Higgins v. Dept. of Rev.

Opinion

IN THE OREGON TAX COURT MAGISTRATE DIVISION Income Tax

WESLEY HIGGINS, KRISTINA ) JACOBSEN, and CHECKMATE SMALL ) BUSINESS SOLUTIONS, ) ) Plaintiffs, ) TC-MD 170047G ) v. ) ) DEPARTMENT OF REVENUE, ) State of Oregon, ) ) Defendant. ) FINAL DECISION1

This is an appeal of adjustments to an S corporation’s income and deductions. Plaintiffs

appealed Defendant’s notices of assessment for the 2012 and 2013 tax years, each of which was

issued after a conference decision. A trial was held on June 29, 2017. Terry K. Schandel

(Schandel), CPA, appeared and testified on behalf of Plaintiffs. Nancy Berwick (Berwick),

Senior Tax Auditor, appeared and testified on behalf of Defendant. Plaintiffs’ exhibits 1 to 8 and

Defendant’s exhibits A to K were received without objection.

I. STATEMENT OF FACTS

During the years at issue, CheckMate Small Business Solutions (CheckMate) was an S

corporation partly owned by Plaintiff Wesley Higgins (Higgins). According to CheckMate’s

Schedule K-1s, Higgins was a 50-percent shareholder in 2012 and a 47.97-percent shareholder in

2013. (Def’s Exs A at 7; B at 12.) In 2012, CheckMate’s address was the same as the address of

the other 50-percent shareholder, Bryan Petersen. (Def’s Ex A at 6.) In 2013, two more people

became shareholders: David Cox and Steven Peck. (Def’s Ex B at 12–17.) Plaintiff Kristina

1 This Final Decision incorporates without change the court’s Decision, entered December 15, 2017. The court did not receive a statement of costs and disbursements within 14 days after its Decision was entered. See Tax Court Rule–Magistrate Division (TCR–MD) 16 C(1).

FINAL DECISION TC-MD 170047G 1 Jacobsen, Higgins’s wife, was not listed as a shareholder on CheckMate’s Schedule K-1s.

Plaintiffs’ sole witness at trial was their certified public accountant, Schandel. Schandel

had been hired by Plaintiffs during Defendant’s audit in late 2015, after Higgins had ceased

operating CheckMate. According to Schandel, CheckMate’s original returns—prepared from

records maintained by Higgins—were inaccurate. Schandel reconstructed profit and loss

statements, ledgers, and journals from CheckMate’s bank statements and from transaction reports

obtained from CheckMate’s principal vendor, an internet-based software company identified as

“Agile.” Schandel testified that the bank accounts from which he constructed the books were

used exclusively for business purposes. He assigned expenses from bank statements to general

ledger accounts, and in some cases consulted Higgins to determine what account an expense fit in.

Plaintiffs presented virtually no details of CheckMate’s business except for Schandel’s

testimony that it was a “payroll service.” Schandel’s hearsay testimony was supported by

CheckMate’s 2012 and 2013 federal tax returns, which listed “payroll and HR” as CheckMate’s

“product or service.” (Def’s Exs A at 2, B at 2.) According to Schandel, Higgins was a

salesperson for whom meal and entertainment expenses were an ordinary part of business.

CheckMate claimed several expense deductions on its 2012 and 2013 returns. Some

expenses that were claimed as deductions in 2012 were claimed as “cost of goods sold” (COGS)

in 2013. Others were changed to different categories, or spread among multiple categories.

Some expenses claimed on the returns were not reflected in Schandel’s reconstructed profit and

loss statements. Other expenses were introduced for the first time on the profit and loss

statements. The following table summarizes the income and deduction amounts claimed on the

original returns. It also shows the amounts on the reconstructed profit and loss statements and

the amounts allowed by Defendant at conference.

