Khuong Duong v. Commissioner; Dung T. Tran v. Commissioner.
U.S. Tax Court, Dkt. No. 14991-13, 15151-13, TC Memo.
2015-90, May 11, 2015.
[Appealable, barring stipulation to the contrary, to CA-4
and CA-11.—CCH.]
[ Code Secs. 61 and 446]
Gross income: Underreported income: Reconstruction of
income: Bank deposits method.–
The IRS established that two nail salon owners underreported
their income by using the bank deposits method. The unreported income was
allocated equally between the taxpayers for the deposits into their joint
accounts, and wholly to one of the business owners for the deposits into his
wholly-owned account. However, the IRS’s determination of additional tip income
for both individuals was arbitrary and erroneous. Although the one owner
performed services as a nail stylist, the IRS’s methodology imputed income to
her for tips that were paid to other employees and there was no support for the
IRS’s contention that the other owner, who acted as the office manager and did
not perform services as a nail technician, received any tip income.—CCH.
[ Code Sec. 6662]
Penalty: Accuracy-related: Negligence.–
A business owner was liable for an accuracy-related penalty
attributed to negligence. She underreported income and failed to maintain
adequate records for the nail salon businesses. In addition, she did not
testify and offered no reliable evidence that she attempted to assess her tax
liability correctly.—CCH.
[ Code Sec. 6663]
Penalty: Fraud: Intent.–
A business owner was liable for fraud penalties for the two
tax years at issue. The "badges of fraud" demonstrated that the
individual evaded payment of tax he knew to be owed. The business owner made
false statements and failed to cooperate with the IRS; he acted with fraudulent
intent and his underpayments for the tax years at issue were attributed to
fraud.—CCH.
Khuong Duong and Dung T. Tran, pro se; Shari A. Salu, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LAUBER, Judge: For the taxable years 2007 and 2008, the
Internal Revenue Service (IRS or respondent) determined against both
petitioners deficiencies [*2] in Federal income tax and civil fraud penalties
under section 6663(a) 1 and against petitioner Tran certain additions to tax.
The deficiencies stem mainly from petitioners' underreporting of income from
two nail salons they jointly operated, AK Nails and Perfection Nails. After
conducting a bank deposits analysis, the IRS made whipsaw determinations by
asserting, in full against each petitioner, all taxable deposits into their
joint bank accounts.
[*3] After
concessions, 2 the issues remaining for decision are: (1) whether petitioners
failed to report income for 2007 and 2008 as determined by respondent using the
bank deposits method; (2) whether petitioners are liable for fraud penalties;
and (3) if petitioner Tran is not liable for the fraud penalty, whether she is
liable for the accuracy-related penalty for 2008. We answer the first question
in the affirmative, and we find that petitioner Duong is liable for the fraud
penalty for both years. We find that respondent has failed to prove by clear
and convincing evidence that petitioner Tran is liable for the fraud penalty
but conclude that she is liable for the accuracy-related penalty for 2008.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The
stipulations of facts and the attached exhibits are incorporated by this
reference. When they petitioned this Court, petitioner Khuong Duong (Duong)
lived in Severn, Maryland, and petitioner Dung T. Tran (Tran) lived in Splant
City, Florida.
[*4] Petitioners jointly owned and operated AK Nails and
Perfection Nails during the years in issue and split the profits and losses
50-50. Each salon had several nail stations so that multiple stylists could
serve customers simultaneously. Tran was the main stylist and often worked
alone; petitioners employed other nail stylists in both salons as necessary to
meet customer demand. Petitioners paid these stylists a wage by check, and the
stylists kept any tips that customers gave them. Customers paid for the salon
services and tips by credit card, debit card, or cash. Duong functioned as a
store manager and did not act as a nail stylist.
Although petitioners were not married during 2007, they
filed a joint Federal income tax return for that year. They attached to this
return a Schedule C, Profit or Loss From Business, reporting gross receipts of
$37,469 from AK Nails. For 2008 each petitioner filed an individual return
using the “single” filing status. Tran attached to her return a Schedule C
reporting gross receipts of $38,347 from AK Nails. Duong attached to his return
a Schedule C reporting gross receipts of $44,377 from Perfection Nails.
