UNITED STATES TAX COURT

T.C. Memo. 2002-164

UNITED STATES TAX COURT

WILLIAM F. MIDDLETON, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11580-97.

Filed June 28, 2002.

William F. Middleton, pro se.

Roger W. Bracken, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

Respondent determined deficiencies in

petitioner’s Federal income tax and additions to tax and

penalties as follows:

- 2 -

Year

1989

1990

1991

Deficiency

$12,411

39,796

50,239

Additions to Tax

Sec.

6651(a)(1)

----$12,957

Penalties

Sec.

Sec.

6662(a)

6663(a)

--$9,308

--29,847

$84

37,366

All section references are to the Internal Revenue Code for

the years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure, unless otherwise indicated.

The issues remaining1 for our consideration are:

(1) Whether, for 1990 and 1991, petitioner is entitled to

Schedule C, Profit or Loss From Business, deductions in excess of

those allowed or conceded by respondent; (2) whether petitioner

is liable for the section 6663(a) fraud penalty for 1990 or 1991;

(3) alternatively, whether petitioner is liable for the section

6662(a) accuracy-related negligence penalty for 1990 or 1991; (4)

whether petitioner is liable for the section 6662(a) accuracyrelated negligence penalty for 1991 with respect to the portion

of the income tax deficiency that involves the omission of

interest income or a claimed loss from the sale of a taxi; and

1

Respondent conceded the income tax deficiency and the sec.

6663(a) penalty for petitioner’s 1989 tax year. For the 1991

taxable year, respondent conceded that petitioner is entitled to

Schedule C deductions in addition to those allowed in the notice

of deficiency. For 1991, petitioner claimed $254,787 in

deductions on his Schedule C, and respondent, in the statutory

notice of deficiency, allowed $112,023. During pretrial

activity, respondent conceded that, in addition to those allowed

in the notice of deficiency, petitioner is entitled to $45,184 of

business deductions.

- 3 (5) whether petitioner is liable for additions to tax under

section 6651(a)(1) for 1991.

FINDINGS OF FACT2

Petitioner resided in Charles Town, West Virginia, when his

petition was filed with this Court.

During the taxable years

under consideration, petitioner owned and operated a taxi cab

business in Montgomery County, Maryland (the county).

Pursuant

to oral agreements, petitioner leased taxi cabs (taxis) to

independent drivers for a daily fee in a range of $55.00 to

$97.00.

The driver/lessees paid their own operating expenses,

including gasoline.

Petitioner maintained a daily record of the

lease of taxis, and the drivers were required to settle their

accounts on a weekly basis.

During 1989 and 1990, petitioner

received $8,812 and $129,136, respectively, from the drivers for

the lease of taxis.

Petitioner also contracted with the county to provide

Medicaid recipients with taxi service to and from approved

locations, such as doctors’ offices and rehabilitation centers.

Under the agreement, the county would fully reimburse petitioner

for amounts specified on his invoices.

In addition to the

reimbursements, the county agreed to pay petitioner 8 percent of

2

The parties’ stipulation of facts and exhibits is

incorporated by this reference.

- 4 his total reimbursements as an administrative fee.

Petitioner

defrauded the county by submitting false invoices.

During 1989, petitioner received $42,953.82 of Medicaid

payments from the county.

During 1990, the county paid

petitioner $219,656.68 in Medicaid payments, of which $17,572

represented administrative fees.

Petitioner intentionally failed

to report the income he received from the taxi leasing and

Medicaid services on his original 1989 and 1990 income tax

returns.

In addition, petitioner’s 1989 and 1990 original income

tax returns did not reflect either activity, and he reported only

a relatively small amount of income from wages and interest

income.

At the time petitioner’s 1991 income tax return was due

(April 15, 1992), he had been under an indictment (since January

1992) for Medicaid fraud and obstruction of justice.

During

1991, the office of the attorney general for the State of

Maryland subpoenaed petitioner’s records, including but not

limited to, financial documents, bank statements, canceled

checks, tax returns and income and expense ledgers.

