T.C. Memo. 2018-160



                         UNITED STATES TAX COURT



              BRIAN D. RAY AND BETSY RAY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 25455-15.                         Filed September 20, 2018.



      James C. Pennington, for petitioners.

      Sheila R. Pattison and Roberta L. Shumway, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: Respondent determined deficiencies in and additions to tax

under section 6651(a)(1)1 and accuracy-related penalties under section 6662(a) on

petitioners’ Federal income tax, as follows:


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
                                        -2-

[*2]                                  Addition to tax       Penalty
           Year       Deficiency      sec. 6651(a)(1)     sec. 6662(a)
           2006         $14,345          $2,868.75         $2,307.00
           2007          16,710           3,446.75          2,757.40
           2008          22,956           4,611.00          3,688.80
           2009          33,746           7,101.25          5,681.00
           2010          34,935           7,414.50          5,931.60
           2011          29,047           6,889.50          5,511.60


       After concessions,2 the issues remaining for decision for tax years 2006,

2007, 2008, 2009, 2010, and 2011 (years at issue) are whether: (1) the income

from checks to petitioners’ children from the National Home Education Research


       2
        As part of his opening statement, respondent conceded that the following
amounts paid to petitioners’ children were not income to petitioners: (1)
$2,774.48 for tax year 2006, (2) $3,075.21 for tax year 2007, (3) $416.11 for tax
year 2008, (4) $100 for tax year 2010, and (5) $3,515.24 for tax year 2011.
Further, on the basis of witnesses’ testimony at trial, respondent conceded that:
(1) the $250 check from Mr. and Mrs. Tindall deposited into petitioners’ Visa
account at the Oregon State University (OSU) Credit Union (OSU Visa account)
was a gift and not taxable income to petitioners for tax year 2006, (2) the $30
check from Eleanor and Steven Briggs deposited into the OSU Visa account was a
gift and not taxable income to petitioners for tax year 2006, (3) the $120 check
from Eleanor and Steven Briggs deposited into the OSU Visa account was a gift
and not taxable income to petitioners for tax year 2006, (4) the $50 check from
Eleanor and Steven Briggs deposited into the OSU Visa account was a gift and is
not taxable income to petitioners for tax year 2007, and (5) the $1,700 check from
Criminology for Dummies deposited into petitioners’ savings account at Marion
and Polk Schools (MAPS) Credit Union (MAPS savings account) was a gift and
not taxable income to petitioners for tax year 2009.
                                         -3-

[*3] Institute (NHERI checks) should be attributed to petitioners, (2) petitioners

failed to report certain receipts on Schedule C, Profit or Loss From Business, (3)

petitioners are liable for additions to tax under section 6651(a)(1), and

(4) petitioners are liable for accuracy-related penalties under section 6662(a).

                                   FINDINGS OF FACT

        Some of the facts are stipulated and are so found. The stipulation of facts

and the attached exhibits are incorporated herein by this reference. Petitioners

resided in Oregon when the petition was filed.

I.      Petitioners’ Background

        During the years at issue petitioners, Brian D. Ray and Betsy Ray, lived on

their six-acre farm in Oregon with six of their eight children.3 During those years


        3
       During the years at issue the ages of petitioners’ children who resided on
the family’s farm were as follows:
                                                Year
     Name        2006        2007        2008          2009      2010        2011
 Hanna R.         20          21          22            23        24          25
 Daniel R.        18          19         2[0]           21        22          23
 C.R.             15          16          17            18        19          20
 E.R.             13          14          15            16        17          

          12          13            14        15          16
 M.R.              8           9          10            11        12          13
                                       -4-

[*4] petitioners home schooled their children. As part of their home school

curriculum, petitioners taught their children the importance of working together to

take care of the household’s needs, including the household’s food, shelter, and

clothing expenses. In accordance with that philosophy, all members of the family

contributed portions of their income to the family’s shared OSU Visa account.4

II.    National Home Education Research Institute (NHERI)

       During the years at issue Mr. Ray worked at NHERI. NHERI is a

tax-exempt section 501(c)(3) organization, cofounded by Mr. Ray to perform,

analyze, and disseminate research on home schooling to the media, policymakers,

and legislators. NHERI is primarily funded through donations but also generated

revenue through book sales and research contracts.

III.   Petitioners’ and Petitioners’ Children’s Income-Producing Activities

       A.    Mr. Ray

       During the years at issue Mr. Ray worked full time as NHERI’s sole

researcher and served as NHERI’s sole financial officer. In his role as NHERI’s

       4
       OSU Credit Union treated its Visa accounts as depository accounts and
allowed individual clients or customers to deposit checks or cash directly against
an outstanding credit card account balance. Accordingly, we consider petitioners’
OSU Visa account as a depository account and treat payments made to that
account as deposits.
      In addition to the OSU Visa account, petitioners had exclusive control over
the MAPS savings account and a savings account at OSU Credit Union.
                                        -5-

[*5] financial officer, Mr. Ray had the exclusive authority to determine wages and

salaries for all of NHERI’s workers, including himself.5 During the years at issue,

however, NHERI did not pay Mr. Ray for his services, citing a lack of funds.

