MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: Respondent determined deficiencies in 1989 income tax, and penalties as follows:

After considering the parties' concessions and stipulations to be bound by the outcome of other cases, the issues remaining for our consideration are: (1) Whether petitioners' partnership's 1989 income was understated; (2) whether petitioners correctly reported their distributive shares of partnership income; (3) whether either petitioner failed to report income with respect to various items respondent determined to be includable in his income; (4) whether either petitioner is liable for additional self-employment tax; and (5) whether either petitioner is liable for the fraud penalty under section 6663. ¹

1996 Tax Ct. Memo LEXIS 84">*85 FINDINGS OF FACT ²

Petitioners Bill McDonald (McDonald) and Richard D. Maynard (Maynard) resided in California at the times each of their petitions was filed in these cases. McDonald and Maynard each filed his 1989 income tax return reflecting that his filing status was "single". Although McDonald and Maynard were each married as of the close of 1989, they, along with their respective spouses, filed for and received annulments of their marriages during 1994. The question of whether McDonald and Maynard were married or single for Federal income tax purposes, considering the annulments of their respective marriages, was decided by this Court in McDonald v. Commissioner, T.C. Memo. 1994-607, and Shackelford v. Commissioner, T.C. Memo. 1995-484, respectively.³ Respondent and petitioners agreed to be bound by the outcome of the above-referenced opinions. The above-referenced1996 Tax Ct. Memo LEXIS 84">*86 opinions hold that the taxpayers were married for Federal income tax purposes, although they had subsequently obtained annulments of their marriages under the laws of the State of California. Accordingly, petitioners' filing status should have been "married filing separately" for purposes of their 1989 tax year.

Petitioners, at all pertinent times, were certified public accountants, with more than 60 years of experience between them, practicing together in an accounting partnership known as Maynard & McDonald (M&M). There was no written1996 Tax Ct. Memo LEXIS 84">*87 partnership agreement through the 1989 tax year. McDonald is also an attorney licensed to practice in the State of Oklahoma. M&M is a cash basis partnership that petitioners formed in 1976 and operated during the 1989 taxable year in Sacramento, California. M&M's principal activities are tax return preparation, assistance to clients in tax-related matters, providing accounting services, and representing clients before various administrative levels of the Internal Revenue Service. In addition, McDonald also filed clients' petitions with this Court. McDonald was familiar with the requirement that tax return preparers are to keep copies of prepared returns or a list of clients. Petitioners' accounting practice specialized in the field of taxation.

M&M's 1989 U.S. Partnership Return of Income (Form 1065), which McDonald prepared, reflected gross receipts of $ 24,590 and a single deduction of $ 24,590 attributable to "Guaranteed payments to partners". Other than on the Schedules K-1, no other information was reflected on the partnership return (i.e., the balance sheet was left blank, and the Schedule M for reconciliation of partners' capital was marked "NA"). The Schedules K-1 revealed1996 Tax Ct. Memo LEXIS 84">*88 that Maynard and McDonald were 50-50 partners, but that McDonald was allocated $ 3,457 of the guaranteed payments to partners, and the remaining $ 21,133 was allocated to Maynard. McDonald's $ 3,457 share of M&M's 1989 income was based on Maynard's estimate. Petitioners did not maintain records of the number of hours worked or number of returns prepared by each partner.

M&M's returns for the fiscal year ended September 30, 1987, the period October 1 through December 31, 1987, and the 1988 calendar year each reflect that petitioners shared profits and losses in a 50-50 ratio. These three returns reflect income and guaranteed payments to petitioners, as follows:

Accordingly, for two of the reporting periods, McDonald received about two-thirds and Maynard about one-third of M&M's income. In the third reporting period, Maynard received about 85 percent and McDonald about 15 percent.

Respondent's agents analyzed the ratio of hours spent during 1989 by Maynard and McDonald in preparing returns of M&M's clients and found it to1996 Tax Ct. Memo LEXIS 84">*89 be about 60 percent for Maynard and 40 percent for McDonald. Respondent, in the notices of deficiency, determined $ 214,393 of 1989 partnership income and attributed $ 79,661 to McDonald and $ 134,732 to Maynard.