The IRS selected petitioners' returns for audit, focusing on
their Schedule C income. A revenue agent met with petitioners and toured both
nail salons. During these visits petitioners stated that they had reported on
their tax returns all income received by the salons. They denied receiving cash
at either location, insisting that [*5] customers made all payments by credit
or debit card. Duong bears principal responsibility for making these false
statements.
Petitioners did not maintain adequate books and records for
their businesses. Duong declined to provide the revenue agent with bank
statements or with the other limited business records that petitioners
possessed. Duong bears principal responsibility for the failure to turn over
business records to the revenue agent.
The revenue agent issued summonses to petitioners' banks in
order to conduct a bank deposits analysis. During 2007 petitioners maintained
three joint bank accounts and Duong maintained a separate joint account with
his father. During 2008 petitioners maintained two joint bank accounts and
Duong maintained a separate individual account. Petitioners comingled funds
from these accounts and used the accounts for both business and personal
activities.
Under the bank deposits method, the IRS estimates the gross
receipts of a business that lacks reliable records. This analysis begins with
the bank deposits made during the tax year, then adds any other income shown to
have been received but not placed in a bank. From that total, various
subtractions must be made for nontaxable deposits. Nontaxable deposits include
loan proceeds, interaccount [*6] transfers, gifts, inheritances, and other
nontaxable items. See Morrison v. United States, 270 F.2d 1, 2-3 (4th Cir.
1959).
The revenue agent followed this procedure here. She started
with petitioners' bank statements and calculated the total deposits made during
2007 and 2008. From these totals she deducted deposits shown to be from
nontaxable sources, including a home equity loan, other loans, transfers from
other accounts, various rebates, insurance proceeds, State and Federal tax
refunds, and for Doung's separate account in 2007, wages earned by his father.
For 2007 the revenue agent calculated total deposits of
$235,679 in petitioners' joint accounts, less $98,866 from nontaxable sources,
yielding $136,813 of presumptive gross receipts. For 2008 she calculated total
deposits of $136,826 in petitioners' joint accounts, less $36,893 from
nontaxable sources, yielding $99,933 of presumptive gross receipts. For Duong's
separate account in 2007 she calculated total deposits of $20,119, less $3,092
from nontaxable sources, yielding $17,027 of additional gross receipts for
Duong. For Duong's separate account in 2008 she calculated total deposits of
$51,553, less zero from nontaxable sources, yielding $51,553 of additional
gross receipts for Duong.
The revenue agent then increased the presumptive gross
receipts set forth above by 8% to account for tips. Under her theory, if a
salon customer tipped the [*7] stylist in cash, the cash tip would probably not
be included in petitioners' bank deposits. The IRS determined that tips
presumptively received should be added to the bank deposit totals as “other
income shown to have been received but not placed in bank.” See Morrison, 270
F.2d at 2.
On the basis of the examination and the revenue agent's
initial calculations, the IRS on April 2, 2013, issued separate notices of
deficiency to Duong and Tran. They timely petitioned this Court, and the cases
were consolidated. Petitioners thereafter provided respondent with documents
substantiating, for their joint bank accounts, additional nontaxable deposits
of $32,078 for 2007 and $12,190 for 2008. After allowing these items,
respondent's revised position was that the gross receipts chargeable to each
petitioner, before adding 8% for tips, were as follows:
[*8] The Court held a
trial on September 30, 2014. Respondent called the revenue agent as a witness,
and she explained in detail her bank deposits analysis. Duong spoke for both
petitioners and testified on his own behalf; Tran, who was present, did not testify
or conduct cross-examination. During the recall of the revenue agent, Duong
questioned her about 17 checks that he contended should be treated as
additional nontaxable deposits. The Court determined that the revenue agent's
schedule of nontaxable deposits already included 14 of these checks.
The remaining three items consisted of a check from J.P.
