Baker v. Comm'r , 96 T.C.M. 309 ( 2008 )

T.C. Memo. 2008-247
UNITED STATES TAX COURT
KEVIN M. BAKER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1051-05. Filed October 30, 2008.
Michael C. Whelan, for petitioner.
Thomas D. Yang, for respondent.
MEMORANDUM OPINION
HOLMES, Judge: Kevin Baker did not file his 2002 tax return
on time. The Commissioner prepared a “substitute for return”
using the information he had to determine how much tax Baker
owed. Baker then belatedly submitted a return that reported much
more income, but also much higher deductions than the
Commissioner had known about. We have to sort through various
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procedural problems to figure out what, if any, deficiency in
Baker’s 2002 income tax remains.
Background
Baker has an entrepreneurial spirit, and he earned income
from numerous ventures in 2002. His largest single source of
income was the wages he earned as president of Blue World
Technologies. He also earned income from his investments in two
passthrough entities:1 He was a 45-percent shareholder in Blue
World and a member of Guardian Enterprises, LLC. To those
sources he added a small amount of interest income and some
miscellaneous income. But despite his success, Baker failed to
file an individual tax return for 2002.
The Commissioner was not totally ignorant about Baker’s
earnings because Blue World had reported the $165,038 in wages
that it had paid Baker. The Commissioner also knew about $157 of
interest income. When the Commissioner learns--usually from
third parties with an obligation to report it--that someone has
received income but not filed a return, section 6020(b)2 gives
1
A passthrough entity pays no tax on income at the
corporate level; instead, profits and losses “pass through” the
entity to the members, who pay individual income tax. The most
common types are partnerships, S corporations, and limited
liability companies.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code for the year at issue; all Rule
references are to the Tax Court Rules of Practice and Procedure.
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him the power to prepare a “substitute for return” (SFR). An SFR
is not a comprehensive return; the Commissioner uses only one of
two filing statuses--single or married filing separately--and he
allows only one personal exemption and no business expenses or
personal deductions. See 2 Administration, Internal Revenue
Manual (CCH), pt. 5.19.2.6.4.5 (10), at 18, 322.
The Commissioner used Baker’s $165,195 in wages and interest
income to prepare the SFR. The Commissioner picked the married-
filing-separately filing status and allowed only the
corresponding standard deduction. See sec. 63(c)(2). After
subtracting the standard deduction from Baker’s income, the
Commissioner calculated that Baker owed a deficiency of $47,629.
The Commissioner credited Baker for the taxes that Blue World had
withheld. He then determined additions to tax for Baker’s
failure to timely file and timely pay. See secs. 6651(a)(1),
6651(a)(2).
The Commissioner notified Baker of all this by sending him a
notice of deficiency with the SFR attached. Because an SFR is
usually stingy with deductions, a taxpayer who gets one often
responds by filing a petition with us and then preparing a return
reflecting the much more complete information he has about
himself--especially about greater deductions, the willingness of
his wife to accept married-filing-jointly status, and whether he
has children or other dependents. Baker’s case started
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normally--he filed a petition with us, and it seemed headed
toward a contest over whether the Commissioner’s SFR included too
much income or too few deductions or chose a less-favorable
filing status. But this case left the road most traveled when
Baker submitted his own 2002 tax return. What made this return
unusual was that it greatly increased Baker’s reported income.
Instead of the $165,195 that the Commissioner knew about and had
included on the SFR, Baker’s own return reported over $575,000,
because Baker reported passthrough income from Blue World and
Guardian as well as miscellaneous and interest income.
But with the increase in income, Baker also reported such
large deductions that he claimed a refund. The Commissioner has
accepted some of these, but a number are still at issue.
Disputed Deduction Amount
Short-term capital loss carryover $138,939
Long-term capital loss carryover 28,191
Blue World loss 136,423
Blue World at-risk-loss carryover 199,105
Guardian Enterprises loss 20,686
Blue World charitable contributions carryover 27,294
Blue World charitable contribution 450
Though Baker submitted his 2002 return before the Commissioner
filed his answer, the Commissioner neither asserted an increased
deficiency in his answer nor filed an amended answer. The
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Commissioner’s pretrial memorandum also stated that only the
original $47,629 deficiency was at issue.
Baker was an Illinoisan when he filed his petition, and the
case was tried in Chicago. The trial largely consisted of the
proffering of unaudited corporate tax returns from Baker’s
passthrough businesses, their accompanying K-1s, and Baker’s own
old 1040s with a litany of assertions of their accuracy. Baker’s
accountant added his own assertions of the accuracy of many of
these documents, even though one of his colleagues had actually
prepared them.