M&M did not have any employees, and petitioners were solely responsible for maintaining M&M's books and records. Petitioners' billing approach was to send a bill for services to clients and retain a copy for M&M's records. When they received payment of a particular bill, M&M's retained copy of the bill was discarded. Petitioners' billing approach made it virtually impossible to verify whether M&M's income was accurately reflected on its books and Federal partnership tax return and on petitioners' Schedules K-1.

M&M's rate schedule, as of January 1, 1989, was $ 130 per hour for tax consulting or compliance work and a $ 275 minimum rate for individual tax return preparation. Petitioners would charge for giving advice, including advice given during telephone calls, with a one-tenth-hour minimum charge. The printed rate schedule contained the notation that, where advice resulted in substantial savings or was out of the ordinary, the billing might reflect petitioners' experience1996 Tax Ct. Memo LEXIS 84">*90 and expertise, rather than the posted rates. Occasionally, petitioners sent no bill because they decided to provide gratuitous services. Actual charges to M&M clients reflect that some clients were billed at a rate in excess of and some less than M&M's minimum rate.

During respondent's examination of their 1989 tax years, petitioners did not provide books, records, copies of M&M's bills to clients, or any other information from which petitioners' clientele could be identified or respondent could verify petitioners' income for 1989. Respondent's computers reflect that M&M was shown as the preparer on more than 300 Federal tax returns for the 1989 processing year. In addition, McDonald filed 13 clients' petitions with this Court during 1989.

Petitioners sought the protection of the Bankruptcy Code, McDonald in December 1980 and Maynard in April 1981. To avoid the possibility of attachment of their accounts receivable, petitioners formed a California corporation, Gold Country Financial, Inc. (Gold), to conduct a tax accounting business concurrently with and at the same location as M&M. Gold also provided petitioners with a means to obtain credit after their bankruptcies because they1996 Tax Ct. Memo LEXIS 84">*91 were employees of Gold. Moreover, Gold's sole shareholder was shown as Terry Feil, a friend of Maynard's.

Corporate Federal income tax returns were filed for Gold's fiscal years ended July 31, 1989 and 1990. Gold's income and expenses were reported on the accrual method of tax accounting. Petitioners maintained the books and records of Gold. M&M did not claim expenses, and any expenses concerning petitioners' tax accounting businesses were paid and/or deducted by Gold. Gold had no employees other than petitioners.

Similar to M&M, petitioners maintained no cash receipts journal, accounts receivable list, or client list for Gold. Also paralleling the practices at M&M, copies of client billing invoices were discarded after payment was received from the clients. Petitioners, however, maintained cash disbursements records for Gold during 1989.

Petitioners maintained a bank account in Gold's name at the Merchants National Bank (Merchants Bank), and some, but not all, of the receipts from clients were deposited into that account. Petitioners' method of determining Gold's annual income for tax purposes began by totaling the Merchants Bank deposits and reducing the total by reimbursements1996 Tax Ct. Memo LEXIS 84">*92 for health insurance. The difference was then adjusted by picking up net increases or decreases in accounts receivable to convert to the accrual method. Finally, the accrual method amount was reduced by expenses that petitioners had billed to and collected from clients.

For the 1989 and 1990 fiscal years, Gold's income was computed and reported by petitioners as follows:

Petitioners also maintained a bank account for Gold at the Bank of Lodi. The existence of Gold's Bank of Lodi account was not brought to the attention of respondent's agent by petitioners. Respondent's agent discovered1996 Tax Ct. Memo LEXIS 84">*93 the Bank of Lodi account from a review of canceled checks obtained from third-party sources (Gold's clients). Petitioners deposited some clients' payments for services by both M&M and Gold in the Bank of Lodi account for the fiscal years 1987, 1988, 1989, and 1990. Petitioners did not report the Bank of Lodi deposits in Gold's income. For 1989, checks were written on the Bank of Lodi account to Maynard and McDonald in the total amounts of $ 20,421 and $ 6,024, respectively. Neither Maynard nor McDonald reported funds for 1989 from Gold's account with the Bank of Lodi.