Morgan Chase for $9,000, a check from Nhut Hong Le for $3,000, and a check from
Baltimore Gas & Electric Co. for $896. Petitioners argued that the first item
was a credit card cash advance, but they did not furnish the revenue agent or
introduce into evidence the relevant credit card statement. Petitioners argued
that the second item was a loan, but they did not advance this contention until
a week before trial and produced no evidence of a loan apart from Duong's
testimony. Petitioners argued that the third item was a utility rebate, but
they provided no evidence as to whether they had deducted the original payment
on a tax return. For these reasons, the revenue agent testified as to her
belief that these three checks should not be treated as nontaxable deposits.
[*9] At the close of trial the Court ordered one round of
seriatim briefs. Respondent timely filed his brief on January 29, 2015.
Petitioners failed to file a posttrial brief. 3
OPINION
I. Burden of Proof
The IRS' determinations in a notice of deficiency are
generally presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). For the presumption of correctness to attach to the deficiency
determination in unreported income cases, the Commissioner must establish a
“minimal evidentiary showing” connecting the taxpayer with the income-producing
activity, see Blohm v. Commissioner, 994 F.2d 1542, 1548-1549 (11th Cir. 1993),
aff'g T.C. Memo. 1991-636, or demonstrate that the taxpayer actually received
unreported income, see Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir.
1982). Once respondent makes the required threshold showing, the burden of
proof shifts to the taxpayer to prove by a preponderance of the evidence that
respondent's determinations are [*10] arbitrary or erroneous. Helvering v.
Taylor, 293 U.S. 507, 515 (1935); Tokarski v. Commissioner, 87 T.C. 74 (1986).
To satisfy his initial burden of production, respondent
introduced records obtained during the IRS audit. These records establish that
petitioners received unreported income. Although not necessarily required to do
so, respondent has also shown that the nail salons are the likely source of
petitioners' unreported income. See Stinnett v. United States, 173 F.2d 129
(4th Cir. 1949); cf. Mills v. Commissioner, 399 F.2d 744, 748-749 (4th Cir.
1968) (when using the bank deposits method, the Commissioner need not prove a
likely source of income), aff'g T.C. Memo. 1967-67; Tokarski, 87 T.C. at 77. On
the basis of this credible evidence, we are satisfied that the IRS'
determinations, as set forth in the notices of deficiency, are entitled to the general
presumption of correctness. See Power-stein v. Commissioner, T.C. Memo.
2011-271.
II. Analysis
A. Unreported Income
Section 61(a) defines gross income as “all income from
whatever source derived,” including income derived from business. A taxpayer
must maintain books and records establishing the amount of his or her gross
income. See sec. 6001. When a taxpayer keeps no books of account or keeps books
that are demonstrably [*11] inaccurate, the IRS may determine his income “under
such method as, in the opinion of the Secretary, does clearly reflect income.”
Sec. 446(b); see Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989). Where a
taxpayer has poor records and large unexplained bank deposits, the Commissioner
may properly employ the bank deposits method to estimate the taxpayer's income.
Estate of Hague v. Commissioner, 132 F.2d 775 (2d Cir. 1943), aff'g 45 B.T.A.
104 (1941); Estate of Mason v. Commissioner, 64 T.C. 651, 657 (1975), aff'd,
566 F.2d 2 (6th Cir. 1977). The IRS has great latitude in reconstructing a
taxpayer's income, and the reconstruction “need only be reasonable in light of
all surrounding facts and circumstances.” Petzoldt, 92 T.C. at 687.
In the instant cases petitioners failed to maintain accurate
books or records from which their Federal tax liabilities could be computed.
They refused during the audit to provide the revenue agent with any records at
all. Respondent was thus authorized to determine their income by using the bank
deposits method.
Bank deposits are prima facie evidence of income. The bank
deposits method starts with the presumption that all money deposited in a
taxpayer's bank account during a given period constitutes taxable income. Price
v. United States, 335 F.2d 671, 677 (5th Cir. 1964). This presumption is
rebutted to the extent the deposits are shown to include nontaxable amounts,
and “the Government must [*12] take into account any non-taxable source * * *
of which it has knowledge.” Ibid.; DiLeo v. Commissioner, 96 T.C. 858, 868
(1991), aff'd, 959 F.2d 16 (2d Cir. 1992).
