T.C. Memo. 1996-313

UNITED STATES TAX COURT

RICHARD K. AND CHRISTINE M. MCGIRL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11510-94. Filed July 11, 1996.

Mark A. Pridgeon, for petitioners.

Jonathan P. Decatorsmith, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined the following

deficiencies in and penalties on petitioners' Federal income

taxes:

Year Deficiency

Accuracy-related penalties

Sec. 6662(a)

Penalty

Sec. 6663

1989 $13,501

 

 ---

 

 $10,126

1990 25,904 $30 19,316

1991 21,334 51 15,809

As an alternative to the section 6663 fraud penalty, respondent

determined additional accuracy-related penalties pursuant to
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1 Petitioners have conceded that they received, but did not

report on their individual Federal income tax returns, taxable

dividend income in the amounts of $26, $992, and $1,726 for the

years 1989, 1990, and 1991, respectively.

2 The Yogurt Station's business activity was reported on Form

1120S, U.S. Income Tax Return for an S Corporation. The record

does not establish whether the Yogurt Station was a validly

formed corporation. However, since the Yogurt Station was wholly

owned by petitioner Richard McGirl, this void in the record does

not affect our decision. 

section 6662(a) in the respective amounts of $2,700, $5,181, and

$4,267 for 1989, 1990, and 1991. 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. After concessions,1 the issues for decision are:

(1) Whether petitioners overstated the Yogurt Station,

Inc.'s, (Yogurt Station)2 automobile mileage deductions for 1989,

1990, and 1991;

(2) whether petitioners understated the Yogurt Station's

gross income for 1989, 1990, and 1991, as determined by

respondent;

(3) whether petitioners understated the Yogurt Station's

deductions for 1989, 1990, and 1991; 

(4) whether petitioners are liable for accuracy-related

penalties under section 6662(a) with respect to the underpayments

of tax resulting from their failure to report dividend income of

$26, $992, and $1,726 for the years 1989, 1990, and 1991,

respectively; and

(5) whether petitioners are liable for penalties for fraud

pursuant to section 6663 for 1989, 1990, and 1991; or in the
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alternative, whether petitioners are liable for the accuracyrelated penalty under section 6662(a).

FINDINGS OF FACT

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

The stipulation of facts and attached exhibits are incorporated

herein by this reference.

Background

Petitioners, Richard K. McGirl (Mr. McGirl) and Christine M.

McGirl (Mrs. McGirl), were married to each other at all relevant

times and resided in St. Paul, Minnesota, at the time they filed

their petition. 

Mrs. McGirl graduated from high school but did not attend

college. She did not take any accounting or bookkeeping courses

in high school. Before she worked at Mickey's Diner and the

Yogurt Station, both described below, Mrs. McGirl worked as a

receptionist at a doctor's office, as a secretary at various

places, and as a cashier at a grocery store. 

Mr. McGirl graduated from the University of Minnesota with a

bachelor of science degree in American history and industrial

relations. He did not take any accounting or bookkeeping courses

in college or high school. Before operating Mickey's Diner and

the Yogurt Station, he worked in a warehouse and as a production

foreman trainee in a foundry. 

Mickey's Diner

Mr. McGirl bought Mickey's Diner, a 24-hour diner, before he

started the Yogurt Station. Mrs. McGirl worked at Mickey's
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Diner, and as part of her duties, she prepared the employees'

payroll records, issued paychecks, and prepared quarterly payroll

tax reports. 

The Yogurt Station

The Yogurt Station was formed in 1985; it was wholly owned

by Mr. McGirl during the years in issue. Petitioners were

involved with the Yogurt Station since its inception. Income and

expenses were reported for Federal income tax purposes on Forms

1120S. 

The Yogurt Station was in the business of operating a fast

food retail store that was located in a shopping mall known as

Bandana Square in St. Paul, Minnesota. It sold yogurt products,

sandwiches, salads, and beverages. The storage space available

to the Yogurt Station was inadequate for the business. 

Petitioners often drove to pick up food and supplies that vendors

would not deliver. The Yogurt Station employed several

individuals to provide services on a part-time basis for

compensation. 

Mrs. McGirl worked full time at the Yogurt Station and was

responsible for depositing its receipts to the business bank

account and for writing checks to suppliers and employees. She

was also primarily responsible for tallying the Yogurt Station's

daily receipts. Mrs. McGirl maintained a notebook in which she

recorded the daily sales figures. She provided the daily sales

figures to Mr. McGirl. 

Mr. McGirl also worked at the Yogurt Station and was
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responsible for performing financial and bookkeeping duties. He

also wrote checks to suppliers. Mr. McGirl was responsible for

providing information to the Yogurt Station's accountant so that

he could prepare the corporate income and sales tax returns. 

Petitioners used a cash register at the Yogurt Station that

recorded sales on a paper tape. Mrs. McGirl used the cash

register tape to tally gross sales on a daily basis. The cash

register had a functioning "X" key that tallied daily sales when

punched. Petitioners received invoices in connection with many

of their purchases; they recorded the particular invoice numbers

on many of the checks used to pay for the purchases. Petitioners

did not prepare, maintain, or have a professional prepare any

accounting ledgers, spreadsheets, or similar items in connection

with operating the Yogurt Station. 

