# Hagen v. Commissioner

> United States Tax Court · August 31, 1989 · 57 T.C.M. 1489

URL: https://www.frixlaw.com/law-library/cases/4632067

## Case

- **Full name:** ED J. HAGEN AND MARTHA JO HAGEN v. COMMISSIONER OF INTERNAL REVENUE, Respondent HAGEN INVESTMENTS, INC. v. COMMISSIONER OF INTERNAL REVENUE
- **Court:** United States Tax Court
- **Decided:** August 31, 1989
- **Citations:** 57 T.C.M. 1489; 1989 T.C. Memo. 473; 1989 Tax Ct. Memo LEXIS 473
- **Precedential status:** Unpublished
- **Opinion:** Opinion
- **Cited by:** 0 later opinions in the Frix Law Library

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## Opinion text

ED J. HAGEN AND MARTHA JO HAGEN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent; HAGEN INVESTMENTS, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Hagen v. Commissioner
Docket Nos. 7700-76; 8342-76
United States Tax Court
T.C. Memo 1989-473 ; 1989 Tax Ct. Memo LEXIS 473 ; 57 T.C.M. (CCH) 1489 ; T.C.M. (RIA) 89473 ;
August 31, 1989
Ed J. and Martha Jo Hagen, pro se in docket No. 7700-76.
Ed J. Hagen (an officer), for the petitioner in docket No. 8342-76.
James D. Thomas and Leroy D. Boyer *483 , for the respondent.
DRENNEN
MEMORANDUM FINDINGS OF FACT AND OPINION
DRENNEN , Judge : These consolidated cases were assigned to Special Trial Judge Francis J. Cantrel pursuant to section 7443A(b)(4) and Rule 180 et seq. 1 We agree with and adopt his opinion which is set forth hereinbelow.
OPINION OF THE SPECIAL TRIAL JUDGE
CANTREL , Special Trial Judge : In his notice of deficiency dated June 30, 1976 respondent determined deficiencies in the Federal income tax of Ed J. Hagen and Martha Jo Hagen and additions to the tax for the taxable calendar years 1964 through 1966 and 1968 through 1971 as follows: 2 Ed J. Hagen and Martha Jo Hagen (docket No. 7700-76)
Additions to Tax, I.R.C. 1954
Years Income Tax Section 6653(a) Section 6653(b)
1964 $ 26,831.86 -0- $ 13,415.93
1965 51,907.66 -0- 25,953.83
1966 20,890.43 -0- 10,445.21
1968 37,081.98 $ 1,854.10 -0-
1969 88,261.30 4,413.07 -0-
1970 7,187.60 359.38 -0-
1971 5,531.34 276.57 -0-
*484
The issues for decision are: 3
1. Whether petitioners understated gross receipts from Hagen Investments, a broker-dealer of securities, on their Federal income tax returns (their "returns") for the taxable years 1964 and 1965 by $ 16,666.00 and $ 68,739.40, respectively, and overstated gross receipts on their Federal income tax return (their "return") for the taxable year 1966 by $ 205,729.09.
2. Whether petitioners understated income from interest, dividends and fees on their 1964, *485 1965 and 1966 returns by $ 11,513.32, $ 8,019.27, and $ 18,118.74, respectively.
3. Whether petitioners understated income from life insurance commissions on their 1965 and 1966 returns by $ 1,906.75 and $ 192.53, respectively.
4. Whether petitioners understated income realized from the partnership of Hagen, Ltd. on their 1964 and 1965 returns by $ 4,969.81 and $ 64,269.46, respectively.
5. Whether petitioners realized income of $ 13,422.35 during 1966 from payments made by Hagen Holding Corporation on their note to Hagen, Ltd.
6. Whether petitioners realized income of $ 5,007.88 and $ 5,879.85 from unidentified sources during 1965 and 1966, respectively.
7. Whether petitioners received income of $ 945.00 during 1965 from The Schallmo Foundation, Inc.
8. Whether petitioners realized unreported income of $ 2,284.00 during 1966 from life insurance premiums paid by Acker Industries, Inc. on a policy insuring Ed J. Hagen.
9. Whether petitioners overstated cost of goods sold on their 1964 and 1966 returns and understated cost of goods sold on their 1965 return in the amounts determined by respondent.
10. Whether petitioners overstated allowable depreciation expenses *486 on their 1964, 1965 and 1966 returns by $ 1,557.53, $ 1,609.77, and $ 2,008.54, respectively.
11. Whether petitioners overstated allowable automobile expenses on their 1964, 1965 and 1966 returns by $ 1,696.72, $ 707.90, and $ 284.28, respectively.
12. Whether petitioners understated commission expenses on their 1964, 1965 and 1966 returns by $ 1,443.24, $ 4,005.35, and $ 5,535.54, respectively.
13. Whether petitioners overstated business expenses other than depreciation, automobile, commission and cost of goods sold expenses on their 1964, 1965 and 1966 returns by $ 4,845.05, $ 3,407.58, and $ 14,419.42, respectively.
14. Whether respondent correctly determined that the net operating loss carryover of $ 6,999.25 claimed on petitioners' 1964 return is not allowable.
15. Whether petitioners are entitled to itemized medical expense deductions for the 1964, 1965 and 1966 taxable years.
16. Whether petitioners overstated their 1964 charitable contributions by $ 45.75 and understated their 1965 and 1966 contributions by $ 55.00 and $ 497.00, respectively.
17. Whether petitioners understated itemized tax expenses on their 1964, 1965 and 1966 returns.
18. Whether petitioners *487 overstated itemized interest expenses on their 1965 return by $ 214.76.
19. Whether respondent correctly determined that the $ 1,000.00 capital loss claimed on petitioners' 1964 return is not allowable.
20. Whether petitioners understated income from life insurance commissions on their 1968 return by $ 461.95 and overstated income from insurance commissions on their 1970 return by $ 413.32.
21. Whether petitioners realized income from unidentified sources in the amounts of $ 44,403.41, $ 20,578.29, and $ 6,678.41 for 1968, 1969 and 1970, respectively.
22. Whether petitioners realized income of $ 1,142.00, $ 1,530.00 and $ 1,552.00 in 1968, 1969 and 1970 from premium payments made by Acker Industries, Inc. on a policy insuring Ed J. Hagen's life.
23. Whether petitioners received distributions taxed as dividends as the result of expenditures made by Hagen Investments, Inc. for their personal benefit, and in what amounts.
24. Whether petitioners received distributions taxed as dividends during 1968, 1969, 1970 and 1971 as the result of expenditures made by Capitol Car Care, Inc. for their personal benefit, and in what amounts.
25. Whether petitioners understated interest *488 income on their 1969 and 1970 returns by $ 52.88 and $ 807.61, respectively.
26. Whether petitioners realized additional income of $ 94,500.00 in 1969 relating to the acquisition of equity in Alliance Corporation.
27. Whether respondent correctly determined that petitioners are entitled to deductions of $ 229.72 for office-at-home expenses for each of the taxable years 1968, 1969, 1970 and 1971.
28. Whether petitioners overstated itemized interest expenses on their 1968 return by $ 1,164.40 and understated interest expenses for 1969, 1970 and 1971 by $ 2,378.20, $ 1,285.74, and $ 2,269.45, respectively.
29. Whether petitioners are entitled to itemized medical expense deductions for the 1968 through 1971 taxable years.
30. Whether petitioners are entitled to capital losses in 1968 with respect to stock warrants of Great Northern Gas Utilities, Ltd. and Western Copper Mills, Ltd.
31. Whether petitioners' underpayments of income tax for 1964, 1965 and 1966 were due to fraud within the meaning of section 6653(b) .
32. Whether petitioners' underpayments of income tax for 1968, 1969, 1970 and 1971 were due to negligence or intentional disregard of rules and regulations *489 within the meaning of section 6653(a) .
In his notice of deficiency issued to Hagen Investments, Inc. on June 30, 1976 respondent determined deficiencies in its corporate income tax and additions to the tax for the taxable fiscal years ended September 30, 1967 through September 30, 1970 as follows: 4 Hagen Investments, Inc. (docket No. 8342-76)
Additions to Tax, I.R.C. 1954
5 Years Income Tax Section 6653(a)
1967 $ 276.21 -0-
1968 155,653.08 $ 7,937.85
1969 147,280.66 7,364.03
1970 1,944.39 97.22
The issues for decision are:
1. Whether the corporation understated gross profits from stock sales on its Federal corporate income tax returns for the *490 taxable years ended September 30, 1968, September 30, 1969 and September 30, 1970 by $ 191,768.95, $ 27,366.21 and $ 58,010.36, respectively. 6
2. Whether the corporation's mutual fund commission income for the 1968, 1969 and 1970 fiscal years was as stated on the corporate returns.
3. Whether the corporation overstated interest income by $ 543.75 on its corporate return for the 1968 fiscal year.
4. Whether the corporation received management fee income of $ 9,750.00 during the 1968 fiscal year rather than $ 9,000.00 as reported on its corporate return.
5. Whether the corporation understated miscellaneous income by $ 60,000.00 on its corporate return for the 1968 fiscal year.
6. Whether the corporation realized ordinary income of $ 263,830.65 from the sale of Financial Reserve, Inc. stock during the 1969 fiscal year which was not reported on its corporate return.
7. Whether the corporation is entitled to a deduction of $ 43,275.00 for the 1968 fiscal *491 year with respect to contributions made to the Hagen Employees Profit-Sharing and Retirement Trust (HEPRET).
8. Whether the corporation overstated auto and travel expenses by $ 727.82, $ 16,015.76, and $ 3,924.56 on its corporate returns for the 1968, 1969 and 1970 fiscal years, respectively.
9. Whether the corporation overstated dues and subscription expenses by $ 994.89, $ 667.95, $ 1,546.95, and $ 144.40 on its corporate returns for the 1968, 1969, 1970 and 1971 fiscal years, respectively.
10. Whether the corporation overstated interest expenses by $ 3,469.75, $ 2,968.43, $ 2,168.04, and $ 2,269.45 on its corporate returns for the 1968, 1969, 1970 and 1971 fiscal years, respectively.
11. Whether the corporation overstated insurance expenses by $ 2,034.47 and $ 856.00 on its corporate returns for the 1968 and 1971 fiscal years, respectively.
12. Whether the corporation overstated office supply expenses by $ 537.96 and $ 1,175.76 on its corporate returns for the 1969 and 1970 fiscal years, respectively.
13. Whether the corporation overstated repair and maintenance expenses by $ 6,600.99, $ 4,151.96, $ 739.16 and $ 277.27 on its corporate returns for the 1968, 1969, *492 1970 and 1971 fiscal years, respectively.
14. Whether the corporation overstated expenses for taxes by $ 700.76, $ 755.14, $ 710.00 and $ 714.58 on its corporate returns for the 1968, 1969, 1970 and 1971 fiscal years, respectively.
15. Whether the corporation overstated travel and entertainment expenses on its corporate returns for the 1968 and 1971 fiscal years by $ 1,830.08 and $ 3,570.79, respectively.
16. Whether the corporation overstated utility expenses by $ 1,572.83, $ 1,500.60, $ 1,293.01, and $ 997.74, on its corporate returns for the 1968, 1969, 1970 and 1971 fiscal years, respectively.
17. Whether the corporation overstated audit and legal expenses on its corporate return for the 1971 fiscal year by $ 15,180.73.
18. Whether the corporation is entitled to a deduction for the 1969 fiscal year for a $ 107.00 expense incurred for William C. "Bill" Hagen, son of petitioners.
19. Whether the corporation is entitled to a $ 59.97 deduction for miscellaneous expenses on its corporate return for the 1971 fiscal year.
20. Whether the corporation overstated depreciation expenses by $ 1,037.47, $ 1,540.88, $ 735.17, and $ 555.55 on its corporate returns for the *493 1968, 1969, 1970 and 1971 fiscal years, respectively.
21. Whether the corporation is entitled to net operating loss carryback deductions for the 1967 and 1968 fiscal years.
22. Whether the corporation understated income from the sale of property in the 1970 fiscal year by $ 8,868.64.
23. Whether the corporation is entitled to investment tax credits for the 1968 and 1969 fiscal years.
24. Whether the corporation's underpayments of income tax for the 1968, 1969 and 1970 fiscal years were due to negligence or intentional disregard of rules and regulations within the meaning of section 6653(a) .
FINDINGS OF FACT
Some of the facts and exhibits have been stipulated. The stipulation and exhibits are incorporated herein by reference.
I. Background Facts
Petitioner graduated from the Frankfurt School of Economics, Frankfurt, West Germany with a Master of Economics Degree. Thereafter, he obtained a Master of Business Administration Degree from Stanford University. 7
As of the beginning of 1964, petitioner was engaged in business as a registered broker-dealer in securities *494 under the Securities and Exchange Act of 1934. He operated as a sole proprietor under the name of Hagen Investments during the taxable years 1964 through 1966 and until approximately April 1, 1967, at which time Hagen Investments, Inc. succeeded Ed J. Hagen as the registered broker-dealer. 8
The day-to-day business of Hagen Investments and its successor, Hagen Investments, Inc., was trading in stocks and securities, although petitioner also sold life insurance. Most stocks traded or sold were low-priced, speculative, over-the-counter issues. Mutual funds were also sold. Stocks were primarily traded at the wholesale level, but also at the retail level; that is, they were sold to and purchased from other broker-dealers but also from retail, or "street" customers. Stocks purchased for resale were placed in a trading account. In addition, petitioner held stocks in his own investment account *495 from time to time. These were not traded in the ordinary course of business. Inventories, principally of stocks, were a material income-producing factor of Hagen Investments and Hagen Investments, Inc.
Petitioners were involved in other business enterprises which are relevant to these cases. The first is Hagen Holding Corporation, formed in 1963 to purchase and own controlling interests in other corporations. Petitioner was Hagen Holding Corporation's president from its formation on November 20, 1963 until March 31, 1969. 9 The second is Capitol Car Care, Inc., formed in 1964, which apparently operated a filling station. Petitioners were its majority shareholders at the time of its incorporation and through 1966. 10 The third was Hagen, Ltd., a limited partnership formed in 1964 with petitioner as its general partner. The business of the partnership was to engage in the ownership and operation of interests in land and in any manufacturing or mercantile business, and to manage property and assets relating to such pursuits.
