section 6663 civil fraud - economic substance

T.C. Memo. 2010-58
DOUGLAS D. AND BRENDA D. CHILD, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
OPINION
The inquiry into whether a transaction has economic substance focuses on (1) whether the transaction at issue had any practical economic consequences other than the creation of tax benefits and (2) whether the taxpayer had a valid business purpose or profit motive. ACM Pship. v. Commissioner , 157 F.3d 231, 247-248 (3d Cir. 1998), affg. on this issue T.C. Memo. 1997-115. The taxpayer bears the burden of proving that the challenged transaction was not a sham transaction lacking economic substance. Rule 142(a); Sheldon v. Commissioner , 94 T.C. 738, 753 (1990).
Respondent argues that petitioners are not entitled to deduct the “premium” payments to Commonwealth because the insurance arrangement lacked economic substance. We must first determine, therefore, whether petitioner's arrangement with Commonwealth was a true insurance arrangement with practical economic consequences. There is no clear set of criteria for determining whether an insurance arrangement exists and this Court will consider all of the relevant facts and circumstances. Sears, Roebuck & Co. v. Commissioner , 972 F.2d 858, 864 (7th Cir. 1992), affg. in part and revg. in part 96 T.C. 61 (1991).
Historically and commonly insurance involves risk-shifting and risk-distributing. Helvering v. Le Gierse , 312 U.S. 531, 539 (1941). Shifting risk entails the transfer of the impact of a potential loss from the insured to the insurer. Clougherty Packing Co. v. Commissioner , 84 T.C. 948, 958 (1985), affd. 811 F.2d 1297 (9th Cir. 1987). If the insured has shifted its risk to the insurer, then a loss by or a claim against the insured does not affect it because the loss is offset by the proceeds of an insurance payment. Id. An insurance premium is generally the cost for shifting risk. See id.
Petitioner's arrangement with Commonwealth was not a true insurance arrangement because it did not effectively shift or distribute any risk from petitioner to Commonwealth. The policy that petitioner argues was in effect for the years at issue limited Commonwealth's liability. Unlike the asserted $3/5 million claim limits, Commonwealth's liability was limited to the amount of premiums petitioner paid during the year of the claim. Petitioner remained liable for any claims exceeding the amount of premiums. Commonwealth never assumed the risk for claims exceeding the premium payments, nor did petitioner and Commonwealth distribute the risk to other parties. We find telling that Commonwealth never paid any claim during any of the years at issue nor for that matter was the alleged policy to cover any claims not already covered under petitioner's claims made policies. We therefore find that petitioner's arrangement with Commonwealth was not a true insurance arrangement with practical economic consequences.
We find instead that the only economic consequence of petitioner's arrangement with Commonwealth was the creation of tax benefits. Petitioner avoided taxation by transferring income disguised as “premium” payments to Commonwealth, an offshore entity. The premium payment amount was based on the amount petitioner sought to shelter from income rather than on the cost of shifting risk. Petitioner was able to further reduce his tax liability by claiming a deduction for the alleged premium payments. Moreover, the arrangement with Commonwealth followed Evanson's fraudulent insurance expense scheme, further indicating that its main purpose was to avoid taxation. We find therefore that the Commonwealth transaction was a sham transaction lacking any economic substance. Accordingly, we hold that petitioner is not entitled to deduct any “premium” payments to Commonwealth for 1997 through 2003.
II. Deductibility of Home Equity Loan Interest Payments
We now turn to the deductibility of interest paid on the Cottonwood home equity loan. Despite a prohibition against deducting personal interest, a taxpayer may deduct interest paid on a mortgage on real property of which he or she is the legal or equitable owner, provided it is qualified residence interest. 3 See sec. 163(h) .
Respondent argues that petitioners are not entitled to deduct the payments to Cottonwood because the home equity loan arrangement was a sham. We agree. The Cottonwood home equity loan did not have any practical economic consequences other than tax benefits. We find instead that the home equity loan was not a legitimate home equity loan. First, the amount of the Cottonwood loan was never tied to the “home equity” of petitioners' property and petitioners were able to borrow in excess of the credit limit without providing updated financial information or an updated property appraisal. Petitioners also did not pay off the loan when they sold the property, which is the quintessential antithesis of normal business practices. Second, neither petitioners nor Cottonwood followed standard protocols with a mortgage. Cottonwood never filed a formal deed of trust or a notice of default against petitioner, and petitioners did not disclose the home equity loan on either the Bank of Utah or the Market Street loan application. Finally, the loan advances were actually repatriation of amounts petitioners paid under the fraudulent insurance expense method.