During the years at issue, the Yogurt Station maintained a

checking account (the business checking account) at Cherokee

State Bank in St. Paul, Minnesota. Some of the checks written on

the business checking account during the years at issue were for

personal expenditures. The total deposits to the business

checking account for the years 1989, 1990, and 1991 were

$126,464.21, $146,054.76, and $153,080.77, respectively. The

parties agree that, with the exception of certain amounts claimed

by petitioners to be loan proceeds, the total deposits to the

business checking account for the years at issue are gross

receipts of the Yogurt Station. 
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Corporate Tax Returns

The Yogurt Station reported the following gross receipts,

cost of goods sold, and expenses on its Federal corporate income
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tax returns for the years in issue:

 1989 1990 1991

Gross receipts $70,154 $54,681 $65,582

Cost of goods sold

Purchases/food supplies $21,046 $13,670 $11,640

Cost of labor 5,886 19,534 20,000

 Total 26,932 33,204 31,640

Expenses

Officer compensation $13,925 $6,000 $6,000

Rent 2,806 4,800 1,250

Taxes 8,478 9,755 9,163

Interest 90 --- ---

Depreciation 9,749 8,307 9,319

Legal 1,500 2,000 1,100

Accounting 600 1,000 800

Vehicle expense 3,825 3,900 4,125

Maintenance 150 500 1,276

Equipment 125 1,000 700

Miscellaneous 75 350 450

Phone --- 1,000 800

Bank charges --- --- 75

Subscriptions --- --- 110

Insurance --- --- 980

 Total 41,323 38,612 36,148

Ordinary income (loss) 1,899 (17,135) (2,206)

Clarence F. Lauth, a relative of Mrs. McGirl, prepared the

corporate tax returns for the years 1987 through 1991 for

compensation. Mr. McGirl provided the information used by Mr.

Lauth to prepare the corporate tax returns. This information was

in the form of a single sheet of paper containing summary figures

of income and expenses (the summary sheet) and a payroll summary;

no breakdown showing how the figures were computed was provided

to Mr. Lauth. Although he told Mr. Lauth that his figures were

accurate, Mr. McGirl simply wrote numbers on the summary sheet
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without making any attempt to calculate the correct amount or

verify their accuracy. The corporate tax returns for the years

1989 and 1991 were signed by Mr. McGirl. The record does not

reflect who signed the 1990 corporate tax return. The corporate

tax returns made no reference to any business activity other than

the Yogurt Station for all of the years in issue.

Petitioners' Joint Federal Income Tax Returns

Mr. Lauth prepared each of petitioners' joint Federal income

tax returns (joint tax returns) for the years 1989 through 1991. 

The information reflected on these joint tax returns was provided

to Mr. Lauth by Mr. McGirl in the form of a single sheet of paper

setting forth total income and deduction figures. Petitioners

reported the following items of income, adjustments to income,

 itemized or standard deductions, and deductions for

exemptions on their joint tax returns for the years in issue:

 1989 1990 1991

Yogurt Station wages $13,925 $19,800 $20,800

Taxable interest income 163 --- 328

Dividend income 2,348 2,911 2,550

Capital gain (loss) (286) --- 8,645

Other income --- 21,500 ---

Yogurt Station income (loss) 1,899 (17,135) (2,206)

 Total income 18,049 27,076 30,117

Adjustments to income 4,000 4,750 5,063

Adjusted gross income 14,049 22,326 25,054

Itemized/standard deductions 6,036 5,540 5,700

Exemptions 4,000 4,100 4,300

 Taxable income 4,013 12,686 15,054

Tax 604 1,916 2,261
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3 Mr. McGirl maintains that Mr. McAllister lent him additional

sums of money that eventually made their way into the Yogurt

Station's business checking account and thus should not be

considered gross receipts.

The "Other income" of $21,500 for the year 1990 came from the

settlement of a lawsuit. The joint tax returns made no reference

to any business activity other than the Yogurt Station for all of

the years in issue. On August 4, 1992, Mr. McGirl told Mr. Lauth

that he had unreported income and that the underreporting "had

been going on for some time." During the years in issue, Mr.

McGirl amassed more than $112,000 in savings.

Mr. McAllister's Alleged Loans to Mr. McGirl

It is undisputed that Michael McAllister, a close friend of

Mr. McGirl since childhood, lent him $10,000 sometime during the

years at issue.3 Mr. McGirl issued a $10,000 check to Mr.

McAllister on or about July 7, 1992, a date after Mr. McGirl was

contacted by the Minnesota Department of Revenue (MDR) regarding

a State tax examination of the Yogurt Station. Mr. McGirl

fabricated promissory notes in which he forged Mr. McAllister's

signature and gave them to his own accountant, Steve Brown. Mr.

Brown represented Mr. McGirl before the MDR and the Internal

Revenue Service (IRS). Mr. Brown gave the fabricated promissory

notes to an MDR agent. 

Since 1985 and continuing through the years in issue, Mr.

McAllister had significant personal debt, including automobile

loans, home mortgages, and credit cards that were utilized to 
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4 It was customary for MDR to work jointly with the IRS.

their full extent and which bore interest at annual rates up to

22 percent.

MDR's Audit of the Yogurt Station

Debora Berg, a tax auditor for the MDR, informed Mr. McGirl

by letter in May of 1992 that she would be examining the Yogurt

Station's State tax liabilities. The letter asked Mr. McGirl to

provide Ms. Berg with the Yogurt Station's business and

accounting records. Mr. McGirl called Ms. Berg on May 20, 1992,

and told her he did not have a business checking account, all of

the store's expenses were paid in cash, and he did not keep

receipts or documents. When Mr. McGirl first met with Ms. Berg

on August 25, 1992, he brought the canceled checks and deposit

slips from the business checking account. When questioned about

his earlier statement that the Yogurt Station did not have a

checking account or records and that all expenses were paid by

cash, Mr. McGirl told Ms. Berg that he thought she would drop the

audit if he dealt solely in cash. Mr. McGirl admitted to Ms.

Berg that the numbers on the Yogurt Station's State tax returns

were just guesses. After inputting the checks and deposits onto

a computer, Ms. Berg discovered that the Yogurt Station's

deposits exceeded the amounts reported on its State tax returns. 

