# UNITED STATES TAX COURT

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

T.C. Memo. 1996-500

UNITED STATES TAX COURT

KONDAMODI S. RAO AND B. SATYAVENI RAO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4468-94.

Filed November 6, 1996.

Sanford Amdur, for petitioners.
Robert W. Mopsick, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge:

Respondent determined deficiencies in and

additions to petitioners' Federal income tax as follows:

Year

Deficiency

Additions to Tax
Sec.
Sec.
Sec.
Sec.
Sec.
6653
6653
6653
6653
6653
(a)(1) (a)(1)(A) (a)(1)(B) (b)(1) (b)(1)(A)

1986
1987
1988

$65,075
33,648
24,644

----$412

$2,025
453
---

*
*
---

--$18,434
--18,448
$12,296
---

Sec.
6653
(b)(1)(B)

Sec.
6661

**
**
---

$16,269
8,412
6,161

* 50 percent of the interest due on the portion of the underpayment due to negligence.
** 50 percent of the interest due on the portion of the underpayment due to fraud.

- 2 All section references are to the Internal Revenue Code in effect
for the years in issue.

All Rule references are to the Tax Court

Rules of Practice and Procedure.
Petitioner Kondamodi S. Rao, hereinafter referred to as Dr.
Rao or petitioner, omitted gross income from his sole
proprietorship psychiatry practice in 1986, 1987, and 1988.
Petitioners deducted losses on their joint Federal income tax
returns in 1986, 1987, and 1988 from the operation of Forest Park
Medical Center (the medical center).

After concessions, the

issues for decision are:
(1)

Whether Dr. Rao1 is liable for the additions to tax for

fraud pursuant to section 6653(b)(1)(A) and (B) for 1986 and 1987
and section 6653(b)(1) for 1988;
(2)

whether petitioners have substantiated deductions from

the operation of the medical center for 1986, 1987, and 1988 in
amounts greater than that allowed by respondent; and, if so,
(3)

whether petitioners had amounts "at risk" under section

465 to enable them to deduct losses from the operation of Forest
Park Medical Center; and, if so,
(4)

whether the passive loss rules under section 469 either

restrict or disallow petitioners' losses from the operation of
the medical center;

1

Respondent conceded the additions to tax for fraud for B.
Satyaveni Rao (Mrs. Rao) at trial.

- 3 (5)

whether petitioners are liable for additions to tax for

negligence under section 6653(a)(1)(A) and (B) for 1986 and 1987
and section 6653(a)(1) for 1988; and
(6)

whether petitioners are liable for additions to tax for

substantial understatement of income tax under section 6661 for
1986, 1987, and 1988.
FINDINGS OF FACT
Petitioners Kondamodi S. Rao and B. Satyaveni Rao are
husband and wife.

They resided in Mountain Lakes, New Jersey, at

the time the petition in this case was filed.

Petitioners timely

filed joint Federal income tax returns for 1986, 1987, and 1988.
Prior to the expiration of time prescribed by section 6501(a) for
the assessment of income tax due for each of the years 1986,
1987, and 1988, petitioners and respondent executed written
agreements pursuant to section 6501(c)(4) extending the period
for the assessment of tax due for the years in issue.

Respondent

timely issued a statutory notice of deficiency whereby she
determined that petitioners fraudulently failed to report
Schedule C gross receipts in the amounts of $50,130, $63,890, and
$49,681 for the years 1986, 1987, and 1988, respectively.
Respondent further determined that petitioners were not entitled
to deduct Schedule E rental losses from the operation of the
medical center of $102,548, $25,000, and $25,000, for the years
1986, 1987, and 1988, respectively.

Respondent further

determined that petitioners were liable for the addition to tax

- 4 for negligence only with respect to the disallowed medical center
losses and that petitioners were liable for the addition to tax
for substantial understatement of income tax.
Dr. Rao
Dr. Rao was born on May 14, 1946, in India.

He graduated

from medical school in Kurnool, India, and finished his
internship in 1970.

Dr. Rao "was very established * * * making a

lot of money" while he worked in India.
United States in 1975.