Although

petitioner requested and was given an extension for the purpose

of photocopying his records, petitioner disregarded the subpoena,

attempted to conceal his activities, and only provided limited

documentation to the attorney general’s office.

Accordingly, a

search warrant was obtained, and petitioner’s records were

- 5 seized, including but not limited to, income and expense

journals, bank statements, canceled checks, and other

incriminating evidence.

Petitioner pleaded guilty to the charges

on October 13, 1992, and he was sentenced to 3 years of

incarceration, with all but 1 year suspended.

During 1993, the State of Maryland informed the Internal

Revenue Service of petitioner’s Medicaid fraud.

During April

1994, after he had been indicted and pleaded guilty to Medicaid

fraud and obstruction of justice, petitioner, with the assistance

of an accountant, filed amended income tax returns for 1989 and

1990 and a delinquent 1991 income tax return.

Petitioner, on his

amended 1989 return, reported gross receipts of $44,942 from his

taxi business, which purported to include the Medicaid payments

from the county.

On his amended 1990 return, petitioner reported

gross receipts of $145,557 from his taxi business, which

purported to include the Medicaid payments from the county.

Also

on his amended 1990 return, petitioner claimed $211,875 in

deductions on a Schedule C.

On his late filed original 1991

income tax return, petitioner reported $263,912 of gross income,

which purported to include the Medicaid payments from the county.

Also on his original 1991 tax return, petitioner claimed $254,787

in taxi business deductions.

In addition, petitioner claimed a loss of $ 1,490 from the

sale of a taxi.

Petitioner did not sell a taxi during 1991.

- 6 After petitioner filed his amended 1989 and 1990 returns and

his original 1991 return, respondent was forced to summons

petitioner’s records to verify the income and deductions reported

by petitioner.

The summonsed records generally did not agree

with petitioner’s tax returns.

In addition, records provided by

petitioner to respondent’s agent were not properly organized or

categorized.

Petitioner’s 1990 records contained duplications

and personal expense receipts.

Due to the discrepancies and poor

records, respondent’s agent reconstructed petitioner’s 1990

income by means of a bank deposit analysis.

Petitioner’s

deductions were determined by means of analyzing the records

summonsed and provided by petitioner.

Respondent’s bank deposits reconstruction of petitioner’s

income revealed that petitioner had unexplained deposits which

petitioner omitted from his original 1990 return.

Respondent’s

determination for petitioner’s 1990 income was that he failed to

report specific identified gross receipts of $17,572 from

Medicaid administrative fees and $129,136 from taxi leasing.

Respondent’s agent was able to verify $127,879 of

petitioner’s claimed deductions of $211,875 for 1990.

With

respect to 1991, respondent’s agent was able to verify $112,023

of the $254,787 petitioner claimed as business deductions.

After

the petition was filed, based on petitioner’s further

substantiation, respondent allowed an additional $45,184 in taxi

- 7 business deductions for the 1991 taxable year.

Accordingly, for

1991, respondent allowed a total of $157,207 of the $254,787 in

deductions claimed by petitioner on the 1991 return.

OPINION

The issues we consider arise from circumstances surrounding

petitioner’s criminal conviction for Medicaid fraud.

Prior to

his indictment, petitioner’s 1989 and 1990 Federal income tax

returns did not reflect that he was engaged in the taxi-leasing

business or that he received payments for Medicaid related

services.

Petitioner’s 1991 return was due a short time after

his indictment.

Following the acceptance of his plea of guilty,

petitioner, during 1994, filed amended 1989 and 1990 returns and

a delinquent 1991 return.

The above events were the motivation

for respondent’s examination of petitioner’s returns, resulting

in a determination that petitioner had understated income for

1989 and 1990.

Respondent also determined that a portion of

petitioner’s claimed deductions on his amended returns for 1989

and 1990 and on his 1991 return should be disallowed.

penalty was determined for all 3 years.

The fraud

For 1989 and 1990, the

fraud penalty was attributable to respondent’s determination that

petitioner failed to report all of his income.

The determination

of the fraud penalty for 1991 was based on respondent’s

determination that petitioner intentionally overstated his

deductions.