Respondent determined that Gold's income for the 1989 fiscal year was understated by $ 63,581 and that $ 29,292 of deductions were not allowable. Gold's petition to this Court was dismissed due to lack of capacity after the State of California had suspended its charter.

Respondent's agent, Arthur Pease (Pease), examined M&M's partnership returns for the taxable year ended September 30, 1987, and the calendar years 1987, 1988, and 1989. Petitioners did not provide the identification of their clients, and Pease was forced to reconstruct client information by using Internal Revenue Service computer data (return preparer1996 Tax Ct. Memo LEXIS 84">*94 information) and by canvassing third parties (petitioners' clients and banks). Pease obtained copies of clients' returns prepared by petitioners that reflected the fee for tax preparation. Pease also received a rate sheet for M&M from one of petitioners' clients. In addition, Pease received numerous letters that contained information about the fees charged for return preparation. Pease also engaged in numerous telephone conversations with petitioners' clients concerning the fees that petitioners charged them.

Based on his research, Pease prepared a schedule of clients, referencing the accumulated information along with references to sources for respondent's reconstruction of petitioners' income for the 1989 taxable year. Where Pease determined that an individual return had been prepared and that no invoice, deposit information, canceled check, or client information was available to reflect the fee charged, he used a $ 275 preparation fee, the minimum charge for an individual return reflected on M&M's rate schedule. Based on the information available to him, Pease determined that the average 1989 return preparation fee was $ 482 for an individual return, $ 1,400 for a corporate return, 1996 Tax Ct. Memo LEXIS 84">*95 and $ 1,250 for a partnership return. In his reconstruction, Pease also accounted for the fact that some returns were prepared gratuitously. Pease determined total 1989 fees of $ 192,201. Based on information provided by petitioners during trial preparation, respondent conceded on brief that total combined reconstructed 1989 fees were $ 185,128.

To determine M&M's income for 1989, deposits into Gold's Merchants Bank account for the first 7 months were eliminated in the total amount of $ 33,388 because Gold had reported that amount for its taxable year ended July 31, 1989. No adjustment for Merchants Bank deposits was made for the last 5 months of 1989 because petitioners did not provide income and accounts receivable records for that period. There was no consistency about which entity prepared a particular client's return (it would indiscriminately vary between M&M and Gold from year to year).

Petitioners, in their respective 1989 income tax returns, did not report the $ 250 monthly payments for automobile expenses received from Gold during 1989. Petitioners reduced the amount of the Merchants Bank deposits reported in Gold's income by the amount petitioners paid for automobile 1996 Tax Ct. Memo LEXIS 84">*96 expenses. Petitioners did not submit any documentation to Gold in support of their automobile mileage or expenses for 1989. Maynard conceded that the 1989 automobile reimbursement received from Gold was income to him for 1989. Maynard testified that all payments to petitioners for 1989 from the Bank of Lodi were his income or expense reimbursement.

Gold, during 1989, paid the California Society of Certified Public Accountants $ 16,325.36 for health insurance for several individuals, including petitioners. One of those individuals was McDonald's former accounting partner, who reimbursed Gold $ 2,765.44 for his portion of the insurance. The remaining insured individuals were petitioners and members of their families. Although petitioners prepared returns on behalf of Gold, they claim to have not received any compensation other than the monthly automobile reimbursement and insurance coverage.

Maynard did not have a personal bank account, and he paid bills with cash or checks from the checking account of another individual. McDonald and Maynard, during 1989, made cash purchases of numerous cashier's checks in amounts of $ 10,000 or less for various purposes. Maynard purchased two $ 7,5001996 Tax Ct. Memo LEXIS 84">*97 cashier's checks on June 8, 1989, from two separate banks. On that same date, McDonald purchased a $ 9,000 and a $ 10,000 cashier's check from separate banks. A series of cashier's checks, including the ones purchased on June 8, 1989, was used as part of the purchase price of a residence which was placed in the name of McDonald's wife. McDonald purchased numerous cashier's checks, mostly with cash, during 1989. The dates, amounts, and bank locations were as follows:

Respondent concedes that the source of the $ 10,000 cashier's check would not result in income to McDonald.

