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to decide whether petitioners are liable for fraud penalties with
regard to the unreported income. Finally, we are asked to decide
whether the limitations period bars respondent from assessing
petitioners’ liabilities. We begin by discussing the unreported
income.
I. Unreported Income
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); Webb v.
Commissioner, 394 F.2d 366, 372 (5th Cir. 1968), affg. T.C. Memo.
1966-81; Factor v. Commissioner, 281 F.2d 100, 117 (9th Cir.
1960), affg. T.C. Memo. 1958-94. Where a taxpayer has destroyed
his or her tax records, the Commissioner’s reconstruction need
not be arithmetically precise. DiMauro v. United States, 706
F.2d 882, 885 (8th Cir. 1983), affg. 81-2 USTC par. 16,373 (D.
Neb. 1981).
A. Mr. Paterson’s Unreported Income: Profit Factor Method
We first discuss respondent’s use of the profit factor
method to reconstruct Mr. Paterson’s income. The Commissioner’s
determinations are generally presumed correct, and the taxpayer
bears the burden of proving that these determinations are
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