Ms. Berg contacted Hubbard Burgess, an IRS representative, and

informed him that she believed the Yogurt Station had unreported

income.4 Seven former Yogurt Station employees provided 
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affidavits to the MDR that stated that the cash register worked

properly.

The IRS Audit

Mr. Burgess met with Mr. McGirl and Ms. Berg on November 23,

1992. Mr. McGirl, for the first time, stated that he had

borrowed money from a friend, Mr. McAllister. Mr. McGirl did not

state the amount of the alleged loans or produce any

documentation to support their existence at this meeting. Mr.

McGirl also mentioned for the first time that he was involved

with another business; i.e., the purchase and sale of used

restaurant equipment. Mr. McGirl never produced the cash

register tapes, invoices, copies of store leases, automobile

logs, or the pieces of paper given to him by Mrs. McGirl on which

she tallied the daily sales. Other than canceled checks and

invoices submitted in connection with legal expenses, Mr. McGirl

failed to present any supporting documentation to substantiate

the Yogurt Station's expenses. 

Petitioners' Check Spreads

Although petitioners did not maintain a cash disbursement

journal in the regular course of their business, they did prepare

check spreads prior to trial, in anticipation of this case. 

There is a separate check spread for each year in issue. Each

check spread lists the number, date, payee, and amount for each

of the business checks. The checks are "spread" across the page
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5 Petitioners only reported $13,925 in wages from the Yogurt

Station on their 1989 joint Federal income tax return.

into specific expense categories. The yearly totals, by 

expense category, are as follows:

1989 1990 1991

Auto $939 $1,372 $2,011

Auction 370 2,460 2,650

Food 33,114 38,397 33,870

Equipment 2,794 6,435 635

Misc. 9,406 7,142 7,670

Personal 1,162 647 4,685

Professional 2,240 4,042 1,200

Repair 5,089 3,075 2,059

Supplies 2,721 2,011 2,118

Taxes 6,618 10,437 9,006

Wages 26,073 24,943 26,111

Mike's Loan 32,185 42,165 38,416

Other 36 6,799 11,774

The "Misc." category includes rent, insurance, and telephone. The

"Other" category includes missing checks not returned with the

bank statement, checks that petitioners could not identify, 

loans, including a $5,000 loan in 1990, and a $10,020 check to

Cherokee State Bank in 1991 for an unknown purpose. The "Mike's

Loan" category consists of checks written by Mr. McGirl to First

Jersey National Bank that were routed into petitioners' Dean

Witter investment accounts. Of the $26,073 in wages for 1989,

$20,861 was paid to petitioners.5

Mr. McGirl's Automobile Logs

Mr. McGirl deducted an amount attributable to 15,000 miles

of business use of a 1985 Honda on each of the Yogurt Station's
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corporate tax returns for the years in question. Although Mr.

McGirl produced auto logs at trial, he never presented the logs 

to any representative of the IRS or the MDR during their

respective audits. 

The original auto logs are composed of 8-1⁄2 by 11 inch sheets

of white paper with the following typed headings above four

columns: Day/Month, Odometer Reading Start, Odometer Reading

End, and Business Purpose. There is a separate page for each

month. Each page has rows numbered 1 through 31 (corresponding

to the days of the month) on the left side. The beginning and

ending mileage columns account for every single mile the

automobile was driven during the 3 years; there are no mileage

gaps between entries. The auto logs reflect total mileage for

1989, 1990, and 1991 as 13,802, 17,626 and 20,079, respectively. 

There is an abbreviated business purpose recorded for every

entry. Almost all of the entries in the business purpose column

are noted as "auction", "supplies", or "food supplies". 

The auto logs are remarkably well preserved; they are not

folded, creased, or crumpled; there are no marks on the papers

that would indicate they were kept on a clipboard. The pages are

in pristine condition.

Petitioners' Business Records

Petitioners have thrown away almost every contemporaneous

piece of documentary evidence of their business activities, with

the exception of the business checking account and allegedly
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contemporaneously prepared auto logs. Petitioners maintained no

books or records other than cash register tapes and a calculation

of daily sales (both thrown away).

Mr. McGirl's State Tax Felony Convictions

On March 18, 1994, Mr. McGirl pleaded guilty to count one of

the amended complaint filed by the State of Minnesota charging

him with making and filing 54 false State sales tax returns, each

involving more than $300 in tax, from the period 1988 through

June 1992.

OPINION

Petitioners admit they underreported the gross receipts of

the Yogurt Station, but argue that they should be allowed

offsetting deductions for expenses which they simultaneously

underreported on the Yogurt Station's corporate tax returns.

Petitioners bear the burden of showing that they are

entitled to the additional deductions and that respondent's

determination of the gross income is incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111 (1933). Since there is

virtually no documentary evidence to support their claims for

increased deductions other than canceled checks, petitioners'

credibility is crucial in meeting their burden. We first shall

examine Mr. McGirl's auto logs as they are offered in support of

the Yogurt Station's automobile expense deductions and are the

only allegedly contemporaneous records retained. 

1. Automobile Mileage Deduction
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Mr. McGirl claimed deductions on the Yogurt Station's 1989,

1990, and 1991 corporate income tax returns for automobile

expenses in the amounts of $3,825, $3,900, and $4,125,

respectively. These expenses were apparently computed by

multiplying 15,000 annual miles by the prevailing standard

mileage rate. We find that the auto logs offered into evidence

by Mr. McGirl were not contemporaneously made, as required by

section 1.274-5(c)(2)(ii)(a), Income Tax Regs. 

Mr. McGirl testified that he only kept track of business

miles on his auto logs, yet every mile driven is accounted for. 