We find that the sole economic consequence of the Cottonwood arrangement was the generation of mortgage interest deductions. The interest rate on the Cottonwood home equity loan was almost double the interest rate on petitioners' other residential loans to generate a larger deduction. Furthermore, the arrangement followed Evanson's fraudulent insurance expense scheme for avoiding taxation. Accordingly, we find that the Cottonwood home equity loan lacked economic substance aside from generating tax benefits and that petitioners therefore are not entitled to deduct any “home equity loan interest” payments to Cottonwood during the years at issue.
III. Unreported Taxable Income for 2002 and 2003
We now address whether petitioner failed to report the amounts of gross income for 2002 and 2003 that respondent determined under the bank account deposits method. Gross income generally includes all income from whatever source derived. Sec. 61(a) . Taxpayers must keep adequate books and records from which their correct tax liability can be determined. Sec. 6001 . When a taxpayer fails to keep records, the Commissioner has discretion to reconstruct the taxpayer's income by any reasonable means. Sec. 446(b) ; Erickson v. Commissioner , 937 F.2d 1548, 1553 (10th Cir. 1991), affg. T.C. Memo. 1989-552; Factor v. Commissioner , 281 F.2d 100, 117 (9th Cir. 1960), affg. T.C. Memo. 1958-94.
We have previously approved the use of the bank deposits method as a means of income reconstruction. Clayton v. Commissioner , 102 T.C. 632, 645 (1994); DiLeo v. Commissioner , 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir. 1992). The bank deposits method assumes that all money deposited into a taxpayer's bank account during a particular period constitutes taxable income. Clayton v. Commissioner , supra at 645. The Commissioner must take into account, however, any known nontaxable source or deductible expense. Id. at 645-646. The taxpayer bears the burden of demonstrating that the Commissioner's determination is erroneous. Mallette Bros. Constr. Co. v. United States , 695 F.2d 145, 148-149 (5th Cir. 1983); Kling v. Commissioner , T.C. Memo. 2001-78; Seidenfeld v. Commissioner , T.C. Memo. 1995-61.
Respondent determined through bank deposits analysis that petitioners failed to report taxable deposits in 2002 and 2003. Petitioners claim that the deposits were interaccount transfers or other nontaxable deposits, such as refunds and reimbursements. In keeping with petitioners' failure to maintain adequate records to substantiate the Evanson's transactions, petitioners did not produce the receipts or otherwise present any books, records, or other testimony that would support this assertion. The only evidence petitioner presented identifying the deposits at issue was documents that petitioner prepared himself. 4 Petitioners produced no corroborating evidence other than petitioner's own self-serving testimony, which we are not required to accept, and which we do not, in fact, find to be credible. See Niedringhaus v. Commissioner , 99 T.C. 202, 219 (1992). We therefore find that petitioners have failed to meet their burden, and we sustain respondent's determination that petitioners failed to report income in the amounts respondent determined for 2002 and 2003.
IV. Section 6663 Fraud Penalty
We next consider whether petitioner is liable for the section 6663 fraud penalties. Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax believed to be owing. Edelson v. Commissioner , 829 F.2d 828, 833 (9th Cir. 1987), affg. T.C. Memo. 1986-223; Akland v. Commissioner , 767 F.2d 618, 621 (9th Cir. 1985), affg. T.C. Memo. 1983-249. A penalty equal to 75 percent of the underpayment will be imposed if any part of the taxpayer's underpayment of Federal ncome tax is due to fraud. See sec. 6663(a) . Further, if any portion of the underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud. Sec. 6663(b) .
Respondent has the burden of proving by clear and convincing evidence that an underpayment exists for each of the years in issue and that some portion of the underpayment is due to fraud. See sec. 7454(a) ; Rule 142(b). Fraud is never presumed but must be established by independent evidence that establishes fraudulent intent. Edelson v. Commissioner , supra at 832; Beaver v. Commissioner , 55 T.C. 85, 92 (1970). Courts have developed several indicia, or “badges of fraud,” from which fraudulent intent can be inferred. They include: (1) understating income; (2) maintaining inadequate records; (3) engaging in a pattern of behavior that indicates an intent to mislead; (4) concealing assets; (5) providing implausible or inconsistent explanations of behavior; (6) filing false documents; and (7) failing to provide documents to the Commissioner during examination. Bradford v. Commissioner , 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601; Cooley v. Commissioner , T.C. Memo. 2004-49. Although no single factor is necessarily sufficient to establish fraud, a combination of several of these factors may be persuasive evidence of fraud. Bradford v. Commissioner , supra at 307-308; Solomon v. Commissioner , 732 F.2d 1459, 1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603; Niedringhaus v. Commissioner , supra at 211.
We now apply these criteria to petitioner's situation to determine whether there are any badges of fraud. First, petitioner's nonreporting of income and claiming of sham deductions resulted in an underpayment for each of the years at issue. We find petitioner's nonreporting of income and overstating deductions to be indicia of fraud.
