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Issue 2: Fraud Penalty
Respondent has determined that petitioners are liable for
fraud penalties under section 6663(a) for 1993, 1994, and 1995.
A taxpayer is liable for a 75-percent penalty on the part of an
underpayment that is attributable to fraud. See secs. 6653(b),
6663(a).
Respondent must prove fraud by clear and convincing
evidence. See sec. 7454(a); Rule 142(b); Rowlee v. Commissioner,
80 T.C. 1111, 1123 (1983); Drabiuk v. Commissioner, T.C. Memo.
1995-260. In order to carry his burden as to fraud, respondent
must prove: (1) Petitioners underpaid their tax in each year,
and (2) some part of each underpayment was due to fraud. See
Laurins v. Commissioner, 889 F.2d 910, 913 (9th Cir. 1989), affg.
Norman v. Commissioner, T.C. Memo. 1987-265; Beddow v.
Commissioner, T.C. Memo. 1999-232; Roots v. Commissioner, T.C.
Memo. 1997-187; Lee v. Commissioner, T.C. Memo. 1995-597.
a. Underpayment of Tax
Respondent can satisfy his burden of proving the first prong
of the fraud test; i.e., an underpayment, when the allegations of
fraud are intertwined with unreported and reconstructed income in
one of two ways. Respondent may prove an underpayment by proving
a likely source of the unreported income. See Holland v. United
States, 348 U.S. 121 (1954); Parks v. Commissioner, 94 T.C. 654,
661 (1990). Alternatively, where the taxpayer alleges a
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