DocketNumber： Docket Nos. 27626-07, 27628-07, 27629-07.
Citation Numbers： 101 T.C.M. 1293, 2011 Tax Ct. Memo LEXIS 63, 2011 T.C. Memo. 65
Judges： GOEKE
Filed Date： 3/16/2011
Status： Non-Precedential
Modified Date： 11/20/2020
Decisions will be entered under
GOEKE,
Respondent determined the following deficiencies, additions to tax, and penalties: *65
| Addition to Tax | Accuracy-Related Penalty | ||
| Year | Deficiency | ||
| 2001 | $67,973 | $6,797 | $13,595 |
| 2002 | 14,957 | -0- | 2,991 |
1Respondent asserts in the answer that Knutsen is liable for the fraud penalty under
| Addition to Tax | Fraud Penalty | ||
| Year | Deficiency | ||
| 1999 | $5,748 | $1,437 | $4,311 |
| 2000 | 83,784 | 8,382 | 62,838 |
| 2001 | 32,403 | 3,240 | 24,302 |
| 2002 | 76,414 | -0- | 57,311 |
1Respondent *64 determined alternatively that PLC is liable for the penalty for negligence under
| Addition to Tax | Fraud Penalty | ||
| Year | Deficiency | ||
| 2000 | $85,780 | $4,289 | $64,335 |
| 2001 | 110,585 | 16,588 | 82,939 |
| 2002 | 15,079 | -0- | 11,309 |
1Respondent determined that the fraud penalty applied only to Mr. Rowell. Respondent determined alternatively that the Rowells are liable for the addition to tax for negligence under
Respondent asserts in an amendment to answer in docket No. 27629-07 that the Rowells are liable for increased deficiencies, additions to tax, and penalties in the following amounts: 1Respondent asserts alternatively in the amendment to answer that the Rowells are liable for the penalty for negligence under Petitioners concede they are liable for the accuracy-related penalties under 1. Whether Knutsen overreported its income for 2001 and 2002. We hold it did not; 2. whether PLC underreported its income for 1999, 2000, 2001, and 2002. We hold it did to the extent stated herein; 3. whether the Rowells underreported their income for 2000, 2001, and 2002. We hold they did to the extent stated herein; 4. whether Knutsen is entitled to deductions of certain expenses and to costs of goods sold reported on its 2001 and 2002 Federal income tax returns. We hold it is to the extent stated herein; and 5. whether any of petitioners is liable for a fraud penalty under The parties submitted to the Court stipulated facts and related exhibits. We find those stipulated facts accordingly and incorporate those facts and exhibits herein. The Rowells, husband and wife, filed joint Federal income tax returns for 2000 through 2002. They resided in California when their petition was filed. Knutsen's mailing address and PLC's principal place of business were in California when *67 their petitions were filed. Mr. Rowell is a trial attorney who has practiced law in California for over 30 years. His practice areas are personal injury and products liability. He has received various awards and certificates of appreciation from several professional organizations. He practiced law during the years in issue through PLC, his wholly owned corporation. Mrs. Rowell is a television and screen writer. During the years in issue she worked as a screenwriter and as a buyer and seller of vintage dolls and similar collectible items (collectively, vintage dolls). She worked through Knutsen, her wholly owned corporation. Each of the Rowells is well educated and devotes long hours to his or her profession. Neither of the Rowells is proficient on the subject of tax law or on the requirements thereof. Mr. Rowell graduated from law school in 1977, and he began practicing law at a law firm specializing in products liability. He formed PLC on September 20, 1982. In 1999 PLC joined the law firm of Cheong, Denove, Rowell, Antablin & Bennett (Cheong firm). The Cheong firm's practice included products liability. During the years in issue, PLC*68 was a partner in the Cheong firm, and Mr. Rowell was PLC's sole shareholder. While Mr. Rowell (through PLC) worked for the Cheong firm, he also (through PLC) worked on some cases for PLC alone. For 1999 the Cheong firm issued PLC a Schedule K-1, Partner's Share of Income, Credits, Deductions, etc., reporting that PLC realized $92,120 of taxable income for 1999 with respect to its partnership interest in the Cheong firm. PLC reported on its 1999 Federal income tax return that it realized $7,574 of taxable income as to that interest. When Mr. Rowell (through the firm for which he worked) retained a client, the retainer agreement stated that the firm would pay certain litigation costs (e.g., costs of depositions, transcripts, and filing fees) for the client and that the firm would recover its payment of those costs (advanced client costs) from any proceeds received at the end of the client's case. Mr. Rowell (through his