Additionally, petitioner failed to maintain adequate records to substantiate the income as well as the deductions. Petitioner failed to produce documents to substantiate the taxable deposits at issue. He also failed to produce all insurance policies that were in effect during the years at issue, including claims made policies, despite respondent's issuance of a subpoena. Petitioner argues that the Commonwealth policy was unwritten and could be modified orally in contrast to his claims made policies, which required changes to be in writing. We find it hard to believe that petitioner would have relied on an unwritten policy with Commonwealth particularly given the substantial amounts of the “premium” payments. Equally telling is the lack of records for the inflated home equity loan arrangement. Petitioner brazenly claimed “interest” deductions on a home equity loan that had exceeded the $50,000 credit limit. We find petitioner's failure to maintain adequate records to be an indicium of fraud.
The sham transactions petitioner participated in were designed by Evanson to mislead the Internal Revenue Service (IRS) into treating otherwise taxable income as nontaxable. In fact, Evanson was convicted of tax evasion for organizing and promoting the transactions. As part of Evanson's tax evasion schemes, petitioner made payments disguised as insurance premiums to an offshore entity. The funds were returned to him disguised as loan advances to avoid taxation. Petitioner further reduced or eliminated his taxable income by claiming sham deductions from the transactions. The tax evasion schemes also enabled petitioner to conceal income. Petitioner had amounts credited on Medcap's offshore accounts that matched the “premium” payments he had made to Commonwealth. We find that petitioner participated in Evanson's schemes to mislead the IRS and conceal assets and that his participation is an indicium of fraud.
Petitioner also provided implausible explanations of his behavior in an attempt to conceal the fraudulent nature of the Evanson's transactions. For example, petitioner claimed that the Commonwealth policy provided supplemental insurance even though the policy was unwritten and failed to provide coverage beyond his existing claims made coverage. Petitioner was unable to explain how he could receive loan advances on the Cottonwood home equity arrangement in excess of the credit limit without providing updated financial information and without Cottonwood's filing a notice of default. We find petitioner's implausible explanations to be indicia of fraud.
Petitioner filed false documents when he failed to report the Cottonwood home equity loan on loan applications submitted to Bank of Utah and Market Street in 2002 and 2003, respectively. Petitioner claims that his failures to disclose the Cottonwood home equity loan on both documents were inadvertent oversights and that someone else prepared the paperwork. He asks us to ignore his obligation to verify the accuracy of the documents before he signed them under penalties of perjury. We are not disposed to turn a blind eye to such oversights, especially when a tax scheme is being used to inflate deductions and deflate income. We find petitioner's failure to disclose the Cottonwood home equity loan to be an indicium of fraud.
Finally, petitioner did not respond to a subpoena issued by respondent. We find petitioner's failure to cooperate with respondent to be a further indicium of fraud.
Most of the badges of fraud upon which this Court customarily relies are present in this case. Respondent has also established that petitioner received unreported income and claimed false deductions and that the nondisclosure of the income and the claiming of sham deductions resulted in an underpayment for each of the years at issue. Considering all the facts and circumstances, we find that respondent has proven by clear and convincing evidence that petitioner fraudulently intended to evade taxes. Accordingly, petitioner is liable for the section 6663 fraud penalties for the years at issue.
Because of our holding regarding the fraud penalties under section 6663 , we need not address whether petitioner is liable for the accuracy-related penalties under section 6662 .
We have considered all other arguments in rendering our decision and to the extent they are not mentioned, we find them to be irrelevant, moot or meritless.
To reflect respondent's concessions,
An appropriate decision will be entered .
Footnotes

1
All numerical amounts are rounded to the nearest dollar. All section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2
Respondent argues alternatively that petitioners are liable for the sec. 6662 accuracy-related penalties for taxable years 1995 through 2003. Respondent concedes that petitioner wife is not liable for the sec. 6663 fraud penalties. Respondent further concedes that petitioner wife is not liable for the sec. 6662 accuracy-related penalties if petitioner husband is found liable for the fraud penalties. Because we find that petitioner husband is liable for the fraud penalties, petitioner wife is not liable for either the fraud or the accuracy-related penalties.
3
Qualified residence interest is any interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness. See sec. 163(h)(3) . Home equity indebtedness is any indebtedness secured by the qualified residence of the taxpayer to the extent the aggregate amount of such indebtedness does not exceed the fair market value of the qualified residence reduced by the amount of acquisition indebtedness on the residence. See sec. 163(h)(3)(C)(i) .

4
Petitioner produced at trial evidence that had already been factored into respondent's bank deposit analysis as nontaxable deposits.