Either Mr. McGirl had no personal use whatsoever of his

automobile over a 3-year period or part, if not all, of the auto

logs is a fabrication. There is no credible evidence in the

record to suggest that Mr. McGirl drove his automobile solely for

business purposes. Based upon this implausibility and on the

following inconsistencies, we find Mr. McGirl's auto logs to be

fabrications. Mr. McGirl never offered the auto logs to the MDR

or the IRS when he was examined. The auto logs show annual

business mileage of 13,802, 17,626, and 20,079 for the years

1989, 1990, and 1991, respectively. However, the Yogurt Station

claimed exactly 15,000 business miles in each of the years in

issue. Mr. McGirl never gave the auto logs to Mr. Lauth, his tax

return preparer. Mr. McGirl saw no need to keep any business

receipts, invoices, books, or records, but maintained that he

kept "very accurate records" of the business use of his car. Mr.
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6 The use of the term "business" is for convenience only and

does not imply a finding that any such business existed.

McGirl testified that he kept the auto logs underneath the front

seat of his automobile, but the individual pages of the logs are

in pristine condition, totally inconsistent with that manner of

storage. The auto logs indicate Mr. McGirl's lack of

credibility. We find that petitioners have not proven that the

Yogurt Station is entitled to automobile expense deductions in

excess of those allowed by respondent.

2. Unreported Income

Mr. McGirl's explanation of the underreporting of the Yogurt

Station's gross receipts revolves around an alleged business

activity that was not reported on the Yogurt Station's or

petitioners' tax returns and purported loans used to finance the

alleged activity.

a. Mr. McGirl's Alleged Restaurant Equipment Business

Mr. McGirl testified that he carried on a business6 totally

apart from the Yogurt Station; i.e., the sale of used restaurant

equipment and maintenance of refrigeration equipment. He

allegedly bought used restaurant equipment at auctions, sometimes

cleaned and fixed it up, and sold the equipment to bars and

restaurants. This business had no fixed location; Mr. McGirl

supposedly would stop by bars and restaurants and offer to sell

them the used equipment or to perform maintenance on their

refrigeration equipment. All of the alleged business activity
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7 The use of the words "borrowed" and "loan" are for convenience

only and do not reflect a finding that any loans existed.

was carried on in cash. No records were kept. Mr. McGirl

testified that "an ideal trip for me would go - - would be to

leave the Twin Cities empty, if it [the auction] was out of town,

and to buy, clean, fix, and sell on the road then come back

empty-handed except, of course, with money." Mr. McGirl

testified that some of the money would be spent on supplies,

meals, motels, and gasoline for the automobile. The money left

over was supposedly given to Mrs. McGirl, who deposited it into

the business checking account. Mr. McGirl further testified that

the business was carried on for all of the years at issue. Mrs.

McGirl did not testify concerning this business. Other than the

fabricated auto logs and his own self-serving testimony, Mr.

McGirl offered no proof of the business' existence.

b. Purported Loans From Mr. McAllister

Mr. McGirl testified that he borrowed7 a total of $73,500

from Mr. McAllister, a longtime friend. According to a computergenerated summary produced by Mr. McAllister after the start of

the MDR audit, Mr. McGirl borrowed money from him 101 times

between September 1988 and March 1991. The amounts supposedly

borrowed were in either $500 or $1,000 amounts, with two

exceptions. Mr. McGirl and Mr. McAllister testified that the

loans were always in cash. According to Mr. McGirl, he borrowed

money from Mr. McAllister before each "auction" trip because he
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needed cash to purchase items at auctions. 

Mr. McAllister testified that each of the 101 loans was

evidenced by a separate IOU. These IOU's supposedly were used by

Mr. McAllister to create the computer-generated summary which was

offered into evidence. Mr. McAllister testified that he gave the

IOU's to Mr. McGirl when the latter signed a consolidated note

for $63,500, the amount Mr. McGirl allegedly owed to Mr.

McAllister after a $10,000 payment. However, Mr. McAllister told

Ms. Berg and Mr. Burgess that he never returned any IOU's to Mr.

McGirl. Petitioners did not offer the IOU's into evidence. 

However, respondent offered into evidence IOU's created by Mr.

McGirl which were given to the MDR's criminal investigator, Mr.

Erickson, by petitioners' representative at the time, Mr. Brown. 

At trial, Mr. McGirl admitted that he made up the IOU's and

forged Mr. McAllister's signature on them.

The consolidated note for $63,500 was put into evidence. It

is a demand note with interest at 10 percent, dated July 7, 1992,

with no stated maturity date or payment schedule. The

consolidated note has no interest on the amounts advanced since

September of 1988.

Mr. McAllister's testimony that he lent Mr. McGirl $73,500

over a 3-year period was vague, incredible, and contradicted in

part by his statements to Ms. Berg. The alleged documentation

for all 101 loans was missing. No payments were ever made on the

loans until a single $10,000 payment was made in July 1992, after
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8 Red is apparently deceased.

9 Mr. McGirl testified: "Well, as I mentioned before, an ideal

trip would be to come back empty-handed. Unfortunately, you

know, I have got a garage full of equipment. I got my basement

full of equipment. I have got - - a friend of mine's garage is

full of equipment." Even if Mr. McGirl's testimony is believed,

he could not deduct the cost of equipment purchased until it was

sold. Mr. McGirl testified that he was in the business of

selling used restaurant equipment and that he used the loans to

(continued...)

the MDR audit had commenced. Mr. McAllister testified that the

loans were all made in cash and were made from a cash hoard of

$25,000, checks for cash from his bank accounts, and cash loans

he received from an individual Mr. McAllister initially referred

to simply as "Red". Mr. McAllister refused to identify who Red

was when he spoke with Ms. Berg. At trial, Mr. McAllister denied

keeping Red's identity a secret from Ms. Berg. The canceled

checks to cash were not offered as evidence. No documentation of

any loan from Red was put into evidence, and although Mr.

