UNITED STATES TAX COURT

T.C. Memo. 1995-593

UNITED STATES TAX COURT

DAVID RENDEL AND RACHEL RENDEL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11878-93.

Filed December 14, 1995.

David M. Kirsch, for petitioners.

Allan D. Hill, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge:

Respondent determined a deficiency in

petitioners' 1983 Federal income tax and additions to tax for

fraud and for a substantial underpayment of tax as follows:

- 2 -

Deficiency

Sec.

6653(b)(1)

Additions to Tax

Sec.

6653(b)(2)

Sec.

6661

$49,846

$24,923

*

$12,462

*

50 percent of interest due on portion of

underpayment attributable to fraud.

All section references are to the Internal Revenue Code in

effect for 1983, and all Rule references are to the Tax Court

Rules of Practice and Procedure.

Petitioners assert that offshore trusts that they

established in 1982 constituted sham trusts that lacked economic

substance and that should be disregarded for Federal income tax

purposes.

Petitioners and respondent, however, disagree on the

year in which funds relating to such trusts should be taxable to

petitioners.

The issues for decision are:

(1) Whether the funds in

question should be treated as taxable to petitioners under the

constructive receipt doctrine in 1982 -- a year not before the

Court -- or as taxable to petitioners in 1983 -- the year in

which petitioners actually received and used the funds; and

(2) whether petitioners filed a fraudulent 1983 joint Federal

income tax return, but for which the period of limitations on

assessment against petitioners for 1983 is barred.

FINDINGS OF FACT

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

- 3 At the time the petition was filed, petitioners resided in

Alameda, California.

In 1980, petitioners formed Columbia Cosmetics

Manufacturing, Inc. (CCMI), as a California corporation to market

and distribute cosmetics.

CCMI was formed and operated as a

subchapter C corporation.

Petitioners were the sole shareholders

and officers of CCMI.

Petitioner David Rendel (David) was

president, and petitioner Rachel Rendel (Rachel) was vice

president of CCMI.

The offices and principal place of business

of CCMI were located in San Leandro, California.

Petitioners' books and records were maintained on the cash

method of accounting.

CCMI's books and records were maintained

on the accrual method of accounting.

Both sets of books and

records were maintained by Crudup C. Howard (Howard), an

accountant petitioners hired for that purpose.

Howard met

monthly with Rachel to reconcile CCMI's bank statements and to

discuss with Rachel the accounting for various transactions.

By late 1981, CCMI was earning a significant profit.

In

late 1981, Howard and petitioners consulted with a number of tax

shelter promoters (namely, Gil Armstrong (Armstrong) who was a

representative of the American Law Association (ALA),1 John Green

(Green), and Michael Panatelli (Panatelli)).

1

These individuals

The ALA was founded by Karl Dahlstrom for the purpose of

promoting offshore trusts.

- 4 advised Howard and petitioners regarding the purported tax

benefits of offshore trusts.

In 1982, with the assistance of Howard, Armstrong, and

Green, petitioners established an ALA-type of offshore trust

program.

Five sham trusts were established and domiciled in

Grand Turk, the capital of the Turks and Caicos Islands, located

in the British West Indies, under the names of five shell

companies (namely, DCH Management (DCH), Ledner Consulting Co.

(Ledner), DARA Co. (DARA), Cosmos Investment Co. (Cosmos), and

Alpha Associates (Alpha)).

Bank accounts were then opened in California, one account

each under the name of four of the five trusts.

Howard was a

trustee and an agent for Alpha, and Howard held signatory

authority over the DCH, Ledner, DARA, and Cosmos bank accounts.

An interest-bearing investment account was also maintained

in California under Alpha’s name with the Capital Preservation

Fund of the First Interstate Bank of California (the Alpha

account).

The Alpha account was maintained under CCMI's

corporate identification number.

Rachel held signatory authority

over the Alpha account.

Pursuant to petitioners' offshore trust program, funds

transferred into the trusts represented profits realized by CCMI.

During 1982 and 1983, $174,308 in profits of CCMI was

transferred from CCMI through the offshore trusts and ultimately

to the Alpha account.

With Howard's participation, the profits

- 5 transferred out of CCMI and into the offshore trusts were

incorrectly recorded on CCMI's books and records as payroll

expenses.