- 8 After this case was commenced, petitioner and respondent met

and exchanged information and documents which resulted in

respondent’s concession of the income tax deficiency and the

section 6663(a) fraud penalty for petitioner’s 1989 tax year.

The remaining issues we must consider are (1) whether petitioner

is entitled to Schedule C deductions in excess of those allowed

by respondent; (2) whether petitioner is liable for the fraud

penalty for 1990 or 1991; (3) as an alternative to fraud, whether

petitioner is liable for the negligence penalty for 1990 or 1991;

(4) for 1991, whether petitioner is liable for the negligence

penalty for the omission of interest income and/or claiming a

loss from the sale of a taxi; and (5) whether petitioner is

liable for a late-filing addition to tax for 1991.

I. Is Petitioner Entitled to Business Deductions in Excess of

the Amounts Allowed by Respondent?

Petitioner claimed business deductions of $211,875 and

$254,787 for his 1990 and 1991 tax years.

Respondent’s agent

examined records provided by petitioner and allowed petitioner

business deductions of $127,879 and $157,207 for the 1990 and

1991 tax years, respectively.

Accordingly, petitioner’s business

deductions in the amounts of $83,996 and $97,580 for 1990 and

1991, respectively, remain in dispute.

Deductions are strictly a matter of legislative grace, and

taxpayers must comply with specific requirements for any

deduction claimed.

See INDOPCO, Inc.

v. Commissioner, 503 U.S.

- 9 79, 84 (1992).

Petitioner must show that respondent’s

determination is in error.

Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933).

Section 162(a) permits a deduction for the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on a trade or business.

Expenses that are personal in

nature are generally not allowed as deductions.

Sec. 262(a).

A

taxpayer is required to maintain records sufficient to establish

the amount of his income and deductions.

Sec. 6001; Higbee v.

Commissioner, 116 T.C. 438, 440 (2001); sec. 1.6001-1(a),(e),

Income Tax Regs.

Petitioner contends that he is entitled to the full amount

of deductions claimed.

Petitioner, however, did not show

entitlement to business deductions in excess of the amounts

allowed by respondent.

At trial and on brief, petitioner

generally attempted to explain the deductions claimed for 1990

and 1991.

Petitioner’s explanations were insufficient to either

show error in respondent’s determination or substantiate

entitlement to more deductions in excess of the amounts already

allowed by respondent.

We must note that testimony during the trial revealed that

respondent’s agent had given petitioner the “benefit of the

doubt” and that some deductions were allowed by respondent

without thorough substantiation or based on a pattern of

- 10 evidence.

Accordingly, we hold that petitioner is not entitled

to Schedule C business deductions in excess of $127,879 and

$157,207 for the taxable years 1990 and 1991, respectively.

II.

Is Petitioner Liable for the Fraud Penalty for 1990?

Section 6663(a) provides for a 75-percent penalty on any

part of an underpayment that is due to fraud.

Respondent bears

the burden of showing by clear and convincing evidence that an

underpayment exists for the year in issue and that it is due to

fraud.

Sec. 7454(a); Rule 142 (b).

Fraud has been defined as an

intentional wrongdoing designed to evade tax believed to be

owing.

Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir.

1986), affg. T.C. Memo. 1984-601.

The existence of fraud is a

question of fact to be resolved upon consideration of the entire

record.

Estate of Pittard v. Commissioner, 69 T.C. 391, 400

(1977).

Fraud is not to be imputed or presumed.

Beaver v.

Commissioner, 55 T.C. 85, 92 (1970).

Because fraud can rarely be shown by direct proof of a

taxpayer’s intention, it may be shown by means of circumstantial

evidence and reasonable inferences drawn from the facts.

Spies

v. United States, 317 U.S. 492 (1943); Bradford v. Commissioner,

supra; Stone v. Commissioner, 56 T.C. 213, 223-224 (1971).

The

taxpayer’s entire course of conduct may establish the requisite

fraudulent intent.

Stone v. Commissioner, supra.