      Independent of his work at NHERI, Mr. Ray earned income for his family

by providing consulting services and giving speeches and expert testimony

regarding home education (Schedule C receipts). Mr. Ray deposited some of his

Schedule C receipts into the OSU Visa account but typically cashed those he

received in check form. Petitioners reported Mr. Ray’s Schedule C receipts as

follows:

                                                  Year
                    2006       2007      2008       2009       2010        2011
 Gross receipts    $15,900 $16,600 $12,400 $17,600 $24,300              $22,500
 Total expenses      -0-        -0-       -0-        -0-        -0-       1,295
 Net profit         15,900    16,600     12,400     17,600    24,300     21,205

Petitioners did not, however, report all of Mr. Ray’s Schedule C receipts on their

Schedules C for the years at issue.




      5
       NHERI did not have written employment contracts with its workers.
Instead, Mr. Ray determined each worker’s compensation on the basis of the
amount of money that NHERI had available at the time it needed to pay its
workers.
                                        -6-

[*6] B.      Ms. Ray

      During the years at issue Ms. Ray generated income by making speeches at

various home education retreats and seminars. She was paid by check for some of

those speaking engagements and deposited those payments into the OSU Visa

account. Petitioners did not report any of Ms. Ray’s income for the years at issue.

      C.     Petitioners’ Children

      During the years at issue five of petitioners’ six children, Hanna R., Daniel

R., C.R., E.R., and A.R., purportedly worked at NHERI as office assistants. Their

responsibilities ostensibly included answering telephone calls and emails,

handling the mailing duties, and filling orders. At no time, however, did their

responsibilities include filling out timesheets or otherwise documenting their

hours worked at NHERI because NHERI did not provide them with, nor require

them to create, timesheets.

      During the years at issue NHERI managed to pay petitioners’ children a

total of $260,120 for their work, despite NHERI’s alleged inability to pay Mr. Ray

for his services due to a lack of funds. All payments to petitioners’ children were
                                       -7-

[*7] made by check (NHERI checks). Mr. Ray, on behalf of NHERI, signed and

authorized those checks.6

      Typically, petitioners’ children would cash the NHERI checks at the bank

where NHERI maintained its bank account. The children would then deposit some

of that cash into the OSU Visa account and retain some of it.7 The record does not

establish the amounts retained by the children nor the amounts of the NHERI

checks deposited into the OSU Visa account.

IV.   Petitioners’ Tax Examination, Returns, and Notice of Deficiency

      A.    Tax Examination

      Petitioners did not timely file their Form 1040, U.S. Individual Income Tax

Return (return), for any of the years at issue. On June 14, 2012, Internal Revenue

Agent Kimberly Clonch (RA Clonch) started her examination concerning



      6
       No Forms W-2, Wage and Tax Statement, or Forms 1099-MISC,
Miscellaneous Income, were ever issued by NHERI, or Mr. Ray, for any of the
amounts paid to petitioners’ children or NHERI’s other workers. Petitioners’
children did not report any of the funds they received from NHERI on their
respective returns.
      7
       On occasion, petitioners’ children would endorse some of the NHERI
checks to Mr. Ray, who would then deposit the entirety of those checks in the
OSU Visa account. In 2006 no NHERI checks were deposited into the OSU Visa
account. In 2007 NHERI checks totaling $4,300 were deposited into the OSU
Visa account. In 2008 NHERI checks totaling $900 NHERI were deposited in the
OSU Visa account.
                                          -8-

[*8] petitioners’ Federal income tax liability for tax year 2010. On August 2,

2012, RA Clonch expanded that examination to include petitioners’ Federal

income tax liabilities for the other years at issue.

      At about this time petitioners sought the assistance of their present counsel,

James C. Pennington, to prepare their returns for the years at issue and later to

represent petitioners during their examination with RA Clonch before

respondent’s Office of Appeals.8 To assist Mr. Pennington in both his

representation of petitioners and preparation of their returns for the years at issue,

petitioners provided Mr. Pennington the following documents: (1) a table which

purported to show estimates of Mr. Ray’s Schedule C receipts for tax years 2006,

2007, 2008, 2009, and 2011, (2) a handwritten note that purported to show Mr.

Ray’s Schedule C receipts for tax year 2010, (3) a handwritten note that purported

to show petitioners’ property tax paid in tax year 2010, (4) a handwritten note that

purported to show petitioners’ medical expenses paid in tax year 2010, and (5) two

documents from Santiam Escrow, Inc., showing that petitioners paid mortgage

interest of $2,906.68 and $2,401.27 for tax year 2010. Petitioners did not




      8
        Mr. Pennington, who is also a certified public accountant, did not provide
petitioners with any tax advice before the respective due dates of those returns.
                                          -9-

[*9] otherwise provide Mr. Pennington any substantive documentation to aid him

in his preparation of their returns for the years at issue.

      B.     Respondent’s Reconstruction of Petitioners’ Income

      RA Clonch issued petitioners information document requests (IDR) for each

of the years at issue. In response to one of the IDRs, petitioners provided

estimates of household expenses for two of their children. Petitioners, however,

did not provide all requested documents to RA Clonch. As a result, RA Clonch

summoned bank records for: (1) petitioners’ MAPS savings account,

(2) petitioners’ savings account at OSU Credit Union, (3) petitioners’ OSU Visa

account, and (4) NHERI’s bank account, and she analyzed those bank records in

order to complete her reconstruction of petitioners’ income.9

             1.     Bank Deposits Analysis

      RA Clonch examined every deposit into each of petitioners’ bank accounts.