Petitioners came to the

Dr. Rao completed 5 years of training in

the field of child psychiatry at Brookdale Hospital.
Dr. Rao was married and had two children by 1980.

He lived

in Bayside (Queens), New York, and was a full-time employee of a
hospital where he did his residency/fellowship training.

From

1979 until the end of 1981, after finishing his residency/
fellowship training, Dr. Rao worked in at least two private
clinics in Queens doing consultation work in the field of
psychiatry.
Dr. Rao's Schedule C Income
During the years in issue, Dr. Rao worked as a psychiatrist
at his private practice office located in Mountain Lakes, New
Jersey, and as a member of the staff of Saint Clares-Riverside
Medical Center in Denville, New Jersey.

Petitioners maintained

three bank accounts at Midlantic National Bank (Midlantic), a
money market account and a checking account, both used in
petitioner's psychiatric practice, and an account in the name of

- 5 Kondamudi Enterprises, Inc., used to make mortgage payments on
the medical center.

A fourth account at Chase Manhattan Bank

(Chase) was used to pay an equipment loan from Chase during the
years in issue.
On petitioners' income tax returns for the years 1986, 1987,
and 1988, petitioners reported on Schedule C gross receipts from
Dr. Rao's private practice of psychiatry in the amounts of
$135,162, $170,569, and $212,522, respectively.

In fact, Dr. Rao

received gross receipts from his psychiatry practice during the
years 1986, 1987, and 1988 in the amounts of $175,507, $220,408,
and $259,637, respectively.

Petitioners failed to report

Schedule C gross receipts from Dr. Rao's psychiatry practice in
the years 1986, 1987, and 1988 in the amounts of $40,345,
$49,839, and $47,115, respectively.
Dr. Rao's Record Keeping
Petitioner kept no books or records; he did not reconcile
his checking accounts against bank statements or check bank
deposits against his monthly bank statement.

Petitioner did not

deduct outstanding checks from his checking account to determine
the amount of funds available in the checking account.
Petitioner never received any instruction in bookkeeping or
accounting in a school, nor had petitioner ever practiced with
another professional.

- 6 Dr. Rao's Accountant
Petitioners authorized their accountant, Victor Raclaw, to
act as their representative before the Internal Revenue Service
(the IRS).

Dr. Rao was referred to Mr. Raclaw through a dentist,

Dr. Sudhakar Shetty, who rented space from Dr. Rao at the medical
center.

Mr. Raclaw started doing tax-related work for Dr. Rao in

either 1982 or 1983.

Mr. Raclaw prepared Federal income tax

returns on behalf of petitioners for the tax years 1986, 1987,
and 1988.

Mr. Raclaw earned 120 credits towards a bachelor's

degree from Brooklyn College and City College.

He does not have

a college degree, nor is he a certified public accountant.
To prepare the tax returns, Dr. Rao provided Mr. Raclaw with
Forms 1099, Forms W-2, bank statements, deposit slips, and
canceled checks.

To determine Schedule C income, Mr. Raclaw

asked Dr. Rao if he had received income from sources other than
Form 1099 payers, and Dr. Rao responded that he received most of
his income from insurance providers and Forms 1099.

Mr. Raclaw

also asked Dr. Rao if he received cash from private patients.
Dr. Rao said most of his income was from insurance carriers, and
"there was very little cash".

Some of the expenses on

petitioners' Schedules E were averages, not specific
expenditures.

- 7 Mr. Raclaw prepared a two-page schedule of the tax
information for the tax year 1986 that was a summary of
petitioners' Forms 1099, interest, money market, and Form W-2
income.

This schedule was Mr. Raclaw's only workpaper for

petitioners' 1986 tax year.

The information contained in the

two-page schedule was derived by Mr. Raclaw from petitioners'
bank statements.

In calculating the total amount of Schedule C

income for petitioner, Mr. Raclaw totaled the Forms 1099 that
were received by petitioner.

Mr. Raclaw did not prepare a

writeup, a cash receipts journal, or a cash disbursements
journal.

As part of his preparation of petitioners' tax returns,

Mr. Raclaw performed an income versus deposit analysis together
with an analysis of petitioners' Forms W-2, Forms 1099, and
Schedule E income in an attempt to verify petitioners' total
income for the years in issue.