*496 Bertha Schallmo ("Mrs. Schallmo") was a friend of petitioners and a customer of Hagen Investments and Hagen Investments, Inc. Mrs. Schallmo was an elderly woman of considerable means who relied on petitioners for investment advice and personal counsel during the years at issue. We mention her at this point because of her involvement in various aspects of these consolidated cases. Mrs. Schallmo was a stockholder in Hagen Holding Corporation in the early years of its existence, and, as a trustee of The Schallmo Foundation, Inc., was a limited partner in Hagen, Ltd.
Hagen Investments and its corporate successor were censored and fined by the National Association of Securities Dealers a number of times between 1964 and 1970 for violating various provisions of its Rules of Fair Practice. 11 The United States Securities and Exchange Commission revoked the registration of Hagen Investments, Inc. as a broker-dealer in 1970. 12 In 1971, petitioner was convicted under section 7201 in the United States District Court for the Western District of Oklahoma for willfully and knowingly attempting to evade and defeat his and Mrs. Hagen's Federal income tax for 1964 and 1965. 13
*497 For convenience and in the interest of clarity and completeness we further divide our Findings of Fact into three parts: the taxable years 1964 through 1966 relating to petitioners, including Hagen Investments in its capacity as a sole proprietorship; the taxable years 1967 through 1971 relating to petitioners in their individual capacity; and all years relating to Hagen Investments, Inc.
II. Ed J. Hagen and Martha Jo Hagen (docket No. 7700-76) Taxable Years 1964 through 1966 Petitioners resided at 5000 N.W. 31st Street, Oklahoma City, Oklahoma on the date they filed their petition. They timely filed joint Federal income tax returns for the taxable years 1964 through 1966 with the Internal Revenue Service. Respondent determined numerous adjustments in his notice of deficiency for these taxable years and they are as follows: Type of
14 Adjustment 1964 1965 1966
Gross Receipts from
15 Business $ 16,692.00 $ 68,739.80 $ (205,729.09)
Interest, Dividends
and Fees 11,591.88 8,019.27 18,118.74
Life Insurance
Commissions 1,906.75 192.53
Income from Hagen, Ltd. 5,545.81 64,269.46 13,422.35
Unidentified Income 5,007.88 5,879.85
Income from Schallmo
Foundation, Inc. 945.00
Additional Compensation 2,284.00
Cost of Goods Sold 18,120.16 (41,570.77) 231,780.21
Depreciation 1,557.53 1,609.77 2,008.54
Automobile Expenses 1,696.72 780.90 284.28
Commission Expenses (1,443.24) (4,005.35) (5,535.54)
Other Business Expenses 4,845.05 3,407.58 14,419.42
Net Operating Loss 6,999.25
Medical Expenses 139.42 92.00 888.22
Contributions 45.75 (55.00) (497.00)
Tax Expenses (165.00) (1,232.28) (623.59)
Interest Expenses 214.76
Capital Loss 1,000.00
$ 66,625.33 $ 108,129.77 $ 76,892.92
*498
Respondent considered the books and records of both petitioners and Hagen Investments incomplete and unreliable sources for determining the correct amounts of income and expense for these taxable years. He therefore determined petitioners' taxable income for 1964, 1965 and 1966 primarily by the bank deposits method. Using this method, he categorized deposits to and withdrawals from petitioners' numerous accounts, both business and non-business accounts. 16 He based his expense adjustments mostly on disbursements he categorized. In all, respondent categorized transactions relating to some 21 bank accounts controlled by petitioners during these 3 years. Certain of his deposit and disbursement categories isolate different types of receipts and expenditures of Hagen *499 Investments for transactions at both the wholesale and retail levels. Respondent also used other types of evidence to establish items of income and expense, making his overall method a hybrid bank deposits and specific items method.
The books and records of petitioners and Hagen Investments were not complete and in fact contained false entries. Therefore, they are not reliable sources of data to correctly *500 determine taxable income for 1964, 1965 and 1966. Accordingly, respondent's use of the bank deposits method was an appropriate method for arriving at taxable income for these years.
Facts relevant to the above types of adjustments are set forth in the following paragraphs.
A. Facts Relating to Income Adjustments
1. Gross Receipts from Hagen Investments
Petitioners reported the following business receipts on their 1964, 1965 and 1966 returns: Year Amount
1964 $ 156,703.90
1965 $ 910,593.00
1966 $ 3,441,725.51.
The gross receipts of Hagen Investments reported on Schedule C of petitioners' returns were taken from the books of account of the business. 17 Petitioners stated on their 1964 return that Hagen Investments kept its books on the cash method. Their 1965 and 1966 returns state that its books were kept on the accrual method.
*501 In 1964, gross receipts using the bank deposits method were from stock sales, commissions from sales of Atkinson Enterprises, Inc. stock and also mutual funds, stock dividends, unidentified income and income received from The Schallmo Foundation, Inc. 18 Receipts also include the value of stock received in trades. In 1965, gross receipts using the bank deposits method were from stock sales and commissions from sales of both mutual funds and Atkinson Enterprises, Inc. stock. Receipts in 1965 again include the value of stock received in trades. In 1966, gross receipts using the bank deposits method were from stock sales, commissions from sales of mutual funds and income from services rendered. No non-cash receipts are added to 1966 receipts derived from the bank deposits method.
*502 Petitioners understated gross receipts received by Hagen Investments for 1964 and 1965 and reportable on Schedule C of their returns. However, they overstated gross receipts on their 1966 return. Gross receipts of Hagen Investments for these years, gross receipts per petitioners' returns and the amounts by which gross receipts were either understated or overstated are: 1964 1965 1966
19 Gross Receipts 20 $ 173,369.90 21 $ 979,332.40 $ 3,235,996.41
Gross Receipts per
Return 156,703.90 910,593.00 3,441,725.50
Understatement
[Overstatement] 22 $ 16,666.00 23 $ 68,739.40 $ [205,729.09]
*503 We use 1964 gross receipts per return of $ 156,703.90 in our computation even though the business incorrectly utilized the cash method to arrive at that figure. In doing so we merely find that petitioners reported 1964 business receipts of $ 156,703.90. However, determined gross receipts are based on sales accruing in each of the 3 years. Use of the cash method in 1964 was improper because inventories were necessary. 24
2. Interest, Dividends and Fees
Petitioners reported the following amounts of interest, dividends and fees on their 1964 return: Source Amount
Commission Fees - Occidental Life $ 7,221.37
Rental Fees 400.00
Stock Dividends 859.73
Income from Services Rendered 5,900.00
Interest -0-
Total $ 14,381.10
No interest or dividend income was reported for the taxable years 1965 and 1966. 25
*504 Petitioner understated interest, dividends and fees for each of these 3 years. Correct interest, dividends and fees, the amounts reported and petitioners' understatements are: 1964 1965 1966
Interest, Dividends and
Fees $ 25,894.42 $ 8,019.27 $ 18,118.74
Interest, Dividends and
Fees per Return 14,381.10 -0- -0-
Understatement 26 $ 11,513.32 $ 8,019.27 $ 18,118.74
3. Life Insurance Commissions
As stated previously, petitioner also sold life insurance. Petitioners reported income from life insurance commissions in 1965 and 1966 in the following amounts: 27 Source 1965 1966
Occidental Life $ 5,540.00 $ 4,756.87
Standard Life 1,805.00 3,557.45
Totals $ 7,345.00 $ 8,314.32
Commissions on life insurance sales were paid *505 to petitioner by the various insurance carriers he represented after the sales were consummated and after the total premium payments were first remitted to the carriers.
Life insurance commissions received and reported by petitioners in 1965 and the amounts by which they were understated are: Commissions-1965
Occidental Life $ 7,285.35
Standard Life 1,966.40
$ 9,251.75
Commissions
per 1965 Return 7,345.00
28 Understatement $ 1,906.75
Life insurance commissions received and reported by petitioners in 1966 and the amounts by which they were understated are: Commissions-1966
Occidental Life $ 4,949.40
Standard Life 3,557.45
$ 8,506.85
Commissions
per 1966 Return 8,314.32
Understatement $ 192.53
4. Income from Hagen, Ltd.
On June 5, 1964 petitioners and Mrs. Schallmo formed Hagen, Ltd., a limited partnership, under the laws of the State of Oklahoma. Petitioner was its general partner and the only partner authorized by the terms of the Limited Partnership *506 Agreement ("the Agreement") to transact the business of the partnership. Mrs. Schallmo was described in the Agreement as participating in the partnership as a "trustee." 29 The ostensible purpose of the partnership was to engage in the ownership and operation of interests in land and other types of businesses and to manage property and assets relating to such pursuits. The partnership had only three partners -- petitioners and Mrs. Schallmo -- during the course of its 15-month existence.
The Agreement provided that net profits would be distributed and net losses borne by the general and limited partners on the basis of the partners' capital accounts at the end of the accounting period before adjusting the amounts to reflect current profits or losses of the partnership. The Agreement also provided that if a partner's account was reduced to zero or below, *507 profits would be distributed and net losses borne on the basis of the ratio of the partners' capital accounts at the end of the last accounting period prior to the reduction of the capital account to zero.
The proposed initial contributions to capital of Hagen, Ltd. are set forth on Exhibit A to the Agreement, as follows: Other
Cash 30 Property Total
Ed J. Hagen $ 2,000 $ 48,000 $ 50,000
Bertha Schallmo 2,000 48,000 50,000
Martha Jo Hagen 1,000 24,000 25,000
Total $ 5,000 $ 120,000 $ 125,000
The initial cash *508 contributions were made by the three partners. However, no deeds or other instruments of conveyance are included in the record to establish conclusively that any "other property" was ever conveyed, and Hagen Investments in fact continued throughout the life of the partnership to depreciate items of office furniture and equipment that Mrs. Hagen was to have contributed as her "other property." The partners also contributed additional cash to the partnership after their initial investments were made. The capital accounts of Hagen, Ltd. during its existence are summarized as follows: Hagen, Ltd.
Capital Accounts
June 5, 1964 to September 1, 1965
Ed J. Martha Jo Bertha
Hagen Hagen Schallmo
Initial Contributions $ 2,000.00 $ 1,000.00 $ 2,000.00
1964 Investments 146,000.00
92,000.00
81,107.78
Total 1964 Contributions 148,000.00 1,000.00 175,107.78
1964 Withdrawals (93,000.00)
(20,000.00) (10,000.00)
(102,000.00)
(94,000.00)
(40.00) (21.50)
Balance before Income
Allocation (67,040.00) (9,000.00) 81,086.28
1964 Allocation of
Income 3,313.20 1,656.61 3,313.20
Capital Accounts
12/31/64 (63,726.80) (7,343.29) 84,399.48
1965 Contributions 4,000.00 2,000.00
424.94 212.94
66,144.00
1,800.00
39,000.00
Total 1965 Contributions 6,842.14 (5,130.35) 125,199.48
1965 Withdrawals (3,056.80)
(4,000.00)
(13,334.23) (6,616.12)
(19,999.34) (10,000.66)
(9,500.00)
(44,000.00)
(4,550.00)
Balance before Income
Allocation (43,048.23) 32 (21,797.13) 76,649.48
1965 Allocation of
Income -0- -0- 416.63
$ (43,048.23) $ (21,797.13) $ 77,066.11
*509 Source of
Investment/
Recipient of
31 Withdrawal
Initial Contributions
1964 Investments Ed J. Hagen
Schallmo Foundation, Inc.
Bertha Schallmo
Total 1964 Contributions
1964 Withdrawals Ed J. Hagen
Ed J. or Martha Jo Hagen
Hagen Investments
Schallmo Foundation, Inc.
Mummer's Theatre (tickets)
Balance before Income
Allocation
1964 Allocation of
Income
Capital Accounts
12/31/64
1965 Contributions Ed J. and/or Martha Jo Hagen
Ed J. or Martha Jo Hagen
Ed J. Hagen
Bertha Schallmo
Schallmo Foundation, Inc.
Total 1965 Contributions
1965 Withdrawals Ed J. Hagen
Ed J. Hagen
Ed J. and/or Martha Jo Hagen
Ed J. and Martha Jo Hagen
Hagen Investments
Schallmo Foundation, Inc.
Bertha Schallmo
Balance before Income
Allocation
1965 Allocation of
Income
*510 a. 1964
As shown in the preceding schedule, all the partners withdrew cash from the partnership in 1964. The capital accounts of petitioner and Mrs. Hagen fell below zero in that year due to withdrawals in excess of contributions. Hagen, Ltd. had gross income of $ 10,177.91 and expenses of $ 1,894.90 in 1964. Its items of income were rental payments and farm income; expenses cannot be categorized as to type. Based on their capital accounts as of the end of 1964, respondent determined that petitioners realized $ 4,969.81 in partnership income, or 60 percent of the partnership's 1964 taxable income of $ 8,283.01. Respondent allocated 60 percent of the taxable income to petitioners because their combined initial investment of $ 3,000.00, was 60 percent of the total initial cash investment. 33 The balance was allocated to Mrs. Schallmo. No partnership income was reported by petitioners in that year.
b. 1965
By the close of the *511 1965 partnership year petitioner and Mrs. Hagen still had negative capital accounts. The partnership had taxable income of $ 416.63 in 1965 (the year of dissolution), and respondent allocated the entire amount to Mrs. Schallmo. Her personal assets were, as of August 11, 1965, under the management and control of a trustee, A. Francis Porta. 34 The partnership never filed any Federal partnership tax returns.
*512 Hagen, Ltd. was dissolved by agreement among the partners on September 1, 1965. 35 Petitioner and Mrs. Hagen never repaid the withdrawals in excess of their capital contributions and were not obligated to do so by the terms of the Agreement. By this time the Schallmo capital account balance was $ 77,066.11. As of that date petitioners had made cash contributions of $ 221,781.88 and withdrawals of $ 291,597.15 with respect to the partnership; Mrs. Schallmo and The Schallmo Foundation, Inc. had made cash contributions of $ 215,907.78 and withdrawals of $ 142,571.50. The partnership's bank account balance at dissolution was only $ 1,206.35.
Because of the excess withdrawals, petitioners realized $ 64,845.36 in 1965. Respondent's adjustment per his notice of deficiency was a lesser amount, $ 64,269.46. He failed to amend his answer to conform his pleadings to reflect the $ 64,845.36 in excess withdrawals per his proof, so we find that petitioners realized $ 64,269.46. None of that amount *513 was reported in 1965.
c. 1966
On December 24, 1964, Hagen Holding Corporation, by Ed J. Hagen, president, and Martha Jo Hagen, secretary, executed a note payable to Hagen, Ltd. for $ 12,500.00. 36 The note was to be repaid on June 24, 1966. It was subsequently assigned to petitioner. 37 He gave no consideration for the note, and nothing in the record shows that it may have been a gift. As president of Hagen Holding Corporation, petitioner paid himself $ 13,422.35 in satisfaction of the note on May 16, 1966. No part of this payment was reported on petitioners' 1966 return. 38
*514 5. Unidentified Income
Petitioners received income in 1965 and 1966 from unidentifiable sources and income that could not be categorized as set forth hereinbefore. The amounts received are: Year Amount
1965 $ 5,007.88
1966 $ 5,879.85
Most of the items of unidentified income were deposits of currency to petitioners' various bank accounts. 39 All income reported on petitioners' 1965 and 1966 returns is from sources identified either on the returns or in the books of Hagen Investments. We therefore find that none of the above amounts were reported on petitioners' 1965 and 1966 returns. 40
*515 6. Income from The Schallmo Foundation, Inc .