Then, using information provided by petitioners’ IDR responses, RA Clonch


      9
        The parties refer to this portion of RA Clonch’s income reconstruction as
her “bank deposits analysis”. For convenience we will adopt the parties’ use of
that term, but we recognize that RA Clonch’s analysis was not fundamentally a
“bank deposits analysis” of the type to which that term of art is typically applied.
To this extent and as discussed further infra, we recognize that RA Clonch’s
methods and analysis in reconstructing petitioners’ income were generally
reasonable and permissible. See, e.g., Brodsky v. Commissioner, T.C. Memo.
2001-240, slip op. at 77-81.
                                        - 10 -

[*10] attempted to ascertain whether any of those deposits were nontaxable or

were previously taxed and adjusted her reconstruction of petitioners’ income

accordingly. In doing so, RA Clonch observed that many of the deposits into the

OSU Visa account were of cash and were made by petitioners and their children.10

RA Clonch concluded that the following taxable deposits were made in

petitioners’ accounts for each of the years at issue:




      10
         For purposes of her analysis, RA Clonch considered petitioners’ PayPal
account to be a deposit account.
       RA Clonch excluded from this portion of her income reconstruction analysis
all NHERI checks that were deposited into the OSU Visa account, as she had
already determined those checks to be income to petitioners elsewhere in her
income reconstruction. At no time during the course of RA Clonch’s examination
of their bank accounts did petitioners inform RA Clonch that, on a number of
occasions, they had deposited into their bank accounts the proceeds of NHERI
checks cashed by their children. RA Clonch testified that had petitioners argued
this position, she would have asked Mr. Pennington to provide her with
contemporaneous records in support. Neither petitioners nor their children,
however, kept contemporaneous records of the movement of cash among members
of the household.
                                       - 11 -

[*11]                       Year                Taxable deposit
                            2006                  $24,018.09
                            2007                   23,236.55
                            2008                   35,712.70
                            2009                   52,381.33
                            2010                   60,600.34
                            2011                   61,935.53
                              Total               257,884.54

              2.      NHERI Checks

        After completing the bank deposits analysis, RA Clonch, using standard

guidelines and information provided to her by petitioners, calculated petitioners’

household expenses for each of the years at issue. She then compared that amount

to her bank deposits analysis and determined that: (1) very few of the general

housing living expenses were paid out of the OSU Visa account and (2) the cash

from the NHERI checks was used, in large part, to pay petitioners’ household

expenses. Accordingly, as part of her reconstruction of petitioners’ income, RA

Clonch also included the NHERI checks in petitioners’ taxable income for each of

the years at issue.
                                        - 12 -

[*12]         3.    Unreported Schedule C Income

        After completing the bank deposits analysis and making her determination

with respect to the NHERI checks, RA Clonch analyzed the amounts deposited

into petitioners’ accounts and compared those amounts to the amounts on

petitioners’ list of Schedule C receipts to determine the extent to which those

receipts were actually deposited in petitioners’ accounts. In doing so, RA Clonch,

using information from petitioners’ IDR responses, determined the following

amounts to be the extent to which petitioners deposited their Schedule C receipts

into their various accounts:

                                                Deposited
                               Year         Schedule C receipts
                               2006              $4,161.18
                               2007               5,102.00
                               2008               2,650.00
                               2009                  ---
                               2010               1,134.15
                               2011               9,758.80
                                Total            22,806.13

        As a result, RA Clonch included the following amounts as taxable deposits

in her reconstruction of petitioners’ income, in addition to those that she found as

a result of her bank deposits analysis of petitioners’ accounts:
                                         - 13 -

[*13]                                           Unreported
                                Year         Schedule C receipts
                                2006              $11,738.82
                                2007               11,498.00
                                2008               9,750.00
                                2009               17,600.00
                                2010               23,165.85
                                2011               11,441.20
                                 Total             85,193.87

After adding up the taxable deposits, NHERI checks, and missing Schedule C

receipts, RA Clonch subtracted the Schedule C income otherwise reported in

petitioners’ returns.

         C.    Petitioners’ Returns

         On October 1, 2012, petitioners filed their 2010 return. On December 31,

2012, they filed their 2006, 2007, 2008, and 2009 returns. On August 15, 2013,

they filed their 2011 return.

         D.    Notice of Deficiency

         On February 5, 2015, RA Clonch received written supervisory approval to

impose an accuracy-related penalty under section 6662(a) for each of the years at

issue.
                                        - 14 -

[*14] On July 6, 2015, respondent issued petitioners a notice of deficiency

(notice) for the years at issue, determining a deficiency arising from additional

unreported Schedule C income for each of the years at issue. In doing so

respondent relied on RA Clonch’s reconstruction of petitioners’ income.

Respondent further determined that for each of the years at issue petitioners are

liable for an addition to tax under section 6651(a)(1) and an accuracy-related

penalty under section 6662(a). Petitioners timely filed a petition for

redetermination.

                                     OPINION

I.    Burden of Proof

      Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer bears the burden of proving that the determination is

improper. Rule 142(a)(1); Welch v. Helvering, 

, 115 (1933).

However, if a taxpayer produces credible evidence11 with respect to any factual

issue relevant to ascertaining the taxpayer’s liability for any tax imposed by

subtitle A or B of the Code and satisfies the requirements of section 7491(a)(2),

      11
        “Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the judicial presumption of
IRS correctness).” Higbee v. Commissioner, 

, 442 (2001) (quoting
H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995).
                                        - 15 -

[*15] the burden of proof on any such issue shifts to the Commissioner. Sec.