Mr. Raclaw made the determination

to report income for all the years in issue based upon the Forms
1099 received from the insurance carriers.

Dr. Rao did not

examine his Federal income tax returns before signing them.
The IRS Audit
Revenue Agent Randall Gardner (agent Gardner) was assigned
to work on the Rao audit in November of 1988.

The audit

encompassed the 3-year period from 1986 through 1988.

As agent

Gardner was an inexperienced agent, Roy Schwarmann (agent

- 8 Schwarmann), a revenue agent with 20 years of experience with the
IRS, acted as his mentor during the course of the audit,
providing guidance and assistance where and when needed.
Petitioner received an IRS audit notice in November 1988
from agent Gardner and turned the audit notice over to Mr. Raclaw
to contact the IRS directly.

All communications subsequent to

the audit notice were exclusively between agents Gardner and
Schwarmann and Mr. Raclaw, acting on behalf of petitioners.

The

initial appointment and many subsequent appointments were
canceled by Mr. Raclaw.

Agent Gardner prepared a case activity

record indicating the activity on this case and the number of
canceled appointments.
Mr. Raclaw indicated that he would get the requested
information concerning petitioners' tax records to agent Gardner.
Mr. Raclaw never furnished the documents to agent Gardner, who
was forced to issue a summons to obtain the documents.
Agents Gardner and Schwarmann first met with Dr. Rao and Mr.
Raclaw on August 30, 1989.

Agent Gardner examined income and

expense issues and also looked at bank statements.

Petitioner,

when asked to produce bank account information, showed agent
Gardner information regarding two Midlantic Bank accounts, the
money market account and checking account.

Agent Gardner became

aware that Dr. Rao received payments from sources other than

- 9 insurance companies; i.e., from individual patients, by analyzing
items that were deposited into Dr. Rao's bank accounts.

Dr. Rao

denied to agents Gardner and Schwarmann that he had received
payments from individual patients or from any source other than
Form 1099 payers.
A second meeting was held on October 23, 1991,2 at agent
Gardner's office.

Dr. Rao, Mr. Raclaw, and agents Gardner and

Schwarmann were present.

Mr. Raclaw was taken by surprise when

agent Gardner stated to Dr. Rao that there were omissions of
income.

At this meeting, Mr. Raclaw learned, for the first time,

that Dr. Rao had a bank account at Chase.

However, this account

only was used to pay an equipment loan made by Chase.
Forest Park Medical Center
Dr. Rao decided to set up a medical center which provided
numerous medical services under one roof.

On October 10, 1980,

Dr. Rao entered into a contract for sale for the purchase of a
two-story building (the building) located at 86-22 85th Street,
Woodhaven (Queens), New York, from Al DiFranco, Inc.

The

building has 6,000 square feet with 3,000 square feet upstairs
and 3,000 square feet downstairs.

On December 18, 1980, by a

bargain and sale deed, Al DiFranco, Inc., conveyed the property

2

The 2-year time lag between meetings was not explained in
the record.

- 10 to petitioners.

The purchase price of the building was $120,000,

which included seller financing and the assumption of an existing
mortgage.
Dr. Rao decided to borrow money for improvements to the
building.

Upon application for a loan to Columbia Savings & Loan

Association (Columbia), the bank told Dr. Rao that it would not
make a loan to him on a personal basis, but rather would make a
loan to a corporation.
Inc. (Kondamudi).

Dr. Rao formed Kondamudi Enterprises,

Kondamudi was formed for the purpose of

obtaining the loan from Columbia.

On September 11, 1981,

Kondamudi obtained a building loan mortgage from Columbia in the
amount of $120,000 at 18 percent interest per annum.
Approximately $43,000 was to retire existing debt on the medical
center, and the remaining $77,000 was designated for
improvements.

Petitioners established a bank account in the name

of Kondamudi at Midlantic National Bank to pay off the Columbia
loan.

The loan payment was approximately $2,400 per month.

Mr.