McDonald's wife remitted three checks to Maynard during 1989 in the following amounts: $ 995.90, $ 550, and $ 699.50. McDonald's daughter also remitted a $ 2,500 check to Maynard during 1989.

OPINION

Procedural Question -- Initially, we consider petitioners' procedural argument that the notices of deficiency are "arbitrary and capricious". Petitioners argue that respondent1996 Tax Ct. Memo LEXIS 84">*98 should have the burden of going forward with the evidence because respondent's determination is arbitrary and capricious and that respondent's determination should not enjoy a presumption of correctness. See Jackson v. Commissioner, 73 T.C. 394">73 T.C. 394, 73 T.C. 394">403 (1979); Weimerskirch v. Commissioner, 596 F.2d 358">596 F.2d 358, 596 F.2d 358">361 (9th Cir. 1979), revg. 67 T.C. 672">67 T.C. 672 (1977). By contending that the notices are arbitrary, petitioners are essentially asking us to look behind the notices of deficiency to examine the evidence used by respondent in making her determinations. Riland v. Commissioner, 79 T.C. 185">79 T.C. 185, 79 T.C. 185">201 (1982); 73 T.C. 394">Jackson v. Commissioner, supra at 400; Greenberg's Express, Inc. v. Commissioner, 62 T.C. 324">62 T.C. 324, 62 T.C. 324">327 (1974); 596 F.2d 358">Weimerskirch v. Commissioner, supra.We have looked behind the notice in those rare instances where respondent relied upon a "'naked' assessment without any foundation whatsoever". United States v. Janis, 428 U.S. 433">428 U.S. 433, 428 U.S. 433">441 (1976); 73 T.C. 394">Jackson v. Commissioner, supra at 401.1996 Tax Ct. Memo LEXIS 84">*99

In 596 F.2d 358">Weimerskirch v. Commissioner, supra, and Dellacroce v. Commissioner, 83 T.C. 269">83 T.C. 269 (1984), the Government possessed no evidence linking the taxpayers to illegal income. In Dellacroce, we held the notice of deficiency to be arbitrary because the reconstruction of income did not link the taxpayer to the income-generating activity.

In this case, by contrast, there is ample evidence, including numerous concessions by petitioners, reflecting that petitioners' income was not fully reported. Respondent has shown a clear and direct linkage to sources of unreported income in this case. See Adamson v. Commissioner, 745 F.2d 541">745 F.2d 541 (9th Cir. 1984), affg. T.C. Memo. 1982-371. Accordingly, we find that respondent's determination is not arbitrary.

Income Reconstruction -- Where, as here, taxpayers have failed to provide adequate records substantiating their income, an indirect method may be used to reconstruct their income. Holland v. United States, 348 U.S. 121">348 U.S. 121 (1954). Petitioners bear the burden of proving that the determinations made1996 Tax Ct. Memo LEXIS 84">*100 by respondent in the notices of deficiency are erroneous. Rule 142(a); Cracchiola v. Commissioner, 643 F.2d 1383">643 F.2d 1383 (9th Cir. 1981) (citing Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933)), affg. per curiam T.C. Memo. 1979-3; Webb v. Commissioner, 394 F.2d 366">394 F.2d 366, 394 F.2d 366">372 (5th Cir. 1968), affg. T.C. Memo. 1966-81. Taxpayers are required to maintain records -- transactions should be documented, contracts provided, and expenses substantiated. Sec. 6001; Norgaard v. Commissioner, 939 F.2d 874">939 F.2d 874, 939 F.2d 874">878 (9th Cir. 1991), affg. in part and revg. in part T.C. Memo. 1989-390.