7491(a)(1). Section 7491(a)(2) requires a taxpayer to demonstrate that he or she

(1) complied with the requirements under the Code to substantiate any item, (2)

maintained all records required under the Code, and (3) cooperated with

reasonable requests by the Secretary12 for witnesses, information, documents,

meetings, and interviews. See also Higbee v. Commissioner, 

, 440-

441 (2001).

      The U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this

case would lie absent a stipulation to the contrary, see sec. 7482(b)(1)(A), (2), has

held that for the presumption of correctness to attach to the notice of deficiency in

unreported income cases, the Commissioner must establish some evidentiary

foundation connecting the taxpayer with the income-producing activity, see

Weimerskirch v. Commissioner, 

, 361-362 (9th Cir. 1979), rev’g 

 (1977), or demonstrating that the taxpayer actually received unreported

income, Edwards v. Commissioner, 

, 1270-1271 (9th Cir. 1982).

The requisite evidentiary foundation is minimal and need not include direct




      12
       The term “Secretary” means the Secretary of the Treasury or his delegate.
Sec. 7701(a)(11)(B).
                                       - 16 -

[*16] evidence. See Banister v. Commissioner, T.C. Memo. 2008-201, aff’d, 418

F. App’x 637 (9th Cir. 2011).

      If the Commissioner introduces some evidence that the taxpayer received

unreported income, the burden shifts to the taxpayer, who must establish by a

preponderance of the evidence that the unreported income adjustment was

arbitrary or erroneous. See Hardy v. Commissioner, 

, 1004 (9th Cir.

1999), aff’g T.C. Memo. 1997-97.

      Respondent has established the necessary foundation linking petitioners

with income-producing activities and with the bank accounts included in

respondent’s bank deposits analysis. Therefore, the presumption of correctness

stands, and petitioners bear the burden of proving that respondent’s determinations

are incorrect unless petitioners demonstrate that the burden of proof should shift to

respondent under section 7491(a)(1) and (2). Petitioners do not contend that they

met the requirements, and the record confirms that they did not do so.

Accordingly, the burden of proof remains on petitioners.

II.   Respondent’s Reconstruction of Petitioners’ Income

      As noted above, respondent’s reconstruction of petitioners’ income

consisted primarily of determining taxable deposits by way of RA Clonch’s bank

deposits analysis. Respondent’s entire reconstruction, however, also comprised
                                       - 17 -

[*17] RA Clonch’s determination that the NHERI checks constituted unreported

income of petitioners.

      Petitioners contend that respondent’s reconstruction of their income is

inaccurate because respondent: (1) improperly assigned the NHERI checks to

petitioners as unreported income (i.e., assignment of income) and (2) improperly

determined that certain bank deposits made by petitioners, their children, and third

parties constituted unreported gross income of petitioners (i.e., the bank deposits

analysis).

      A.     Assignment of Income (NHERI Checks)

      Section 61(a) defines gross income as “all income from whatever source

derived”. A fundamental principle of income taxation is that income is taxable to

the person who earns it. Lucas v. Earl, 

, 114-115 (1930). “The ‘true

earner’ of income is the person or entity who controlled the earning of such

income, rather than the person or entity who received the income.” Barmes v.

Commissioner, T.C. Memo. 2001-155, slip op. at 78, aff’d, 89 A.F.T.R.2d (RIA)

2002-2249 (7th Cir. 2002). “The crucial question * * * [is] whether the assignor

retains sufficient power and control over the assigned property or over the receipt

of the income to make it reasonable to treat him as the recipient of the income for

tax purposes.” Id. (quoting Commissioner v. Sunnen, 

, 604 (1948)).
                                        - 18 -

[*18] Petitioners contend that respondent erred in including the NHERI checks in

petitioners’ income in his reconstruction for the years at issue because with respect

to petitioners’: (1) adult children, there is “clear evidence that the children had

dominion and control over the amounts paid to them by NHERI” and (2) minor

children, “section 73(a) requires that the amounts [paid to them by NHERI] must

not be included in * * * [petitioners’] gross income.” Petitioners further contend

that if this Court finds that respondent did not err in assigning the NHERI checks

as income to petitioners in his reconstruction of petitioners’ income for the tax

years at issue, then petitioners are nonetheless entitled to a deduction for the

amounts their children received.

      Respondent, however, contends that he did not err in including the NHERI

checks as income to petitioners in his reconstruction of petitioners’ income for the

tax years at issue because: (1) by purporting to pay five of his six children, instead

of himself, Mr. Ray attempted to disguise petitioners’ receipt of over $260,120

during the years at issue; (2) petitioners exercised complete dominion and control

over the bank accounts, including the OSU Visa account, into which petitioners

and their children deposited cash from the NHERI checks; and (3) petitioners’

children would regularly endorse NHERI checks to Mr. Ray, who then either
                                       - 19 -

[*19] deposited the checks into petitioners’ bank account or cashed them and used

that cash to pay petitioners’ household expenses. We agree with respondent.

       First, during the years at issue Mr. Ray worked full time at NHERI as its

sole researcher and financial officer. As NHERI’s financial officer, Mr. Ray had

the exclusive authority to determine wages and salaries for all of NHERI’s

workers, including himself. Yet during those years NHERI, citing a lack of funds,

did not pay Mr. Ray for his services in those aforementioned roles but did manage

to pay petitioners’ children $260,120 for their purported work as office assistants

during that same period.13 We also note that at no time were any of those

payments reported to the Internal Revenue Service on Forms W-2, 1099, or any

other return. Nor did Mr. Ray inform his children that they might be required to

file returns for the years at issue.