Raclaw prepared the corporate tax returns for Kondamudi.
On May 17, 1981, Dr. Rao entered into a contract with, and
employed, general contractor Kostas Tsichlis (Tsichlis) to make
improvements to the medical center.

Tsichlis furnished

petitioner with a $70,000 estimate for improvements to the
medical center.

Though improvements to the medical center were

- 11 made by Tsichlis and paid for by petitioner, their actual cost
has not been established.

By 1982, the first floor of the

medical center was complete, including dental equipment,
ophthalmology equipment, and x-ray equipment.

The second floor

facility was intended to be expanded by petitioner into a
physical therapy center; however, it was not completed.

Most of

petitioner's expenditures went to the remodeling and purchase of
equipment located on the first floor.

No further renovations

have been made at the medical center since 1983.
Petitioners maintained a Chase bank account in the name of
the medical center for the purpose of paying a $50,0003 equipment
loan provided by Chase.

Dr. Rao transferred funds monthly from

his Midlantic money market account into the Chase account in
order to make the loan payments.
Dr. Rao entered into an agreement with Tilden Financial
Corp. for the lease of dental equipment in the amount of $38,180.
Petitioner was the chief individual responsible for
operating the medical center.

He paid for all expenses incurred

in the operation of the medical center.

Such expenses included

maintenance, x-ray supplies and film, gloves, and supplies for
all doctors and a nurse.

3

The record does not establish what part of the loan was
used to purchase equipment.

- 12 Physicians and a dentist working at the medical center paid
rent to Dr. Rao either every time they came in for a session, or
on a monthly basis.

The medical center is still available for

rental to physicians.

Petitioner rented the upstairs portion to

the Forest Park Senior Citizens Center since May of 1986.4
In order to calculate the medical center's expenses, as
reported on Schedule E, Mr. Raclaw conferred with Dr. Rao to
determine his monthly expenses for medical supplies, utilities,
paper goods, other supplies, and payments to an assistant who
worked there.
Petitioners reported the medical center's gross income and
deductions and claimed the following losses on Schedules E for
the years in issue:
1986

1987

1988

Rents received

$45,000

$46,800

$104,550

Expenses:
Advertising
Auto & travel
Cleaning & maint.
Insurance
Mortgage interest
Repairs
Supplies
Taxes
Utilities
Telephone
Office expense
Salary
Water

950
600
1,100
2,628
59,719
7,558
3,600
6,698
5,951
1,118
2,370
12,000
422

--240
2,400
2,782
16,182
3,100
2,000
6,811
6,000
1,263
4,185
12,000
512

----3,750
3,175
58,196
9,202
2,186
12,191
5,510
2,489
2,680
12,000
1,580

4

This lease was entered into through Dr. Rao's
corporation, Kondamudi.

- 13 Other
Depreciation
Total expenses

1,800
41,034
$147,548

--22,370
$79,845

--23,834
$136,793

Net Loss

($102,548) ($33,045)

($32,243)

Loss claimed

($102,548) ($25,000)

($25,000)

For 1986 and 1987, the claimed losses relate solely to the
medical center.

For 1988, the claimed loss includes $10,105 of

deductions for some undetermined rental activity.

In her notice

of deficiency, respondent allowed petitioners deductions equal to
the gross income reported each year for the medical center.
OPINION
1.

Preliminary Matters
Respondent on brief renews her objection to the admission

into evidence of a 1995 video tape.

The tape was authenticated

at trial as representing the medical center's physical layout and
equipment during the years in issue.

We hold the tape is

admissible.
Petitioner moved to dismiss the civil fraud addition to tax.
Our decision makes that motion moot.
2.

Civil Fraud Issue
A.

Parties' Positions

Respondent argues that Dr. Rao committed fraud in his
admitted failure to include all of his income from his psychiatry
practice.

Respondent points out that Dr. Rao is a highly

educated businessman.