FINAL DECISION TC-MD 170047G 2 TAX YEAR 2012 TAX YEAR 2013 Return P & L Conference Return P&L Conference INCOME Gross Receipts $58,028 $63,801 $63,801 $105,585 $113,458 $130,132 Other Income $593 -0- $593 $25 -0- Bus. Prop. Sales ($30) -0- -0- COGS Agile Process. Fee $31,603 $32,555 $32,555 Office Supplies $3,441 $5,768 $2,916 Postage & Delivery $3,792 $3,663 $1,215 Professional Fees $7,147 $3,533 -0- Swipeclock $983 -0- -0- “Other client expenses” -0- $1,362 $1,362 DEDUCTIONS Officer comp. $4,645 -0- -0- $28,000 -0- $28,000 Salaries and wages -0- $4,645 $4,645 $3,162 $31,162 $3,162 Repairs & maint. -0- $1,048 -0- Rents $331 $320 -0- $6,057 $5,805 $4,605 Taxes and licenses $3,686 $373 $373 -0- $215 $215 Payroll taxes $719 $719 $3,822 $8,878 $2,644 Interest $479 -0- -0- 4562 depreciation $2,854 -0- -0- Advertising $1,894 -0- $225 Employee benefit $189 -0- -0- OTHER DEDUCTIONS Agile Process. Fee -0- $27,426 $19,933 Legal/professional $20,956 -0- -0- Office $2,793 $2,862 $1,488 Postage $3,300 $2,815 $272 Professional fees -0- $1,063 -0- “Other client expenses” -0- $2,625 -0- L & I taxes -0- -0- $2,625 Auto and truck $1,684 $684 -0- $5,135 $4,680 -0- Bank charges ($40) ($10) ($10) -0- $400 $400 Bookkeeping -0- $586 -0- -0- $72 -0- Commissions $886 -0- -0- -0- $3,173 -0- Contract services -0- $350 -0- $14,424 $20,244 -0- Dues/subscriptions $275 -0- -0- -0- $445 -0- Garnishments -0- $872 $150 Insurance $2,302 $2,678 $1,897 $2,897 $2,706 $1,397 Marketing -0- $2,217 -0- $89 $597 -0- Meals/Entertain. $385 $929 -0- $686 $1,423 -0- Miscelleneous $901 $1,663 -0- $896 $2,133 -0- Software -0- $2,297 $2,297 -0- $3,582 $3,582 Internet -0- $5,221 -0- -0- $4,101 $4,101 Telephone $13,704 -0- $5,221 $4,891 $1,311 $1,311

FINAL DECISION TC-MD 170047G 3 Additional details regarding the returns and profit and loss statements will be introduced where

pertinent in the analysis.

All but a few pages of Plaintiffs’ exhibits consisted of the reconstructed books, bank

statements for two of CheckMate’s bank accounts, and spreadsheets captioned

myPayrollDepartment Revenue and Fees, identified by Schandel as 2012 and 2013 “Agile

Reports” (Ptfs’ Exs 1–6). The statements of accounts provided with the ledgers showed that

CheckMate had four bank accounts. (See, e.g. Ptfs’ Ex 1 at 2–3.) The conference decisions

indicate that documents were presented at conference to substantiate expenses that were not

provided to the court—such as leases, insurance policies, and telephone expense statements.

(See, e.g., Def’s Ex E at 3–4.) In this proceeding, Plaintiffs submitted just a few additional

documents besides the books, bank statements, and Agile Reports: an annotated copy of

CheckMate’s 2012 and 2013 “Meals and Entertainment” accounts (reportedly prepared by

Higgins sometime after the ledgers were created in late 2015); a 2013 Form 1099-MISC that

identified Jacobsen as the recipient of $408.00 of “other income” from CheckMate; a copy of an

executed “Independent Contractor Agreement” between CheckMate and one Tina Nielsen,

effective December 21, 2012; a Form W-9 signed by Tina Nielsen on February 19, 2013; and

copies of several business cards from vendors named in the ledgers (Ptfs’ Exs 7–8).

With respect to the disallowed deductions, Schandel testified that he concluded the

expenses shown in the ledgers were business-related because they were all paid from

CheckMate’s business accounts. He testified that he personally knew some of the vendors

named in the ledger, and that those vendors only performed work for businesses. Schandel

conceded that expenses for life insurance contained in the ledger were not deductible.

///

FINAL DECISION TC-MD 170047G 4 Berwick testified that she had adjusted CheckMate’s 2013 gross receipts after conducting

a bank deposit analysis. Her summary of that analysis shows that deposits made to two accounts

at First Republic Bank and two accounts at Pacific Continental Bank were added up. (Def’s Ex

H.) Then, because Agile had netted its processing fees out of its deposits into CheckMate’s

accounts, Berwick added those processing fees to the total of bank deposits. After removing one

large deposit that was shown to be a loan, Berwick arrived at a total 2013 income of $130,132.