After the IRS reconstructs a taxpayer's income and
determines a deficiency, the taxpayer bears the burden of proving that the IRS'
implementation of the bank deposits analysis was unfair or inaccurate. See
Clayton v. Commissioner, 102 T.C. 632, 645 (1994); DiLeo, 96 T.C. at 871-872.
The taxpayer may do so by showing (among other things) that certain deposits
came from nontaxable sources. See Clayton, 102 T.C. at 645. Nontaxable sources
include funds attributable to “loans, gifts, inheritances, or assets on hand at
the beginning of the taxable period.” Burgo v. Commissioner, 69 T.C. 729, 743
n.14 (1978) (quoting Troncelliti v. Commissioner, T.C. Memo. 1971-72).
The revenue agent employed the bank deposits method to
reconstruct petitioners' 2007 and 2008 income. She used their bank account
statements (which are part of the record) to prepare schedules listing all
deposits. She eliminated $138,851 of nontaxable deposits using evidence of
which she had knowledge. Upon receiving more documentation from petitioners,
she determined that $44,268 of additional deposits should be treated as
nontaxable and eliminated them from her analysis. In the end, she determined
that $183,119 of the deposits, roughly [*13] half the total, was nontaxable.
She then estimated petitioners' unreported gross receipts by subtracting from
their taxable deposits the gross receipts reported on their tax returns. We
find that her implementation of the bank deposits method was reasonable.
Petitioners' primary challenge at trial to the revenue
agent's methodology was the contention that she should have treated 17 specific
checks as additional nontaxable deposits. We determined that the revenue
agent's schedule of nontaxable deposits already included 14 of these checks. We
will discuss the other three.
Duong testified that a $9,000 check from J.P. Morgan Chase
was a credit card cash advance. If this allegation were true, petitioners could
easily have verified it by providing the revenue agent or the Court with a
credit card statement showing the alleged advance. We decline to credit Duong's
uncorroborated testimony in the absence of such evidence. See, e.g., Tokarski,
87 T.C. at 77.
Duong next testified that a $3,000 check from Nhut Hong Le
represented a loan from a personal friend, and that his parents later paid off
this loan on his behalf. Petitioners did not advance this contention during the
IRS audit, and Duong first made the argument a week before trial. Duong
provided no documentary evi- [*14] dence that this check represented a loan or
that his parents paid off the loan. Again, we decline to credit his
uncorroborated testimony.
Finally, Duong testified that an $896 check from Baltimore
Gas & Electric Co. was a utility rebate that should be treated as
nontaxable. However, when an amount is deducted from gross income in one year
and recovered in a subsequent year, such amount is taxable in the later year if
the original deduction yielded a tax benefit. See Unvert v. Commissioner, 72
T.C. 807, 812 (1979), aff'd, 656 F.2d 483 (9th Cir. 1981); W. Adjustment &
Ins. Co. v. Commissioner, 45 B.T.A. 721 (1941). Petitioners failed to prove
that this check was a rebate for residential electric service as opposed to
electric service provided to their nail salons and previously deducted by them
as such. In the absence of such evidence we will not treat the $896 check as a
nontaxable receipt. See Clayton, 102 T.C. at 645.
We find that the agent's bank deposits analysis was
reasonable and that petitioners failed to prove the nontaxability of any
deposits beyond the $183,119 that the IRS allowed. On top of the taxable bank
deposits thus determined, the revenue agent added 8% to capture tips presumptively
received by petitioners but not deposited in a bank. We reject as unreliable
this aspect of the IRS' approach.
The record demonstrates that only stylists received tip
income. Because Duong functioned as an office manager and did not perform
services as a nail [*15] stylist, there is no support for respondent's
contention that he received tip income. We thus cannot sustain respondent's
determination of tip income for Duong.
Tran was a nail stylist and presumably received some tips.
But many customers paid by credit or debit card. If the tip was included in the
total amount charged, the tip (like the fee for services) would presumably be
accounted for already in the bank deposits analysis. To the extent customers
paid in cash, respon-dent's methodology implausibly assumes that Tran
methodically segregated each service charge from the corresponding tip,
depositing the former in the bank but pocketing the latter. Moreover, Tran
could keep tips only for work that she performed. Because the salons employed
other stylists, respondent's methodology would impute income to Tran for tips
that other employees received.