       Moreover, petitioners’ children would then cash those NHERI checks at the

bank where NHERI maintained its bank account. The children would deposit

some of that cash into the OSU Visa account and retain some of it.14 The record

does not establish what petitioners’ children did with the cash they retained, nor


       13
         The record does not establish how many hours petitioners’ children
ostensibly worked because NHERI did not provide them with, nor require them to
create, timesheets.
       14
            See supra note 7.
                                       - 20 -

[*20] does the record establish the extent to which petitioners’ children actually

deposited the cash proceeds from the NHERI checks into the OSU Visa account

because neither petitioners nor their children maintained a contemporaneous

ledger or other account book that might establish the source or ownership of the

cash deposited into the family OSU Visa account. Nevertheless, the record does

establish that the cash from the NHERI checks was used to pay petitioners’

household expenses.

      Finally, since we have found that respondent did not err in assigning the

NHERI checks as income to petitioners, we must address petitioners’ contention

with respect to section 73(a). We find petitioners’ contention to be without merit.

This is because while section 73(a) requires inclusion of “[a]mounts received in

respect of the services of a child” in the child’s own gross income rather than that

of the parents, it applies only to income the child is deemed to have earned.

Fritschle v. Commissioner, 

, 157-158 (1982).15 To determine the true

earner, we looked to who had the “ultimate direction and control over the earning”

      15
        Before the enactment of the predecessor of sec. 73, income received in
respect of the services of a child was reported by parents who held rights to such
services under local law. H.R. Rept. No. 78-1365, at 21 (1944), 1944 C.B. 821,
876-877. However, States had varying laws and exceptions concerning parental
entitlement to the services of a child. Id. Congress sought to create uniformity by
requiring inclusion of amounts received for a child’s services in the child’s own
gross income. Id.
                                        - 21 -

[*21] of the income. Vercio v. Commissioner, 

, 1254 (1980)

(quoting Nesenberg v. Commissioner, 

, 1010-1011(1978)); see

Fritschle v. Commissioner, 79 T.C. at 158. As we noted above, we determined the

“true earner” of the income to be petitioners, not their children. Therefore, section

73(a) is inapplicable and does not operate to include any portion of those amounts

in the gross incomes of petitioners’ children.16

      Accordingly, on the record before us, we find that respondent properly

included the NHERI checks in petitioners’ income in his reconstruction for the tax

years at issue.

      B.     Bank Deposits Analysis

      As stated above, gross income includes “all income from whatever source

derived”, including income derived from business. Sec. 61(a)(2). A taxpayer


      16
        On brief petitioners claim that if this Court finds that respondent properly
included the NHERI checks in their income for the tax years at issue, then they
“would be entitled to any ordinary and necessary business expenses related to such
self-employment income” with respect to cash retained by their children from the
NHERI checks. Petitioners fail to cite any statutory authority or caselaw but assert
that given such a finding, they “would then be in the position of being taxed on
certain amounts now as independent contractors of NHERI.”
       To the extent we understand petitioners’ contention, we find it to be without
merit. To the extent petitioners’ children may have retained any money from the
NHERI checks, the record lacks any evidence to establish that these amounts were
deductible business expenses of petitioners, rather than nondeductible, personal,
parenting expenses. See Romine v. Commissioner, 

, 877 (1956).
                                       - 22 -

[*22] must maintain books and records establishing the amount of his or her gross

income. See sec. 6001; Petzoldt v. Commissioner, 

, 686 (1989); sec.

1.446-1(a)(4), Income Tax Regs. When a taxpayer fails to keep adequate books

and records, the Commissioner is authorized to determine the existence and

amount of the taxpayer’s income by any method that clearly reflects income. Sec.

446(b); Petzoldt v. Commissioner, 92 T.C. at 693. The Commissioner may use

indirect methods, and he has latitude in determining which method of

reconstruction to apply when a taxpayer fails to maintain adequate books and

records. Petzoldt v. Commissioner, 92 T.C. at 693. The Commissioner’s

reconstruction of a taxpayer’s income need only be reasonable in the light of all

surrounding facts and circumstances. Schroeder v. Commissioner, 

, 33

(1963); see also Giddio v. Commissioner, 

, 1533 (1970). The method

of reconstruction that the Commissioner uses is not invalidated solely because the

Commissioner’s income determination may not be completely correct. Halle v.

Commissioner, 

, 502-503 (2d Cir. 1949), aff’g 

 (1946);

DiLeo v. Commissioner, 

, 868 (1991), aff’d, 

 (2d Cir.

1992).

      Respondent used the bank deposits method because petitioners failed to

maintain or produce for examination adequate books and records for the tax years
                                       - 23 -

[*23] at issue. A bank deposit is prima facie evidence of income. DiLeo v.

Commissioner, 96 T.C. at 868; Tokarski v. Commissioner, 

, 77 (1986).