The Schallmo Foundation, Inc. ("The Foundation"), referred to earlier in conjunction with Hagen, Ltd., was an organization founded by Mrs. Schallmo for charitable pursuits. She contributed substantial sums of money to it in the early 1960's for the purpose of constructing a nursing home in Okeene, Oklahoma. When Schallmo Manor opened its doors in 1965, Mrs. Schallmo, petitioner and Mrs. Hagen were members of its board of directors.
The Foundation purchased a piano from Mrs. Hagen on January 13, 1965. Mrs. Hagen was then treasurer of the organization in addition to being a director, and she wrote herself a check for $ 945.00 in payment for the piano on that date. Mrs. Hagen's basis in the piano is not known. Petitioners failed to report the $ 945.00 received by Mrs. Hagen on their 1965 return.
By the time Mr. Porta was appointed trustee of the Bertha Schallmo Trust on August 11, 1965, the nursing home was being operated by The Foundation at a substantial financial loss, which had, in turn, become a serious and continuing drain on Mrs. Schallmo's personal resources. The board of directors therefore decided at the recommendation *516 of Mr. Porta to transfer Schallmo Manor to the Town of Okeene. The consideration for the transfer was assumption by the Town of Okeene of a $ 150,000.00 liability of The Foundation relating to the construction of the facility, and the release of The Foundation on the underlying obligation.
7. Additional Compensation from Acker Industries, Inc .
As early as December, 1964, petitioner had assumed control of Acker Industries, Inc., ("Acker") an Oklahoma corporation involved in the manufacture of metal products. Petitioner was chairman of the board and treasurer of Acker after its reorganization in 1964 as a Hagen Holding Corporation subsidiary. He was also president of Hagen Holding Corporation until March 31, 1969.
On November 9, 1965, Acker paid a semi-annual premium of $ 1,142.00 for the purchase of a preferred whole life insurance policy insuring the life of petitioner. The policy, Standard Life and Accident Insurance Company ("Standard Life") policy No. OL-92440, was sold by petitioner, and Mrs. Hagen was the original owner. The date of issue on the policy was October 21, 1965 and the amount of insurance purchased was $ 100,000.00.
Mrs. Hagen assigned the Standard *517 Life policy to Acker on the date of purchase. She continued as primary beneficiary. Acker paid additional semi-annual premiums to Standard Life on policy No. OL-92440 during 1966. In all, Acker made premium payments totalling $ 2,284.00 in 1966. The premiums paid by the corporation during 1966 were additional compensation to petitioner. 41 Petitioners did not include this amount on their 1966 return.
B. Facts Relating to Expense Adjustments
1. Cost of Goods Sold
Petitioners reported the following amounts of cost of goods sold for Hagen Investments on Schedule C of their 1964, 1965 and 1966 returns: Year 42 Cost of Goods Sold
1964 $ 129,669.26
1965 $ 890,464.00
1966 $ 3,400,862.26
*518 Respondent determined that these amounts were incorrect. He therefore reconstructed cost of goods sold for 1964 through 1966, based again on the bank deposits method. His overall system was to (a) adopt Hagen Investments' closing inventory figures for the 1963, 1964 and 1965 business years as the correct opening inventory figures for 1964, 1965 and 1966, respectively; (b) add to opening inventory the cost of inventory purchases in 1964, 1965 and 1966, derived from respondent's check classifications, to arrive at goods available for sale; and (c) subtract from goods available for sale Hagen Investments' own closing inventory figures for 1964, 1965 and 1966. 43 We have adopted respondent's method.
*519 In the interest of greater clarity, we treat separately each of the 3 years to which cost of goods sold adjustments have been made.
a. 1964
Hagen Investments' cost of goods sold for 1964 was: Opening Inventory $ 13,886.38
Add: Inventory Purchases
and Other Increases 122,910.56
$ 136,796.94
Less: Miscellaneous Decreases 7,402.59
Goods Available for Sale $ 129,394.35
Less: Closing Inventory 17,803.85
Cost of Goods Sold 44 $ 111,590.50
Cost of goods sold per Schedule C of petitioners' 1964 return was $ 129,669.26. They therefore overstated Hagen Investments' 1964 cost of goods sold as follows: Cost of Goods Sold Claimed $ 129,669.26
Cost of Goods Sold - 1964 111,590.50
Overstatement to 1964 Cost of
Goods Sold 45 $ 18,078.76
b. 1965
Hagen Investments' cost of goods sold for *520 1965 was: Opening Inventory $ 17,803.85
Add: Inventory Purchases
and Other Increases 983,835.87
$ 1,001,639.72
Less: Miscellaneous Decreases 8,957.10
Goods Available for Sale $ 992,682.62
Less: Closing Inventory 60,647.85
Cost of Goods Sold 46 $ 932,034.77
Cost of goods sold per Schedule C of petitioners' 1965 return was $ 890,464.00. They therefore understated Hagen Investments' 1965 cost of goods sold as follows: Cost of Goods Sold Claimed $ 890,464.00
Cost of Goods Sold - 1965 932,034.77
Understatement to 1965 Cost of
Goods Sold $ (41,570.77)
c. 1966
Hagen Investments' cost of goods sold for 1966 was: Opening Inventory $ 60,647.85
Add: Inventory Purchases
and Other Increases 3,359,866.96
$ 3,420,514.81
Less: Miscellaneous Decreases 152,491.54
Goods Available for Sale $ 3,268,023.27
Less: Closing Inventory 88,539.62
Cost of Goods Sold 47 $ 3,179,483.65
*521 Cost of goods sold per Schedule C of petitioners' 1966 return was $ 3,400,862.26. They therefore overstated Hagen Investments' 1966 cost of goods sold as follows: Cost of Goods Sold Claimed $ 3,400,862.26
Cost of Goods Sold - 1966 3,179,483.65
Overstatement to 1966 Cost of
Goods Sold 48 $ 221,378.61
2. Depreciation
Petitioners depreciated equipment, and furniture and fixtures used by Hagen Investments on their 1964, 1965 and 1966 returns. They overstated depreciation expenses for each of these years. Allowable depreciation expenses for the taxable years 1964 through 1966 and the amounts by which petitioners overstated them are: 1964 1965 1966
Depreciation Claimed $ 2,565.08 $ 2,438.00 $ 3,234.59
49 Depreciation Allowable 1,007.55 828.23 1,226.05
Overstatement $ 1,557.53 $ 1,609.77 $ 2,008.54
*522
3. Automobile Expenses
For the taxable years 1964 through 1966 the books of account of Hagen Investments recorded business-related mileage as follows: Years Mileage
1964 26,834
1965 11,391
1966 8,928
Petitioners claimed automobile expenses on their 1964, 1965 and 1966 returns. The amounts claimed were incorrect. Automobile expenses claimed and allowable and the amounts by which they were overstated are: 1964 1965 1966
Auto Expense Claimed $ 4,025.10 $ 1,901.00 $ 2,516.28
Allowable Auto
50 Expense 2,328.38 1,193.10 51 2,232.00
Overstatement $ 1,696.72 52 $ 707.90 $ 284.28
*523 4. Commission Expenses
Hagen Investments incurred commission expenses in 1964, 1965 and 1966, which were charged against gross receipts on Schedule C of petitioners' returns. The commissions were paid to retail salespersons and wholesale traders employed by Hagen Investments. 53 Expenses claimed and allowable and the amounts by which they were understated are: 1964 1965 1966
Commission Expenses
Claimed $ 5,423.85 $ 8,848.00 $ 11,788.37
Commission Expenses
Allowable $ 6,867.09 $ 12,853.35 $ 17,323.91
Understatement $ 1,443.24 $ 4,005.35 $ 5,535.54
5. Other Business Expenses
Petitioners reported business expenses of Hagen Investments other than cost of goods sold, depreciation expenses, automobile expenses and commissions on their 1964, 1965 and 1966 returns. The types and amounts, set forth on Schedule C of petitioners' returns, are: 1964 1965 1966
Salaries $ 1,312.50 $ 2,667.00 $ 6,700.73
Materials and Supplies 694.83 1,665.00 3,919.60
Taxes, Licenses, Bonds
and Filing Fees 2,082.24 2,456.00 3,346.01
Repairs 423.89 592.00 2,999.99
Legal and Professional Fees 100.00 506.00 249.28
Interest 291.32 (2,060.00) 3,035.58
Rent -0- -0- 1,094.00
Inventory Adjustments -0- -0- (1,068.13)
Other Costs:
Utilities 197.03 159.00 719.59
Dues and Subscriptions 972.63 934.00 1,150.45
Advertising 699.11 220.00 288.53
Telephone and Postage 1,338.54 2,045.00 14,739.77
Tax Stamps 138.67 104.00 59.68
Travel and Entertainment 544.64 214.00 2,672.91
Miscellaneous 871.43 388.00 275.10
Outside Work 1,155.66 2,579.00 3,168.25
$ 10,822.49 $ 12,469.00 $ 43,351.34
*524 Based on our examination of checks written for such expenditures, we find that petitioners overstated other business expenses for each of these years. These expenses, per return and allowable, and the amounts by which petitioners overstated them are: 1964 1965 1966
Other Expenses
Claimed $ 10,822.49 $ 12,469.00 $ 43,351.34
Other Expenses
54 Allowable 5,977.44 9,061.42 28,931.92
Overstatement $ 4,845.05 $ 3,407.58 $ 14,419.42
6. Net Operating Loss
Petitioners claimed a net operating loss carryover of $ 6,999.25 on their 1964 return. They had sustained a net operating loss in 1963 of $ 6,999.25, according to their 1963 return. Carried back to 1960, the 1963 net operating loss is totally absorbed because petitioners had adjusted gross income in excess of $ 10,000.00 in 1960. Petitioners sustained no net operating losses in 1961 and 1962.
7. Medical Expenses
Petitioners claimed *525 medical expense deductions on their 1964, 1965 and 1966 returns in the amounts of $ 139.42, $ 92.00 and $ 888.22, respectively. For these years, medical expense deductions are calculated by reference to a taxpayer's adjusted gross income: medical expenses are deductible to the extent they exceed 3 percent of adjusted gross income. Medicine and drug expenses are includible as medical expenses to the extent that they exceed 1 percent of adjusted gross income. 55
Petitioners' medical expenses for the taxable years at issue were: 1964 1965 1966
56 Medicine and Drugs $ 79.52 $ 933.00 $ 33.22
57 Other Medical Expenses $ 574.38 $ 476.31 $ 2,169.41
8. Contributions
Petitioners claimed charitable contributions as itemized deductions on their 1964, 1965 and 1966 returns. They overstated the amount of their contributions in 1964 and understated them in 1965 and 1966. The correct contribution amounts, the amount of contributions *526 per return and the amounts by which the contributions are adjusted are: 1964 1965 1966
Contributions Claimed $ 50.00 $ 50.00 $ 50.00
Contributions Allowable 4.25 105.00 547.00
Overstatement
(Understatement) $ 45.75 $ (55.00) $ (497.00)
9. Tax Expenses
Petitioners did not report general sales tax expenses on their 1964 return, but they did report general sales tax expenses on their 1965 and 1966 returns. In addition, they reported real estate tax expenses on their 1964 and 1966 returns. Respondent adjusted general sales tax expenses using the state sales tax optional deduction tables, and he used the check classifications to identify other tax expenses. He determined that total tax expenses allowable for each year had been understated.
We find as follows with respect to petitioners' tax expenses: 1964 1965 1966
Taxes Paid per Check
Classification $ 718.00 $ 1,158.28 $ 876.19
Taxes Paid per Return $ 718.99 $ 91.00 $ 483.60
Petitioners' allowable expense for general sales taxes paid will be determined from the amount of adjusted gross income finally determined. *527 58
10. Interest Expenses
Petitioners paid nonbusiness interest in 1965 in the total amount of $ 2,541.32. They claimed an itemized deduction of $ 2,756.87 for interest paid in 1965. Their deduction was overstated by $ 215.55. 59
*528 C. Capital Loss Carryover
During the taxable years 1961 through 1965 petitioners reported net capital losses and took deductions for capital losses on their tax returns, as follows: Capital Loss in 1961, per Return: $ 1,070.28
Capital Loss Used in 1961: (1,000.00)
Unused Capital Loss-1961: $ 70.28
Capital Loss in 1962, per Return: $ 1,735.32
Capital Loss Carried Forward: 70.28
Total of Capital Losses: $ 1,805.60
Capital Losses Used in 1962: (1,000.00)
Unused Capital Loss-1962: $ 805.60
Capital Loss in 1963, per Return: $ 1,293.48
Capital Loss Carried Forward: 805.60
Total of Capital Losses: $ 2,099.08
Capital Losses Used in 1963: (1,000.00)
Unused Capital Loss-1963: $ 1,099.08
Capital Loss in 1964, per Return: $ -0-
Capital Loss Carried Forward: 1,099.08
Total of Capital Losses: $ 1,099.08
Capital Losses Used in 1964: (1,000.00)
Unused Capital Loss-1964: $ 99.08
Capital Loss in 1965, per Return: $$-0-
Capital Loss Carried Forward: 99.08
Total of Capital Losses: $ 99.08
Capital Losses Used in 1965: (-0-)
Unused Capital Loss-1965: $ 99.08
*529 As shown, petitioners reported a capital loss carryover of $ 1,099.08 in 1964, and used $ 1,000.00 of that amount to offset 1964 income. At trial, petitioners were unable to substantiate the capital losses from which their capital loss carryover to the 1964 taxable year arose.