(See Def’s Ex E at 4.)

Plaintiffs requested that their income and expense deductions be adjusted to conform to

Schandel’s reconstructed books (column labeled “P & L”).2 Defendant requested that its

assessment be upheld (column labeled “conference”).

II. ANALYSIS

At issue are CheckMate’s income and the expense deductions over the years at issue,

which flow through to the other plainiffs.

Subject to exceptions not pertinent here, taxable income in Oregon is identical to taxable

income under federal law. ORS 316.022(6); ORS 316.048.3 So far as practicable, Oregon

follows the “administrative and judicial interpretations of the federal income tax law.” ORS

314.011(3). Plaintiffs must show their entitlement to relief by a preponderance of the evidence.

ORS 305.427.

/// 2 Schandel indicated in his second status report that the disallowance of Higgins’s and Jacobsen’s Schedule A employee business expenses had “not been resolved.” No such claim was stated in the Complaint and no evidence of employee expenses was provided at trial. Employee business expenses are not at issue. 3 The court’s references to the Oregon Revised Statutes (ORS) are to 2015.

FINAL DECISION TC-MD 170047G 5 A. Income

1. 2012 other income

Defendant increased CheckMate’s 2012 total income by $593 over the amount stated in

Schandel’s profit and loss statement. CheckMate had reported “other income” of $593 on its

2012 return in addition to gross receipts. Schandel’s profit and loss statement reported additional

income of over $5,000, including income from payroll processing fees, consulting fees, and

“other fees.” Defendant increased CheckMate’s gross receipts to match the amount shown on

Schandel’s profit and loss statement but did not adjust CheckMate’s “other income.”

Plaintiffs did not provide evidence that the amount reported as “other income” on

CheckMate’s return was included in Schandel’s profit and loss statement. No transaction in the

reconstructed ledger clearly corresponds to the amount of the “other income.” Over $3,400 in

transactions were labeled “other fees”; it is not clear whether any of those transactions represents

the “other income” reported on the return. Plaintiffs did not offer firsthand testimony of

CheckMate’s sources of income in 2012. Plaintiffs did not offer testimony from anyone

knowledgeable about the 2012 return. They did not bear their burden to prove the “other

income” that Checkmate reported should be eliminated. See ORS 305.427.

2. 2013 gross receipts

Where a taxpayer’s books do not clearly reflect income, the Department of Revenue may

demonstrate unreported income “by any practicable proof that is available in the circumstances

of the particular situation.” Brenner v. Dept. of Rev., 9 OTR 299, 306–07 (1983) (quoting 2

Mertens Law of Federal Income Taxation § 12.12); cf. U.S. v. Doyle, 234 F2d 788, 793 (7th Cir

1956). Bank deposit analysis, which involves inferring that deposits into a taxpayer’s bank

account represent income, is one such indirect method. See Brenner, 9 OTR at 302 n 2; Doyle,

FINAL DECISION TC-MD 170047G 6 234 F2d at 793. “A bank deposit is prima facie evidence of income * * *.” Tokarski v. C.I.R.,

87 TC 74, 77 (1986).

Here, CheckMate admits that its initial returns were based on inaccurate records.

Defendant was therefore charged with looking beyond CheckMate’s records to determine its

income. See Brenner, 9 OTR at 306–07. The sum of CheckMate’s deposits into its four bank

accounts is prima facie evidence of its income. See Tokarski, 87 TC at 77. Defendant’s method

of adding the Agile processing fees to the gross receipts is reasonable to avoid CheckMate

gaining a windfall from deducting those fees.

Plaintiffs did not provide evidence to overcome the evidence of income from the bank

deposit analysis and Agile reports. Plaintiffs provided bank statements for only two of the

accounts; the other two accounts were not made available for the court’s review. Plaintiffs did

not offer testimony from anyone with firsthand knowledge of the sources of CheckMate’s

income and its deposits. Nor did Plaintiffs offer any corroborating documentation to show that

CheckMate received a loan or other source of capital that was not taxable as income. Plaintiffs

did not bear their burden of proof on the issue of gross receipts in 2013.

B. Deductions and COGS

The court will analyze the items claimed by CheckMate as COGS in 2013 as deductions.