The bank deposits method of reconstruction assumes that all of the money

deposited into a taxpayer’s account is taxable income unless the taxpayer can

show that the deposits are nontaxable. See DiLeo v. Commissioner, 96 T.C. at

868; see also Price v. United States, 

, 677 (5th Cir. 1964). The

Commissioner need not show a likely source of the income when using the bank

deposits method, but the Commissioner must take into account any nontaxable

items or deductible expenses of which the Commissioner has knowledge. See

Price, 335 F.2d at 677; Tokarski v. Commissioner, 87 T.C. at 77. To this extent,

however, the Commissioner is not obligated to follow any “leads” that suggest a

taxpayer has deductible expenses. DiLeo v. Commissioner, 96 T.C. at 872.

      When the Commissioner reconstructs a taxpayer’s income using the bank

deposits method and determines a deficiency, the taxpayer bears the burden of

proving the Commissioner’s analysis and determinations are erroneous. See

Clayton v. Commissioner, 

, 645 (1994); DiLeo v. Commissioner, 96

T.C. at 883. The taxpayer may prove that the Commissioner’s reconstruction of

income is in error, in whole or in part, by proving that a deposit is nontaxable. See

Clayton v. Commissioner, 102 T.C. at 645.
                                       - 24 -

[*24] Petitioners did not produce all books and records requested during audit.

RA Clonch subsequently needed to summon bank records directly from

(1) petitioners’ MAPS savings account, (2) a savings account at OSU Credit

Union, (3) the OSU Visa account, and (4) NHERI’s bank account, in order to

accurately determine petitioners’ income for the years at issue. From these

records, RA Clonch prepared the bank deposits analysis upon which respondent’s

determinations of income tax deficiencies are partly based.

      Petitioners contend that RA Clonch’s bank deposits analysis is inaccurate

because RA Clonch erred in determining: (1) that certain reimbursements,

transfers between accounts, and gifts were taxable deposits and (2) that certain

cash deposits were double counted. Because petitioners bear the burden of

proving that respondent’s bank deposits analysis is erroneous, they must prove

that respondent erred in preparing it. See sec. 446(b); Petzoldt v. Commissioner,

92 T.C. at 693; sec. 1.446-1(b)(1), Income Tax Regs.

      We address each of petitioners’ contentions in turn. As discussed below, we

generally find that RA Clonch’s methodology for determining petitioners’ taxable

income and the resulting income tax deficiencies was reasonable.
                                          - 25 -

[*25]         1.     Reimbursements, Transfers Between Accounts, and Gifts

        Petitioners contend that the bank deposits analysis is inaccurate because RA

Clonch erred in determining that certain reimbursements, transfers between,

accounts, and gifts were taxable deposits. Respondent contends that petitioners

failed to identify any nontaxable deposits during the examination and that

respondent eliminated nontaxable sources of income and transfers between

accounts based on available information.

        At trial Mr. Ray conceded that petitioners failed to report all of their

Schedule C income in their untimely filed returns.17 Further at trial, Mr. Ray

testified, without providing any corroborating evidence, that many of the disputed

items were in fact reimbursements, gifts, income of another, or transfers between

accounts. We find Mr. Ray lacked credibility and decline to rely on his

uncorroborated and self-serving testimony to establish that the disputed items


        17
        To the extent any of petitioners’ arguments can be construed to contend
that respondent erred in including petitioners’ missing Schedule C income in his
reconstruction of petitioners’ income, we find such a contention to be without
merit. In calculating petitioners’ missing Schedule C income, RA Clonch
calculated the difference between the amounts that petitioners reported on their
respective Schedules C for the years at issue and the deposits she could identify as
being Schedule C income on the basis of documents petitioners provided to her
during the examination. Petitioners have failed to provide any evidentiary support
to establish that RA Clonch erred in preparing this portion of the bank deposits
analysis.
                                        - 26 -

[*26] were reimbursements, gifts, income of another, or transfers between

accounts. See Tokarski v. Commissioner, 87 T.C. at 77.

      On the record before us, we find that petitioners failed to introduce credible

evidence that the aforementioned deposits are not taxable income, and to that

extent we find that no adjustment to respondent’s bank deposits analysis is

required.

             1.     Cash Deposits

      Petitioners also contend that respondent’s bank deposits analysis is

inaccurate because it fails to properly account for certain cash deposits.

Specifically, petitioners contend that, in the light of our holding above that the

NHERI checks constitute income to petitioners for the years at issue, inclusion of

those cash deposits resulted in the double counting because petitioners allege that

the cash deposits into the OSU Visa account came from cashed NHERI checks.

      Although Mr. Ray did not support his testimony with evidence of any worth

and did not even make the argument about “double counting” until after the audit,

in which petitioners were not particularly cooperative, it is logical that some of the

checks made out to the children from NHERI were deposited into the OSU Visa

account. To that extent, we find that respondent’s bank deposits analysis would

have double counted at least some portion of petitioners’ taxable income for each
                                        - 27 -

[*27] of the years at issue. The conundrum is how to determine what portions of

the NHERI checks were actually deposited into the OSU Visa account given the

shortcomings of the evidence at trial.18 Because we believe that petitioners

engaged in a pattern of behavior to replace what ordinarily would be taxable salary

payments to Mr. Ray with what petitioners argue are nontaxable payments to their

children, the Court believes that the deposits into the OSU Visa account most

likely to be the subject of this sleight of hand were those deposits which were

evenly divisible by 100 and not otherwise the subject of a stipulation by one or

both parties.19 We make a further refinement to this calculation for tax year 2010