Respondent did not analyze what percentage of the salons'
customers paid in cash or what percentage of the stylist services Tran
performed. Adding 8% to Tran's share of the total gross receipts would
overstate her tip income substantially, to a degree that cannot be determined.
We accordingly find that respon-dent's determination of additional tip income,
as applied to Tran as well as to Duong, is arbitrary and erroneous.
[*16] In the notices of deficiency, respondent reasonably
made whipsaw determinations and treated 100% of taxable deposits in the joint
accounts as gross receipts of both petitioners. Respondent concedes on brief
that “the unreported income should be allocated equally between the petitioners
for the unreported deposits from their joint accounts, and wholly to petitioner
Duong for the money deposited into the accounts that were not held jointly with
petitioner Tran.” We agree with this assessment. With that concession and with
the elimination of any additional tip income to either petitioner, we sustain
respondent's determinations of unreported income consistent with the revenue
agent's bank deposits analysis. 4
B. Civil Fraud Penalty
Respondent determined fraud penalties against Duong for 2007
and 2008 and against Tran for 2008. “If any part of any underpayment of tax
required to be shown on a return is due to fraud,” section 6663(a) imposes a
penalty of 75% of the portion of the underpayment due to fraud. Respondent has
the burden of proving fraud, and he must prove it by clear and convincing
evidence. Sec. 7454(a); Rule 142(b); Richardson v. Commissioner, 509 F.3d 736,
743 (6th Cir. [*17] 2007), aff'g T.C. Memo. 2006-69. To sustain his burden
respondent must establish two elements: (1) that there was some underpayment of
tax for each year in issue; and (2) that at least some portion of the
underpayment for each year was due to fraud. Hebrank v. Commissioner, 81 T.C.
640, 642 (1983). Respondent has carried his burden of proving that petitioners
underreported their income and underpaid their tax for 2007 and 2008. The
remaining question is whether any part of these underpayments was due to fraud.
Fraud is intentional wrongdoing designed to evade tax
believed to be owing. Neely v. Commissioner, 116 T.C. 79, 86 (2001). The
existence of fraud is a question of fact to be resolved upon consideration of
the entire record. Estate of Pittard v. Commissioner, 69 T.C. 391, 400 (1977).
Fraud is not to be presumed or based upon mere suspicion. Petzoldt, 92 T.C. at
699-700. However, because direct proof of a taxpayer's intent is rarely
available, fraudulent intent may be established by circumstantial evidence.
Grossman v. Commissioner, 182 F.3d 275, 277-278 (4th Cir. 1999), aff'g T.C.
Memo. 1996-452.
Circumstances that may indicate fraudulent intent, commonly
referred to as “badges of fraud,” include but are not limited to: (1)
understating income; (2) keeping inadequate records; (3) giving implausible or
inconsistent explanations of behavior; (4) concealing income or assets; (5)
failing to cooperate with tax [*18] authorities; (6) engaging in illegal
activities; (7) providing testimony lacking credibility; (8) filing false
documents, including false income tax returns; (9) failing to file tax returns;
and (10) dealing extensively in cash. Spies v. United States, 317 U.S. 492, 499
(1943); Morse v. Commissioner, T.C. Memo. 2003-332, 86 T.C.M. (CCH) 673, 675,
aff'd, 419 F.3d 829 (8th Cir. 2005). No single factor is dispositive; however,
the existence of several factors “is persuasive circumstantial evidence of
fraud.” Vanover v. Commissioner, T.C. Memo. 2012-79, 103 T.C.M. (CCH) 1418,
1420-1421.
Numerous badges of fraud demonstrate that Duong
intentionally evaded the payment of tax he knew to be owed. He understated his
income for both years in issue. See Stone v. Commissioner, 56 T.C. 213, 214,
224-226 (1971). He maintained inadequate records and failed to provide relevant
records to the revenue agent. See Ark. Oil & Gas, Inc. v. Commissioner,
T.C. Memo. 1994-497. He gave the revenue agent inconsistent explanations,
stating falsely that neither business received cash payments from customers. At
trial he contradicted himself by stating, implausibly, that AK Nails customers
sometimes paid in cash but that Perfection Nails customers never did so.