Discussion
We start with the threshold question: How much is at issue?
The Commissioner sent Baker a notice of deficiency based solely
on the SFR. But Baker reported substantially more income on his
2002 tax return. We have jurisdiction to increase the amount of
the deficiency “if claim therefor is asserted by the Secretary at
or before the hearing or a rehearing.” Sec. 6214(a).
To assert an increased deficiency, the Commissioner must
formally plead a claim for an increase in either the answer or an
amended answer. Estate of Petschek v. Commissioner, 81 T.C. 260,
271-72 (1983), affd. 738 F.2d 67 (2d Cir. 1984); Koufman v.
Commissioner, 69 T.C. 473, 475-76 (1977). Even if the parties
stipulate an increase in income the Commissioner is required to
formally plead an increase in the deficiency. Tool Producers,
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Inc. v. Commissioner, T.C. Memo. 1995-407, affd. 97 F.3d 1452
(6th Cir. 1996). This, the Commissioner did not do.3 And the
Commissioner did not amend his answer, either.
Even if we peek outside the pleadings, we can find no
assertion of an increased deficiency. The Commissioner’s
pretrial memorandum and amended pretrial memorandum both list
$47,629 as the amount in dispute, and he sticks to that number in
his posttrial brief. The only time the Commissioner refers to
Baker’s increases in income is in the “Respondent’s Request for
Finding of Fact” section of his posttrial brief. The reference
is a list that begins: “Petitioner also included in his 2002
income tax return income items which were not set forth in the
notice of deficiency; these income items are conceded by
Petitioner and are as follows.” The Commissioner then lists the
increases. But this list is not an amended answer and is
therefore not a claim for an increased deficiency. Thus, we hold
that only the $47,692 deficiency is at issue, and the burden is
on Baker to prove that it is erroneous. See Rule 142(a).
3
The Commissioner’s pretrial memorandum shows a smaller
addition to tax than that shown on the notice of deficiency. The
reason is that he conceded that Baker is not liable for the
section 6651(a)(2) addition to tax for failure to timely pay.
Therefore, under section 6651(c)(1), the rate used to determine
the section 6651(a)(1) addition will be increased.
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Baker’s defense to the deficiency is that he had sufficient
deductions in 2002 to offset nearly all of his income. A
significant obstacle to his success is that he chooses to argue
that it is the Commissioner’s burden to disprove his entitlement
to these deductions. He argues that his deductions are new
matters because the Commissioner did not deny them in the notice
of deficiency. Baker is not the first taxpayer to try this. See
Widemon v. Commissioner, T.C. Memo. 2004-162. In Widemon, we
decided that the burden remained with the taxpayer because his
deductions were a new theory and not a new matter. Id. And in
Rappaport v. Commissioner, T.C. Memo. 2006-87, just as in this
case, a taxpayer filed a tax return claiming extra income and
large deductions after the Commissioner had already sent a notice
of deficiency. We held in Rappaport that, because the taxpayer
himself had raised the matter of the new deductions, we would not
shift the burden of proof onto the Commissioner to disprove them.
Id.
Widemon and Rappaport remain good law, and the distinction
that they draw would enable us to quickly reject Baker’s claim,
but we can dismiss his argument even without them. In this case,
the Commissioner determined a deficiency based on Baker’s
unreported wage and interest income. Baker then petitioned us to
redetermine the deficiency, alleging that he was not liable for
the deficiency because the “Notice of Deficiency may not have
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given him credit for * * * business deductions or other items
affecting taxable income.” He never alleged that the income was
not his or not taxable. Therefore, the issue of whether he is
entitled to his claimed deductions is not a new matter, but it is
the original and only matter he has asked us to decide.
Now that these procedural obstacles are settled into place,
and we have the burden of proof worked out, we can determine the
correct amount of the deficiency. We begin by determining
Baker’s 2002 income. This step is easy because Baker reported
his income on a signed tax return. We treat his tax return as an
admission to all the reported income. See Lare v. Commissioner,
62 T.C. 739, 750 (1974), affd. without published opinion 521 F.2d
1399 (3d Cir. 1975). Therefore, we find that Baker earned
$578,997 in 2002.
Our next step is to determine if Baker substantiated any of
the deductions he claimed on his 2002 tax return. We can make
this determination easier by dividing his deductions into two
classes: Those that Baker tried to substantiate with old tax
returns and those that he tried to substantiate with more
persuasive documentation.
We start with those deductions supported with nothing more
than old tax returns--a class which includes all the deductions
at issue except for Baker’s short-term capital-loss carryover.