McAllister claims he paid Red's estate8 back by check, the

canceled check also was not offered into evidence. Mrs. McGirl

did not testify concerning the alleged loans. 

In summary, Mr. McGirl's explanation of the unreported gross

receipts is that $32,000, $30,500, and $7,000 for the years 1989,

1990, and 1991, respectively, are amounts lent to him by Mr.

McAllister to purchase auction items. Since the cash remaining

after an auction trip was allegedly deposited into the business

checking account, Mr. McGirl maintains that total deposits

overstate income by the amount of the loans.9 Therefore, Mr.
- 20 -

9(...continued)

buy the equipment. The purchased equipment would be his

inventory. A taxpayer may not deduct inventory purchases. 

Molsen v. Commissioner, 85 T.C. 485, 502 (1985). No documentary

evidence or testimony was offered by petitioners to establish the

cost of the ending inventory for each year in question. 

McGirl argues that the understated income should be calculated as

follows:

Year

 Total

deposits

McAllister

 loans 

Reported

deposits

Understated

 Income 

1989 $126,464 $32,000 $70,154 $24,310

1990 146,055 30,500 54,681 60,874

1991 153,081 7,000 65,582 80,499

c. Reconstruction of Income

Every individual liable for tax is required to maintain

books and records sufficient to establish the amount of his or

her gross income. Sec. 6001; DiLeo v. Commissioner, 96 T.C. 858,

867 (1991), affd. 959 F.2d 16 (2d Cir. 1992). Where a taxpayer

fails to maintain or produce adequate books and records, the

Commissioner is authorized to compute the taxpayer's taxable

income by any method that clearly reflects income. Sec. 446(b);

Holland v. United States, 348 U.S. 121 (1954); Webb v.

Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), affg. T.C.

Memo. 1966-81. The reconstruction of income need only be

reasonable in light of all surrounding facts and circumstances. 

Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). The

Commissioner is given latitude in determining which method of

reconstruction to apply when a taxpayer fails to maintain
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records. Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).

For the years under consideration herein, petitioners

maintained inadequate books and records for the Yogurt Station. 

As a result, respondent used the bank deposit method to

reconstruct the Yogurt Station's gross income. "The bank deposit

method assumes that all money deposited in a taxpayer's bank

account during a given period constitutes taxable income." DiLeo

v. Commissioner, 96 T.C. at 868. Bank deposits are prima facie

evidence of income. Tokarski v. Commissioner, 87 T.C. 74, 77

(1986); Estate of Mason v. Commissioner, 64 T.C. 651, 656 (1975),

affd. 566 F.2d 2 (6th Cir. 1977).

Only Mr. McGirl testified at trial about his used restaurant

equipment auction and maintenance business. No records, no bills

of sale, no original IOU's, or any other document, with the

exception of the fabricated auto logs, were offered to support

Mr. McGirl's testimony. It is up to petitioners to prove a

nontaxable source of the deposits. Petitioners stipulated that,

except for loans from Mr. McAllister, all the Yogurt Station's

deposits were income. Viewing the record as a whole, we find it

improbable and unconvincing that Mr. McAllister provided the

funds as claimed. We are not required to accept blindly

testimony which patently appears to he "highly improbable or

manifestly unreasonable." Carmack v. Commissioner, 183 F.2d 1, 2

(5th Cir. 1950), affg. a Memorandum Opinion of this Court. Mr.

McGirl would have the Court believe that during a period when Mr.
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10 Even if we accepted Mr. McGirl's testimony that Mr.

McAllister provided him with funds 101 times, which we do not,

petitioners would still have to show that the transfers of funds

truly were loans. Beaver v. Commissioner, 55 T.C. 85, 91 (1970).

McAllister had automobile loans, home mortgages, and fully

utilized his credit cards at interest rates up to 22 percent, he

kept a cash hoard of $25,000, lent Mr. McGirl money 101 times at

a rate of 10 percent with no fixed payment schedule, and

consolidated 3 years of loans after receiving one payment of

principal, without adding accrued, yet unpaid interest. Mr.

McGirl would have the Court believe that he borrowed money almost

weekly during a period when he amassed more than $112,000 in

savings, for an alleged business whose existence he was unable to

document by any reliable evidence. The record as a whole

contradicts the testimony of Mr. McGirl and Mr. McAllister;

simply put, we do not believe them. 

Petitioners have not proven that any purported transfers

were loans. Therefore, they have not met their burden of proof

in establishing a nontaxable source for the deposits.10

3. Increased Expenses

Petitioners argue that the Yogurt Station is entitled to

offset its unreported gross receipts with additional expenses

that were not claimed on its corporate tax returns. 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. v. Helvering, 292 U.S. 435, 440 (1934). Mr.
- 23 -

11 Respondent made a hearsay objection to petitioners'

introduction of the check spreads into evidence. This objection

was renewed on brief. As a practical matter, when the

substantiation of 3 years of expenses is at issue and copies of

all checks are in evidence, summarizing the check activity does

assist the Court. Fed. R. Evid. 1006. We shall treat these

check spreads prepared by petitioners as admissible evidence. 

McGirl made up the numbers he provided Mr. Lauth to prepare the

Yogurt Station's corporate tax returns. At trial, petitioners

put into evidence check spreads that summarized their business

checking account activity by year.11 Other than for attorney's

fees, petitioners failed to provide any invoices, receipts, or

other documentary evidence to substantiate the claimed increased

deductions. Petitioners testified at trial as to the business

purpose of checks to most payees. We must decide if the check

spreads, coupled with petitioners' testimony, adequately

substantiate the increased expenses. 

