UNITED STATES TAX COURT

T.C. Memo. 2002-58

UNITED STATES TAX COURT

TERRELL EQUIPMENT COMPANY, INC., ET AL.,1 Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 13059-98, 13060-98,

13112-98.

Filed February 27, 2002.

William A. Roberts and Kyle Coleman (specially recognized),

for petitioners Vernon W. Griffin and Terrell Equipment Co., Inc.

Stephen C. Coen, for petitioner Janet M. Griffin.2

Audrey M. Morris, for respondent.

1

Cases of the following petitioners are consolidated

herewith: Vernon W. Griffin, docket No. 13060-98; Janet M.

Griffin, docket No. 13112-98.

2

Petitioner Janet M. Griffin was represented by Stephen C.

Coen at trial and for the opening brief; however, Mr. Coen

withdrew as counsel after the initial brief, but before the reply

brief, was submitted.

- 2 MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge:

Respondent determined the following

deficiencies in, additions to, and penalties on petitioners’

Federal income taxes:

Petitioner Terrell Equipment Co., Inc.:

Tax Year

Ended

9/30/87

9/30/88

9/30/89

1

Deficiency

Additions to Tax

Sec. 6653 Sec. 6653 Sec. 6653

(b)(1)(A) (b)(1)(B)

(b)(1)

Penalty

Sec.

6663

$162,029

65,423

84,891

$121,522

-----

1

----$63,668

-----

--$49,067

---

50 percent of the statutory interest on $162,029

Petitioners Vernon W. Griffin and Janet M. Griffin:

Year

Deficiency

1987

1988

1989

$56,169

50,696

33,994

1

Additions to Tax

Sec. 6653 Sec. 6653 Sec. 6653

(b)(1)(A) (b)(1)(B)

(b)(1)

$42,127

-----

1

-----

Penalty

Sec.

6663

--$38,022

---

----$25,496

50 percent of the statutory interest on $56,169

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

The primary issue for decision is whether petitioners are

liable for the additions to tax and penalties for fraud.3

3

If we

Sec. 6653(b)(1), the successor to sec. 6653(b)(1)(A) and

(continued...)

- 3 find that they are liable for the additions to tax and penalties

for fraud, then we must decide issues regarding petitioner

Terrell Equipment Co., Inc.’s (TECO), liability for deficiencies

for its taxable years ended September 30, 1987 (TY 1987),

September 30, 1988 (TY 1988), September 30, 1989 (TY 1989), and

petitioners Vernon W. Griffin (Vernon) and Janet M. Griffin’s

(Janet) liability for deficiencies for 1987, 1988, and 1989.4

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts, the supplemental stipulation of facts,

and the attached exhibits are incorporated herein by this

3

(...continued)

(B), is applicable to returns the due date for which (determined

without regard to extensions) is after Dec. 31, 1988. Technical

and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, sec.

1015(b)(2)(B), (b)(4), 102 Stat. 3342, 3569. Sec. 6663, the

successor to sec. 6653(b)(1), is applicable to returns the due

date for which (determined without regard to extensions) is after

Dec. 31, 1989. Omnibus Budget Reconciliation Act of 1989, Pub.

L. 101-239, sec. 7721(a), (c), (d), 103 Stat. 2106, 2395-2400.

Sec. 6072(b) provides that a return of a corporation made on

the basis of a fiscal year shall be filed on or before the 15th

day of the third month following the close of the fiscal year.

TECO’s 1988 and 1989 fiscal years ended on Sept. 30, 1988, and

Sept. 30, 1989, respectively.

Accordingly, TECO’s 1988 and 1989 fiscal year returns were

due on Dec. 15, 1988, and Dec. 15, 1989, respectively.

Therefore, in TECO’s notice of deficiency, respondent mistakenly

referenced sec. 6653(b)(1) instead of sec. 6653(b)(1)(A) for

TECO’s 1988 fiscal year and sec. 6663 instead of sec. 6653(b)(1)

for TECO’s 1989 fiscal year.

4

Respondent concedes that if we do not find fraud the

periods of limitations on assessment have expired.

- 4 reference.

At the time they filed their petitions, TECO had a

mailing address in New Braunfels, Texas, Vernon resided in New

Braunfels, Texas, and Janet resided in Edgewood, Texas.

In the early 1960s, TECO began operations.

TECO specialized

in manufacturing commercial kitchen sinks and counter tops.

TECO

promoted its products at trade shows throughout the United

States.