The schedule below describes the transfers that occurred

between January 10, 1982, and February 2, 1983, of CCMI's profits

from CCMI to and among the offshore trusts and into the Alpha

account:

Amount

$ 35,500

23,350

26,650

27,696

35,699

9,115

16,298

$174,308

Date Transferred

From CCMI

Transferred

Through Trusts

Date Deposited

Into Alpha Acct.

1/10/82

3/15/82

3/22/82

5/12/82

9/8/82

11/23/82

12/29/82

DCH-DARA-Cosmos

DCH-DARA-Cosmos

Ledner-DCH-DARA-Cosmos

DCH-DARA-Cosmos

DCH-DARA-Cosmos

DCH-DARA-Cosmos

DCH-DARA-Cosmos

2/23/82

3/31/82

4/14/82

5/26/82

9/20/82

12/7/82

2/2/83

In 1983, certain additional transfers occurred of the same

profits or funds of CCMI that had been transferred out of CCMI in

1982 and into the offshore trust bank accounts.

In particular,

on June 9, 1983, $135,000 was transferred out of the Alpha

account and back into CCMI's bank account.

Between June 11,

1983, and June 17, 1983, this same $135,000 was transferred yet

again from CCMI through the above offshore trusts and back into

the Alpha account.

- 6 On June 24, 1983, $184,630 was withdrawn from the Alpha

account2 by the purchase of a cashier's check and was used by

petitioners as part payment on the purchase of a new personal

residence for petitioners in Alameda, California (referred to

hereinafter as the Oyster Pond Property).

An installment note

from petitioners to Alpha with respect to this $184,630 was

drafted but was never signed by petitioners, and petitioners made

no repayments to Alpha of this $184,630.

Alpha did receive a

deed of trust on the Oyster Pond Property as stated security

relating to this $184,630.

Petitioners have implicitly conceded

that petitioners' withdrawal of this $184,630 did not constitute

a valid loan from Alpha.

In August and September of 1983, petitioners purchased

appliances and other items for the Oyster Pond Property using

$3,148 in CCMI's funds.

The schedule below describes these

purchases:

Date

Item

Cost

8/11/83

8/31/83

9/8/83

Home appliances

Wallpaper

Other expenses

$2,051

800

297

$3,148

On November 8, 1982, this Court decided Zmuda v.

Commissioner, 79 T.C. 714 (1982), affd. 731 F.2d 1417 (9th Cir.

2

This amount includes accrued interest and appears to have

been the entire balance of the Alpha account at the time of

withdrawal.

- 7 1984).

In the Zmuda case, we held that certain offshore trust

programs similar to those established by petitioners herein

constituted shams, lacked economic substance, and were to be

disregarded for Federal income tax purposes.

The $174,308 in profits from CCMI that in 1982 was

transferred out of CCMI and through the above offshore trusts

into the Alpha account was not reported on petitioners' 1982

Federal income tax return.

Howard alleges that in August of 1983 he first learned that

this Court had decided Zmuda v. Commissioner, supra, under the

authority of which the $174,308 transferred in 1982 out of CCMI,

through the offshore trusts, and into the Alpha account arguably

should be treated as taxable income to petitioners in 1982.

On

August 24, 1983, Howard conveyed the information about Zmuda and

its ramifications to petitioners.

On August 31, 1983, Howard, on behalf of petitioners,

"discontinued" the DCH, Ledner, DARA, Cosmos, and Alpha trusts

and closed the accounts of Ledner, DARA, and Cosmos.

The record

does not reflect whether or when the bank accounts of DCH and

Alpha were closed.

Also in August or early September of 1983, Howard prepared

for petitioners a proposed amended joint 1982 Federal income tax

return (proposed amended 1982 return).

On this proposed amended

1982 return, the $174,308 in profits of CCMI that had been

- 8 transferred in 1982 into the offshore trusts was reflected as

taxable income to petitioners.

On September 14, 1983, Howard gave petitioners the proposed

amended 1982 return.

Petitioners, however, refused to sign the

proposed amended 1982 return, and Rachel tore it in two, stating,

"We'll wait until * * * [respondent] catches us."