firm) represented plaintiffs in lawsuits that involved significant amounts of advanced client costs. PLC did not always recover the full amount of advanced client costs paid on behalf of a client. PLC recorded its payment of a client's advanced client *69 costs as a loan to that client. Mrs. Rowell organized Knutsen on September 2, 1982. Mrs. Rowell was Knutsen's only employee. Initially, Knutsen's sole business was the leasing of Mrs. Rowell's writing services. In 2001 Mrs. Rowell's earning capacity as a writer began to decline, and Mrs. Rowell decided to expand Knutsen's business to include the purchase and sale of vintage dolls. During 2001 and 2002 Knutsen bought and sold vintage dolls through an eBay store. Knutsen initially bought and sold collectible Barbie dolls but later expanded into other collectible items. During 2001 and 2002 Knutsen generally maintained a daily inventory of 900 to 1,000 vintage dolls. Knutsen attempted to sell each of its vintage dolls above cost but was not always able to do so. During 2001 and 2002 Knutsen paid its business expenses (including inventory purchases) primarily by check or credit card. During those respective years Knutsen paid $157,258 and $29,661 for vintage dolls it purchased for resale. Knutsen also paid the following expenses: The *70 listing fees expense related to Knutsen's doll business, and the research, dues, and shared residuals expenses related to Knutsen's screenwriting business. All of the remaining expenses related to both businesses. During 2001 and 2002 Knutsen deposited into its operating accounts the following amounts related to its doll and screenwriting businesses: The Rowells maintained petitioners' financial records using Quicken, a computerized accounting system. Each of the Rowells (sometimes with the help of others) entered petitioners' financial information into Quicken's database. This information related to checks, expenses, transfers, deposits, and payees. Petitioners' expenses would be input into various categories of the database that reflected the character of the expenditures. Petitioners used a "split" function in Quicken to apportion the amount of an expenditure into various categories of expenses and to account for that expenditure by the various categories. Petitioners generally did not maintain supporting documents for entries input into *71 the database. The Rowells maintained various personal checking accounts. The Rowells also maintained a personal equity line of credit account and various personal brokerage accounts. PLC maintained various bank accounts for its operation (collectively, PLC operating accounts). PLC also maintained various client trust accounts. During the years in issue each of the Rowells authorized disbursements out of the PLC operating accounts. Knutsen maintained various bank accounts for its operation (collectively, Knutsen operating accounts). Knutsen also maintained a brokerage account. During the years in issue each of the Rowells authorized disbursements out of the Knutsen operating accounts. The Rowells had many credit card accounts. Neither PLC nor Knutsen had any credit card account in its name. During 2000, 2001, and 2002 the Rowells took funds from PLC's operating accounts for their personal use. The Rowells took those funds through checks, withdrawals, and transfers, and they used those funds to pay their *72 living expenses (including the expenses of their children) or otherwise spent them at their discretion. With one exception, none of the transactions underlying the taking or the use of those funds related to PLC's business, and the Rowells did not report any of those funds as a distribution (or other type of income). The Rowells' Personal Use of Knutsen Funds During 2001 and 2002 the Rowells took funds from Knutsen's operating accounts for their personal use. The Rowells took those funds through checks, withdrawals, and transfers, and they used those funds to pay their living expenses (including the expenses of their children) or otherwise spent them at their discretion. None of the transactions underlying the taking or the use of those funds related to Knutsen's business, and the Rowells *73 did not report any of those funds as a distribution (or other type of income). The amounts of those funds were $222,871 in 2001 and $97,675 in 2002. The Rowells transferred $69,030 and $58,675 to Knutsen during 2001 and 2002, respectively. The Rowells routinely used their personal credit cards to pay the business expenses of the subject corporations. Edward Cutter (Mr. Cutter) prepared all of the Federal income tax returns at issue. Mr. Cutter is a certified public accountant who was the Rowells' longtime tax return