The Commissioner is entitled to use a reconstruction method where a taxpayer's books and records are either inadequate or nonexistent. 348 U.S. 121">Holland v. United States, supra; United States v. Johnson, 319 U.S. 503">319 U.S. 503 (1943); Campbell v. Guetersloh, 287 F.2d 878">287 F.2d 878, 287 F.2d 878">880 (5th Cir. 1961); 745 F.2d 541">Adamson v. Commissioner, supra; Keogh v. Commissioner, 713 F.2d 496">713 F.2d 496 (9th Cir. 1983),1996 Tax Ct. Memo LEXIS 84">*101 affg. Davies v. Commissioner, T.C. Memo. 1981-438; United States v. Stonehill, 702 F.2d 1288">702 F.2d 1288 (9th Cir. 1983). Petitioners do not dispute that respondent is entitled to use a reconstruction method. Petitioners argue that the method of reconstruction used by respondent was flawed and/or arbitrary. ⁴

Petitioners, who are tax professionals, failed to keep any record of cash receipts, although they did maintain records of their cash expenditures. Petitioners intentionally discarded the only records from which their income could have been verified. Although petitioners' tax accounting business activity has been continuous from 1976 through 1989, the year at issue, 1996 Tax Ct. Memo LEXIS 84">*102 it was operated through several entities. Until both petitioners had financial difficulties and went through bankruptcy, they had operated their business as a partnership. After the financial difficulties, petitioners interposed a corporate entity partly to deceive creditors and others. The corporate entity allegedly paid all expenses of petitioners' tax accounting business, and only a part of the income from such activity was reported by the corporate entity. Allegedly, the corporate entity did not pay petitioners' salary for their return preparation activity. Instead, petitioners allegedly received benefits such as insurance and automobile allowances, and their business overhead was borne by the corporation.

After the corporate formation, the partnership entity continued to operate and report some of the business income, but none of the expenses. The income reported on the partnership return was distributed as guaranteed payments to partners in unequal amounts, even though petitioners were shown in the Schedules K-1 as 50-50 partners and no partnership agreement was in existence. Petitioners, by commingling these entities and their business activities, created a murky environment1996 Tax Ct. Memo LEXIS 84">*103 in which it is difficult to discern the sources of income or the entity by which an expense had been incurred. Petitioners' discarding records of income made this situation even more difficult to unravel. Finally, petitioners did not cooperate in the examination process, forcing respondent's agent to seek third-party records from banks and clients in order to reconstruct income.

Under these circumstances, Pease was able to specifically determine the identity of some clients and a range of the fees charged. Where the amount of a client's fee was not available, Pease used the minimum fee. In instances where it was possible to discern that specific income had been reported on Gold's return (the corporate return), Pease eliminated that amount from his reconstruction of the partnership return. Where the corporate income, if any, could not be discerned or verified, Pease, in order to protect the Government's interest, attributed the income to the M&M partnership. In those instances, there may have been duplication between the income reported for Gold and the income determined for petitioners through M&M. With respect to one of those instances, respondent conceded on brief that the amount1996 Tax Ct. Memo LEXIS 84">*104 of partnership income determined for 1989 should be reduced by $ 4,938 for the deposits in Gold's Merchants Bank account during the last 5 months of 1989.

Courts have approved methods of reconstruction which project or extrapolate from a limited amount of information. See, e.g., Gerardo v. Commissioner, 552 F.2d 549">552 F.2d 549 (3d Cir. 1977), affg. in part and revg. in part T.C. Memo. 1975-341; 745 F.2d 541">Adamson v. Commissioner, supra. In 745 F.2d 541">Adamson v. Commissioner, supra at 548, the court stated as follows:

Where the government has introduced evidence linking the taxpayer to the illegal activity, the taxpayer should not be allowed to avoid paying taxes simply because he keeps incomplete records. The absence of tax records cannot automatically deprive the Commissioner of a rational foundation for the income determination. As the Fifth Circuit recognized in Webb v. C.I.R., 394 F.2d 366">394 F.2d 366, 394 F.2d 366">373 (5th Cir. 1968):