On petitioners' 1983 joint Federal income tax return that

was timely filed with respondent, neither the $174,308

transferred out of CCMI through the offshore trusts and into the

Alpha account, nor the $184,630 withdrawn in 1983 from the Alpha

account and used by petitioners to purchase the Oyster Pond

Property was reported as income by petitioners.

On petitioners'

1983 Federal income tax return, petitioners did report as

miscellaneous income $21,058 relating to their personal use of

CCMI funds.

This amount was not otherwise described.

On CCMI's 1983 Federal corporate income tax return, $3,158

in interest income earned on the Alpha account in 1983 was

reported as interest income.

On November 24, 1984, Howard, as trustee for Alpha, and

without consideration, signed a reconveyance deed transferring

Alpha's purported security interest in the Oyster Pond Property

from Alpha to petitioners.

On April 10, 1991, a Federal Grand Jury indicted petitioners

for conspiracy to defraud the United States during 1981 through

1986 with regard to petitioners' joint individual and CCMI's

- 9 corporate Federal income taxes and for tax evasion for 1984 and

1985 with regard both to petitioners' joint individual and CCMI's

corporate Federal income taxes.

On August 5, 1992, respondent determined deficiencies in and

additions to petitioners' joint Federal income taxes and CCMI's

corporate Federal income taxes for 1984 and 1985 in the total

amount of $299,908.

The tax deficiencies and additions to tax

determined by respondent against petitioners for 1984 and 1985

bore no specific relationship to the offshore trust tax shelter

scheme at issue in this case but did relate to petitioners'

diversion of CCMI funds for their personal benefit in 1984 and

1985 through other schemes.

On October 17, 1991, petitioners paid to respondent the

total of $299,908 in Federal income tax deficiencies determined

against petitioners and CCMI for 1984 and 1985.

On October 22, 1991, petitioners each pleaded guilty to one

count of tax evasion for 1984.

The Government dropped the

remaining counts of the above criminal indictment.

On March 16, 1993, respondent mailed to petitioners the

notice of deficiency for 1983 that is at issue in this case, in

which respondent determined that petitioners received in 1983,

not in 1982, unreported distributions from CCMI of $191,2783 as a

3

Respondent computed the $191,278 in distributions based on

the $184,630 withdrawn in 1983 from the Alpha account to purchase

the Oyster Pond Property, plus the $3,148 in furnishings paid

(continued...)

- 10 result of petitioners' use in 1983 of the profits of CCMI for

personal purposes (namely, to purchase and improve the Oyster

Pond Property), and respondent determined that, as a result of

petitioners' alleged fraudulent failure to report such

distributions on their 1983 joint Federal income tax return, the

period of limitations on assessment was still open.

OPINION

1983 Constructive Dividends

Numerous court opinions establish that if shareholders of a

corporation receive distributions of corporate funds or other

corporate property for their personal use or benefit, the

distributions from the corporation may be taxed to the

shareholders as constructive dividends to the extent of the

corporation's earnings and profits.

Ireland v. United States,

621 F.2d 731, 735 (5th Cir. 1980); Loftin &

Woodard, Inc. v.

United States, 577 F.2d 1206, 1214 (5th Cir. 1978); Commissioner

v. Riss, 374 F.2d 161, 166-167 (8th Cir. 1967), affg. in part,

revg. in part, and dismissing in part T.C. Memo. 1964-190; Melvin

v. Commissioner, 88 T.C. 63 (1987), affd. per curiam 894 F.2d

1072 (9th Cir. 1990); Challenge Manufacturing Co. v.

Commissioner, 37 T.C. 650, 663 (1962); American Properties, Inc.

3

(...continued)

with CCMI funds, plus $3,500 in allegedly omitted commission

income paid by CCMI to David. Respondent now concedes that the

$3,500 treated as commission income represents a nontaxable

repayment by CCMI of a loan CCMI had received from David.

- 11 v. Commissioner, 28 T.C. 1100, 1115 (1957), affd. 262 F.2d 150

(9th Cir. 1958).

In Zmuda v. Commissioner, supra, and in the decisions that

followed,4 the courts held that funds received by certain

offshore trusts were taxable in the year of receipt to the

taxpayers who controlled the trusts.

Petitioners herein argue that the offshore trust program in

which they participated is not distinguishable from the offshore

trust program that in Zmuda v. Commissioner, supra, was held to

constitute a sham and that was disregarded for Federal income tax

purposes.