Respondent argues that Dr. Rao reported

income only as reported on Forms 1099; lied to IRS agents about

- 14 payments he received directly from patients; attempted to conceal
the existence of two bank accounts; omitted substantial amounts
of income over a 3-year period; and was uncooperative with IRS
agents because his representative canceled many meetings.
Respondent further argues that Dr. Rao cannot shift
responsibility to his accountant since he did not provide him
with all the information necessary to prepare accurate returns.
Petitioners argue that Dr. Rao has not committed fraud
because the omissions from income were caused by his return
preparer on whom Dr. Rao reasonably relied; no bank accounts into
which income was deposited were concealed from the IRS agents;
Dr. Rao has no accounting or financial expertise; Mr. Raclaw's
cancellation of appointments cannot be considered lack of
cooperation by Dr. Rao; and Dr. Rao provided his accountant with
all the information necessary to compute gross income.
B.

The Law of Fraud

The addition to tax in the case of fraud is a civil sanction
provided primarily as a safeguard for the protection of the
revenue and to reimburse the Government for the heavy expense of
investigation and the loss resulting from a taxpayer's fraud.
Helvering v. Mitchell, 303 U.S. 391, 401 (1938).

Respondent has

the burden of proving, by clear and convincing evidence, an
underpayment for each year and that some part of the underpayment
was due to fraud.

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

Commissioner, 90 T.C. 1130, 1143 (1988); Otsuki v. Commissioner,

- 15 53 T.C. 96, 105 (1969).

For 1986 and 1987, section 6653(b)(1)(A)

provides for a 75-percent addition to tax on the portion of the
underpayment which is attributable to fraud, and section
6653(b)(1)(B) provides for an addition equal to 50 percent of the
interest payable on such portion.

For 1988, section 6653(b)(1)

provides for a 75-percent addition to tax on the portion of the
underpayment that is attributable to fraud.
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 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).

Respondent's burden is

met if she shows that petitioner intended to evade taxes known to
be owing by conduct intended to conceal income, mislead, or
otherwise prevent the collection of taxes.

Stoltzfus v. United

States, 398 F.2d 1002, 1004 (3d Cir. 1968); Rowlee v.
Commissioner, 80 T.C. 1111, 1123 (1983).

Respondent must meet

this burden through affirmative evidence because fraud is never
imputed or presumed.

Toussaint v. Commissioner, 743 F.2d 309,

312 (5th Cir. 1984), affg. T.C. Memo. 1984-25; Beaver v.
Commissioner, 55 T.C. 85, 92 (1970).
of conduct can be indicative of fraud.

Petitioners' entire course
Stone v. Commissioner, 56

T.C. 213, 224 (1971); Otsuki v. Commissioner, supra at 105-106.

- 16 C.

Underpayment of Tax

Petitioners have conceded an underreporting of Schedule C
gross income of $40,345, $49,839, and $47,115 for the years 1986,
1987, and 1988, respectively.

This underreporting creates an

underpayment of tax for all 3 years.

Consequently, the first

part of the test for fraud is satisfied.
D.

Fraudulent Intent

Respondent must also prove that a portion of such
underpayment was due to fraud.

Professional Servs. v.

Commissioner, 79 T.C. 888, 930 (1982).
Because direct proof of a taxpayer's intent is rarely
available, fraud may be proven by circumstantial evidence and
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).

An intent to conceal or mislead may be inferred from

a pattern of conduct, Spies v. United States, supra at 499, or
from a taxpayer's entire course of conduct, Stone v.
Commissioner, 56 T.C. 213, 223-224 (1971).
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) failing to file tax returns, (4)
implausible or inconsistent explanations of behavior, (5)
concealment of income or assets, (6) failing to cooperate with

- 17 tax authorities, (7) engaging in illegal activities, (8) an
intent to mislead which may be inferred from a pattern of
conduct, (9) lack of credibility of the taxpayer's testimony,
(10) filing false documents, and (11) dealing in cash.

See 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.

We note that some conduct and evidence can be

classified under more than one factor and not all badges are
applicable in every case.

The sophistication, education, and

intelligence of the taxpayer are relevant to this determination.
Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
a.

Petitioner's Sophistication and Experience

Dr. Rao is a medical doctor and also manages the medical
center.

He has no experience in accounting or tax return

preparation.

Based upon these facts, we shall not hold Dr. Rao

to either a higher or lower standard while evaluating his
actions.
b.

Consistent and Substantial Understatements of Income

The mere failure to report income is not sufficient to
establish fraud.