The concept of COGS is applicable in “manufacturing, merchandising, or mining” businesses,

where the “cost of goods purchased for resale” is offset against total receipts to obtain gross

income. Treas. Reg. §§ 1.61–3(a), 1.162–1(a). The court has not located authority for claiming

COGS where no tangible “goods” are purchased and resold. Because CheckMate’s business was

payroll services, the items it claimed as COGS in 2013 may be deducted from its gross income if

they satisfy the conditions of Internal Revenue Code (IRC) section 162.

FINAL DECISION TC-MD 170047G 7 IRC section 162(a) allows taxpayers to deduct “all the ordinary and necessary expenses

paid or incurred during the taxable year in carrying on any trade or business[.]”

“An expense is ‘ordinary’ if it is ‘normal, usual, or customary’ in the taxpayer’s trade or business. An expense is ‘necessary’ if it is ‘appropriate and helpful’ in the taxpayer’s business, but it need not be absolutely essential. Whether an expense is deductible under section 162 is a question of fact to be decided on the basis of all the relevant facts and circumstances.”

Adams v. Comm’r, 105 TCM (CCH) 1029 (2013), 2013 WL 135103 at *9 (US Tax Ct) (citations

omitted). “To prove entitlement to deduct an expense, the taxpayer must prove not only the fact

of the expenditure but also the business purpose (or other deductible character) of the expense.”

Rogers v. Comm’r, 108 TCM (CCH) 39 (2014), 2014 WL 3537775 at *7 (US Tax Ct), amended

on recons in part, 2014 WL 6805465 (Nov 26, 2014). Business expenses are those that are

“directly connected with or pertaining to the taxpayer’s trade or business.” Treas. Reg. § 1.162–

1(a).

The business purpose of expenses not subject to heightened substantiation requirements

can be established by credible testimony. In the absence of such testimony, bank statements and

payment records alone may be unpersuasive. See, e.g., Odelugo v. C.I.R., 95 TCM (CCH) 1355

(2008), 2008 WL 976914 at *9 (US Tax Ct) (finding bank statements and canceled checks did

not establish expenses were incurred in conducting business); Alemasov v. C.I.R., 93 TCM

(CCH) 1254 (2007), 2007 WL 1484527 at *5 (US Tax Ct) (finding credit card statements did not

establish business purpose of purchases).

In the present case, Plaintiffs did not present firsthand testimony of the business purpose

of the expenses. Instead, they relied on bank statements and canceled checks, which Schandel

had organized into ledgers and profit and loss statements. Schandel testified that all the expenses

FINAL DECISION TC-MD 170047G 8 were incurred for business purposes because they were paid from a business bank account.

However, Schandel was hired after Higgins had ceased operating CheckMate.

What is more, Plaintiffs did not show that CheckMate’s deductions were claimed for

ordinary and necessary expenses. Plaintiffs provided only a rudimentary picture of CheckMate’s

business—it was a “payroll service.” Even assuming that all expenses in the ledger were

incurred for business purposes, the court is left without a standard to measure whether the

expenses were ordinary and necessary in CheckMate’s business. It is certain that not all of the

expenses were ordinary and necessary; Schandel conceded as much with respect to certain life

insurance payments made from CheckMate’s accounts.

Without firsthand testimony of the nature of the expenses or of the business, the court

does not have enough evidence to find that the expenses were incurred for business purposes.

III. CONCLUSION

Plaintiffs have not carried their burden of proof with respect to either the amount of

CheckMate’s income or the character of its expenses. Now, therefore,

IT IS THE DECISION OF THIS COURT that Plaintiffs’ appeal is denied.

Dated this day of January, 2017.

POUL F. LUNDGREN MAGISTRATE

If you want to appeal this Final Decision, file a complaint in the Regular Division of the Oregon Tax Court, by mailing to: 1163 State Street, Salem, OR 97301-2563; or by hand delivery to: Fourth Floor, 1241 State Street, Salem, OR. Your complaint must be submitted within 60 days after the date of the Final Decision or this Final Decision cannot be changed. TCR-MD 19 B.

This document was signed by Magistrate Lundgren and entered on January 3, 2018.

FINAL DECISION TC-MD 170047G 9 FINAL DECISION TC-MD 170047G 10