Moreover, the

intent to conceal or mislead may be inferred from a pattern of

conduct.

Spies v. United States, supra at 499.

- 11 Traditionally, certain “badges” of fraud have been

considered in deciding whether the penalty applies:

(1) Understatement of income, (2) lack of adequate records, (3)

failure to cooperate with tax authorities, (4) concealment of

assets, (5) engagement in illegal activities, (6) dealing in

large amounts of cash, (7) making of implausible and inconsistent

statements, and (8) the willingness to defraud another in a

business transaction.

Bradford v. Commissioner, supra at 307-

308; Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).

Although no single factor is necessarily sufficient to establish

fraud, the existence of several indicia may provide persuasive

circumstantial evidence of fraud.

Miller v. Commissioner, 94

T.C. 316, 334 (1990).

Respondent contends that, with respect to the original 1990

income tax return, petitioner fraudulently omitted taxi leasing

and Medicaid income.

At the time his original 1990 return was

filed, petitioner was receiving income from his taxi-leasing

business and from the county government in connection with

Medicaid transportation services.

Petitioner, in an attempt to

conceal that income, did not report that he was involved in a

taxi business or that he was being paid by the county in

connection with Medicaid services.

Respondent, by means of a bank deposit analysis for 1990,

has shown that petitioner’s unexplained deposits far exceeded the

amount of gross income reported.

In addition, after petitioner’s

- 12 fraudulent Medicaid activity was uncovered and he pleaded guilty

to criminal charges, petitioner filed amended returns for 1989

and 1990 reflecting substantial income from the taxi business.

Petitioner also claimed substantial expenses on the amended

returns which, if correct, would have resulted in relatively

small taxable income.

For 1990, however, petitioner has been

able to substantiate only $127,879 of $211,875 in deductions

claimed on the amended 1990 return.

In addition to failing to report the income-producing

activities and gross income to respondent, petitioner was also

defrauding the county by claiming reimbursement for Medicaid

transportation services that were either not performed, to

unapproved locations, and/or for longer distances than traveled.

Although the 1989 year is no longer in dispute, petitioner

also failed to report the fact that he operated a taxi-leasing

business and/or gross income from that business on his 1989

Federal income tax return.

This also shows that petitioner’s

intentional omissions were part of a pattern of activity to

deceive.

Accordingly, we hold that respondent has shown, by clear and

convincing evidence, that petitioner fraudulently omitted income

on his original 1990 tax return.3

3

Petitioner’s 1990 underpayment, for purposes of sec. 6663,

is equal to the unreported income from the taxi leasing,

administrative Medicaid payment, less the amount of business

deductions allowed, including any deductions allowed after the

issuance of the notice of deficiency. The parties will be

- 13 III.

Is Petitioner Liable for the Fraud Penalty for 1991?

For his 1991 tax year, petitioner did not file a return

until 1994, after he had already pleaded guilty to Medicaid

fraud.

Respondent, in the notice of deficiency, did not

determine that petitioner had understated gross income.

On his

1991 return, petitioner reported gross income of $263,912

(including a $24,826 administrative Medicaid fee) and deductions

of $254,787, resulting in a reported net profit from his taxi

business of $9,125.

Respondent, in the notice of deficiency,

allowed $112,023 of the $254,787 in claimed business deductions.

Accordingly, respondent determined that the underpayment was

attributable to the disallowed deductions and that the

underpayment was subject to the 75-percent fraud penalty of

section 6663(a).

Petitioner hired a certified public accountant to assist him

in the preparation of his 1991 return.

For 1989 and 1990,

petitioner’s records were inadequate, disorganized, and may have

contained duplications and personal expenses.

For 1991,

petitioner’s records had been reconstructed by his accountant

from available information.

Respondent has not shown that

petitioner intentionally and knowingly overstated his deductions

for 1991.

Although petitioner was unable to adequately

substantiate slightly more than 39 percent of the claimed

required to compute the underpayment under Rule 155 of the Tax

Court Rules of Practice and Procedure.

- 14 business deductions, that failure, on this record, does not rise

to the level of being fraudulent.