preparer. He prepared the subject returns following his regular practice whereby Mr. Rowell brought in petitioners' data, Mr. Cutter input the data into his tax preparation system, Mr. Cutter and Mr. Rowell discussed the data superficially, and Mr. Cutter printed the returns (and possibly in some cases reprinted a return after correcting a mistake that Mr. Rowell identified on the return). With respect to each of the Rowells' Federal income tax returns at issue, Mr. Cutter spent a total of approximately 1 hour preparing that return and the related State income tax return *74 for the year. With respect to each of the subject corporations' Federal income tax returns at issue, Mr. Cutter spent a total of approximately 1 hour preparing that return. Mr. Cutter prepares a lot of tax returns each tax season, and he tries not to get involved with a client's financial situation or to offer a client advice on the particulars of tax law. Mr. Cutter did not help (nor did he want to help) the Rowells ascertain petitioners' data for their tax returns, or explain to them the requirements for any particular deduction. When he prepared each of the tax returns for the subject corporations, Mr. Cutter checked the return to make sure it was consistent with the prior year's return, and he checked to make sure the balance sheet balanced. PLC's 1999 through 2002 returns reported that at the end of those respective years PLC owed Mr. Rowell $428,234, $513,801, $561,674, and $574,862 in loans. *75 nor Mrs. Rowell charged interest on any amount that was lent to his or her separate corporation. None of the amounts reported as loans were collateralized, and none of those amounts were repayable pursuant to a schedule or any other specific term. The Rowells and the subject corporations did not record the amount of any loan between them or otherwise keep track of it accurately. PLC's 1999 through 2002 Federal income tax returns reported total income and claimed total deductions in the following amounts: Mr. Rowell did not anticipate before these returns were prepared that PLC would owe any tax for 1999 through 2002. Such was so because PLC had limited cases and had just closed a case where it was unable to recover approximately $200,000 in advanced client costs. Knutsen's 2001 and 2002 Federal income tax returns reported total income and claimed total deductions in the following amounts: The *76 Rowells did not anticipate before these returns were prepared that Knutsen would owe any tax for 2001 or 2002. Such was so because Knutsen had purchased what the Rowells considered to be a significant amount of inventory in 2001. Respondent audited petitioners' Federal income tax returns that are the subject of the notices of deficiency (subject tax returns). Respondent also included the Rowells' 1999 tax return in the audit. Respondent started auditing PLC on February 6, 2003, and expanded the audit on October 23, 2003, to include the Rowells. Respondent further expanded the audit on June 29, 2004, to include Knutsen. Initially, Mr. Cutter was petitioners' representative in the audit, and Mr. Rowell gave Mr. Cutter documents to give to respondent's revenue agent (agent). Mr. Rowell eventually met repeatedly with the agent, and he personally produced many documents to the agent and answered many questions. The agent also interviewed Mrs. Rowell. PLC's records for 1999 through 2002 were incomplete and conflicting and did not reconcile to its tax returns. Respondent ascertained PLC's gross receipts for 1999 through 2002 using a bank deposits *77 analysis that included a review of deposits, canceled checks, and transfers into and out of PLC's operating accounts. PLC's gross receipts for 1999 through 2002 as reported by PLC and as ascertained by respondent through the bank deposits analysis are as follows: 1Includes $8,220 of legal fees realized by PLC but deposited into the Rowells' personal bank accounts. 2Includes $27,073 that respondent determined was taxable income that Mr. Rowell won in a chess tournament on behalf of PLC but which was deposited into the Rowells' personal bank accounts. Respondent allowed PLC certain deductions for each year. Two deductions were for advanced client costs and bad debts with respect to advanced client costs. Respondent allowed *78 PLC to deduct advanced client costs to the extent that its clients' cases were settled and the clients' reimbursements of the advanced client costs were included in PLC's reconstructed gross receipts. Respondent allowed PLC to deduct a bad debt with respect to advanced client costs to the extent that PLC could not recover advanced client costs because its clients' cases were concluded without available