D. Section 6653(b) Additions to Tax
Petitioners failed to report income received in a number of specific transactions occurring in 1964, 1965 and 1966. We describe these transactions in detail because of their relevance to the issue of whether any underpayment of tax for 1964, 1965 and 1966 was due to fraud. 60
*530 1. 1964
The 1964 transactions and the amounts of unreported income are: Source and Correct Amount Amount Not
Type of Income Amount Reported Reported
W. P. Bill Atkinson
Enterprises, Inc. -
Commission Income $ 7,437.60 $ 5,287.60 $ 2,150.00
Occidental Life -
Commission Income 9,485.68 7,221.37 2,264.31
Totals $ 16,923.28 $ 12,508.97 $ 4,414.31
W. P. "Bill" Atkinson Enterprises, Inc. ("Atkinson") was incorporated under Oklahoma law in 1963 for the purpose of establishing a second daily newspaper for Oklahoma City. W. P. Atkinson, the president of the corporation, entered into an agreement with petitioner on March 15, 1964 under which Hagen Investments was to sell shares of Atkinson stock on a 15-percent commission basis. Atkinson's stock records show that Hagen Investments withheld $ 7,437.60 in commissions on gross stock sales of $ 56,384.00 in 1964. 61 Only $ 5,287.60 of the total commissions withheld were recorded in Hagen Investments 1964 general journal, and only that amount was reported as business receipts on petitioners' 1964 return.
*531 Occidental Life paid commissions to petitioner in 1964 in the total amount of $ 9,485.68. None of these receipts were entered in any of petitioners' business records. Only $ 7,221.37 of the amount paid was reported. 62
2. 1965
The specific transactions for 1965 are: Source and Correct Amount Amount Not
Type of Income Amount Reported Reported
Occidental Life -
Commission Income $ 7,093.08 $ 5,540.00 $ 1,553.08
Oklahoma Steel
Corporation - Interest 945.00 -0- 945.00
Hagen Holding
Corporation - Dividends 645.50 -0- 645.50
Hagen Holding
Corporation - Income
from Sale of Stock 23,731.00 231.00 23,500.00
National Foundation
Life - Income from Sale
of Stock 250.00 -0- 250.00
United Income Life -
Income from Sale of Stock 1,850.13 -0- 1,850.13
Dreyfus Fund, Inc. and
Fundamental Investors,
Inc. - Income from Sale
of Mutual Funds 4,996.00 -0- 4,996.00
Totals $ 39,510.71 $ 5,771.00 $ 33,739.71
We *532 previously found that Occidental Life paid commissions of $ 7,285.35 to petitioner in 1965. 63 Copies of Occidental Life commission checks totalling a slightly lesser amount, $ 7,093.08, payable to Ed J. Hagen, are part of the record. We therefore use $ 7,093.08 to arrive at unreported income from Occidental Life in 1965. No part of the $ 7,093.08 was recorded in any business records and only $ 5,540.00 was reported on petitioners' 1965 return. 64
The 1965 interest payments from Oklahoma Steel Corporation and the Hagen Holding Corporation dividend payments made in 1965 need no additional explanation. Income from petitioner's sales of Hagen Holding Corporation stock in 1965 is a more complex matter, requiring that the following calculation be set forth: Amount Realized on Sales of
Hagen Holding Corporation Stock $ 46,536.00
Less: Cost of Stock 22,805.00
Gain on Sale $ 23,731.00
Less: Gain Entered on Books
and Recognized 231.00
Gain Not Recognized or Reported $ 23,500.00
*533 Hagen Investments did not trade in Hagen Holding Corporation stock. Similarly, sales and purchases of Hagen Holding Corporation shares were not entered in Hagen Investments' general journal. However, petitioner used Hagen Investments' confirmation slips and receipts when selling Hagen Holding Corporation stock he owned individually, and buyers made their checks for the purchase of these shares payable to the order of Hagen Investments. 65 The $ 231.00 of gain reported was actually the consequence of two sales transactions incorrectly entered in Hagen Investments' general journal and thereby treated as inventory sales. 66 In short, little effort was expended to keep Hagen Holding Corporation stock transactions separate and distinct from transactions of Hagen Investments.
In all, petitioner sold 30,800 of his Class A shares and 1,488 of his Class B shares in Hagen Holding Corporation in 1965. The amount realized on the sales, $ 46,536.00, was *534 deposited into FNB 0-350-079. Petitioner's only records of his personal sales and purchases of Hagen Holding Corporation stock were the corporation's stockholder cards.
Ownership of the shares sold and therefore petitioner's basis and amount realized were issues extensively argued at trial. Petitioner testified that 18,669 Class A and 902 Class B shares were purchased by Charles D. Dudley ("Mr. Dudley") in 1965 pursuant to a subscription agreement with Hagen Holding Corporation. He also testified that Mr. Dudley subscribed to and purchased an additional 6,000 Class A shares and 300 Class B shares in a separate transaction in 1965, and that all the Class A and Class B shares obtained in the transactions were sold by Mr. Dudley in that year. Hagen Holding Corporation's stock transfer records show that Mr. Dudley purchased and sold the shares in 1965. 67
We find that petitioner *535 rather than Mr. Dudley purchased the 18,669 Class A shares and the 902 Class B shares from Hagen Holding Corporation in 1965. 68 Also, it was petitioner, not Mr. Dudley, who acquired the 6,000 Class A shares and the 300 Class B shares in 1965. Petitioner acquired the 6,000 Class A shares from Hagen Holding Corporation in a trade of 6,000 shares of his own United Income Life stock worth $ .25 per share, and he purchased the 300 Class B shares directly from the corporation. 69 Petitioner finally admitted at trial that it was he and not Mr. Dudley who acquired all the described shares. We find that the cost of all the Class A and Class B shares purchased in these transactions, $ 21,371.00, is includible in the above cost of stock figure of $ 22,805.00. We also find that petitioner sold all these shares in 1965 and that his amount realized is includible in his 1965 sales of $ 46,536.00. And, based on petitioner's admissions at trial regarding his purchase and sale of these shares, we find that Hagen Holding Corporation's stockholder records are false as to the ownership of the shares. 70
*536 Further findings with respect to this matter are necessary. When petitioner sold the Class A and Class B shares obtained in the above-described transactions to various purchasers in 1965, the number of shares reissued exceeded the number of shares petitioner had acquired. The excess shares issued were obtained by petitioner directly from Hagen Holding Corporation, which he controlled, at no cost. The following shows the number of excess shares issued: Shares Purchased Shares Reissued Excess Shares
in 1965 71 Upon Sale Issued
February 24, 1965
18,669(A) 19,765(A) 1,096(A)
902(B) 902(B) --
October 7, 1965
6,000(A) 10,145(A) 4,145(A)
December 28, 1965
300(B) 560(B) 260(B)
Totals 29,910(A) 1,462(B) 5,241(A) 260(B)
As a result, petitioner's amount realized in 1965, $ 46,536.00, includes the amount realized upon the sale of 5,241 Class A and 260 Class B zero basis shares.
Petitioner purchased 1,000 shares of National Foundation Life Insurance *537 Company ("National Foundation Life") for his investment account in 1965. He sold the shares to Buddy Brixey in the same year for $ 4,250.00. Petitioner's basis in the National Foundation Life stock was $ 4,000.00. The $ 250.00 gain on the sale was not reported.
Bookkeeping irregularities surrounded this stock sale. Petitioner's original mail deposit slip for the check received in the transaction described the deposit of $ 4,250.00 as a check from "Buddy Brixey." On the duplicate mail deposit slip for the transaction "Buddy Brixey" is crossed out and "Ed J. Hagen, Add'l Investment" is substituted. It is from the duplicate mail deposit slip that the transaction was recorded in Hagen Investments' general journal. The journal entry describes the transaction as one in which $ 4,250.00 was received as "Add'l Inv.", i.e., an addition to capital of Hagen Investments rather than the result of a stock sale. In this manner $ 4,250.00 in receipts from 1965 stock sales bypassed any income accounts. The journal entry for the sale falsely represents the nature of the Brixey transaction.
Hagen Investments purchased 14,148 shares of United Income Life stock for petitioner's investment account *538 in 1965 for $ 3,537.00, or $ .25 per share. Of the total number, petitioner sold 7,800 shares for $ 3,800.13 to various purchasers in the same year. His basis in the shares sold was $ 1,950.00 and his gain on the sales totalled $ 1,850.13. None of the sales were entered in either the general journal or petitioner's investment account records, and no gain was reported. Of the 6,348 shares not sold, 6,000 were traded by petitioner for 6,000 shares of Hagen Holding Corporation's Class A stock. 72 Those 6,000 Class A shares were the same shares that petitioner had originally claimed were purchased by Mr. Dudley in 1965.
Petitioner sold interests in Dreyfus Fund and Fundamental Investors, Inc. from his investment account in 1965. The sales generated gains of $ 4,996.00. Petitioner's purchase and resale of these interests were not properly entered in petitioner's investment account records; entries relating to these sales transactions are very confusing. Wesley J. Long, the certified public accountant who prepared Hagen Investments' 1965 audit report, called these items of additional gain to petitioner's attention but *539 the gains were not reported on the 1965 return.
3. 1966
The specific transactions for 1966 are: Source and Correct Amount Amount Not
Type of Income Amount Reported Reported
Confederate Steel
Corporation/Oklahoma
Steel Corporation -
Interest $ 4,534.71 $ 279.71 $ 4,255.00
Acker Industries, Inc. -
Interest 4,925.00 95.00 4,830.00
Hagen Holding Corporation -
Interest 2,544.18 -0- 2,544.18
Dale Wrobbel -
Interest 81.00 -0- 81.00
Liberty National Bank
#584-667-6 - Interest 204.75 -0- 204.75
First National Bank
73 #7-350-369 - Interest 153.23 -0- 153.23
Local Federal Savings &
Loan Assn. #51293 -
74 Interest 234.50 -0- 234.50
Acker Industries, Inc.,
Payments to Standard Life
and Accident Insurance
Co. - Premiums 2,284.00 -0- 2,284.00
Hagen Holding Corporation -
Dividends 1,617.06 -0- 1,617.06
$ 16,578.43 $ 374.71 $ 16,203.16
*540 As to the first item, the note which gave rise to the $ 4,255.00 in unreported interest income was given by Confederate Steel Corporation to Oklahoma Steel Corporation on June 30, 1965. The face amount of the note was $ 24,992.43. Oklahoma Steel Corporation assigned the note to Hagen Investments on November 11, 1965, at which time the balance owed was $ 20,492.43. Confederate Steel Corporation retired the note in 1966 by making payments of principal and interest to Hagen Investments. Of the $ 4,534.71 in interest income, only $ 279.71 was reported on petitioners' 1966 return. 75 Similarly, only $ 279.71 of the total amount was recorded in Hagen Investments' general journal.
Acker borrowed $ 33,000.00 from petitioners and Hagen Investments in a series of loan transactions in 1966. It repaid all the loans in the same year with interest totalling $ 4,925.00. The only loan transactions for which interest was recorded in any account books were loans from Hagen Investments. As to those loans, only $ 95.00 in interest payments were recorded in *541 Hagen Investments' general journal, and only $ 95.00 of the $ 4,925.00 in interest was reported on petitioners' 1966 return. 76
Hagen Holding Corporation made interest payments of $ 2,544.18 to petitioner in 1966 which were not reported on the 1966 return. 77 The three interest payments involved are recorded in Hagen Holding Corporation's general journal. 78 Petitioner was still president of Hagen Holding Corporation at the time the payments were made. He signed the checks involved in these transactions but none of the income was reported. Petitioners also failed to report interest of $ 81.00 in 1966 on a loan made by Hagen Investments in 1964 to Dale Wrobbel.
*542 Petitioners failed to report savings account interest in 1966. The savings accounts for which no interest was reported and the amounts not reported are shown above. Premium payments made by Acker in 1966 for the benefit of petitioners are explained in detail in Part II.A.7., supra . None of the premium payments were reported on petitioners' 1966 return.
Finally, petitioners received dividends of $ 1,617.06 from Hagen Holding Corporation which they did not report. Mrs. Hagen signed petitioners' dividend check for $ 1,617.06, dated January 15, 1966, as treasurer of Hagen Holding Corporation. Payment of the dividend was recorded in the corporation's 1966 general journal, but this item of income also failed to make its way onto the 1966 return.
4. Books and Records
The general journals of Hagen Investments for 1964 and 1965 contain entries recording checks written to various customers as shown below. The journal entries record that Hagen Investments purchased stock in each of these transactions. However, the checks were not written to the customers whose names were entered in the journals. Rather, they were written either to petitioner or Hagen Holding Corporation. *543 The transactions are: Payee Per Amount of Date of Payee per
Journal Entry 79 Check Check Check
Hugh B. Warren $ 1,021.50 9/10/64 Ed J. Hagen
Paul J. Ottis $ 3,654.00 9/17/64 Ed J. Hagen
Mary Jean Wise $ 5,413.66 12/28/64 Hagen Holding
Corporation
Richard M. Taliaferro $ 13,200.00 12/22/65 Ed J. Hagen
Richard S. Roberts $ 1,075.00 12/27/65 Ed J. Hagen
Petitioner's business records failed to correctly record the nature of the above transactions.
As to the last two transactions, petitioner sold Hagen Holding Corporation stock to Messrs. Taliaferro and Roberts on or about the same dates that he received the $ 13,200.00 and $ 1,075.00 checks from Hagen Investments. The amounts realized on the sales equalled the amounts received by petitioner. Each of the sales generated gain. The sales are not recorded in any income accounts kept by petitioner (either business or personal) and gains from these transactions were not reported in 1965. 80
*544 The general journal of Hagen Investments for 1964 and its cash receipts and disbursements journal for April 1, 1966 to December 31, 1966 contain entries recording a number of checks written to petitioner as shown below. The checks were not in fact written to petitioner; they were written to various customers of Hagen Investments. The transactions are: Payee per Amount of Date of Payee per
Journal Entry 81 Check Check Check
Ed J. Hagen $ 1,900.00 9/23/64 Max E. Sanders
Ed J. Hagen $ 2,272.50 8/30/64 Dorothy Tyler
Ed J. Hagen $ 87.50 9/2/64 Richard Taliaferro
Ed J. Hagen $ 11,371.50 5/14/66 Mary Jean Wise
Petitioner's business records failed to correctly record the above transactions as well. 82
*545 We have found petitioners' personal and business records for 1964 through 1966 to be woefully inadequate and confusing. They are false as to numerous transactions and incomplete because many transactions were not recorded at all. On the basis of these discrepancies we find that petitioners failed to keep satisfactory books and records during these years.
