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 18 A.R. 11 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, 290 U.S. 111, 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, 116 T.C. 438, 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, 116 T.C. 438, 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, 596 F.2d 358, 361-362 (9th Cir. 1979), rev’g 67
T.C. 672 (1977), or demonstrating that the taxpayer actually received unreported
income, Edwards v. Commissioner, 680 F.2d 1268, 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, 181 F.3d 1002, 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, 281 U.S. 111, 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, 333 U.S. 591, 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, 79 T.C. 152, 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, 73 T.C. 1246, 1254 (1980)
(quoting Nesenberg v. Commissioner, 69 T.C. 1005, 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, 25 T.C. 859, 877 (1956). - 22 -
[*22] must maintain books and records establishing the amount of his or her gross
income. See sec. 6001; Petzoldt v. Commissioner, 92 T.C. 661, 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, 40 T.C. 30, 33
(1963); see also Giddio v. Commissioner, 54 T.C. 1530, 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, 175 F.2d 500, 502-503 (2d Cir. 1949), aff’g 7 T.C. 245 (1946);
DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (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, 87 T.C. 74, 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, 335 F.2d 671, 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, 102 T.C. 632, 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, 39 F.2d 540 (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,
149 T.C. 23 (2017), supplementing and overruling in part 147 T.C. 460 (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,
469 U.S. 241, 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, 77 F.3d 236, 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, 25 T.C. 13,
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, 149 T.C. __, __ (slip op. at 14) (Dec. 20, 2017), supplementing and overruling in part 147 T.C. 460 (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