Petitioners then argue that, in light of the holdings

in Zmuda and its progeny, and under the claim of right doctrine,

the profits or funds of CCMI that, at the end of 1982, were

transferred into the offshore trusts should be treated as

constructively received by petitioners in 1982, not in 1983.

Petitioners, in other words, contend that respondent has chosen

4

See Sandvall v. Commissioner, 898 F.2d 455 (5th Cir. 1990),

affg. on consolidated appeal T.C. Memo. 1989-56 and T.C. Memo.

1989-189; Akland v. Commissioner, 767 F.2d 618 (9th Cir. 1985),

affg. T.C. Memo. 1983-249; Professional Serv. v. Commissioner, 79

T.C. 888 (1982); Spencer v. Commissioner, T.C. Memo. 1994-531;

Dahlstrom v. Commissioner, T.C. Memo. 1991-265, affd. without

published opinion 999 F.2d 1579 (5th Cir. 1993); Dahlstrom v.

Commissioner, T.C. Memo. 1991-264, affd. without published

opinion 999 F.2d 1579 (5th Cir. 1993); Able Co. v. Commissioner,

T.C. Memo. 1990-500; Denali Dental Serv. v. Commissioner, T.C.

Memo. 1989-482; Pauli v. Commissioner, T.C. Memo. 1989-481;

Melvin L. Cochran, D.D.S., Inc. v. Commissioner, T.C. Memo.

1989-102.

- 12 the wrong year in which to tax petitioners on the $174,308

withdrawn from CCMI and deposited into the offshore trusts.

Respondent argues that the $184,630 that in June of 1983

petitioners withdrew from the Alpha account and used to purchase

the Oyster Pond Property should be treated as a constructive

dividend taxable to petitioners in 1983.

We agree with respondent.

In the instant case, during 1982

and early 1983, sufficient control over the offshore trust bank

accounts was maintained and exercised on behalf of CCMI so that

the funds transferred by CCMI in 1982 through the trusts and into

the Alpha account are to be treated as properly taxable to

petitioners in 1983, the year in which CCMI's funds were first

used by petitioners for petitioners' personal benefit.

During June of 1983, before petitioners withdrew the

$184,630 from the Alpha account, $135,000 of the funds in that

account was transferred to CCMI, and then from CCMI through the

offshore trusts, back to the Alpha account.

Interest of $3,158

that was earned on the Alpha account in 1983 was reported on

CCMI's 1983 corporate Federal income tax return.

From the

inception of the Alpha account, CCMI's taxpayer identification

number was used for the Alpha account.

Lastly, petitioners made

no personal use of the funds in the Alpha account until June 24,

1983, when $184,630 was withdrawn from the account for purchase

by petitioners of the Oyster Pond Property.

- 13 We conclude that the $184,630 first withdrawn on June 24,

1983, from the Alpha account for petitioners' personal use and

benefit, is properly treated as constructive dividend income

taxable to petitioners in 1983.

In light of the fact that petitioners did report on their

1983 joint Federal income tax return $21,078 relating to their

personal use of CCMI funds, we conclude, however, that

petitioners are not taxable on the $3,148 relating to the items

purchased for the Oyster Pond Property.

Fraud Addition to Tax

Respondent has the burden of establishing fraud by clear and

convincing evidence.

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

Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo.

1984-601.

Respondent must prove both that an underpayment in tax

exists and that a portion of the underpayment was due to fraud.

Laurins v. Commissioner, 889 F.2d 910, 913 (9th Cir. 1989), affg.

T.C. Memo. 1987-265; Edelson v. Commissioner, 829 F.2d 828, 832

(9th Cir. 1987), affg. T.C. Memo. 1986-223; King's Court Mobile

Home Park, Inc. v. Commissioner, 98 T.C. 511, 515 (1992); Wenz v.

Commissioner, T.C. Memo. 1995-277.

Respondent has shown that the $184,630 withdrawn from the

Alpha account is taxable to petitioners for 1983 and that the tax

reflected on petitioners' 1983 Federal income tax return was

therefore understated.

- 14 Fraudulent intent consists of an intentional wrongdoing for

the purpose of avoiding the payment of taxes known to be owed.

Powell v. Granquist, 252 F.2d 56, 60 (9th Cir. 1958); DiLeo v.