Duong also failed to cooperate with tax authorities. The
revenue agent requested bank statements but never received them. Duong
indicated that he had [*19] merchant receipts but likewise failed to provide
those to respondent. Eventually, the revenue agent had to summons the bank
statements. See Good v. Commissioner, T.C. Memo. 2012-323 (finding lack of
cooperation where revenue agent was forced to summons taxpayer's bank records).
Duong regularly commingled business and personal funds, as the bank deposits
analysis made clear. And his testimony at trial concerning cash receipts and
alleged nontaxable deposits lacked credibility. See Scott v. Commissioner, T.C.
Memo. 2012-65.
We find that the facts, taken as a whole, clearly and
convincingly establish that Duong acted with fraudulent intent and that his
underpayments of tax for 2007 and 2008 were due to fraud. While several of the
same badges of fraud apply to Tran, we reach the opposite conclusion as to her.
Duong bears principal responsibility for the false statements made to, and the
lack of cooperation with, the IRS revenue agent. Unlike Duong, Tran did not
present testimony lacking credibility at trial. Our assessment of the evidence
is that Tran followed the direction and actions of Duong and that her behavior
does not rise to the level of fraud. We accordingly conclude that respondent
did not prove fraud by Tran by clear and convincing evidence.
[*20] C. Accuracy-Related Penalty
Respondent contends in the alternative that Tran is liable
for an accuracy-related penalty under section 6662(a) for 2008. The Code
imposes a 20% accuracy-related penalty on any underpayment of tax attributable
to (among other things) “[n]egligence or disregard of rules or regulations.”
See sec. 6662(a) and (b)(1). “Negligence” is defined as “any failure to make a
reasonable attempt to comply” with the provisions of the Code. Sec. 6662(c).
The Commissioner bears the burden of production with respect to this penalty.
Sec. 7491(c). Once the Commissioner satisfies his burden, the burden shifts to
the taxpayer to prove that the penalty does not apply. Higbee v. Commissioner,
116 T.C. 438, 447 (2001). Respondent met his burden of production by showing
that Tran underreported income and failed to maintain adequate records for the
nail salons. The burden thus shifts to her.
The accuracy-related penalty does not apply to any portion
of an underpayment “if it is shown that there was a reasonable cause for such
portion and that the taxpayer acted in good faith” with respect thereto. Sec.
6664(c)(1). Tran did not testify and offered no reliable evidence that she
attempted to assess her tax liability correctly. We accordingly sustain
respondent's imposition of the accuracy-related penalty for 2008.
[*21] To reflect the foregoing,
Decisions will be entered under Rule 155
Footnotes
1
All statutory references are to the Internal Revenue Code
(Code) in effect for the years in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. We round all dollar amounts to the
nearest dollar.
2
Respondent has conceded the section 6651 additions to tax
against petitioner Tran for 2007. Petitioner Duong is deemed to have conceded
the disallowance of a mortgage interest deduction of $22,574 on his 2007
Schedule C, Profit or Loss From Business. He did not present any evidence
concerning this issue at trial, and he did not file a posttrial brief. See
Schladweiler v. Commissioner, T.C. Memo. 2000-351, aff'd, 28 Fed. Appx. 602
(8th Cir. 2002). Petitioners did not raise any affirmative defenses, such as
the statute of limitations, in their pleadings, and we find that any such
defenses are likewise waived. See Rule 39; Goings v. Commissioner, T.C. Memo.
1997-87.
3
When a party fails to file a brief on issues that have been
tried, we may consider those issues waived or conceded. See, e.g., Nicklaus v.
Commissioner, 117 T.C. 117, 120 n.4 (2001); Stringer v. Commissioner, 84 T.C.
693, 704-708 (1985), aff'd without published opinion, 789 F.2d 917 (4th Cir.
1986). We will exercise our discretion not to do so here for issues that were
addressed at trial.
4
While there is no longer any dispute as to the amounts of
petitioners' deductible Schedule C expenses, the allocation of those expenses
(and of petitioners' reported Schedule C gross income) will have to be
determined as part of the Rule 155 computations. The best evidence is that
petitioners split both income and expenses 50-50.
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