Accordingly, we hold that respondent has failed to show by

clear and convincing evidence that petitioner is liable for the

75-percent fraud penalty under section 6663(a).

IV. Is Petitioner Liable for the Failure to File Penalty for

Taxable Year 1991?

Section 6651(a)(1) provides for an addition to tax of 5

percent of the tax required to be shown on a return for each

month or fraction thereof for which there is a failure to file,

not to exceed 25 percent.

A taxpayer may avoid this addition to

tax if it can be shown (1) that the failure did not result from

willful neglect, and (2) that the failure was due to reasonable

cause.

See United States v. Boyle, 469 U.S. 241, 245 (1985).

Here, petitioner does not deny that he failed to file his

1991 income tax return until 1994.

The circumstances in which

petitioner found himself when the 1991 return was due (April 15,

1992) were precarious; i.e., petitioner had been indicted for

Medicaid fraud and he had failed to report his business income in

returns filed for 1989 and 1990.

Accordingly, although

petitioner has provided a reason for intentionally failing to

file, he has not provided a reason for which his failure to file

can be excused.

Accordingly, we hold that petitioner is liable for a 25

percent section 6651 addition to tax for 1991.

- 15 V. For 1991, is Petitioner Liable for the Negligence Penalty

With Respect to Omitted Interest Income, a Claimed Loss From the

Sale of a Taxi, or Unsubstantiated Business Deductions?

On his delinquently filed 1991 return, petitioner claimed a

$1,490 loss from the sale or involuntary conversion of a taxi.

In the notice of deficiency, respondent determined an $84

accuracy-related negligence penalty under section 6662

attributable to those two items for 1991.

Respondent also

determined, as an alternative to the fraud penalty for 1991, that

petitioner was liable for an accuracy-related negligence penalty

under section 6662(b)(1) or (c).

Because we have decided that

petitioner is not liable for the fraud penalty for 1991, we

consider whether petitioner is liable for the negligence penalty

with respect to unsubstantiated Schedule C business deductions

for 1991.

Section 6662 provides that if any portion of any

underpayment is due to negligence, then a taxpayer will be liable

for a penalty equal to 20 percent of the underpayment of tax

required to be shown on the return that is attributable to the

taxpayer’s negligence.

See sec. 6662(a) and (b)(1).

Negligence

is defined as the “lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.”

Cir. 1996).

Korshin v. Commissioner, 91 F.3d 670, 672 (4th

As pertinent here, “negligence” includes the failure

to make a reasonable attempt to comply with the provisions of the

Internal Revenue Code and also includes any failure to keep

- 16 adequate books and records or to substantiate items properly.

See sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.

“Disregard” has been categorized as any careless, reckless, or

intentional disregard.

Sec. 6662(c).

A taxpayer may avoid the accuracy-related penalty by showing

that (1) there was reasonable cause for the underpayment and (2)

he acted in good faith with respect to such underpayment.

sec. 6664(c).

See

Whether the taxpayer acted with reasonable cause

and in good faith is determined by the relevant facts and

circumstances, and most importantly, the extent to which he

attempted to assess his proper tax liability.

See Neely v.

Commissioner, 85 T.C. 934 (1985); Stubblefield v. Commissioner,

T.C. Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.

It is petitioner’s responsibility to establish that he is

not liable for the accuracy-related negligence penalty imposed by

section 6662(a).

See Rule 142(a); Tweeddale v. Commissioner, 92

T.C. 501, 505 (1989).

In attempting to show that he had reasonable cause,

petitioner argues that he relied on his accountant who assisted

him in preparing his 1991 return.

Under certain circumstances,

reliance on the advice of a competent adviser can be a defense to

the accuracy-related penalty.

United States v. Boyle, supra at

252); Zfass v. Commissioner, 118 F.3d 184 (4th Cir. 1997); sec.

1.6664-4(b)(1), Income Tax Regs.

However, reliance on professional advice, standing alone, is

- 17 not automatically a defense to negligence, but it is one factor

to be considered.