5. Criminal Tax Fraud
On September 17, 1971 a criminal indictment was filed in the United States District Court for the Western District of Oklahoma in which the Grand Jury charged as follows:
COUNT 1
That on or about the 15th day of April, 1965, in the Western District of Oklahoma, Ed J. Hagen a resident of Oklahoma City, Oklahoma, who during the calendar year 1964 was married, did wilfully and knowingly attempt to evade and defeat a large part of the income tax due and owing by him and his wife to the United States of America for the calendar year 1964, by filing and causing to be filed with the District Director of Internal Revenue for the Internal Revenue District of Oklahoma City, at Oklahoma City, Oklahoma, a false and fraudulent joint income tax return on behalf of himself and his said wife, wherein it was *546 stated that their adjusted gross income for said calendar year was the sum of $ 3,750.24 and that the amount of tax due and owing thereon was zero, whereas, as he then and there well knew, their joint adjusted gross income for the said calendar year was the sum of $ 22,082.94 and their joint taxable income was the sum of $ 16,886.67, upon which said taxable income there was owing to the United States of America an income tax of $ 3,220.04, in violation of Section 7201, Internal Revenue Code ; 26 U.S.C., Section 7201 .
COUNT 2
That on or about the 15th day of April, 1966, in the Western District of Oklahoma, Ed J. Hagen a resident of Oklahoma City, Oklahoma, who during the calendar year 1965 was married, did wilfully and knowingly attempt to evade and defeat a large part of the income tax due and owing by him and his wife to the United States of America for the calendar year 1965, by filing and causing to be filed with the District Director of Internal Revenue for the Internal Revenue District of Oklahoma City, at Oklahoma City, Oklahoma, a false and fraudulent joint income tax return on behalf of himself and his said wife, wherein *547 it was stated that their taxable income for said calendar year was the sum of $ 3,329.00 and that the amount of tax due and owing thereon was the sum of $ 505.93, whereas, as he then and there well knew, their joint taxable income for the said calendar year was the sum of $ 39,482.09, upon which said taxable income there was owing to the United States of America an income tax of $ 8,738.96, in violation of Section 7201, Internal Revenue Code ; 26 U.S.C., Section 7201 . 83
The Judgment and Commitment filed in the District Court on January 6, 1972 recites in part:
* * *
IT IS ADJUDGED that the defendant upon his plea of not guilty, and a verdict of guilty has been convicted of the offense *548 of violation of Title 26, U.S.C., Section 7201 (filing fraudulent income tax returns), as charged in Counts 1 and 2 of the Indictment. 84
* * *
Petitioner appealed his conviction and it was affirmed by the Court of Appeals for the Tenth Circuit. 85 The United States Supreme Court denied certiorari. 86
As stated in Parts II.A. through II.B., supra , hereinbefore, petitioners failed to report income and overstated expenses on their 1964, 1965 and 1966 returns as follows: Income
Adjustments 1964 1965 1966
Gross Receipts $ 16,666.00 $ 68,739.40 $ (205,729.09)
Interest, Dividends
and Fees 11,513.32 8,019.27 18,118.74
Life Insurance
Commissions 1,906.75 192.53
Income from Hagen, Ltd. 4,969.81 64,269.46 13,422.35
Unidentified Income 5,007.88 5,879.85
Income from The Schallmo
Foundation 945.00
Additional Compensation 2,284.00
Expense
Adjustments
Cost of Goods Sold 18,078.76 (41,570.77) 221,378.61
Depreciation 1,557.53 1,609.77 2,008.54
Auto Expenses 1,696.72 707.90 284.28
Commission Expenses 1,443.24 4,005.35 5,535.54
Other Business Expenses 4,845.05 3,407.58 14,419.42
87 Medical Expenses * * *
Contributions 45.75 (55.00) (497.00)
Tax Expenses * * *
Interest Expenses 215.55
Capital Loss 1,000.00
Increase to Income $ 61,816.18 $ 117,208.14 $ 77,297.77
*549
Petitioners' 1964, 1965 and 1966 returns reported the following amounts: 88 1964 1965 1966
Adjusted Gross Income $ 3,750.24 $ 9,318.00 ($ 11,713.01)
Taxable Income -0- 3,329.00 (19,891.02)
Income Tax Liability -0- 505.93 -0-
Based on the preceding schedules, we find that petitioners with intent to evade and defeat tax substantially underreported taxable income for 1964 through 1966. Also with intent to evade and defeat tax, petitioners did not report their correct income tax liability for 1964, 1965 and 1966. Part of the underpayment of tax required to be shown on petitioners' returns for 1964, 1965 and 1966 is due to fraud. 89 Petitioners with intent to evade and defeat tax filed false and fraudulent returns for the years 1964 through 1966.
*550 III. Ed J. and Martha Jo Hagen (docket No. 7700-76) Taxable Years 1968 through 1971
Petitioners timely filed joint returns for the taxable years 1968 through 1971 with the Internal Revenue Service. Respondent determined numerous adjustments in the notice of deficiency for these years and they are: Type of Adjustment 1968 1969 1970 1971
Life Insurance $ 461.95 $ (413.32)
Commissions
Unidentified Income 44,403.41 $ 20,578.29 6,678.41
Additional
Compensation 1,142.00 1,530.00 1,552.00
Income from 30,427.14 37,125.11 21,448.27 $ 28,221.49
90 Distributions
Interest Income 52.88 807.61
Income from Equity 94,500.00
Acquired
Office-at-Home (229.72) (229.72) (229.72) (229.72)
Expenses
Interest Expenses 1,164.40 (2,378.20) (1,285.74) (2,269.45)
Medical and Dental 716.00 1,151.00 1,023.24 213.02
Expenses
Capital Losses 537.00
$ 78,622.18 $ 152,329.36 $ 29,580.75 $ 25,935.34
*551 Respondent employed third party records and indirect methods to make the above determinations. He was required to do so because petitioners' records were not complete when received for use in the audit process. When respondent requested to see petitioners' records he was informed that all business records had been lost and that only a few personal records still existed. Miscellaneous records were later turned over in an incomplete, piecemeal fashion.
Facts relating to the various adjustments are in the following paragraphs.
A. Facts Relating to Income Adjustments
1. Life Insurance Commissions
Petitioners reported the following commissions from the sale of life insurance on their 1968 and 1970 returns: Source 1968 1970
Occidental Life $ 5,090.00
Standard Life 3,658.00
Unidentified Sources $ 4,729.82
$ 8,748.00 $ 4,729.82
Petitioners understated life insurance commission income in 1968 and overstated it in 1970, as follows: 91 1968 1970
Commissions Received $ 9,209.95 $ 4,316.50
Commissions per Return 8,748.00 4,729.82
Understatement
(Overstatement) 92 $ 461.95 $ (413.32)
*552
2. Unidentified Income
Petitioners received income in 1968, 1969 and 1970 from sources that have not been identified by either party. Income falling into this category took the form of deposits to three accounts controlled by petitioners. 93 The total of unidentified deposits for these years and the resulting understatements to income are: Bank Account Amount
1968
94 Liberty 584-667-6 $ 37,000.00
95 State Capitol 040-001-9 7,125.00
FNB X-XXX-079 278.41
Total 1968 Unidentified Deposits $ 44,403.41
Less: Unidentified Income per Return -0-
Understatement $ 44,403.41
1969
Liberty XXX-667-6 $ 12,000.00
State Capitol XXX-XX1-9 8,050.00
FNB X-XX0-079 5,959.29
Total 1969 Unidentified Deposits $ 26,009.29
Less: Unidentified Income per Return 5,431.00
Understatement $ 20,578.29
1970
Liberty XXX-XXX-6 $ 1,000.00
State Capitol XXX-XX1-9 5,678.41
Total 1970 Unidentified Deposits $ 6,678.41
Less: Unidentified Income per Return -0-
Understatement $ 6,678.41
*553
3. Additional Compensation from Acker Industries, Inc .
Acker continued to pay premiums on Standard Life policy No. OL-92440 in 1968, 1969 and 1970. 96 Again, these premium payments were for the benefit of petitioners and constituted compensation to them. The payments were in the following amounts: 1968 $ 1,142.00
1969 $ 1,530.00
1970 $ 1,552.00
These amounts were not reported on petitioners' 1968, 1969 and 1970 returns.
4. Distributions from Hagen Investments, Inc. and Capitol Car Care, Inc .
In conjunction with his examination *554 of petitioners' returns for 1967 through 1971, respondent examined the corporate returns of Hagen Investments, Inc. and Capitol Car Care, Inc. 97 In the process of doing so respondent determined that many expenditures of these enterprises were in fact made for the personal benefit of petitioners, and hence "distributions." Sometimes the corporations expensed these items and sometimes they did not. 98 We have characterized the distributions as to type.
A major part of Hagen Investments, Inc.'s business was conducted from offices in petitioners' residence. Expenditures for maintenance and utilities relate to the upkeep of the structure or to purchases such as vacuum cleaners and wallpaper. Hagen Investments, Inc. has not shown that these expenditures were business expenditures, so we treat them as personal expenditures and as distributions. *555 Corporate expenditures for dues and subscriptions, travel and entertainment, office supplies, and the like also appear to have been personal in nature, particularly when the various payees are considered. Since neither the corporation nor the petitioners have carried their respective burdens of proof with respect to the purpose for which these expenditures were made, we treat them as distributions also.
Distributions made for petitioners' benefit in these years were: Source and Type
of Distribution 1968 1969 1970 1971
Hagen Investments, Inc.
Interest Income $ 573.75
Auto Expenses 727.82 $ 6,158.96 $ 530.59
Dues and Subscriptions 234.40 362.45 1,509.45 $ 144.40
House Payments 3,408.00 3,408.00 3,408.00 3,408.00
Insurance Premiums 5,583.47 4,951.74 4,060.75 4,471.00
Office Supplies 3,460.03 537.96 1,175.76
Repairs and Maintenance 5,984.75 2,681.70 649.15 145.06
Travel and Entertainment 2,232.57 10,168.80 1,059.22 3,326.67
Utilities 1,572.83 1,820.84 1,217.57 752.94
Training Program
(Bill Hagen) -0-
Miscellaneous Expenses 26.49 33.48
Legal Fees 15,180.73
Capitol Car Care, Inc.
Auto Expenses 193.00 902.69 996.97 300.00
Insurance Premiums 619.75 -0- 918.45 -0-
Taxes 338.05
Dividend Exclusion (200.00) (200.00)
Totals $ 24,590.37 $ 30,993.14 $ 15,690.45 $ 27,562.28
*556 Our additional findings relating to these distributions are set forth in Appendices E, F, G and H. Facts relating to corresponding corporate expenditures are also set forth in these appendices and in our findings for docket No. 8342-76, Hagen Investments, Inc. v. Commissioner , infra .
Petitioners presented no evidence relating to the corporation's current or accumulated earnings and profits for these 4 years. None of the distributions were reported on petitioners' 1968, 1969, 1970 and 1971 returns.
5. Interest Income
Petitioners received interest income from bank accounts in 1969 and 1970 that was not reported on any returns. 99 For 1969 unreported interest income was: Liberty 584-667-6 $ 1,857.52
FNB 7-350-369 866.36
$ 2,723.88
Less: Amount Reported 2,671.00
Unreported Interest $ 52.88
For 1970 unreported interest income was: Liberty 584-667-6 $ 603.88
FNB 7-350-369 203.73
$ 807.61
Less: Amount Reported -0-
Unreported Interest $ 807.61
*557 6. Income Relating to Alliance Corporation
Respondent determined that petitioners received income of $ 94,500.00 in 1969 when petitioner acquired "additional equity" in Alliance Corporation, an investment company. The record is extremely confusing with respect to this adjustment, and we have winnowed the facts from pages of complicated testimony and dozens of exhibits.
As stated before, Alliance Corporation was the successor corporation to Hagen Holding Corporation. Petitioner was a major shareholder. He was also a member of its board of directors and president of the corporation from its founding until his resignation on march 31, 1969. During this time he was in control of the records of the corporation and continued to be in control of them after he resigned.
When Hagen Holding Corporation was organized in 1963, two classes of common stock were authorized, Class A and Class B. The Class A shares were nonvoting shares. The Class B shares were designated in Article V of the Articles of Incorporation as voting shares "in the election of directors and in all other matters, except as may be otherwise provided by statute." As early as November 20, 1964, a corporate policy *558 was in place whereby Hagen Holding Corporation stock was to be issued in "units," each unit containing 20 shares of Class A nonvoting stock and one share of Class B voting stock. This policy never became part of the corporation's bylaws but it was adhered to in numerous transactions involving the sale of stock. The 20 to 1 ratio was perceived to be an established corporate policy by most shareholders and was followed with respect to transactions occurring through 1966.
Neither the Articles of Incorporation of Hagen Holding Corporation nor its bylaws stated that the Class A stock carried a liquidation preference or any other type of preference. That class was simply described as "Class A nonvoting common." However, on February 3, 1966, amendments to the Articles of Incorporation were filed with the Oklahoma Secretary of State's Office adding the following language to Article V of the Articles of Incorporation: "Each share of outstanding common stock, either Class A or Class B, shall share equally in all dividends and any other distributions, in liquidation or otherwise, made in respect of the common stock of the corporation." The amendment was voted on at the January 26, 1966 Special *559 Meeting of Shareholders and passed unanimously.
The directors of the corporation voted in favor of splitting the Class B voting shares a number of times between November, 1963 and September, 1969. In conjunction with these stock splits the Articles of Incorporation were amended to increase the number of authorized shares and to reduce the par value of each share. The stock splits were always proposed by and passed by the directors and then approved by the shareholders at the recommendation of petitioner.
By August, 1969, petitioners had acquired the following Class B voting shares by stock splits or purchase: Date of Class B Shares Method of Acquisition
Issue 100 to Petitioners (Par Value/Price)
11/25/63 1,000 Cash Purchase (1.00)
6/15/64 5,000 Cash Purchase (1.00)
10/10/64 6,000 2:1 Split (.50)
12/16/64 18,000 Cash Purchase (.50)
12/22/65 23,000 Cash Purchase (.50)
1/26/66 53,000 2:1 Split (.25)
11/15/66 14,000 Cash Purchase (.25)
1/27/67 30,000 5:4 Split (.20)
8/4/69 150,000 2:1 Split (.10)
300,000
*560 For reasons not made apparent in the record, the Class A shares did not increase at the 20 to 1 ratio of Class A to Class B shares when the Class B shares split. Petitioners acquired Class B shares directly from the corporation from time to time. Petitioners' separate purchases of Class B shares occurred on December 22, 1965 and November 15, 1966, for 23,000 and 14,000 Class B shares, respectively. 101 Most shareholders were unaware of these very substantial purchases.