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

- 18 Cir. 1962), affg. T.C. Memo. 1959-172; Parks v. Commissioner, 94
T.C. 654, 664 (1990).

However, consistent and substantial

understatement of income may be strong evidence of fraud.

Marcus

v. Commissioner, 70 T.C. 562, 577 (1978), affd. without published
opinion 621 F.2d 439 (5th Cir. 1980).

Moreover, a pattern of

consistent underreporting of income, when accompanied by other
circumstances indicating an intent to conceal income, justifies
the inference of fraud.
137 (1954).

Holland v. United States, 348 U.S. 121,

Dr. Rao concedes that gross income of $40,345,

$49,839, and $47,115 was omitted from his 1986, 1987, and 1988
Federal income tax returns, respectively.

Therefore, he has

consistently and substantially understated his income.

However,

Dr. Rao has made no attempt to conceal his income; all of his
income was deposited into one of two bank accounts, and these
bank records were given to his tax return preparer and the IRS
agents.
c.

Failure To Maintain Adequate Books and Records

Failure to maintain adequate books and records of income is
indicative of fraud.

Truesdell v. Commissioner, 89 T.C. 1280,

1302 (1987); Gajewski v. Commissioner, 67 T.C. at 200.
Petitioner kept no books or records.

Dr. Rao attempts to blame

his tax return preparer for failing to instruct him on
bookkeeping requirements when, in fact, there is no evidence that
he requested such instruction.

- 19 d.

Intent To Mislead

Misleading statements to an investigating agent may be
evidence of fraud.

Gajewski v. Commissioner, supra at 200.

Dr. Rao did mislead the IRS agents when he told them that he
received no income directly from patients and that all of his
income was from insurance companies or third party providers.
e.

Credibility of Dr. Rao's Testimony

A taxpayer's lack of credibility, inconsistent testimony, or
evasiveness are factors in considering the fraud issue.
Toussaint v. Commissioner, 743 F.2d at 312.
was basically consistent and credible.

Dr. Rao's testimony

Even if Dr. Rao's

testimony is not credible in all respects, we may still be left
with no more than a suspicion of fraud.

See Jenkins v.

Commissioner, T.C. Memo. 1995-563.
f.

Other Factors

Dr. Rao provided his accountant, Mr. Raclaw, with all of the
information necessary to compute gross income for his Schedule C
business.

A taxpayer's reliance upon his accountant to prepare

accurate returns may indicate an absence of fraudulent intent.
Marinzulich v. Commissioner, 31 T.C. 487, 490 (1958).

However,

the taxpayer must provide his accountant "with all of the data
necessary for maintaining complete and accurate records".
Merritt v. Commissioner, 301 F.2d 484, 487 (5th Cir. 1962), affg.
T.C. Memo. 1959-172.

Dr. Rao willingly provided Mr. Raclaw with

- 20 whatever information he requested.

Mr. Raclaw was provided with

Forms 1099, bank statements, and deposit slips from the two
accounts into which Dr. Rao deposited income.

There is no

allegation of any income's not being deposited into the two bank
accounts.

Mr. Raclaw decided to calculate gross income by

totaling the Forms 1099 rather than preparing a cash receipts
journal.

Though obviously in error--he missed substantial

amounts of income--Mr. Raclaw believes he reconciled total
deposits to total income.

We find that Dr. Rao relied on Mr.

Raclaw to prepare his tax returns accurately and that he supplied
Mr. Raclaw with all the information necessary to properly compute
gross income.
Respondent argues that Dr. Rao misled his accountant by
telling him that he only received income from third-party payers,
such as insurance companies.

Respondent is mistaken.

When asked

by respondent's counsel "How did you go about determining the
income on the Schedule C's that you filed with the tax returns",
Mr. Raclaw answered:
I went over the 1099, all the 1099s that he received,
asked pertinent questions pertaining to other income,
if he [Dr. Rao] received any income from any other
sources, and the response was that he received most of
his income from insurance -- insurance providers and
the 1099s.
Mr. Raclaw did not testify that Dr. Rao told him that "all" or
"almost all" of his income came from insurance and Form 1099

- 21 issuers; Mr. Raclaw used the word "most" to describe income from
Form 1099 issuers, which is true.