By the mid-1960s, Jack Knauss (Mr. Knauss), Janet’s father,

and Bernie Knauss (Bernie) owned TECO.

Janet.

In 1968, Vernon married

That same year, Vernon began working at TECO as a janitor

(cleaning up the shop area).

full time for TECO.

Starting in 1969, Vernon worked

Until approximately 1979, Vernon worked in

the shop area of TECO operating the steel grinder, doing lab

work, and supervising shipping.

Around 1979, Mr. Knauss moved Vernon to TECO’s front office

to groom Vernon to run TECO.

bottom” of the office.

Initially, Vernon started at “the

From 1979 through 1982, Mr. Knauss

trained Vernon on how to operate TECO.

In 1982, Mr. Knauss

retired from TECO.5

5

During the years in issue, Vernon was the president of

TECO. Up until the time Mr. Knauss retired, Mr. Knauss owned 370

shares of TECO and Bernie owned the remaining 330 shares of TECO.

In 1982, pursuant to a divorce decree, Mr. Knauss transferred his

370 shares of TECO to his ex-wife, Hallie Jean Culpepper (Ms.

Culpepper), making Ms. Culpepper the majority shareholder of

TECO--she owned 52.85 percent of TECO. Ms. Culpepper was Janet’s

mother.

(continued...)

- 5 Mr. Knauss put TECO’s accounting system in place.

Sometime

after Mr. Knauss retired, Vernon hired Patrick Allison, C.P.A.

(Mr. Allison), to prepare TECO’s income tax returns for the years

in issue.

At the time, Mr. Allison was the only C.P.A. located

in Grand Saline, Texas.6

In order to prepare TECO’s tax returns, Mr. Allison was

given ledgers, summaries, bank statements, and canceled checks.

Mr. Allison had full access to TECO’s employees and could ask

them any questions relating to the preparation of TECO’s tax

returns.

Neither Vernon nor Janet had an advanced knowledge of

taxation.

Vernon graduated from high school and attended Tyler

Junior College for one semester.

Vernon never took any

5

(...continued)

In 1985, Ms. Culpepper transferred 185 shares of her TECO

stock to Janet. Janet then transferred 92 shares of her TECO

stock to Vernon. At this time, Bernie owned 47.14 percent of

TECO, Ms. Culpepper owned 26.43 percent of TECO, Janet owned

13.29 percent of TECO, and Vernon owned 13.14 percent of TECO.

Later that year, TECO purchased 329 shares of its stock from

Bernie, and Vernon purchased 1 share of TECO stock from Bernie

giving Vernon a total of 93 shares of TECO stock. At this time,

Ms. Culpepper owned 49.86 percent of TECO, Janet owned 25.07

percent of TECO, and Vernon owned 25.07 percent of TECO.

Although at this time there was no single majority

shareholder, if Janet and Vernon decided to combine their voting

power they could outvote Ms. Culpepper--i.e., Janet and Vernon

together owned 50.14 percent of TECO. As a result, Ms. Culpepper

sued Vernon, Janet, and TECO to gain control of the company.

6

From 1976 through part of 1989, TECO’s manufacturing

plant was located in Grand Saline, Tex.

- 6 accounting classes.

Janet graduated from high school and never

attended college.

TECO issued Forms 1099-MISC, Miscellaneous Income, to Vernon

for 1987, 1988, and 1989.

The Forms 1099 listed nonemployee

compensation in the amounts of $5,250, $18,300, and $68,000 for

1987, 1988, and 1989, respectively.

Vernon and Janet believed

that the amounts listed on these Forms 1099 covered the amount of

personal expenses paid for, and withdrawals made by, Vernon out

of TECO’s funds.

Vernon and Janet mailed these Forms 1099 to the

IRS.

Janet handled all of Vernon’s personal finances.

Janet

prepared the joint individual Federal income tax returns filed by

Janet and Vernon for the years in issue.

return for 1987.

Vernon did not sign the

He was out of town at the time Janet prepared

it, and he did not review the return prior to its being filed.

On TECO’s Forms 1120, U.S. Corporation Income Tax Return,

for TY 1987, TY 1988, and TY 1989, TECO reported overpayments of

taxes in the amounts of $14,187.50, $66,674.56, and $81,561.09,

respectively.

Janet and Vernon’s Form 1040, U.S. Individual

Income Tax Return, for 1988 also reported an overpayment of

taxes.