The events precipitating the August 1969 stock split involved Hagen Holding Corporation's wholly-owned subsidiary, Western Bank & Office Supply Company ("Wesbanco") and Wesbanco's subsidiary, Financial Reserve, Inc. ("FRI"). 102 Wesbanco *561 was acquired by Hagen Holding Corporation in early 1967. (Hagen Holding Corporation changed its name to "Alliance Corporation" on September 12, 1966 and it is hereinafter known as "Alliance".) Wesbanco in turn acquired 1,000,000 shares of FRI from Thurston National Insurance Company in 1968. The acquisition made FRI a second-tier subsidiary of Alliance. Petitioner negotiated the FRI transaction, which was to have placed Wesbanco in control of the majority of FRI's capital stock. However, in consummating the transaction, petitioner diverted 400,000 shares of FRI stock to Capitol Car Care, Inc. and 200,000 shares to The Schallmo Foundation, Inc. Petitioner did so, in his own words, as Wesbanco's "nominee" and as collateral for all "past, present and future loans." 103
*562 In mid-1969, FRI became the subject of an investigation by the Oklahoma Securities Commission. On July 7, 1968 FRI filed an "Application for Registration by Notification" with the Oklahoma Securities Commission to register 2,000,000 shares of its common stock, par value $ .05 per share. On July 11, 1969 the Oklahoma Securities Commission notified FRI that it intended to revoke the registration. In issuing its notice the Oklahoma Securities Commission alleged that FRI's March 31, 1969 consolidated balance sheet had seriously overvalued its assets and that, in particular, stocks owned by FRI which were stated as having a fair market value of $ 1,203,220.33 actually had little if any fair market value. The notice also alleged that a sale of FRI stock could operate as a fraud upon any purchaser of its stock relying on the financial information in FRI's consolidated balance sheet. 104 It was as a result of Oklahoma Securities Commission investigation that the board of directors of FRI first learned of the earlier diversion of FRI stock by petitioner to Capitol Car Care, Inc. and The Schallmo Foundation, Inc.
*563 While the matter was still pending, petitioner caused the 600,000 shares of FRI to be reregistered to Wesbanco. Contemporaneously, the board of directors of Alliance voted to distribute 500,000 shares of FRI as a dividend to the shareholders of Alliance, Wesbanco's parent. The vote was taken at the August 4, 1969 directors meeting. These actions followed lengthy negotiations with the Oklahoma Securities Commission and were taken in an effort to settle the controversy over the registration of FRI's stock. One of the principal purposes of the dividend, which the Oklahoma Securities Commission had insisted upon, was to place the ownership of the 1,000,000 shares of FRI stock in the hands of more than one stockholder. In fact, the FRI stock was never reregistered.
The two-for-one split of August 4, 1969, the last of the four stock splits, was devised by petitioner. He suggested to the board of directors that a two-for-one split of the Class B voting shares would facilitate distribution of the 500,000 FRI shares to Alliance's shareholders. Prior to the stock split 770,000 shares of Alliance stock were outstanding: 540,000 Class A Shares
230,000 Class B Shares
770,000 Total Shares Outstanding
*564 Thus, a two-for-one split of the Class B shares would increase Alliance's outstanding shares to an even 1,000,000, or 540,000 Class A shares and 460,000 (i.e., 230,000 X 2) Class B shares. One FRI share could then be distributed for every two shares of Alliance issued and outstanding.
The resolution to split the shares passed after a heated discussion over the problems associated with the FRI purchase and stock registration. Petitioner was the target of much criticism on these issues. During the August 4th meeting he was asked to produce Alliance's stock records but he stated they were not available. He nevertheless assured the board that the stock split would not significantly reduce any stockholder's equity interest and that every stockholder would be treated approximately equally. The measure passed unanimously. 105
At the August 4th meeting, the board of directors also passed a resolution to revamp Alliance's capital structure. The recapitalization was proposed by petitioner. The resolution to recapitalize, *565 which also passed unanimously, was as follows:
THEREFORE BE IT RESOLVED: That the officers of the corporation call a special stockholders meeting for the purpose of presenting a recommendation to split the Common Stock Class B of Alliance Corporation by issuing one additional share for each one share presently held and to reduce the par value of all of Class B stock from [$ .]20 per share to [$ .]10 per share, and after said stock split and as a part of the same plan of re-organization to reclassify all of the outstanding shares of Alliance Corporation, irregardless of whether Class A or Class B, as voting common stock, so that after said re-organization there will then be outstanding one million shares of Common Stock-Full Voting having a par value of $ 1.00 each.
A special meeting of stockholders was convened on August 20, 1969. The meeting was called to vote on the two-for-one split and the recapitalization. Petitioner was not present at the meeting. However, Alliance's president, Vincent V. Messer, assured the shareholders that all would benefit equally from the recapitalization. When a question arose as to the number of outstanding Class B shares, Mr. Messer advised *566 the shareholders that the stock records were in petitioner's possession and not available for examination.
The shareholders unanimously passed the resolutions relating to the split of the Class B shares and the recapitalization. After the split 1,000,000 shares were outstanding: 540,000 Class A Shares
460,000 Class B Shares (230,000 X 2)
1,000,000 Total Shares
Total stockholders' equity as of December 31, 1969 was $ 899,494.17. 106
In 1970, Alliance, Wesbanco and Acker filed a suit in the United States District Court for the Western District of Oklahoma (the District Court) against petitioner, Capitol Car Care, Inc., Hagen Investments, Inc., The Schallmo Foundation, Inc., Mrs. Hagen, and her father, T. Ernest Summers, who was then president of both Capitol Car Care, Inc. and The Schallmo Foundation, Inc. The First Amended Complaint in Alliance Corporation et al vs. Ed J. Hagen, et al (Cause No. CIV-70-536) alleged that petitioner had defrauded and deceived Alliance's stockholders and creditors by employing manipulative *567 and deceptive practices in contravention of Rule 10(b)(5) of the United States Securities and Exchange Commission Rules. Specifically, the plaintiffs alleged that petitioner, the defendant therein, had altered dividend and liquidation rights to the detriment of Alliance's Class A shareholders as the result of stock purchases and stock splits between 1963 and 1969.
The District Court suit was settled in 1973 with petitioner returning 146,500 shares of Alliance's stock to the corporation. In return, the plaintiffs paid approximately $ 43,000 in cash to petitioner. Additionally, all other shares of Alliance's common stock owned by petitioners were to be placed in a voting trust for 5 years. Before the suit was initiated, however, the same plaintiffs brought an earlier suit in the District Court to recover the books and records of Alliance remaining in petitioner's possession after he ceased to be president and a board member of Alliance. The records obtained in the earlier suit provided the basis for the second suit, Cause No. CIV-70-536.
B. Facts Relating to Expense Adjustments
1. Office-at-Home Expenses
Respondent allowed office-at-home expenses of $ 229.72 for *568 1968 through 1971 for the business use of the 5000 N.W. 31st Street property. When we consider the corporation's expenditures relating to the property (which are treated as distributions, infra ), and consider as well the level of business activity carried on at the subject property, the $ 229.72 expense for each year strikes us as low. Even so, petitioner did not reallocate the expenditures to reflect the business use of the property. We therefore find that $ 229.72 is allocable to the partial use of the residence as a home office.
2. Interest Expenses
Petitioners claimed itemized interest expenses for the taxable years 1968 through 1971 in the amounts of $ 3,600.00, $ 883.00, $ 1,031.68 and $ 1,019.48, respectively. They overstated their interest expenses for 1968 and understated them for 1969, 1970 and 1971. The understatements were in part the result of respondent's treatment of house payments made by the corporation. He treated 4 years of house payments as corporate distributions. That portion of each house payment which was interest was deductible by petitioners under section 162 .
Interest expenses claimed and allowable, and the resulting adjustments are: *569 1968 1969 1970 1971
Interest Expense
Claimed $ 3,600.00 $ 883.00 $ 1,031.68 $ 1,019.48
Allowable Interest
Expense 2,435.60 3,261.20 2,317.42 3,288.93
Overstatement $ 1,164.40
(Understatement) ($ 2,378.20) ($ 1,285.74) ($ 2,269.45)
3. Medical and Dental Expenses
Petitioners claimed itemized medical expense deductions on their 1968, 1969, 1970 and 1971 returns in the amounts of $ 716.00, $ 1,151.00, $ 1,023.24 and $ 213.02, respectively. Petitioners' medical expenses for these taxable years were: 1968 1969 1970 1971
Medicine and
Drugs $ 495.00 $ 456.00 $ 273.78 $ 114.71
Other Medical
Expenses $ 833.00 $ 1,064.00 $ 938.65 $ 231.50
Whether these itemized expenses qualify as deductions depends upon petitioners' adjusted gross income as redetermined.
C. 1968 Capital Losses
Petitioners reported a $ 537.00 long term capital loss on Schedule C of their 1968 return relating to stock warrants that petitioner did not exercise. The warrants were for 100 shares of Great Northern Gas Utilities, Ltd. and 200 shares of Western Copper *570 Mills, Ltd. The Great Northern Gas Utilities, Ltd. warrant was exercisable from October 1, 1957 to September 14, 1965 and the Western Copper Mills, Ltd. warrant was exercisable from August 15, 1962 to August 15, 1967. The failure to exercise the warrants did not generate capital losses in 1968.
D. Section 6653(a) Additions to Tax
During 1968 through 1971 petitioners did not keep satisfactory books and records and as a result failed to report substantial amounts of income relating to life insurance commissions, unidentified bank deposits, premiums paid on a life insurance policy by Acker, and corporate distributions relating to Hagen Investments, Inc. If the transactions were properly recorded in any books of account, the books are not part of the record.
Respondent determined that petitioners' underpayments of tax for 1968 through 1971 were due to negligence or intentional disregard of rules and regulations within the meaning of section 6653(a) . In certain instances he made minor concessions to adjusted items, and the Court redetermined additional allowances. Petitioners presented no credible evidence to further modify respondent's determinations respecting the section *571 6653(a) additions to tax.
IV. Hagen Investments, Inc. (docket No. 8342-76) Taxable Years 1967 through 1971
Petitioner Hagen Investments, Inc. (hereinafter "the corporation") timely filed Federal corporate income tax returns for the taxable fiscal years ended September 30, 1967 through September 30, 1971. 107 Respondent determined numerous adjustments in the notice of deficiency for these years and they are: Type of Adjustment 1968 1969 1970 1971
Gross Profits $ 191,768.95 $ 27,366.21 $ 58,010.36
108 Commission Income (6,535.62) (31,671.39) (3,644.92)
Interest Income (543.75)
Management Fees 750.00
Miscellaneous Income 60,000.00 268,104.00
Profit Sharing Trust 43,275.00 (43,275.00)
Auto and Travel Expenses 727.82 16,015.76 3,924.56
Dues and Subscriptions 994.89 667.95 1,546.95 $ 144.40
Interest Expenses 3,469.75 2,968.43 2,168.04 2,269.45
Insurance Expenses 2,187.47 1,204.61 1,933.84 856.00
Office Supply Expenses 976.48 537.96 1,175.76
Repairs and Maintenance 6,600.99 4,151.96 739.16 277.27
Tax Expenses 700.76 755.14 710.00 714.58
Travel and Entertainment 1,830.08 3,570.79
Utility Expenses 1,572.83 1,500.60 1,293.01 997.74
Audit and Legal Expenses 15,180.73
Training Program Expenses 107.00
Miscellaneous Expenses 59.97
Depreciation 1,037.47 1,540.88 735.17 555.55
Net Operating Loss (6,016.27)
Gain on Sale of Assets 8,868.64
$ 302,796.85 $ 293,249.11 $ 34,185.57 $ 24,626.48
*572
Respondent also disallowed investment tax credits for the 1968 and 1969 fiscal years, and disallowed the net operating loss which the corporation had tentatively carried back from 1969 to 1967.
Again, respondent was required to use third party records and indirect methods in his determinations because the records of the corporation were not made available to him.
A. Facts Relating to Income Adjustments
1. Gross Profits from Stock Sales/Commission Income
On its corporate income tax returns (Forms 1120) filed with the Internal Revenue Service for its fiscal years ended September 30, 1968, September 30, 1969 and September 30, 1970, the corporation reported gross receipts from the sale of securities, cost of goods sold and gross profits as follows: FYE 9/30/68 FYE 9/30/69 FYE 9/30/70
Gross Receipts -
Sale of Securities $ 14,743,165.41 $ 11,046,930.75 $ 1,744,376.45
Cost of Goods Sold 14,253,590.57 10,698,097.49 1,686,369.19
Gross Profits $ 489,574.84 $ 348,833.26 $ 58,007.26
*573 The corporation failed to provide respondent with adequate books and records relating to its gross receipts and cost of goods sold. In such posture, respondent was unable to determine the corporation's gross business income by subtracting cost of goods sold from gross receipts. 109 Therefore, he determined the corporation's gross profit for these years by (a) ascertaining the amounts paid to each wholesale "trader" and retail "salesperson" during each year; 110 (b) determining the percentage of the gross profit paid to each trader and salesperson; and then (c) applying the appropriate multiplier to arrive at total gross profit.
Traders, with the exception of Tom Summers and Bobby Summers, Mrs. Hagen's brothers, were paid 25 percent of the gross profit on stock sales and 25 percent of total commissions on mutual fund sales. Tom Summers and Bobby Summers were paid 30 percent of the gross profit on stock sales and 40 percent of mutual fund commissions. Retail salespersons *574 were paid 50 percent of the gross profit on their stock sales and 50 percent of total mutual fund commissions generated by them. The amounts paid to these traders and salespersons during 1968, 1969 and 1970 -- their "sales commissions" -- are shown on Appendices I through K, attached hereto. Also shown on these Appendices are the applicable percentages and multipliers, and the resulting gross profits generated by each of them.
a. 1968
For 1968, gross profits, less gross profits and mutual fund commissions reported, resulted in a $ 184,928.64 understatement of gross profits: Gross Profits (on Sales
Commissions of $ 283,809.57) 111 $ 681,039.10
Less: Gross Profits per Return 489,574.84
Subtotal $ 191,464.26
Less: Mutual Fund Income per
Return 6,535.62
Understatement 112 $ 184,928.64
*575 b. 1969
In 1969, the corporation charged 50 percent of total wire and telephone expenses to the traders. Specifically, the corporation deducted 50 percent of these expenses from gross profits (including mutual fund commissions) before applying the appropriate multipliers to profits generated by each of the traders. Fifty percent of these expenses were $ 41,244.41 in that year.