See Freytag v. Commissioner, 904 F.2d 1011

(5th Cir. 1990), affd. 501 U.S. 868 (1991).

It must be

established that the reliance was reasonable, in good faith, and

based upon full disclosure.

Ewing v. Commissioner, 91 T.C. 396,

423-424 (1988), affd. without published opinion 940 F.2d 1534

(9th Cir. 1991); Metra Chem

Corp. v. Commissioner, 88 T.C. 654, 662 (1987); Pritchett v.

Commissioner, 63 T.C. 149, 175-176 (1974).

In his defense, petitioner claims that he did not have a

great deal of time to file the 1991 return by April 1994.

This

was due to respondent’s examination that followed petitioner’s

plea of guilty to Medicaid fraud.

Petitioner hired an accountant

who reconstructed petitioner’s records because adequate records

had not been maintained for his taxi-leasing business and

Medicaid activities.

Petitioner’s accountant reconstructed

petitioner’s tax reporting position from the records available

and from information provided by petitioner.

With respect to the income side of petitioner’s 1991

reporting, respondent made no adjustments with the exception of

$1,313 of interest income.

With respect to petitioner’s

deductions, however, respondent disallowed a claimed

from the sale or involuntary conversion of a taxi.

$1,490 loss

Respondent,

in the notice of deficiency, allowed $112,023 of the $254,787

petitioner claimed as business deductions.

During pretrial

- 18 activity, respondent conceded that petitioner was entitled to

additional business deductions of $45,184, for a total allowance

of $157,207.

With respect to the $1,490 claimed loss, petitioner

contended that he provided his accountant with information that a

taxi had been set on fire during an unlawful use, but that he is

unsure how the accountant used that information.

Concerning

petitioner’s $97,580 ($254,787 claimed less $157,207 allowed) of

unallowed business deductions for 1991, petitioner was not able

to show supporting documentation or provide other evidence that

would show that he was entitled to more deductions than allowed

by respondent.

Petitioner did contend that his business information or

records were unavailable due to the criminal prosecution and

respondent’s examination.

Petitioner has not shown that he was

denied access to the information and records used by the State in

his prosecution.

The State of Maryland investigator testified

that petitioner’s records that were seized by the State were

available to petitioner at all times.4

In addition, the record

in this case reflects that respondent’s examination was extensive

and that respondent was reasonable in the allowance of deductions

4

The investigator also testified that petitioner lied to

him during the investigation for Medicaid fraud. In addition,

the investigator stated that petitioner had concealed records

from the State grand jury.

- 19 based upon the information provided by petitioner.

In that

regard, petitioner has not shown that respondent should have

allowed more based on any record that is available to

petitioner.5

Finally, petitioner argues that his reliance on his

accountant was reasonable.

Petitioner contends that he simply

provided the information to his accountant and that the

accountant decided the amount of deductions to which petitioner

was entitled for 1991.

Petitioner, however, did not corroborate

this contention, and he failed to present his accountant as a

witness to show that his reliance was reasonable.

See Zfass v.

Commissioner, supra at 189.

More importantly, petitioner has admitted that (1) the

preparation of his 1991 return was accomplished in a rush and (2)

he may not have provided his accountant with complete

information.

Finally, petitioner was unable to substantiate

almost 40 percent of the business deductions he claimed.

Therefore, petitioner’s claim of reliance was, in the

circumstances of this case, unreasonable.

Accordingly, we hold

that petitioner is liable for the accuracy-related negligence

penalty for 1991 on the underpayments attributable to the omitted

5

Petitioner also contended that the State of Maryland had

accepted his amended and 1991 State income tax returns without

change. Petitioner has not shown, however, how that fact (if it

is a fact) would show that petitioner was reasonable in

connection with the filing of his Federal income tax returns.

- 20 interest income, claimed loss, and unsubstantiated deductions.

We have considered all other arguments advanced by the

parties and to the extent that we have not addressed these

arguments, we consider them irrelevant, moot, or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.

REPORTER’S NOTE: THIS MEMORANDUM OPINION WAS MODIFIED BY ORDER DATED NOVEMBER

7, 2002.