For each of these taxable years, instead of taking a

refund, petitioners requested that the overpayment be applied to

the next year’s estimated taxes.

In 1990, Vernon and Janet separated.

They later divorced.

- 7 In May 1991, Vernon and Janet’s joint Federal income tax

returns for 1987, 1988, and 1989 were selected for audit.

Revenue Agent Danny Craddock (RA Craddock) was assigned to the

audit.

During the audit, Vernon cooperated with RA Craddock.

Vernon gave RA Craddock a desk inside TECO’s office and allowed

RA Craddock to copy documents and to speak with TECO employees

unsupervised.

TECO’s officers, employees, and agents cooperated

with the IRS during the audit of petitioners.

Craddock’s questions.

Vernon answered RA

When requested by RA Craddock, petitioners

extended the period of limitations on assessment several times.

On August 22, 1991, RA Craddock referred the 1987, 1988, and

1989 tax years to the Internal Revenue Service (IRS) Criminal

Investigation Division.

Special Agent Andrew D. Bishop (SA

Bishop) was assigned to conduct a criminal investigation of

Vernon.

RA Craddock assisted SA Bishop.

No criminal charges were brought against Janet.

Vernon,

however, was tried for violating section 7206(1), willfully

making and subscribing a return under penalties of perjury that

he did not believe to be true and correct as to every material

matter, for 1988 and 1989.

He was acquitted on both counts.

During the years in issue, TECO did not have income from

illegal activities and did not deal in cash to avoid reporting

income.

Neither Vernon nor Janet had unexplained increases in

net worth, had substantial expenditures over available sources,

- 8 had bank deposits from unexplained sources that substantially

exceeded reported income, concealed bank accounts, used

fictitious names or names of relatives to disguise ownership of

assets, used a safe deposit box to hide valuables, utilized large

sums of currency, kept a double set of books, made fictitious

entries in or altered TECO’s books, created fictitious invoices

or other documents, concealed records, destroyed records, failed

to keep records, refused to make records available, asked third

parties to alter their records or hide their transactions with

petitioners, had income from illegal activities, failed to file

tax returns, made implausible or inconsistent explanations, or

attempted to hinder, delay, or interfere with the IRS’s

investigation.

OPINION

The statutory notices of deficiency determined that the

deficiencies in their entirety were due to fraud.

Respondent

concedes that absent a finding of fraud, the periods of

limitations for all the years in issue have expired.

Respondent

argues that the only reasonable inference that can be drawn from

the facts of these cases is that Vernon, Janet, and TECO

fraudulently understated their taxable income for each of the

years in issue.

We disagree.

The addition to tax and penalty in the case of fraud is a

civil sanction provided primarily as a safeguard for the

- 9 protection of the revenue and to reimburse the Government for the

heavy expense of investigation and the loss resulting from a

taxpayer's fraud.

(1938).

Helvering v. Mitchell, 303 U.S. 391, 401

Fraud is intentional wrongdoing on the part of the

taxpayer with the specific purpose to evade a tax believed to be

owing.

McGee v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519

F.2d 1121 (5th Cir. 1975).

The Commissioner has the burden of proving fraud by clear

and convincing evidence.

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

this burden, the Commissioner must show:

To satisfy

(1) An underpayment

exists; and (2) the taxpayer intended to evade taxes known to be

owing by conduct intended to conceal, mislead, or otherwise

prevent the collection of taxes.

654, 660-661 (1990).

Parks v. Commissioner, 94 T.C.

The Commissioner must meet this burden

through affirmative evidence because fraud is never imputed or

presumed.

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

Fraudulent Intent

The Commissioner must prove that a portion of the

underpayment for each taxable year in issue was due to fraud.

Profl. Servs. v. Commissioner, 79 T.C. 888, 930 (1982).

The

existence of fraud is a question of fact to be resolved from the

entire record.

Gajewski v. Commissioner, 67 T.C. 181, 199

(1976), affd. without published opinion 578 F.2d 1383 (8th Cir.

1978).

Because direct proof of a taxpayer's intent is rarely

available, fraud may be proven by circumstantial evidence, and

- 10 reasonable inferences may be drawn from the relevant facts.

Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v.

Commissioner, 79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th

Cir. 1984).

Mere suspicion, however, does not prove fraud.