For 1969, gross profits, less gross profits and mutual fund commissions reported, resulted in a $ 4,305.18 overstatement of gross profits: Gross Profits (on Sales
Commissions of $ 96,468.87) $ 334,955.06
Plus: 50 percent of Wire and
Telephone Expenses 41,244.41
Adjusted Gross Profits $ 376,199.47
Less: Gross Profits per Return 348,833.26
$ 27,366.21
Less: Mutual Fund Income per
Return 31,671.39
Overstatement $ (4,305.18)
c. 1970
For 1970, gross profits, less gross profits and mutual fund commissions reported, resulted in an understatement of gross receipts in the amount of $ 54,365.44: Gross Profits (on Sales
Commissions of $ 29,677.63) $ 116,017.62
Less: Gross Profits per Return 58,007.26
Subtotal $ 58,010.36
Less: Mutual Fund Income per
Return 3,644.92
Understatement $ 54,365.44
*576 2. Interest Income
The corporation reported $ 937.40 in interest income on its 1968 return. Of the total, $ 543.75 reported was not earned by the corporation. It was earned by petitioners on personal accounts established at financial institutions in Oklahoma City. 113 The corporation's interest income was therefore overstated by $ 543.75 for 1968.
3. Management Fees
The corporation received a total of $ 9,750.00 in management fees in 1968. Of that amount, $ 9,000.00 was paid to the corporation by Capitol Car Care, Inc. We are unable to determine from the record what type of management services the corporation rendered to Capitol Car Care, Inc. The corporation also received a $ 750.00 management fee from Acker in 1968. Acker was at that time a wholly-owned subsidiary of Alliance, which petitioner controlled. Only $ 9,000.00 of the $ 9,750.00 in total management fees was reported on the corporate return.
4. Miscellaneous Income
a. 1968
The corporation received $ 60,018.98 from unknown sources in 1968. Income of $ 60,000.00 is described in an entry in the corporation's ledger as "miscellaneous income." Only *577 $ 18.98 of the $ 60,018.98 was reported. The corporation therefore understated income from miscellaneous sources by $ 60,000.00 in that year.
b. 1969
Our findings relating to the corporation's gross profits in 1969 do not take into account income realized by the corporation on its 1969 sales of FRI stock. Petitioner "made the market" for the corporation's sales of FRI stock. That is, petitioner himself set the "bid" and "ask" prices for this stock. FRI's stock records were made available to respondent during his examination and they are part of the record in this case. Because of the availability of these records, it is from them rather than the indirect method that we have redetermined income from the corporation's 1969 sales of FRI stock. 114
*578 Transactions in FRI stock are noted hereinbefore in conjunction with petitioner's acquisition of additional equity in Alliance, also in 1969. Petitioner attempted to gain control of FRI by diverting 600,000 of its shares to Capitol Car Care, Inc. and The Schallmo Foundation, Inc. when Wesbanco, a subsidiary of Alliance, purchased a controlling interest in FRI in 1968.
As previously noted, the Oklahoma Securities Commission took up the issue of FRI's stock registration in mid-1969. Its concern was that FRI's consolidated balance sheet overvalued stock that it owned in Alliance, Thurston National Insurance Company, Thurston National Life Insurance Company and Computek Corporation. By August 8, 1969, FRI's earlier registration by notification became ineffective by order of the Oklahoma Securities Commission. As of that date most of the FRI sales which generated income for the corporation in 1969 had been made, although a few transactions occurred after that date.
The corporation sold 163,949 shares of FRI stock in 1969 of which it was record owner. The record shows that the number of shares sold may actually have been much higher. The corporation purchased hundreds of shares *579 of FRI stock in 1968 and 1969 that it did not cause to have reissued in the corporate name. Subsequent sales of these shares are not shown on FRI's stock transfer records as having been sold by the corporation. We do not take any sales of FRI stock not reissued to the corporation into account in calculating gain on the corporation's FRI sales.
The corporation realized income of $ 263,827.65 from the sale of 163,949 shares in 1969: Amount Realized $ 366,068.25
Cost of Shares 102,240.60
Gain on Sale 115 $ 263,827.65
None of the gain was reported on the 1969 corporate return.
5. Hagen Employees Profit Sharing and Retirement Trust (HEPRET)
On May 1, 1968 the corporation entered into an agreement with T.E. Summers, M.F. Oaks and petitioner establishing the Hagen Employees Profit Sharing and Retirement Trust ("HEPRET"). Petitioner signed the agreement as president of the corporation, and Messrs. Summers, Oaks and *580 Hagen signed as HEPRET's trustees.
The first contribution to HEPRET was made on May 15, 1968, in the amount of $ 25,665.00. On September 30, 1968 a second contribution was made in the amount of $ 17,610.00. On May 16, 1968 petitioner forwarded a copy of the HEPRET trust agreement to the District Director of the Internal Revenue Service in Oklahoma City and requested a determination that HEPRET was a qualified trust under section 401(a) and therefore exempt from income tax under section 501(a). The District Director identified a number of problems in the plan as drafted. Because of these problems, he did not issue a determination letter by the end of the corporation's 1968 fiscal year.
The District Director and petitioner corresponded a number of times between May 16, 1968 and the end of 1969 regarding modifications to the profit sharing plan as embodied in the trust agreement. The principal area of difficulty was the plan's Article V, its vesting and forfeiture provisions. Article V reads in pertinent part as follows:
ARTICLE V
FORFEITABLE AND NON-FORFEITABLE INTERESTS
1. Allocations to Participants in accordance with the provisions of Article IV shall not vest any *581 right or title to any part of the assets of the Trust.
2. At the end of his first year in the Plan, a Participant shall have a vested and non-forfeitable interest in 10% of the amount credited to his account. At the end of each additional full year of continuous service, an additional 10% of the amount shall become vested , so that after ten full years of continuous service the full amount credited to his account shall become vested and non-forfeitable, except that:
(a) Upon death, severance due to permanent total disability or retirement at or after age 65 the full amount credited to his account shall become vested and non-forfeitable.
3. Upon severance of employment except as under 2(a) above or to join the Armed Forces of the United States or by leave of absence, all as defined in Article II, 2(b), a Participant's non-vested interest shall be forfeited.
4. When a Participant ceases to be in the service of the Company, the Company shall promptly give notice thereof to the Trustees together with any information necessary to determine the percentage of vesting applicable to the account of the Participant. The Trustees or their Agent, if any, shall then determine the *582 value of the vested interest of the Participant as of the close of the day when the Trustees (or the Agent if it is in charge of Trust accounting) received notice that said termination had occurred. The vested interest shall consist of the applicable percentage of the following:
(a) * * *
(b) Forfeitures for the prior year if not yet apportioned to the accounts of the Participants, said forfeitures to be apportioned among said accounts in the same manner as the contributions for the prior year . [Emphasis added.]
The District Director took the position that the vesting and forfeiture provisions discriminated in favor of well paid personnel, such as petitioner himself, and that they needed to be modified. He also required that changes be made to plan provisions relating to employee eligibility and valuation of plan assets. He summarized these requirements in a letter to the corporation dated April 23, 1969.
As of February 26, 1970 no action had been taken by the corporation to comply with the District Director's requirements. On that date the District Director issued a final adverse determination letter to the corporation stating that "the plan fails to meet the *583 requirements of section 401(a) of the Code and the trust is not entitled to exemption under section 501(a)." With respect to Article V, Part 2, providing for vesting at a rate of 10 percent per year, he stated in an accompanying letter that "(the corporation's) experience of employee turnover during 1968 shows that most of the amount which was contributed under the plan, as a result of forfeitures, has been reallocated to the accounts of those individuals in whose favor discrimination is expressly prohibited." The District Director also reiterated other areas of difficulty discussed in previous correspondence. The corporation did not seek a review of the adverse determination although advised by the District Director that the plan could be reconsidered by the Exempt Organization and Pension Trust Division at the National Office of the Internal Revenue Service in Washington, D.C.
The corporation deducted $ 43,275.00 on its 1968 corporate return for contributions made to HEPRET in that year. It included this amount in income on its 1970 corporate return. In his notice of deficiency, respondent disallowed the 1968 deduction in its entirety and correspondingly reduced the corporation's *584 1970 income by $ 43,275.00.
B. Facts Relating to Expense Adjustments
1. Business Expenses
As stated before, the corporation's fiscal year ended on September 30th. A portion of the disallowed expenses addressed in the following paragraphs were treated as distributions to petitioners in overlapping calendar years. Some payments made by the corporation which primarily benefitted petitioners were not expensed by the corporation. 116
a. Auto and Travel Expenses
The corporation reported auto and travel expenses on its 1968, 1969 and 1970 corporate returns. It was unable to substantiate many of these expenses at trial as ordinary and necessary business expenses. Auto and travel expenses claimed and allowable and the amounts by which they were overstated are: 1968 1969 1970
Auto Expenses Claimed $ 1,718.85 $ 17,605.02 $ 5,222.40
Allowable Auto Expenses 991.03 1,965.27 1,297.84
Overstatement $ 727.82 117 $ 15,639.75 $ 3,924.56
*585 b. Dues and Subscription Expenses
The corporation reported dues and subscription expenses on its 1968 through 1971 returns and those it was unable to substantiate have been treated as distributions to petitioners. 118 Dues and subscription expenses claimed and allowable, and the amounts by which they were overstated are: 1968 1969 1970 1971
Expenses
Claimed $ 2,244.16 $ 6,297.09 $ 5,452.95 $ 144.40
Allowable
Expenses 2,009.76 5,934.64 3,943.50 - 0 -
Overstatement 119 $ 234.40 120 $ 362.45 121 $ 1,509.45 122 $ 144.40
c. Interest Expenses
The corporation took excess interest *586 expense deductions on its 1968, 1969, 1970 and 1971 corporate returns. The overstated interest expense deductions related primarily to mortgage payments made by the corporation on petitioners' personal residence. Respondent treated these payments as distributions to petitioners and in addition adjusted petitioners' interest expense deductions. 123
Interest expenses claimed and allowable, and the amounts by which these expenses were overstated are: 1968 1969 1970 1971
Interest Expenses
Claimed $ 6,363.92 $ 5,918.42 $ 3,669.89 $ 2,689.57
Allowable Interest
Expenses 2,894.17 2,949.99 1,501.85 420.12
Overstatement $ 3,469.75 $ 2,968.43 $ 2,168.04 $ 2,269.45
d. Insurance Expenses
The corporation reported excess insurance and license expenses on its 1968 through 1971 corporate returns. 124 Insurance and license expenditures that the corporation was unable to substantiate under section 162 have been reallocated to petitioners as distributions. Some premium payments which benefitted petitioners were not expensed. Expenses claimed and allowable, and the amounts *587 by which they were overstated are: 1968 1971
Insurance Expenses Claimed $ 6,029.42 $ 922.00
Allowable Insurance Expenses 3,994.95 66.00
Overstatement 125 $ 2,034.47 $ 856.00
e. Office Supply Expenses
The corporation overstated expenses for office supplies on its 1969 and 1970 corporate returns. 126 Office supply expenditures that it was unable to substantiate have been reallocated to petitioners. Expenses claimed and allowable, and the amounts by which they were overstated are: 1969 1970
Office Supply Expenses Claimed $ 7,910.62 $ 1,175.76
Allowable Office Supply Expenses 7,372.66 - 0 -
Overstatement $ 537.96 $ 1,175.76
f. Repair *588 and Maintenance Expenses
The corporation overstated deductions for repairs and maintenance expenses on its 1968, 1969, 1970 and 1971 corporate returns. Appendices E through H fully set forth facts relating to this adjustment. Expenses claimed and allowable, and the amounts by which they were overstated are: 1968 1969 1970 1971
Repair and Main-
tenance Expenses
Claimed $ 6,672.54 $ 4,700.41 $ 1,116.41 $ 277.27
Allowable Repair
and Maintenance
Expenses 109.53 587.08 377.25 132.21
Overstatement 127 $ 6,563.01 128 $ 4,113.33 $ 739.16 129 $ 145.06
g. Tax Expenses
Most of the deductions for taxes paid during the corporation's 1968 through 1971 fiscal years were allowable deductions. However, we have disallowed ad valorem taxes paid by the corporation which related to 5000 N.W. 31st Street. *589 The amount disallowed constitutes a portion of the house payments made by the corporation for the benefit of petitioners; the house payments have been treated as distributions. The amounts by which deductions for taxes paid were overstated are: 1968 1969 1970 1971
Expenses Claimed $ 2,391.48 $ 5,474.31 $ 2,240.12 $ 1,705.31
Allowable Expenses
for Taxes 1,690.72 4,719.17 1,530.12 990.73
Overstatement $ 700.76 $ 755.14 $ 710.00 $ 714.58
h. Travel and Entertainment Expenses
The corporation overstated travel and entertainment expenses for its 1968 and 1971 corporate years. 130 For 1968 respondent disallowed $ 1,830.08 in travel and entertainment expenses. Petitioner substantiated $ 321.99 of this amount at trial, thus reducing the amount of the overstatement for that year. 131 The corporation overstated allowable travel and entertainment expenses for 1968 and 1971 in the following amounts: 1968 1971
Travel and Entertainment
Expenses Claimed $ 1,856.93 $ 3,570.99
Allowable Travel and Entertainment
Expenses 348.84 - 0 -
Overstatement $ 1,508.09 $ 3,570.99
*590 i. Utility Expenses
All utility expenses deducted on the corporate returns for 1968 through 1971 were disallowed by respondent. Correspondingly, respondent allowed petitioners modest home office expense deductions for 1968 through 1971 after having treated the expenditures disallowed to the corporation as distributions to petitioners. At trial petitioners did not establish what portion of the utilities were attributable to the corporation's business activities at the 5000 N.W. 31st Street property.