We note at the outset that petitioners do not wish to

substitute their check spread category totals for all the

deductions claimed on the Yogurt Station's corporate tax returns;

they only want to substitute selected categories. This selective

use of the check spread ignores the expenses on the Yogurt

Station's corporate tax returns that are greater than the check

spread totals. For example, the Yogurt Station's 1989 corporate

tax return has a deduction of $8,478 for taxes; the 1989 check

spread lists total taxes of $6,618. 

There are basic problems with the check spreads. Without

receipts, we are left with petitioners' self-serving testimony 
- 24 -

12 On their respective 1989 returns, petitioners reported

$13,925 as wages from the Yogurt Station and it deducted a like

amount. However, the check spread indicates that the Yogurt

Station paid petitioners $20,861 in 1989. 

to identify what was purchased and whether it was for business or 

personal use. One of the Yogurt Station's largest suppliers,

Sam's Wholesale Club, is well known for selling nonfood items. 

Petitioners wish to deduct as rent three checks payable to

Cherokee State Bank, which is both the Yogurt Station's and

petitioners' personal bank. There were no leases, documents, or

nonparty testimony explaining why checks were made payable to

Cherokee State Bank. Petitioners wish to deduct checks, some of

which are in excess of $1,000, payable to individuals and to cash

for maintenance and repair. Without supporting documentation,

deductions for checks written to cash and to individuals are

highly suspect.

Petitioners claim to have underreported the Yogurt Station's 

payment of compensation and wages; the amount allegedly

underreported for 1989 is $6,262. The 1989 check spread shows

that petitioners were paid $6,936 more than the amount reported

on their return.12 Petitioners want the Yogurt Station to have

an increased deduction for wages, although they have failed to

personally report a corresponding increase in wages. Their claim

to the additional deduction has not been substantiated. 

Petitioners wish to claim deductions for equipment

purchases; it is a separate category on the check spreads. 
- 25 -

13 The store's returns made no mention at all of an auction

(sale of used restaurant equipment) business.

Generally, there is no deduction for the purchase of equipment. 

On a timely filed tax return, subject to limitations, a taxpayer

can elect to treat the cost of section 179 property as an

expense. To avail oneself of the benefits of section 179, the

taxpayer must make an irrevocable election on the tax return. 

Sec. 179(a), (c). Petitioners made no such election. In order

to depreciate an asset, there must be evidence that it was put

into service during the year in question for use in a trade or

business. Petitioners offered no such evidence.

Although the Yogurt Station's tax returns had no deduction

for auction expenses,13 petitioners seek to deduct checks made

payable to cash under this category. Petitioners have not met

their burden of showing that this side business existed.

 After carefully reviewing the 1989, 1990, and 1991 check

spreads, based on the observations made above, we conclude that

they are unreliable as substantiation for additional expenses. 

Based on the record as a whole, and as discussed below, we find

that petitioners' testimony lacks credibility. The check spreads

are simply too little, too late. In fact, were we to rely on

them, we would allow petitioners fewer total deductions than

respondent has already allowed in her notice of deficiency. We

find insufficient evidence in the record to justify allowance of

any deductions in excess of those claimed on the Yogurt Station's
- 26 -

tax returns; petitioners have failed to prove the Yogurt

Station's entitlement to additional deductions for unclaimed

business expenses. Accordingly, we sustain respondent's

determination of the deficiencies for 1989, 1990, and 1991. 

4. Civil Fraud Penalty

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,

53 T.C. 96, 105 (1969). If respondent establishes that any

portion of the underpayment is attributable to fraud, the entire

underpayment is treated as attributable to fraud and subjected to

a 75-percent addition to tax or penalty, except with respect to

any portion of the underpayment that the taxpayer establishes is

not attributable to fraud. Sec. 6663(b).

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.
- 27 -

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 petitioners 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). Petitioners' entire course

of conduct can be indicative of fraud. Stone v. Commissioner, 56

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

A. Underpayment of Tax

Even if all of petitioners' arguments regarding additional

unclaimed deductions and alleged loans were accepted, there would

still be an underreporting of income in 1990 and 1991. This

underreporting would give rise to an underpayment of tax for both

1990 and 1991. Therefore, we next consider whether respondent

has shown an underpayment for 1989 as well. 

The Commissioner can satisfy her burden of proving the first

prong of the fraud test; i.e., an underpayment, when the

allegations of fraud are intertwined with unreported and

reconstructed income in one of two ways. The Commissioner may

prove an underpayment by proving a likely source of the
- 28 -

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

(1954); Parks v. Commissioner, 94 T.C. 654, 661 (1990). 

Alternatively, where the taxpayer alleges a nontaxable source,

the Commissioner may satisfy her burden by disproving the

nontaxable source so alleged. United States v. Massei, 355 U.S.

595 (1958); Parks v. Commissioner, supra.

 We find that respondent has proven by clear and convincing

evidence a likely source of the underreported deposits; i.e.,

that they are income from the Yogurt Station's business.

We also find that respondent has disproved, by clear and

convincing evidence, the nontaxable source alleged by

petitioners. Mr. McGirl's explanation of loans from Mr.

McAllister is implausible and incredible. The McAllister loans

were supposedly included in the Yogurt Station's deposits. In

1991, the alleged loans were only $7,000, yet the Yogurt

Station's deposits substantially increased from the previous year

when the alleged loans were $30,500. This inconsistency was not

explained by petitioners. Mr. McAllister's testimony was vague

and incredible. Further, we find it implausible that Mr.