Katz

v. Commissioner, 90 T.C. 1130, 1144 (1988); Shaw v. Commissioner,

27 T.C. 561, 569-570 (1956), affd. 252 F.2d 681 (6th Cir. 1958).

Over the years, courts have developed a nonexclusive list of

factors that demonstrate fraudulent intent.

fraud include:

These badges of

(1) Understating income, (2) maintaining

inadequate records, (3) implausible or inconsistent explanations

of behavior, (4) concealment of income or assets, (5) failing to

cooperate with tax authorities, (6) engaging in illegal

activities, (7) an intent to mislead which may be inferred from a

pattern of conduct, (8) lack of credibility of the taxpayer's

testimony, (9) filing false documents, (10) failing to file tax

returns, and (11) dealing in cash.

Spies v. United States,

supra at 499; Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.

1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.

1986), affg. T.C. Memo. 1984-601; Recklitis v. Commissioner, 91

T.C. 874, 910 (1988).

Although no single factor is necessarily

sufficient to establish fraud, the combination of a number of

factors constitutes persuasive evidence.

Solomon v.

Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), affg. per

curiam T.C. Memo. 1982-603.

- 11 Petitioners’ Sophistication

The sophistication, education, and intelligence of the

taxpayer are relevant to determining fraudulent intent.

Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992); Stephenson

v. Commissioner, supra at 1006; Iley v. Commissioner, 19 T.C.

631, 635 (1952).

There is no evidence suggesting that Vernon or

Janet had any training in accounting, tax planning, or tax return

preparation.

They both have a high school education, and Vernon

attended only one semester of junior college.

Petitioners’ Credibility

Respondent repeatedly claims that petitioners’ contentions

are merely supported by their self-serving testimony.

We

disagree.

Several witnesses corroborated Vernon and Janet’s

testimony.

This included establishing:

(1) TECO’s bookkeepers

coded TECO’s checks, and when the bookkeepers were uncertain

about how to code a check, they let Mr. Allison code the checks;

(2) TECO checks were paid to Vernon so he could purchase business

items for TECO in cash in order to get better prices; (3) Vernon

conducted TECO business outside the office, including at home and

in a separate structure (home office) located on the same

property as Vernon and Janet’s residence during the years in

issue; (4) trips to Las Vegas, Nevada, were business related; (5)

hunting trips were business related; (6) a country club

membership was used for business related events; (7) a tractor

was used at TECO for business purposes; and (8) Vernon was very

- 12 cooperative with the IRS and gave the IRS access to all of TECO’s

records.

Janet credibly testified that she made an honest attempt to

come up with the figures listed on the Forms 1099.

Additionally,

the parties stipulated that Vernon and Janet intended for the

amounts listed on these Forms 1099 to cover the amount of

personal expenses paid for, and withdrawals made by, Vernon out

of TECO’s funds.

Furthermore, RA Craddock testified that Vernon

stated that he wanted to add the amounts listed on the Forms 1099

to his income for the years in issue to make sure that he did not

owe any taxes.

At trial, respondent asked Janet7 whether she thought she

owed any more taxes.

Janet responded:

“There is no way on God’s

green earth that I thought I owed any taxes.”

Vernon also

testified that when they filed their tax returns for 1987, 1988,

and 1989 he was certain that they had paid more taxes than they

owed.

Vernon testified:

was overpaying.

“at this time, I was positive that I

I was really proud to pay that amount of tax.”

RA Craddock testified that Vernon was forthcoming and did

not do anything to hide or cover up issues RA Craddock raised.

Having had the opportunity to observe Janet and Vernon at trial,

we find that their testimony was honest, forthright, and

credible.

7

Accordingly, we hold that their testimony does not

We note that prior to the trial of this case, no

representative of the IRS interviewed Janet.

- 13 indicate the presence of fraud.

Stipulations Related to the Badges of Fraud

The parties stipulated facts that expressly state or support

the conclusion that most of the traditional badges of fraud do

not exist in these cases.

petitioners did not:

These stipulations included that

Maintain inadequate records, make

implausible or inconsistent explanations, conceal assets, fail to

cooperate with tax authorities, engage in illegal activities,

intend to mislead, fail to file tax returns, or deal in cash.

The trial testimony further leads us to conclude that none of the

aforementioned badges of fraud are present in this case.

1.

Profit Sharing Plan

Respondent claims that petitioners’ transactions with TECO’s

profit sharing plan were fraudulent.

RA Craddock had a B.B.A. in

general business and accounting and an M.B.A.

Even with his

experience as an auditor, his advanced degrees, and far more tax

expertise than petitioners, he needed help from an expert on

profit sharing plans about various highly technical issues

regarding TECO’s profit sharing plan.

tax background or expertise.