The utility expenses reported on the corporation's returns were incorrectly reported, resulting in the following overstatments: 1968 1969 1970 1971
Utility Expenses
Claimed $ 1,572.83 $ 1,500.60 $ 1,293.01 $ 997.74
Allowable Utility
Expenses - 0 - - 0 - - 0 - - 0 -
Overstatement $ 1,572.83 $ 1,500.60 $ 1,293.01 $ 997.74
j. Audit and Legal Expenses
Of the $ 18,337.08 in audit and legal expenses reported by the corporation in 1971, $ 15,180.73 were not ordinary and necessary business expenses. Respondent contended at trial that the $ 15,180.73 constituted legal fees incurred in relation to the criminal action brought *591 against petitioner under section 7201 , noting the attorneys involved. Petitioner did not challenge this assertion at trial. 132
k. Training Program Expenses
The corporation deducted $ 1,557.00 in 1969 for training program expenses for Bill Hagen (petitioners' son) and others. Respondent disallowed $ 107.00 of the total deduction, thereby allowing $ 1,450.00 of the expense taken on the corporate return. After a review of the record, we find that the $ 107.00 balance was business related as well. Petitioners established at trial that expenditures totalling that amount were for the same general purpose as those allowed. They were to pay for books used in a business training program. 133
1. Miscellaneous Expenses
The corporation made miscellaneous expenditures of $ 59.97 during 1971 which do not qualify as ordinary and necessary business expenses. The expenditures were primarily for flowers. We are unable to determine why the flowers and other items were purchased. 134
*592 m. Depreciation
The corporation reported depreciation on its corporate returns for 1968 through 1971 in the following amounts: Year Amount
1968 $ 2,843.44
1969 $ 4,171.64
1970 $ 2,442.97
1971 $ 1,355.55
The corporation's depreciable assets were office furniture and fixtures, and business machines. Many of the assets depreciated by the corporation on its returns were not depreciable assets, such as bar stools and a gazebo. Depreciation claimed and allowable, and the amounts by which it was overstated are: 1968 1969 1970 1971
Depreciation Claimed $ 2,843.44 $ 4,171.64 $ 2,442.97 $ 1,355.55
Allowable Depreciation 1,805.97 2,630.76 1,707.80 800.00
Overstatement $ 1,037.47 $ 1,540.88 $ 735.17 $ 555.55
2. Net Operating Loss Deductions
a. 1967
Respondent determined that the net operating loss which the corporation attempted to carry back from the 1969 to the 1967 fiscal year and tentatively allowed was eliminated by his adjustments. We sustain his determination on the basis of our findings relating to the 1969 taxable fiscal year.
b. 1968
The corporation determined that it *593 had no taxable income in its 1970 fiscal year -- that it had in fact sustained total tax losses of $ 25,768.29. On the basis of this figure the corporation concluded that it had a 1970 net operating loss of $ 18,179.31. In late 1970 it applied to respondent for a refund with respect to its 1968 fiscal year resulting from a carryback of the 1970 net operating loss. The application for the tentative carryback was incorrectly filed, and respondent advised the corporation of the problems with the application. The corporation never made the suggested corrections.
On the basis of the adjustments shown in the notice of deficiency, respondent determined that the corporation's 1970 fiscal year generated no net operating losses. Respondent did, however, conclude after audit adjustments that the corporation operated at a loss in 1971, and carried back the entire amount of the loss, $ 6,016.27, to 1968.
Notwithstanding certain modifications made herein with respect to the adjustments per the notice of deficiency, we are able to state that the corporation operated at a loss in 1971. The amount of the loss, to be determined under Rule 155, is a net operating loss.
C. Gain on Sale *594 of Assets
All the office furniture and office machines owned by the corporation (and depreciated as described hereinbefore) were sold on or about February 1, 1970 when the corporation closed its doors. 135 By that time the total adjusted basis of the furniture and machines was $ 4,316.57. The items were sold for $ 12,000.00 in that year, and the corporation claimed a $ 1,185.24 loss on the sales. 136 The sale of these assets was placed in a category for property other than capital assets on the 1970 return's "Sales or Exchanges of Property" schedule.
The gain on the sale of these assets in 1970 was: Amount Realized (Accepted as Filed) $ 12,000.00
Less: Adjusted Basis 4,316.57
Taxable as Ordinary Income $ 7,683.43
Add: Loss per Return 1,185.24
Gain $ 8,868.67
The gain was not reported on the 1970 return.
D. *595 Investment Tax Credit
Respondent disallowed investment credits of $ 498.67 for the 1968 fiscal year and $ 529.90 for the 1969 fiscal year after having determined that the property upon which the credits were based were not qualified investments. The $ 529.90 tentative investment credit of 1969 was not applied because the corporation calculated that it owed no tax in that year.
Respondent was unable to determine the nature of the property upon which the investment credits were based, and we are unable to make such a determination from the record.
E. Section 6653(a) Additions to Tax
The corporation failed to maintain adequate, complete and correct books and records during each of its fiscal years 1968 through 1970. As a result it did not record nor report substantial amounts of income received from the following sources: stock sales of Hagen Investments, Inc., management fees, gain on the sale of assets, and gain on the sale of FRI stock. Additionally, it expensed on its books and records items which, in the aggregate, were significant in amount and which did not serve any business purpose. The expenditures were for autos, dues and subscriptions, interest, insurance, *596 office supplies, repairs and maintenance, taxes, travel and entertainment, utilities, audit and legal fees and a deduction claimed for HEPRET.
V. ULTIMATE FINDINGS OF FACT
Our ultimate findings of fact in these consolidated cases are:
A. Adjustments to Taxable Income: Ed J. Hagen and Martha Jo Hagen
Taxable Years 1964 through 1966
Type of Adjustment 1964 1965 1966
Gross Receipts $ 16,666.00 $ 68,739.40 $ (205,729.09)
Interest, Dividends
and Fees 11,513.32 8,019.27 18,118.74
Life Insurance Commissions 1,906.75 192.53
Income from Hagen, Ltd. 4,969.81 64,269.46 13,422.35
Unidentified Income 5,007.88 5,879.85
Income from Schallmo
Foundation, Inc. 945.00
Additional Compensation 2,284.00
Cost of Goods Sold 18,078.76 (41,570.77) 221,378.61
Depreciation 1,557.53 1,609.77 2,008.54
Car Expenses 1,696.72 707.90 284.28
Commission Expenses (1,443.24) (4,005.35) (5,535.54)
Other Business Expenses 4,845.05 3,407.58 14,419.42
Net Operating Loss 6,999.25
Medical Expenses ? ? ?
Contributions 45.75 (55.00) (497.00)
Tax Expenses ? ? ?
Interest Expenses 215.55
Capital Loss 1,000.00
*597 Ed J. Hagen and Martha Jo Hagen
Taxable Years 1968 through 1971
Type of Adjustment 1968 1969 1970 1971
Commission Income $ 461.95 $ (413.32)
Unidentified Income 44,403.41 $ 20,578.29 6,678.41
Additional Compensation 1,142.00 1,530.00 1,552.00
Income from
Distributions
Hagen Investments, Inc.
Interest Income 573.75
Auto Expenses 727.82 6,158.96 530.59
Dues and Subscriptions 234.40 362.45 1,509.45 $ 144.40
House Payments 3,408.00 3,408.00 3,408.00 3,408.00
Insurance Premiums 5,583.47 4,951.74 4,060.75 4,471.00
Office Supplies 3,460.03 537.96 1,175.76
Repairs and
Maintenance 5,984.75 2,681.70 649.15 145.06
Travel and
Entertainment 2,232.57 10,168.80 1,059.22 3,326.67
Utilities 1,572.83 1,820.84 1,217.57 752.94
Training Program
(Bill Hagen) - 0 -
Miscellaneous Expenses 26.49 33.48
Legal Fees 15,180.73
Capitol Car Care, Inc.
Auto Expenses 193.00 902.69 996.97 300.00
Insurance Premiums 619.75 - 0 - 918.45 - 0 -
Taxes 338.05
Dividend Exclusion (200.00) (200.00)
Interest Income 52.88 807.61
Income from Equity
Acquired - 0 -
Office-at-Home Expenses (229.72) (229.72) (229.72) (229.72)
Interest Expenses 1,164.40 (2,378.20) (1,285.74) (2,269.45)
Medical and Dental
Expenses ? ? ? ?
Capital Loss 537.00
*598 Hagen Investments, Inc.
Taxable Years 1967 through 1971
Type of Adjustment 1968 1969 1970 1971
Gross Profit $ 184,928.64 $ (4,305.18) $ 54,365.44
Interest Income (543.75)
Management Fees 750.00
Miscellaneous Income 60,000.00 263,827.65
Profit Sharing Trust 43,275.00 (43,275.00)
Auto and Travel
Expenses 727.82 15,639.75 3,924.56
Dues and Subscription
Expenses 234.40 362.45 1,509.45 $ 144.40
Interest Expenses 3,469.75 2,968.43 2,168.04 2,269.45
Insurance Expenses 2,034.47 856.00
Office Supply
Expenses 537.96 1,175.76
Repairs and
Maintenance Expenses 6,563.01 4,113.33 739.16 145.06
Tax Expenses 700.76 755.14 710.00 714.58
Travel and
Entertainment
Expenses 1,508.09 3,570.99
Utility Expenses 1,572.83 1,500.60 1,293.01 997.74
Audit and Legal
Expenses 15,180.73
Training Program - 0 -
Miscellaneous
Expenses 59.97
Depreciation 1,037.47 1,540.88 735.17 555.55
Net Operating Loss ?
Gain on Sale of
Assets 8,868.64
B. Hagen Investments, Inc. is not *599 entitled to investment tax credits for any of the taxable years under review.
C. Petitioners, with intent to evade and defeat tax, substantially underreported taxable income for 1964 through 1966 and did not report their correct income tax liability for those taxable years. D. Petitioners underreported taxable income for 1968 through 1971 and did not report their correct income tax liability for those taxable years. Their failure to correctly report and to pay the correct tax liability was due to negligence or intentional disregard of rules and regulations within the meaning of section 6653(a) .
E. Hagen Investments, Inc. underreported taxable income for 1968 through 1971 and did not report its correct tax liability for those taxable years. This failure to correctly report and to pay the correct tax liability was due to negligence or intentional disregard of rules and regulations within the meaning of section 6653(a) .
OPINION
I. Ed J. Hagen and Martha Jo Hagen (docket No. 7700-76) Taxable Years 1964 through 1966
At this juncture, it is probably apparent that these cases involve some measure of complexity. That complexity is reflected in the magnitude of the record *600 and is exacerbated by the contentiousness of the parties. Not surprisingly, our task of finding the facts has been laborious and frequently frustrating. We have listened to the testimony of some 70 witnesses, plodded through over 2,300 pages of the trial transcript and scrutinized some 600 exhibits, many embracing innumerable charts and figures. We have done our best to reconcile the conflicting portions of the record. In too many instances, however, we have reluctantly concluded that perfect harmony is not attainable.
A. Adjustments to Income
1. Income Established by Bank Deposits Method
Respondent used the bank deposits method to determine that petitioners failed to report the following types of income on their 1964, 1965 and 1966 returns:
1964
Gross Receipts from Hagen Investments 137
Interest, Dividends and Fees
Income from Hagen, Ltd.
1965
Gross Receipts from Hagen Investments
Interest, Dividends and Fees
Unidentified Income
Income from Hagen, Ltd.
Income from The Schallmo Foundation, Inc.
1966
Gross Receipts from Hagen Investments
Interest, Dividends and Fees
Unidentified Income
Income from Hagen, Ltd.
He used *601 this method to determine income because petitioners failed to keep adequate records relating to both business and personal receipts.
Under section 6001 all taxpayers are required to keep sufficient records to enable respondent to determine their correct tax liability. In the absence of adequate books and records, the existence and amount of a taxpayer's income may be proven by any method that clearly reflects income. Sec. 446(b) ; Harper v. Commissioner , 54 T.C. 1121 , 1129 (1970) . The bank deposits method has long been an accepted method of reconstructing income received. Estate of Mason v. Commissioner , 64 T.C. 651 , 656 (1975) , affd. 566 F.2d 2 (6th Cir. 1977) ; Halle v. Commissioner , 175 F.2d 500 (2d Cir. 1949) , affg. 7 T.C. 245 (1946) , cert. denied 338 U.S. 949 (1950) . *602 Bank deposits are prima facie evidence of the receipt of income. Estate of Hague v. Commissioner , 132 F.2d 775 , 777 (2d Cir. 1943) , cert. denied 318 U.S. 787 (1943) . Petitioners therefore have the burden of showing that respondent's determinations are not correct. Reaves v. Commissioner , 31 T.C. 690 (1958) , affd. 295 F.2d 336 (5th Cir. 1961) . Use of the bank deposits method is proper even when, as is the case for these 3 years, the taxpayer keeps books and records which support his return as filed. Campbell v. Guetersloh , 287 F.2d 878 , 880 (5th Cir. 1961) .
Petitioners argued at trial that respondent should be compelled to rely on their books and records in determining taxable income, and that, in any event, income of a broker/dealer whose recordkeeping activities are governed by the Securities Exchange Act of 1934 cannot be reconstructed using the bank deposits method. We disagree. Because petitioners' personal records and books of account were incomplete and in dozens of instances misleading, respondent properly treated bank deposits to their accounts as income (subject to offsets for expenses *603 and nontaxable receipts). His reconstruction of income was not carried out capriciously or in haste. After a painstaking compilation of deposits made to some 21 accounts during 1964, 1965 and 1966, respondent eliminated all deposits determined to be gifts, transfers between accounts, loan proceeds, cash from the Bertha Schallmo Trust and other receipts deemed nontaxable. Whatever recordkeeping is required of a broker/dealer under the Federal securities laws was not respondent's immediate concern, and it is not ours. Respondent's reconstruction of income was therefore proper under the circumstances before us.
a. Gross Receipts from Hagen Investments
Section 61(a) includes "gross income derived from business" in its general definition of gross income. Sec. 61(a)(2) . Gross income from business means total sales, less cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Sec. 1.61-3(a), Income Tax Regs. A determination of the correct amount of Hagen Investment's 1964, 1965 and 1966 gross business receipts *604 (and also its cost of goods sold, addressed infra ) is thus a necessary step in finally determining whether Hagen Investment's gross income was accurately reported in those years.
Petitioners urge us to accept the gross receipts figures derived from Hagen Investments' books of account and reported on their returns. We found hereinbefore that these books are incomplete and that they contain false and misleading entries. Respondent is not therefore required to rely on them. Furthermore, petitioners' self-serving testimony and oftentimes baffling exhibits, taken together, do not overcome the presumption of correctness that attaches to respondent's 1964, 1965 and 1966 gross receipts determinations. They are presumptively correct. Anson v. Commissioner , 328 F.2d 703 , 706 (10th Cir. 1964) , affg. a Memorandum Opinion of this Court. 138 We therefore uphold them, subject to concessions previously noted. Welch v. Helvering , 290 U.S. 111 (1933) . We also sustain respondent's decision to adjust gross receipts to reflect sales accruing in their respective years.
*605 b. Interest, Dividends and Fees
Gross income includes interest, dividends and fees. Sec. 61(a) . 139 Dividends are included in gross income under section 61(a)(7) and section 301(c)(1) . Petitioners' receipts of interest, dividends and fees during 1964, 1965 and 1966 were well documented by respondent using the bank deposits me

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4632067. Public record. Not legal advice.