funds to reimburse the advanced client costs. The amounts of these allowed deductions are as follows: Respondent determined that PLC owed Mr. Rowell $45,192 in loans at the end of 1999. Respondent determined that PLC had no loans payable to Mr. Rowell at the end of 2000, 2001, or 2002. Knutsen's records for 2001 and 2002 were incomplete and conflicting and did not reconcile to its tax returns. Respondent determined Knutsen's gross receipts for 2001 and 2002 using a bank deposits analysis that included a review of deposits, canceled checks, and transfers in and out of Knutsen's operating accounts. Knutsen's gross receipts for 2001 and 2002 as reported by *79 Knutsen and as initially determined by respondent through the bank deposits analysis are as follows: 1Respondent concluded that Knutsen's receipts from doll sales were Mrs. Rowell's personal proceeds and omitted those proceeds from these amounts. Respondent later determined that some of Knutsen's gross receipts were not deposited into the Knutsen operating accounts and superseded his initial computation of Knutsen's gross receipts as follows: Respondent disallowed all of Knutsen's reported deductions and costs of goods sold for 2001 and 2002 except for $2,681 and $4,063 of deductions that Knutsen claimed for the respective years as "other deductions". The amounts of these disallowed items are as follows: Respondent determined that Knutsen had no loans payable to Mrs. Rowell *80 at the end of 2001 or 2002. The Rowells' records for 2000 through 2002 were incomplete and conflicting and did not reconcile to their tax returns. Respondent determined the Rowells' income for 2000 through 2002 primarily on the basis of the bank deposits analyses of the subject corporations. Respondent also reviewed deposits, canceled checks, and transfers into and out of the Rowells' personal bank accounts. As stated With respect to the constructive distributions that he determined Mr. Rowell received from PLC*81 during 2000 through 2002, respondent determined, first, that PLC's current and accumulated earnings and profits (E & P) for 2000, 2001, and 2002 were such that $225,678, $124,967, and $92,487 of the distributions in the respective years were dividends. Second, because the distribution for 2001 exceeded PLC's current and accumulated E & P (as determined by respondent), respondent determined that $1,000 of that distribution was a nontaxable return of capital and the remainder, $98,395, a taxable capital gain. In sum, respondent characterized Mr. Rowells' constructive distributions from PLC as follows: As stated Respondent determined that the characterization of constructive distributions received by the Rowells was as follows: The Rowells reported on their 2000 Federal income tax return that they were entitled to deduct a net operating loss (NOL) carryover of $31,996. The 2000 return provides no explanation of the computation or genesis of the claimed NOL carryover. Respondent disallowed this deduction. In 2001 Mr. Rowell and a fellow businessman, Phil Weber (Mr. Weber), began discussing a possible joint investment in a charter school to be formed by Mr. Weber and another individual. Mr. Weber worked hard on the project during 2002, and he aspired to *84 form the school. On December 31, 2002, as part of the joint investment, Mr. Rowell caused $100,000 to be transferred from a PLC operating account to the bank account of Sandra Raposa (Ms. Raposa). Ms. Raposa was the domestic partner of Mr. Weber, and she (at the request of Mr. Weber) accepted the $100,000 transfer on his behalf. Mr. Weber used Ms. Raposa's account because he did not have a bank account at the time. Mr. Rowell caused the $100,000 to be transferred so late in 2000 because Mr. Rowell anticipated claiming for that year a tax deduction (or a tax credit) as to the payment. As of that time, Messrs. Rowell and Weber did not have a set investment plan. On January 2, 2003, Ms. Raposa transferred $88,500 of the $100,000 to a personal account of the Rowells. She did so because Messrs. Rowell and Weber did not yet have a set investment plan and Mr. Weber did not want to keep the funds in Ms. Raposa's account without such a plan. Mr. Rowell used the $88,500 to pay down a loan he had received in his individual capacity. Mr. Weber retained the remaining $11,500 as a payment due him for previous business dealings with Mr. Rowell. Respondent asserts in the amendment to answer in docket *85 No. 27629-07 that the $100,000 is a constructive dividend that the Rowells failed to include in their income for 2002. The charter school project fell through in April or May of 2003 when the individual whom Mr. Weber had been dealing with opted out of