the improper deductions for research and development
expenses that were allegedly paid to Aker, but were in fact
deposited into petitioner’s Franklin Funds account, were the
result of misrepresentations that Burton made to the return
preparers. He falsely told them that research and development
had been done and failed to disclose the existence of the
Franklin Funds account. And, as he did with respect to NPI
invoices, Burton also fabricated invoices from Aker in another
attempt to mislead respondent’s agent regarding the validity of
the research and development expenditures.
- 48 -
underpayment is treated as attributable to fraud except for any
portion that the taxpayer establishes is not due to fraud.
Petitioner bears the burden of showing by a preponderance of
the evidence what portion, if any, of the underpayment in each
year is not attributable to fraud. See sec. 6663(b). Petitioner
has failed to meet its burden.15
We hold that the entire underpayment for each of the years
at issue is subject to the fraud penalty. Accordingly, we
sustain respondent’s determinations regarding the fraud penalty
under section 6653(b) for 1988 and section 6663 for 1989 through
1995.
C. $100,000 Retirement Plan Expense
On December 22, 1989, a $100,000 check was written on
petitioner’s Merrill Lynch Ready Asset Trust account made payable
to “ERG-Retirement Trust”. The memo section of the check shows
“BBC [sic] Muir Terrace”. In the notice of deficiency for tax
year 1989, respondent allowed the $100,000 expense as a pension
plan deduction, even though petitioner did not claim a deduction
for it on its 1989 tax return.
15
On brief petitioner has not asserted that any specific
portion of the underpayment in each year was not attributable to
fraud; rather, petitioner’s argument was that no portion of any
underpayment was attributable to fraud because Burton lacked “the
specific intent” to evade income tax when he signed and filed
petitioner’s tax returns.
- 49 -
Respondent has not offered any convincing evidence to
contradict the position originally taken in the notice of
deficiency. Accordingly, we hold that petitioner is entitled to
deduct $100,000 as a pension plan payment on its 1989 tax return
under section 162.
D. $94,401 Understatement of Gross Receipts
Respondent reconstructed petitioner’s gross receipts using a
bank deposits analysis. The parties agree to the bank deposits
analysis, except for the inclusion of a $94,401 deposit into
petitioner’s Merrill Lynch account on March 27, 1992.
Muir Terrace was having financial problems which resulted in
a lawsuit’s being filed in Contra Costa Superior Court in 1989.
In March 1992 a settlement was effected and a $94,401 check was
paid to “Burton O. Benson, Tee, Research & Generation Ret.
Trust.” At trial Burton testified that the check was “a return
on another investment that the ERG retirement trust had * * *
made in something that was termed BBC (sic) Muir Terrace, which
was an investment of the ERG retirement trust.” Burton also
acknowledged that the $94,401 check was deposited into
petitioner’s general operating account rather than its retirement
trust. Petitioner asserts that knowledge of the mistaken deposit
was not discovered until pretrial preparation in spring 2008.
Petitioner, however, has not shown by any probative evidence that
the settlement funds were ever transferred into petitioner’s
- 50 -
retirement trust. In fact, the only testimony Burton provided
regarding whether the $94,401 had been transferred to
petitioner’s retirement trust was that he did not know whether it
had been transferred.
On brief respondent asserts that he believes the appropriate
adjustments are to allow the previously mentioned $100,000
deduction in 1989 and include the $94,401 in income in 1992. We
agree with respondent. Accordingly, we hold that petitioner must
include in its 1992 income the $94,401 it received and deposited
into its general operating bank account.
E. Section 6651 Additions to Tax
Respondent determined that petitioner was liable for an
addition to tax under section 6651(a)(1) for tax years 1989
through 1992.
Section 6651(a)(1) provides for an addition to tax when a
taxpayer fails to file a timely return. Section 6651(a)(1)
provides an exception to the addition to tax when the failure to
file a timely return “is due to reasonable cause and not due to
willful neglect”.
The parties agree that petitioner’s 1989, 1990, 1991, and
1992 tax returns were received by respondent on August 28, 1994,
November 20, 1994, July 16, 1995, and July 16, 1995,
respectively. On brief petitioner has not contested the addition
to tax under section 6651(a)(1) for any of the tax years 1989
- 51 -
through 1992. Consequently, we treat petitioner’s failure to
argue or address this issue on brief as a concession by
petitioner. See Rule 151(e)(4) and (5); Petzoldt v.
Commissioner, 92 T.C. at 683. Accordingly, we sustain
respondent’s determinations regarding the addition to tax under
section 6651(a)(1) for tax years 1989 through 1992.
We have considered all of petitioner’s contentions,
arguments, requests, and statements. To the extent not discussed
herein, we conclude that they are meritless, moot, or irrelevant.
To reflect the foregoing, and because of the numerous concessions
by the parties,
Decisions will be entered
under Rule 155.