Vernon and Janet had no

We do not believe that they had a

level of tax knowledge or sophistication such that they intended

or attempted to evade taxes via the profit sharing plan.

2.

Alleged Misleading of RA Craddock

Respondent claims that Vernon misled RA Craddock by

providing RA Craddock with false or incomplete information.

We

- 14 disagree.

Respondent makes this argument even though, as we

previously noted, RA Craddock testified that Vernon was

forthcoming and did not do anything to hide or cover up issues RA

Craddock raised.

There is no evidence in the record that

petitioners misled RA Craddock.

3.

Personal Expenses

Respondent contends that he established fraud by proving

that Vernon and Janet paid personal expenditures with TECO funds,

TECO deducted these personal expenses, and Vernon and Janet

failed to report these amounts as income.

Petitioners do not deny that TECO paid personal expenses of

Vernon and Janet.

In fact, Vernon was forthcoming and forthright

in his testimony that TECO paid personal expenses of Vernon and

Janet.

As we noted supra, Janet credibly testified that she made an

honest attempt to come up with the figures listed on the Forms

1099, and the parties stipulated that Vernon and Janet intended

for the amounts listed on these Forms 1099 to cover the amount of

personal expenses paid for, and withdrawals made by, Vernon out

of TECO’s funds.

If petitioners failed to list the exact amount

of Vernon and Janet’s personal expenses paid for with TECO funds

on the Forms 1099, we conclude that it was not due to fraud.

4.

Remaining Badges of Fraud

The remaining badges of fraud are understating income and

filing false documents.

The evidence does not establish that

- 15 petitioners filed false documents.

Thus, the only badge left is

understating income.

Relying Solely on an Understatement of Income To Establish Fraud

Respondent argues that he can establish fraud by relying

solely on an understatement of income.

Respondent cites

Schneider v. Commissioner, T.C. Memo. 1977-179, for the

proposition that substantial amounts of unreported income over a

period of years, without more, are sufficient evidence to

establish fraud by clear and convincing evidence when the case is

based on the specific items method of proof.

Respondent is

incorrect.

In Schneider, Mr. Schneider pleaded guilty to filing a false

and fraudulent income tax return for one of the years in issue in

that case.

Additionally, Mr. Schneider converted income omitted

from his returns to cash.

Thus, in Schneider, we did not base

our finding of fraud solely on an understatement of income.

The

criminal tax conviction (which established that the taxpayer

filed false documents) and the conversion of omitted income to

cash further supported our conclusion that Mr. Schneider’s

actions were fraudulent.

The U.S. Court of Appeals for the Fifth Circuit, to which an

appeal in this case would lie, has held that “The mere

understatement of income, standing alone, is not enough to carry

- 16 the burden cast upon the Commissioner in seeking to recover fraud

penalties.”

Merritt v. Commissioner, 301 F.2d 484, 487 (5th Cir.

1962), affg. T.C. Memo. 1959-172.

Additionally, the Court of

Appeals has held that even a consistent and substantial

understatement of income is insufficient, by itself, to support a

finding of fraud.

Loftin & Woodard, Inc. v. United States, 577

F.2d 1206, 1239 (5th Cir. 1978).

Respondent agrees that these cases are still good law in the

Fifth Circuit.

We are left, however, with nothing more than the

possibility that petitioners understated their income.8

On this

record, we are not persuaded that the evidence establishes fraud

on the part of petitioners.

Id.; Merritt v. Commissioner,

supra at 487.

Conclusion

After reviewing all of the facts and circumstances, we

conclude that respondent has failed to sustain his heavy burden

of proving by clear and convincing evidence that Vernon, Janet,

or TECO intended to evade taxes known to be owing by conduct

intended to conceal, mislead, or otherwise prevent the collection

of taxes for any of the years in issue.

Accordingly, we do not

sustain any of the additions to tax or penalties for fraud.

8

“A taxpayer who honestly but erroneously claims a

deduction or fails to declare income is not liable for fraud.”

Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1238

n.72 (5th Cir. 1978).

- 17 Period of Limitations/Deficiencies

As we noted supra, respondent concedes that absent a finding

of fraud the period of limitations for all of the years in issue

expired.

Accordingly, petitioners are not liable for the

deficiencies, additions to tax, or penalties for the years in

issue.

To reflect the foregoing,

Decisions will be entered

for petitioners.