the project. On December 21, 2005, Mr. Rowell retained an enrolled agent, Donald Cormier, Sr. (Mr. Cormier), to replace Mr. Cutter as petitioners' representative in the audit because Mr. Rowell was no longer comfortable with Mr. Cutter's representation of petitioners' interests. Mr. Cormier met with the agent, and he gave the agent information the agent requested. On October 2, 2006, the agent gave Mr. Cormier respondent's proposed reports for the Rowells' 2000, 2001, and 2002 taxable years, and the agent discussed those proposed reports with Mr. Cormier. Mr. Cormier then discussed the proposed reports with Mr. Rowell. Mr. Rowell anticipated that respondent's audit would cause the State of California to audit petitioners' 2000 through 2002 State income tax returns, and he thought that the Rowells would not have to pay the State of California any penalty for those years *86 if he voluntarily informed the State that the Rowells had realized more income than they had previously reported to the State. On December 29, 2006, the Rowells filed amended California income tax returns to report additional income of $789,287, $572,181, and $349,915 for 2000, 2001, and 2002, respectively. The amended California returns reflected the following information: Mr. Cormier's accounting firm prepared the amended California returns on the basis of the amounts of additional income that Mr. Rowell told Mr. Cormier to report. Mr. Rowell set the amounts of that income to generate a State tax liability that represented a portion of the Federal income tax adjustment proposed by respondent. The amended California returns stated that the Rowells had become aware of additional income not reported on their State returns but did not disclose that petitioners' Federal income tax returns for the related years were under audit by the Internal Revenue Service. The Rowells paid the State *87 income tax liabilities reported on the amended California returns. The Rowells did not tell the agent that they filed the amended California returns. The Rowells did not amend any of their Federal income tax returns for 2000 through 2002. On August 31, 2007, respondent mailed petitioners the notices of deficiency in issue. The Commissioner's determinations of deficiencies in tax (as listed in a notice of deficiency) generally are presumed correct, and the taxpayer bears the burden of proving those determinations wrong. See Respondent in an amendment to answer in docket No. 27629-07 asserts that the Rowells are liable for deficiencies in amounts greater *89 than the amounts listed in the corresponding notices of deficiency. Respondent bears the burden of proof as to these increased deficiencies. See Respondent determined (or asserts in his answer or an amendment thereto) that petitioners are liable for fraud penalties under Gross income includes all income from whatever source derived, see Respondent reconstructed petitioners' income by using the bank deposits method. The bank deposits method is an acceptable method for reconstructing income. See Respondent's *91 initial bank deposits analysis of Knutsen's bank accounts showed that Knutsen's deposits for 2001 and 2002 were $38,393 and $62,712, respectively, less than the gross receipts reported on Knutsen's 2001 and 2002 Federal income tax returns. Petitioners argue that Knutsen may adjust its reported gross receipts to match the reduced amounts reflected in respondent's initial bank deposits analysis. We disagree. Petitioners cite no authority (nor are we aware of any authority) which allows a corporate taxpayer such as Knutsen to reduce its reported gross receipts to the amount of its deposits as ascertained through a bank deposits analysis without further proof that the lower amount is correct. Such is especially so where, as here, the record does not establish that Knutsen's reported gross receipts reflected only the amounts that Knutsen deposited into its bank accounts and respondent's superseding bank deposits analysis reflected gross receipts that were not deposited into Knutsen's bank accounts. See Respondent's bank deposits analysis of PLC's accounts determined that PLC failed to report gross receipts of $184,047 for 1999, $51,652 for 2000, $60,032 for 2001, and $4,749 for 2002. Petitioners concede that respondent correctly determined PLC's deposits for each year but argue that respondent failed to characterize PLC's advanced client costs reimbursements as nontaxable income. Petitioners argue that those reimbursements are nontaxable pursuant to We disagree with petitioners' assertion that PLC is entitled to an adjustment with respect to respondent's treatment of its advanced client costs. While respondent included