McAllister would have a $25,000 cash hoard given his financial

situation during the years in question. Thus, respondent has

proven, by clear and convincing evidence, that an underpayment of

tax existed with respect to each of the years under
- 29 -

14 Since petitioners' alleged additional expenses are less than

the unreported income for each of the years in issue, we need not

concern ourselves with the line of cases that state that even in

criminal tax evasion cases where the Government bears the burden

of proof beyond a reasonable doubt, "evidence of unexplained

receipts shifts to the taxpayer the burden of coming forward with

evidence as to the amount of offsetting expenses, if any." 

Siravo v. United States, 377 F.2d 469, 473 (1st Cir. 1967).

consideration.14

B. Fraudulent Intent

Next, respondent must 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. These badges of

fraud include: (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

tax authorities, (7) engaging in illegal activities, (8) an
- 30 -

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. The sophistication,

education, and intelligence of the taxpayer are relevant to this

determination. Niedringhaus v. Commissioner, 99 T.C. 202, 211

(1992).

a. Petitioners' Sophistication and Experience

Mr. McGirl attempts to counter evidence of fraud with the

defense that he had no accounting or bookkeeping training and was

ignorant as to all recordkeeping and tax reporting requirements. 

We are not impressed with Mr. McGirl's attempt to characterize

himself as an inexperienced and unknowledgeable business person. 

Mr. McGirl has a college education. He operated a restaurant

before petitioners started the Yogurt Station. The record shows

that he managed to accumulate more than $112,000 in savings in

just 3 years of the Yogurt Station's operation. Even if we were

to believe in Mr. McGirl's naivete, which we do not, the record
- 31 -

is still replete with indica of fraud on his part.

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

Cir. 1962), affg. T.C. Memo. 1959-172; Parks v. Commissioner,

supra at 664. 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. Holland v. United States, 348 U.S. 121,

137 (1954). Even if we were to subtract the alleged loans,

petitioners have admitted to understating the Yogurt Station's

gross income in the amounts of $24,310, $60,874, and $80,499 for

1989, 1990, and 1991, respectively. These understatements are

both consistent and substantial; they are evidence of fraud.

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. Although

Mr. McGirl had owned and operated a restaurant for over a decade,

he claims that invoices, receipts, and cash register tapes were
- 32 -

treated as "garbage". Petitioners kept no books or records, much

less adequate ones. Mr. McGirl attempts to blame his tax return

preparer for failing to instruct him on bookkeeping requirements

when, in fact, he requested no such instruction. Mr. McGirl

always claimed to have support for the expense and income numbers

listed on the summary sheets given to the tax return preparer. 

No evidence has been presented to show that the Yogurt Station's

corporate tax returns did not accurately reflect the information

provided to the tax return preparer. Although Mrs. McGirl wrote

down the daily sales figure and gave it to Mr. McGirl, he

promptly discarded it. Mr. McGirl's destruction of the Yogurt

Station's business records is evidence of fraud.

d. Implausible or Inconsistent Explanations of

Behavior

Mr. McGirl has made many implausible and inconsistent

statements. We find Mr. McGirl's claims to be self-serving and,

at least in part, incredible. A partial listing of such

implausible or inconsistent testimony and behavior follows:

(a) Mr. McGirl's auto logs purport to show 100 percent

business usage of his automobile;

(b) Mr. McGirl purported to keep detailed auto logs while

discarding other business records;

(c) Mr. McGirl testified that the cash register was dropped

in the first year of the Yogurt Station's existence and was never

repaired or replaced. Although he amassed more than $112,000 in

savings, Mr. McGirl testified that it was not economically
- 33 -

feasible to get the cash register repaired, and petitioners never

replaced it;

(d) Mr. McGirl testified to and offered into evidence a loan

summary which shows 101 separate loans over a 3-year period. At

all times, petitioners had more in savings than they allegedly

owed. According to petitioners' exhibits, a $1,000 check was

written on February 21, 1989, to their savings account. Yet 2

days later, on February 23, 1989, Mr. McGirl allegedly borrowed

$1,000 from Mr. McAllister. On July 7, 1989, Mr. McGirl wrote a

$1,500 check for deposit into the savings account and then

supposedly borrowed $1,000 on the same day. This pattern of

borrowing money shortly after depositing money into savings is

repeated over the 3-year period.

(e) Mr. McGirl claimed that he did not make up the numbers

on the Yogurt Station's corporate tax returns, but instead

"guesstimated" them. According to Mr. McGirl, a guesstimate is a

number that he believes is accurate, erring on the conservative

side. Mr. McGirl's guesstimates of income and expense, when

considered as a whole, showed a net loss over a 3-year period

while petitioners accumulated more than $112,000 in savings. 

When questioned by Ms. Berg as to how he came up with the

numbers, Mr. McGirl said "he just guessed, he pulled the numbers

'out of the air.'"

(f) Mr. McGirl testified that he saw no need to keep

records, receipts, invoices, cash register receipts, leases, or

any other business records.
- 34 -

Any one statement might be overlooked or rationalized, but the

cumulative effect of such testimony is indicative of fraud on the

part of Mr. McGirl.

e. Intent to Mislead

Misleading statements to an investigating agent may be

evidence of fraud. Gajewski v. Commissioner, supra at 200. Mr.