Dr. Rao may, or may not have,

intentionally confused his accountant; the record is not clear,
and clear and convincing proof is required to prove fraud.
We hold that respondent has not shown, by clear and
convincing evidence, that Dr. Rao intended to omit gross income
from his tax returns.

We are bothered by Dr. Rao's attempt to

mislead the IRS agents and lack of record keeping, but we shall
not sustain respondent's determination of fraud when we are only
left with a suspicion of fraud.

Green v. Commissioner, 66 T.C.

538, 550 (1976); see Comparato v. Commissioner, T.C. Memo. 199352.
3.

Substantiation of Schedule E Expenses
Respondent allowed petitioners Schedule E deductions equal

to the gross rents reported in each of the years in issue, that
is, $45,000, $46,800, and $104,550 for the years 1986, 1987, and
1988, respectively.

Respondent disallowed deductions in excess

of gross rents as being unsubstantiated.

Petitioners' burden of

proving that respondent's determinations in her deficiency notice
are erroneous includes the burden of substantiation.

See

Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per
curiam 540 F.2d 821 (5th Cir. 1976).

Deductions are a matter of

legislative grace; petitioners have the burden of showing that
they are entitled to any deduction claimed.

New Colonial Ice Co.

- 22 v. Helvering, 292 U.S. 435, 440 (1934).

Section 6001 requires

taxpayers to maintain adequate records from which their tax
liability may be determined.

Petzoldt v. Commissioner, 92 T.C.

661, 686 (1989).
Petitioners offered no evidence or argument concerning the
$10,105 of deductions taken for an undetermined rental activity.
We hold that petitioners have abandoned that portion of the
substantiation issue.
Petitioners have offered nothing other than vague testimony
by Dr. Rao to substantiate expenses other than interest,
equipment lease payments, and depreciation.
other expenses are not substantiated.

We hold that these

"We know of no rule that

uncontradicted testimony must be accepted by a court finding the
facts, particularly where, as here, the testimony is given by
interested parties."

Wood v. Commissioner, 338 F.2d 602, 605

(9th Cir. 1964), affg. 41 T.C. 593 (1964).
Petitioners proved that they bought the medical center
building in 1980 for $120,000.

Dr. Rao testified that in the

early 1980's he borrowed $70,000 from Columbia to make
improvements to the medical center and $50,000 from Chase to
purchase equipment.

However, no invoices or canceled checks were

offered to substantiate any improvements or equipment purchases.
We do not know exactly what equipment was purchased, how much the

- 23 equipment cost, or when it was placed in service.5

In order to

support a deduction for depreciation, a taxpayer must establish a
property's depreciable basis by showing the cost of property, its
useful life or recovery period, and the previously allowable
E.g., Delsanter v. Commissioner, 28 T.C. 845, 863

depreciation.

(1957), affd. in part, revd. in part, and remanded per curiam 267
F.2d 39 (6th Cir. 1959).

We hold that petitioners have not

substantiated their depreciation deductions.
Petitioners leased $38,180 of equipment from Tilden
Financial Corp.

Petitioners rely on a schedule of lease payments

entered into evidence to show they paid $14,445 in 1986 and
$11,170 in 1987.6

Petitioners rely on what appears to be a

computerized schedule from Columbia to support interest
deductions on Kondamudi's $120,000 loan.7

The schedule shows

interest payments of $16,182 in 1987 and $18,614 in 1988.

No

canceled checks or Forms 1098 were offered to substantiate
petitioners' interest deductions.

These amounts, although

questionable, are the only amounts substantiated by petitioners.

5

Pictures and a videotape in evidence show equipment
exists at the time the pictures and videotape were taken, but
they do not establish cost or when the equipment was placed into
service.
6

7

Petitioners classified the lease payments as interest.

Due to petitioners' overall lack of substantiation, we
need not address the issue of whether petitioners can deduct
interest payments made on behalf of their corporation.

- 24 Respondent, by allowing petitioners to deduct amounts equal to
the medical center's gross rents, had allowed deductions in
excess of those substantiated by petitioners.