      18
        The record does not establish what petitioners’ children did with the cash
they retained, nor does it establish the extent to which petitioners or their children
actually deposited the cash proceeds from the NHERI checks into the OSU Visa
account as neither petitioners nor their children maintained a contemporaneous
ledger or other account book that established the source or ownership of such
cash.
      19
         Using our best judgment, we conclude that some of the cash deposits were
in fact cash from the NHERI checks that has already been counted against
petitioners as income for the years at issue. See Cohan v. Commissioner, 

 (2d Cir. 1930); Buske v. Commissioner, T.C. Memo. 1998-29 (applying
Cohan to determine the amount of unreported income); Kale v. Commissioner,
T.C. Memo. 1996-197 (same); Alanis v. Commissioner, T.C. Memo. 1995-263
(holding that in cases of unreported income it may be appropriate for the Court to
make estimates of the amount of income that the taxpayer has failed to report,
applying the Cohan principle); Smith v. Commissioner, T.C. Memo. 1993-548
(applying Cohan to adjust both bank deposits and nontaxable items in
reconstructing income). The appendix infra pp. 33-35 details which deposits were
                                                                      (continued...)
                                        - 28 -

[*28] when we employ the lesser of the sum of such deposits and the total amount

of checks made out that year from NHERI to petitioners’ children.

       Accordingly, on the record before us, we find that $6,200 for 2006, $4,000

for 2007, $17,000 for 2008, $42,500 for 2009, $48,000 for 2010, and $29,800 for

2011 must be excluded in calculating petitioners’ alleged unreported Schedule C

income.

III.   Penalties and Additions to Tax

       A.    General

       The Commissioner bears the burden of production with respect to the

taxpayers’ liability for penalties and additions to tax and must produce sufficient

evidence indicating that it is appropriate to impose them. See sec. 7491(c);

Higbee v. Commissioner, 116 T.C. at 446. As part of that burden, with respect to

certain penalties, the Commissioner must also show that he complied with the

written approval requirement of section 6751(b)(1). See Graev v. Commissioner,

 (2017), supplementing and overruling in part 

 (2016).20


       19
        (...continued)
actually cash from the NHERI checks.
       20
        Sec. 6751(b)(1) provides that “[n]o penalty under this title shall be
assessed unless the initial determination of such assessment” receives supervisory
approval. This provision does not apply to “any addition to tax under section
                                                                        (continued...)
                                        - 29 -

[*29] Once the burden of production is met, the taxpayers must come forward

with persuasive evidence that the Commissioner’s determination is incorrect or

that the taxpayers had reasonable cause or substantial authority for their position.

See Higbee v. Commissioner, 116 T.C. at 446-447.

      B.     Section 6651: Addition to Tax for Failure To File Timely

      Section 6651(a)(1) imposes upon taxpayers an addition to tax for failure to

file a timely return. The addition to tax will not apply if the taxpayers show their

failure was due to reasonable cause, not willful neglect. Id. Taxpayers

demonstrate reasonable cause when they show that, despite exercising ordinary

business care and prudence, they were unable to file the return on time. Sec.

301.6651-1(c)(1), Proced. & Admin. Regs. The obligation to file timely is the

taxpayers’, unambiguous and nondelegable, and reliance on an agent generally

will not amount to reasonable cause for untimely filing. United States v. Boyle,

, 249-252 (1985). Taxpayers bear a heavy burden when attempting to

prove reasonable cause for failure to file timely. Id. at 245; see Boles Trucking,

Inc. v. United States, 

, 241 (8th Cir. 1996).


      20
        (...continued)
6651, 6654, or 6655”. Sec. 6751(b)(2). Accordingly, respondent was not required
to verify that the additions to tax determined against petitioners for the years at
issue under sec. 6651(a)(1) had been approved by a supervisor.
                                         - 30 -

[*30] Petitioners failed to file timely returns for the years at issue. Petitioners

argue, however, that they had reasonable cause because they were unaware of their

filing requirement for the years at issue and therefore “their failure to timely file

was neither conscious nor intentional.” Petitioners’ mistake as to or ignorance of

the law does not amount to reasonable cause and thus will not relieve them from

the imposition of the addition to tax pursuant to section 6651(a)(1). Rayhill v.

Commissioner, T.C. Memo. 2013-181 (citing Joyce v. Commissioner, 

,

15 (1955), and West v. Commissioner, T.C. Memo. 2011-272).

      On the record before us, we find that petitioners have failed to carry their

burden of establishing that their failure to timely file returns for the years at issue

was due to reasonable cause and not due to willful neglect. On that record, we

sustain respondent’s imposition of the addition to tax under section 6651(a)(1).

      C.     Section 6662(a): Accuracy-Related Penalty

      Section 6662(a) and (b)(1) and (2) imposes an accuracy-related penalty on

any portion of an underpayment of tax that is attributable to the taxpayers’

“[n]egligence or disregard of rules or regulations” or “substantial understatement

of income tax”. Negligence includes “any failure by the taxpayer to keep adequate

books and records or to substantiate items properly.” Sec. 1.6662-3(b), Income

Tax Regs. An understatement of income tax is substantial if the amount of the
                                        - 31 -

[*31] understatement for the taxable year exceeds the greater of 10% of the tax

required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).

      On the record before us, we find that if the Rule 155 computations confirm

substantial understatements of income tax for the years at issue, then respondent

has met his burden of production.21 Further, we find that petitioners were

required, but failed, to maintain adequate records to substantiate their deductions.