We finish our consideration by citing our long series of
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precedents in which we have held that a taxpayer’s returns do not
substantiate deductions or losses because they are nothing more
than a statement of his claims. Wilkinson v. Commissioner, 71
T.C. 633, 639 (1979); Roberts v. Commissioner, 62 T.C. 834, 837
(1974). To hold otherwise would undermine our presumption that
the Commissioner’s determination is correct. See Rule 142; Halle
v. Commissioner, 7 T.C. 245, 247 (1946), affd. 175 F.2d 500
(2d Cir. 1949). For the same reason, we long ago established
that under circumstances like these, a taxpayer can’t undermine
the rule that old returns are not substantiation of deductions or
losses by adding to them the bare testimony that those old
returns are correct, without records or credible testimony about
the individual items on the returns. See id. at 250. And a
taxpayer also can’t successfully substantiate his old returns by
arguing that the Commissioner is somehow estopped from
challenging his deductions because the Commissioner failed to
challenge the same or similar deductions in earlier years. Lerch
v. Commissioner, 877 F.2d 624, 627 n.6 (7th Cir. 1989), affg.
T.C. Memo. 1987-295; Pekar v. Commissioner, 113 T.C. 158, 166
(1999).
Much the same rules apply to the K-1s that Baker offered to
substantiate the deductions from his passthrough businesses;
they, too, are only statements of his claims, not proof of them.
LeBouef v. Commissioner, T.C. Memo. 2001-261. Baker’s LLC,
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Guardian Enterprises, had only two members in 2002, so the
Commissioner classified it as a partnership under the Code in the
absence of the firm’s election to be treated as a corporation.
Sec. 301.7701-3(b)(1)(i), Proced. & Admin. Regs. The Code’s
default rule for small partnerships, section 6231(a)(1)(B)(i),
also applies to Guardian, so the Commissioner was allowed to
audit Guardian at the individual partner level. And this means,
under precedents like LeBouef, that Baker had to prove the
accuracy of the items on the K-1 that he got from Guardian--he
couldn’t just rely on them in the absence of a partnership-level
audit as partners in some larger partnerships might be able to
do.
Taxpayers do have a duty to report the losses and deductions
from S corporations consistently with their corporation’s return.
Sec. 6037(c). But since 1996, individual S corporation
shareholders have been answerable for all the issues on their
corporation’s returns. See Small Business Job Protection Act of
1996, Pub. L. 104-188, sec. 1307(c)(1), 110 Stat. 1781 (repealing
unified audit procedures for S corporations). Baker has given us
no reason for not applying our holding in LeBouef to his
S-corporation K-1s, as we do to his LLC K-1, and he introduced
nothing but those bare K-1s in proof of his deductions and
losses.
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What a taxpayer needs to substantiate his deductions and
losses are records sufficient to permit verification of a
deduction or loss. See sec. 6001; sec. 1.6001-1(a), Income Tax
Regs. By offering only old tax returns and K-1s, with
nonspecific testimony of their accuracy, Baker has failed to
substantiate almost all his claimed deductions.
The one exception is his deduction for a short-term capital-
loss carryover. For this, he had 1099s dating back to 1996. We
find this to be persuasive that he had realized a loss back in
1996. Baker’s problem is that their use to prove a deduction in
2002 requires that he prove his capital gains and losses from
1996-2002 to show the 1996 loss hadn’t been used up. Burns v.
Commissioner, T.C. Memo. 1997-83; Williams v. Commissioner, T.C.
Memo. 1991-317, affd. without published opinion 996 F.2d 1230
(9th Cir. 1993). See sec. 1.1212-1(b), Income Tax Regs. Baker
offers only tax returns for the intervening years, so we find
that he also failed to substantiate the short-term capital loss
that he wanted to carry into 2002.
In conclusion, we find that Baker admitted to $578,997 in
income by reporting the income on his 2002 tax return. The only
defense he offered was that in 2002 he had enough deductions to
offset most of this income. We find that he failed to
substantiate any of those in dispute. But only the $47,692
deficiency is at issue, and the Commissioner has conceded many of
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Baker’s other deductions. Therefore (though unlikely given the
size of his income compared to the concessions we know about),
Baker’s liability may be reduced.
The last issue is whether Baker is liable for an addition to
tax under section 6651(a)(1) for a failure to timely file his tax
return. The Commissioner has the burden of production. Sec.
7491(c). He met his burden because Baker conceded that he filed
his 2002 tax return late and offers no explanation for his
tardiness.
Because computations may be needed,
Decision will be entered
under Rule 155.