McGirl admits that he fabricated IOU's and gave them to his

representative while he was being audited by the MDR. In hopes

of avoiding a State audit, Mr. McGirl told Ms. Berg that the

Yogurt Station had no checking account and that he paid all bills

by cash. 

f. Lack of Credibility of Mr. McGirl'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. Although Mr. McGirl

had operated two restaurants and was responsible for their

finances, he testified "I am not even sure I know--if I know what

an invoice is." Petitioners amassed more than $112,000 in

savings. Monthly brokerage statements were entered into evidence

that clearly show the magnitude of their savings. Mr. McGirl

wrote checks almost weekly on the business checking account to

the savings account during the years in question; the checks were

for $1,000 to $5,000 each. Petitioners' own check spreads detail

and total the amounts put into the savings account. Yet, the

following colloquy took place between Mr. McGirl and respondent's 

attorney at trial:
- 35 -

Q Now, during the time period that is the

subject of this case, 1989 through 1991, you

had an account with Dean Witter, a liquid

asset fund, didn't you?

A Yes.

Q And you made some deposits to that account

over the course of those three years?

A Yes.

Q Can you estimate for me what the amount of

those deposits were?

A I couldn't possibly.

Q Would you say it is closer to $100, $1,000,

$10,000, $100,000?

A I made those deposits. I believe I told Mike

[Mr. McAllister] I was doing it on a monthly

basis. This is the money that was earmarked

to repay Mike. The amount, I have no idea.

Q You have no idea how much you put into this

liquid assets account?

A I have no idea.

Mr. McGirl's auto logs, for the reasons detailed above, show his

lack of credibility. Both Mr. and Mrs. McGirl testified that the

cash register broke in the first year of the Yogurt Station's

operation and that they never had it repaired. The cash register

supposedly was unreliable because it would randomly repeat

entries. However, when Mr. McGirl was being investigated by Mr.

Erickson, a criminal investigator for the MDR, seven former

Yogurt Station employees provided affidavits that stated that the

cash register worked properly, and that it did not repeat

entries. After the MDR audit was underway, Mr. McGirl told Mr.
- 36 -

Lauth, his tax return preparer, that he had unreported income and

that it had been going on for some time.

Mr. McGirl testified that he conservatively "guesstimated"

the store's gross income and expenses. Mr. McGirl's guesstimates

of gross income and expense were so far off the mark that we

conclude that they were not good faith estimates at all. Even if

we were to believe the loan story, petitioners still saved more

than $38,000 in excess of the alleged loan proceeds. Even when

the alleged loans ended, the Yogurt Station's deposits kept

increasing. 

Mr. McGirl testified that: (1) He did not know if he was

the sole owner of Mickey's Diner; (2) he had no idea if his

corporation had stock; (3) he cannot remember the name on the

Yogurt Station's tax return; and (4) neither the MDR or the IRS

auditors ever asked to see his auto logs. The above statements,

when taken as a whole, show Mr. McGirl's lack of credibility and

are evidence of fraud.

g. Dealing in Cash

Mr. McGirl testified that his purported side business and

alleged borrowings were transacted exclusively in cash. The

existence of cash transactions is difficult to disprove. 

However, the exclusive use of cash when conducting business

transactions, when coupled with a lack of recordkeeping, is

evidence of fraud. 

h. Other factors

We also consider it significant that Mr. McGirl pleaded
- 37 -

guilty to State sales tax violations. Although this conviction

does not, in and of itself, establish a fraudulent intent, we

consider the crime evidence of a propensity to defraud. Petzoldt

v. Commissioner, 92 T.C. at 701-702 (1989), McGee v.

Commissioner, 61 T.C. 249, 260 (1973), affd. 519 F.2d 1121 (5th

Cir. 1975).

To summarize, after carefully reviewing all of the facts and

circumstances present in this record, we conclude that respondent

has clearly and convincingly proven that an understatement of tax

for 1989, 1990, and 1991 was due to fraud on the part of Mr.

McGirl. Petitioners have failed to show that any portion of the

underpayment was not due to fraud. Therefore, we sustain

respondent's determination that Mr. McGirl is liable for the 

penalty for fraud under section 6663(a) for all of the years

under consideration.

C. Mrs. McGirl Not Liable for Fraud

Mrs. McGirl's testimony was not fully credible. Her support

of Mr. McGirl's statement that the cash register was broken and

that it was economically infeasible to repair it demonstrates

that part of her testimony was not plausible. 

Fraud is never presumed or imputed; it must be established

by independent evidence that establishes a fraudulent intent on

the taxpayer's part. Otsuki v. Commissioner, 53 T.C. at 106. 

Even if Mrs. McGirl'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. We shall not
- 38 -

15 Since we have upheld respondent's determination of fraud with

respect to Mr. McGirl, we cannot also find him liable for

negligence. Therefore, we cannot find Mrs. McGirl liable for

negligence as she filed a joint return with Mr. McGirl and he

would be jointly liable for any negligence penalty imposed on his

wife. See Aflalo v. Commissioner, T.C. Memo. 1994-596.

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. 1993-52. 

Fraud cannot be imputed from one spouse to another. Sec.

6663(c).15

Respondent has failed to show that Mrs. McGirl was

responsible for understating income, destroying the Yogurt

Station's invoices and records, misleading the MDR or IRS agents,

or that she was in any way involved in creating the fabricated

auto logs. 

Respondent has not affirmatively established, by clear and

convincing evidence, that Mrs. McGirl intended to evade taxes. 

We cannot conclude on this record that Mrs. McGirl committed

fraud where respondent has failed to adduce evidence showing

intentional wrongdoing.

5. Negligence Penalty on Unreported Taxable Dividends

Petitioners admit they omitted the dividend income from

their joint Federal income tax returns. Petitioners have offered

no evidence that they were not negligent or had reasonable cause

to omit the dividend income. In fact, petitioners' briefs fail

to address the negligence issue at all. We cannot be sure if
- 39 -

petitioners intended to abandon the issue, but in any case

respondent's determination of the applicable penalty as to these

items must be sustained as petitioners have failed to satisfy 

their burden of proof on this issue.

To reflect the foregoing,

Decision will be entered

under Rule 155.