Sec. 1.6662-3(b), Income Tax Regs. On that record, we find that respondent has

also met his burden of production with respect to the accuracy-related penalties

under section 6662(a) attributable to petitioners’ negligence.

      The accuracy-related penalty under section 6662(a) does not apply to any

portion of an underpayment if it is shown that there was reasonable cause for, and

that the taxpayer acted in good faith with respect to, that portion. Sec. 6664(c)(1).

The determination of whether the taxpayer acted with reasonable cause and in

good faith depends on all the pertinent facts and circumstances, including the

taxpayer’s efforts to assess the taxpayer’s proper tax liability, the knowledge and




      21
       We note that the record contains evidence, in the form of a civil penalty
approval form, that respondent complied with the requirements of sec. 6751(b)(1).
See Graev v. Commissioner, 

__, __ (slip op. at 14) (Dec. 20, 2017),
supplementing and overruling in part 

 (2016).
                                         - 32 -

[*32] experience of the taxpayer, and the reliance on the advice of a professional,

such as an accountant. Sec. 1.6664-4(b)(1), Income Tax Regs.

      On the record before us, we find that petitioners have failed to carry their

burden of establishing that there was reasonable cause for, and that they acted in

good faith with respect to, the underpayments for the years at issue. On that

record, we find that petitioners have failed to carry their burden of establishing

that they are not liable for the years at issue for the accuracy-related penalties

because of underpayments attributable to negligence, or alternatively, substantial

understatements of income tax, under section 6662(a) and (b)(1) and (2).

      We have considered all the other arguments of the parties, and to the extent

not discussed above, find those arguments to be irrelevant, moot, or without merit.

      To reflect the foregoing,


                                                  Decision will be entered

                                        under Rule 155.
                                                                - 33 -

[*33]                                                     APPENDIX

         2006                 2007                 2008                     2009                  2010                 2011
  Date          Amt    Date          Amt    Date          Amt        Date          Amt     Date          Amt    Date          Amt
3/29        $400      4/25       $800      1/2        $500          1/8       $1,400      1/4       $1,400     1/11       $100
5/23            900   9/4        1,600     2/19       1,000         1/28           900    1/11       1,700     1/12       1,000
6/15            100   11/14          300   3/6            100       2/9        1,000      1/19       2,000     1/20       3,000
6/20            500   12/11      1,300     3/11           200       3/3            400    1/20       1,000     1/31       1,400
7/7             200                        3/18       1,000         3/25       1,000      1/25           500   2/1            100
8/9             300                        4/15           200       3/30       2,900      1/28       2,000     2/10       1,200
8/18            200                        4/17           500       4/20            500   2/1        1,100     2/11       1,300
10/16           100                        4/22           500       4/27       1,500      2/26           500   2/24       1,700
12/8       1,600                           4/29           100       5/4        1,000      3/1        1,600     3/3        1,000
12/12           300                        5/9            100       5/12       1,600      3/9        1,700     3/10           400
12/20      1,600                           5/13           800       5/22           700    3/24           900   3/18           500
                                           5/13           100       5/28           900    4/2            500   3/22           400
                                           5/20           200       6/1            600    4/13       1,400     4/18           200
                                           7/22           100       6/2        1,300      4/15           900   5/12           300
                                                            - 34 -

[*34] 2006                2007                 2008                     2009                 2010                 2011
 Date        Amt   Date          Amt    Date          Amt        Date          Amt    Date          Amt    Date          Amt
                                       7/23           200       6/9            900   4/21           900   5/13           900
                                       7/28       1,400         6/10           500   5/5            700   5/25       1,000
                                       8/5        1,200         6/11           800   5/6        2,100     6/17       3,500
                                       8/26       1,900         6/17           800   5/10           400   6/27       2,500
                                       9/15           600       6/22           300   5/21       4,400     7/21           200
                                       9/22           300       7/6        1,000     5/25           200   8/26           700
                                       9/24           600       7/10           800   6/28       1,100     8/30           300
                                       9/30           800       7/17       2,800     7/9        1,100     9/1        1,000
                                       10/1           200       7/27       1,200     7/16       2,000     9/16       1,300
                                       10/6           200       8/3        1,000     7/22           500   10/5           700
                                       10/14      1,400         8/4        2,000     8/3            500   11/28      1,200
                                       11/21          100       8/18       2,500     8/6            500   11/29          500
                                       11/28          200       8/19           300   8/9        6,000     12/2           500
                                       12/8       1,400         8/20           300   8/18       1,000     12/9           900
                                       12/10          300       9/8        1,500     9/17       1,500     12/15      2,000
                                                             - 35 -

[*35] 2006                 2007                 2008                     2009                 2010                 2011
 Date        Amt    Date          Amt    Date          Amt        Date          Amt    Date          Amt    Date          Amt
                                        12/29          800       9/30           900   9/27       1,000
                                                                 10/1           700   10/11          300
                                                                 10/7       1,000     10/14      2,000
                                                                 10/14          600   10/18          700
                                                                 10/19      1,500     10/25          500
                                                                 10/30      1,200     12/2           600
                                                                 11/9       1,000     12/2           700
                                                                 11/18      1,400     12/8           100
                                                                 11/24          700   12/13          800
                                                                 12/11          300   12/27      1,200
                                                                 12/14          500
                                                                 12/28          300


Total   6,200      Total     4,000      Total     17,000         Total     42,500     Total     48,000     Total     29,800