the reimbursements in PLC's reconstructed gross receipts, respondent also allowed the related costs to be deducted. Thus, *93 if we were to accept petitioners' invitation now to exclude the reimbursements from income because they are akin to the repayment of loans, we would be compelled to deny the accompanying deductions because they are akin to the making of loans. While petitioners are correct that advanced client costs are generally considered to be loans rather than expenses, and hence that the reimbursements of these costs are generally considered nontaxable income as are amounts received in repayment of loans, petitioners have offered no reason why respondent's treatment of these costs does not accomplish the same result in these cases. Nor have petitioners persuaded us that any advanced client cost that was reflected in the reconstructed gross receipts was not deducted from their gross income. Petitioners also identify nine deposits in respondent's bank deposits analysis that petitioners claim represent nontaxable income. These deposits are in the amounts of $10,000, $5,000, $3,500, $5,000, $5,000, $10,000, $3,000, $15,000, and $30,000. Petitioners state that these deposits "appear to be either shareholder loan repayments, interbank transfers or partnership distributions" because PLC had "no likely *94 source of income that would generate 'round' number deposits". Petitioners ask the Court to characterize these deposits as nontaxable income. We decline to do so. As stated above, PLC's bank deposits are prima facie evidence of income, and all money deposited into PLC bank accounts is presumed to reflect taxable income unless petitioners establish otherwise. Petitioners have not submitted sufficient evidence to rebut this presumption. Petitioners' mere belief that the amounts "appear" to be from a nontaxable source and that PLC did not have a "likely source of income" that would be in "round" numbers is not sufficient to disprove respondent's determination under the bank deposits analysis. The Rowells' Disputed Income Respondent adjusted the Rowells' income to reflect his determination that they received constructive distributions from the subject corporations. Respondent also adjusted the Rowells' income to reflect the disallowed NOL deduction. *95 Respondent also adjusted the Rowells' income to reflect the amended California returns and the $100,000 transfer to Ms. Raposa's account. We address each adjustment in turn. Respondent determined that the Rowells received constructive distributions from the subject corporations and that some of the distributions were taxable to the Rowells as constructive dividends while others were taxable to the Rowells as capital gains. We agree with this determination for the most part. Under Corporate funds that a controlling shareholder diverts to personal use are generally characterized as constructive distributions to the shareholder for tax purposes. See The subject corporations' payments of the Rowells' personal expenses primarily benefited the Rowells, and the payments had no connection with the subject corporations' businesses. We reject petitioners' claim as unsupported by the record. The record does not establish that the subject corporations and the Rowells intended at the time of any distribution that the distribution be an actual repayment of a loan to a shareholder or the actual making of a loan to a shareholder. Nor does the record establish that the Rowells and the subject corporations conducted themselves as if the distributed amounts were loans or repayments of loans. The purported shareholder loans were not evidenced by notes or other writings, they were not secured by collateral, they did not require the payment of interest, and they were not subject to repayment schedules or to any specific terms of repayment. The Rowells and the subject corporations *100 did not record the amount of any loan between them or otherwise keep track of it accurately. The distributed amounts were not contemporaneously designated as the proceeds of a loan or the repayment of a loan. Petitioners also have not persuaded us that there was any outstanding loan at the time of any distribution (other than those loans that were reflected in the payments for which respondent gave the Rowells credit in arriving at the amounts of the distributions), *102 or that the Rowells reimbursed the subject corporations any of the funds reflected in the distributions. Nor have they persuaded us that either the Rowells or the subject corporations had sufficient funds either to make loans of that magnitude or to repay loans of that magnitude. In fact, it appears from the record that the subject