Therefore, we hold

that petitioners have not substantiated deductions in the
aggregate in excess of that allowed by respondent.
The issues of limitation of loss under section 465 and
section 469 passive loss limitations are thus rendered moot and
need not be addressed.
4.

Substantial Understatement
Section 6661 provides for a 25-percent addition to tax on

any substantial understatement.
T.C. 498 (1988).

Pallottini v. Commissioner, 90

A substantial understatement is one that

exceeds the greater of 10 percent of the tax required to be shown
on the return or $5,000.

Sec. 6661(b)(1).

The amount of the

understatement, for purposes of section 6661, is to be reduced by
the portion attributable to any item for which there was
substantial authority or any item that was adequately disclosed.
Sec. 6661(b)(2)(B).
Petitioners have not argued that they had either substantial
authority or adequate disclosure on their tax returns; rather,
they argue that the Commissioner abused her discretion by not
waiving the addition to tax.

The Secretary may waive all or part

of a section 6661 addition to tax upon a showing by the taxpayer
that there was reasonable cause for the understatement and that

- 25 the taxpayer acted in good faith.

Petitioners have the burden of

persuading the Court that in refusing to waive this addition to
tax, respondent has exercised this discretion "arbitrarily,
capriciously, or without sound basis in fact."
Commissioner, 91 T.C. 1079, 1084 (1988).

Mailman v.

In determining whether

petitioners had reasonable cause and acted in good faith, the
Court primarily looks to the extent of the taxpayers' efforts to
assess their proper tax liability. Id. at 1084; sec. 1.6661-6(b),
Income Tax Regs.
Petitioners attempt to blame their accountant for all their
underreporting.

The cause of petitioners' problems is an absence

of record keeping and an unexplained failure to provide even the
most basic documentary evidence, such as canceled checks, Forms
1098, invoices, and promissory notes.

These shortcomings are not

the fault of petitioners' accountant; he was not hired to perform
these services.

Dr. Rao testified that he did not even examine

the tax returns before signing them; he cannot now claim that
such action is reasonable and in good faith.

We hold that the

Commissioner did not abuse her discretion in not waiving the
substantial understatement addition to tax under section 6661.
5.

Negligence
For 1986 and 1987, section 6653(a)(1)(A) generally imposes

an addition to tax equal to 5 percent of the entire underpayment
if any part of it was due to negligence or disregard of rules or

- 26 regulations.

Section 6653(a)(1)(B) imposes a further addition to

tax in an amount equal to 50 percent of the interest payable with
respect to the portion of the underpayment which is attributable
to negligence or disregard of rules or regulations.

For 1988,

section 6653(a)(1) only provides for the 5-percent addition to
tax.

For purposes of section 6653(a)(1), the term

"negligence"

includes any failure to make a reasonable attempt to comply with
the provisions of the Code, and the term "disregard" includes any
careless, reckless, or intentional disregard.

Sec. 6653(a)(3).

Negligence also has been defined as a lack of due care or the
failure to do what a reasonable and ordinarily prudent person
would do under the circumstances.

See Crocker v. Commissioner,

92 T.C. 899, 916 (1989); Neely v. Commissioner, 85 T.C. 934,
947-948 (1985).

Failure by a taxpayer to keep adequate records

may justify imposition of the addition to tax for negligence.
See Lysek v. Commissioner, 583 F.2d 1088, 1094 (9th Cir. 1978),
affg. T.C. Memo. 1975-293; Crocker v. Commissioner, supra at 917.
Failure to maintain adequate records also indicates disregard of
the rules or regulations that require a taxpayer to keep
permanent records sufficient to establish, inter alia, the
taxpayer's gross income and deductions.
Commissioner, supra at 917.

See Crocker v.

Respondent only asserts the

additions to tax for negligence to the extent that Schedule E
expenses are disallowed.

Petitioners failed to keep or maintain

- 27 adequate records, as described above.

They are liable for the

additions to tax for negligence for all the years in issue.
To reflect the foregoing and concessions of the parties,
Decision will be entered
under Rule 155.

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ad87466c379f8b84e. Public record. Not legal advice.