Commissioner, 96 T.C. 858, 874 (1991), affd. 959 F.2d 16 (2d Cir.

1992).

Fraud may be inferred from certain "badges of fraud,"

such as understatements of income, inadequate records, the

failure to file tax returns, the concealment of assets,

implausible or inconsistent behavior, and the failure to

cooperate with tax authorities.

Bradford v. Commissioner, 796

F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601.

Because fraud can rarely be proved by direct evidence, fraud

is often established by circumstantial evidence.

Spies v. United

States, 317 U.S. 492, 499 (1943); Bradford v. Commissioner, 796

F.2d at 307; Akland v. Commissioner, 767 F.2d 618, 621 (9th Cir.

1985), affg. T.C. Memo. 1983-249.

Consistent and substantial

understatements of income may constitute evidence of fraud.

Marcus v. Commissioner, 70 T.C. 562, 577 (1978), affd. without

published opinion 621 F.2d 439 (5th Cir. 1980); Merritt v.

Commissioner, 301 F.2d 484, 487 (5th Cir. 1962), affg. T.C. Memo.

1959-172.

Fraud determinations against taxpayers who have participated

in sham offshore trust programs similar to that in which

petitioners participated generally have been sustained.

Akland v. Commissioner, supra; Professional Serv. v.

Commissioner, 79 T.C. 888, 930-931 (1982); Dahlstrom v.

See

- 15 Commissioner, T.C. Memo. 1991-265, affd. without published

opinion 999 F.2d 1579 (5th Cir. 1993); Dahlstrom v. Commissioner,

T.C. Memo. 1991-264, affd. without published opinion 999 F.2d

1579 (5th Cir. 1993); Able Co. v. Commissioner, T.C. Memo. 1990500.

But see Spencer v. Commissioner, T.C. Memo. 1994-531;

Denali Dental Serv. v. Commissioner, T.C. Memo. 1989-482; Pauli

v. Commissioner, T.C. Memo. 1989-481.

Petitioners, citing United States v. Claiborne, 765 F.2d

784, 798 (9th Cir. 1985), argue that they did not have the

requisite fraudulent intent to conceal their income because they

in good faith relied on the advice of Howard, Armstrong, Green,

and Panatelli to the effect that their offshore trust program was

a legitimate tax shelter.

We disagree.

Petitioners falsely reflected the withdrawals

from CCMI and the deposits to the trust bank accounts as payroll

expenses of CCMI.

Petitioners attempted to conceal the $184,630

they used to purchase the Oyster Pond Property through a sham

loan transaction.

Petitioners participated in a pattern of

fraudulent underreporting of income in 1984 and 1985 that we

believe began in 1983, if not earlier.

We conclude that the

underpayment of petitioners’ income tax for 1983 resulting from

their participation in the sham offshore trust program was due to

fraud.

See Akland v. Commissioner, supra at 622; Dahlstrom v.

Commissioner, T.C. Memo. 1991-264.

- 16 We also sustain respondent's determination under section

6661, which provides for an addition to tax where the taxpayer

makes a substantial understatement of income tax liability.

A

"substantial understatement" is described as an understatement

that exceeds the greater of 10 percent of the tax required to be

shown on the return or $5,000.

Sec. 6661(b)(1)(A).

The evidence

establishes that petitioners' tax liability falls within these

parameters, and we sustain respondent's determination on this

issue.5

Decision will be entered

under Rule 155.

5

Petitioners, for the first time in their reply brief, raise

a new issue as to whether CCMI in 1983 had sufficient earnings

and profits to support the taxability of the $184,630 in

constructive distributions from CCMI that we have concluded

petitioners received in 1983. This issue is untimely raised by

petitioners. It would now be prejudicial to respondent to allow

this new issue to be raised, and we treat this issue as waived.

See Seligman v. Commissioner, 84 T.C. 191, 198 (1985), affd. on

other grounds 796 F.2d 116 (5th Cir. 1986); Graham v.

Commissioner, 79 T.C. 415, 423-424 (1982). Nevertheless, we have

examined the record and find nothing to support petitioners’

argument as to the lack of earnings and profits. To the

contrary, Howard's uncontroverted testimony indicates that the

offshore trusts were funded with net profits of CCMI.