corporations' repayment to the Rowells of any loan of that magnitude would not be assured with any reasonable likelihood but would be subject to the risk of the success of the subject corporations' businesses. Cf. As discussed Respondent's application of the rules of The Rowells claimed on their Federal income tax return for 2000 that they were entitled to deduct an NOL of $31,996. Respondent determined that the Rowells were not entitled to this deduction. We agree. The Rowells admit that they lack any documentation to support their NOL deduction claimed for 2002 and have failed to establish that they otherwise are entitled to any of that claimed NOL deduction. We sustain respondent's determination that the Rowells are not entitled to the claimed NOL deduction. Through an amendment to answer, respondent asserts that petitioners failed to report "other earned income" of $789,287, $572,181, and $349,915 for 2000, 2001, and 2002, respectively, and additional dividend income of $100,000 for 2002. The first three amounts, respondent asserts, result from the Rowells' filing of the amended California returns reporting income in amounts *105 greater than the amounts reported for Federal income tax purposes. The $100,000 dividend, respondent asserts, results from the $100,000 transfer to Ms. Raposa. Respondent argues that the Rowells' filing of the amended California returns means that they underreported their Federal income by like amounts. Respondent relies primarily upon the case of As to the additional income from the $100,000 transfer, we generally agree with respondent on this point. Gross income includes all accessions to wealth over which a taxpayer has complete dominion, see Respondent disallowed all of Knutsen's reported deductions for 2001 and 2002, except for $2,681 and $4,063 of deductions that Knutsen claimed for the respective years as "other deductions". Petitioners argue that they may deduct some or all of the disallowed amounts because Knutsen engaged in the doll business for profit, and petitioners substantiated Knutsen's entitlement to the disallowed amounts through documentation and the testimony of Mrs. Rowell. We agree in part. The parties spend undue time disputing the applicability of We decide whether any of petitioners is liable for a fraud penalty under Petitioners concede that they underpaid *111 their taxes for each year to which the notices of deficiency apply. We conclude as to each of those years that respondent has met the first part of his burden of proof; i.e., establishing underpayments of tax. The second part of respondent's burden requires that he establish the presence of fraud. Fraud requires an intentional wrongdoing on the part of a taxpayer with the specific purpose of evading a tax believed to be owing. See Fraud is never presumed or imputed; it must be established by independent evidence that establishes a fraudulent intent on the taxpayer's part. See Respondent argues that the Rowells are financially sophisticated and tax-savvy individuals who were intimately involved with and highly knowledgeable of petitioners' finances and who consciously perpetrated a scheme for petitioners to evade Federal income taxes by understating income and overstating deductions. We are not clearly convinced that such is the case. Nor are we persuaded by respondent's view of the indicia of fraud that support his findings of fraud. First, we disagree with respondent's view that the Rowells' understanding of taxes and their involvement with and knowledge of petitioners' finances support the requisite finding of fraud. The record establishes, and we find as facts, that neither of the Rowells is proficient on the subject of tax law or on the requirements thereof and that each of the Rowells devoted long hours to his or her profession to the neglect of recordkeeping responsibilities. In addition, we are left unpersuaded by the record that the Rowells knew that petitioners' reported tax liabilities failed to reflect petitioners' true tax liabilities. Although respondent notes that Mr. Rowell was the source of *114 most of the data reported on petitioners' returns, we do not find that Mr. Rowell understood the tax significance of that data or sufficiently consulted petitioners' records (or attempted to compile supporting documentation) before giving that data to Mr. Cutter. We do find, however, that Mr. Cutter was of limited assistance to the Rowells when it came to their receiving professional advice on the preparation of petitioners' returns and that he chose to prepare those returns quickly rather than accurately. Second, we disagree with respondent's view that petitioners' underreporting of income on each of the subject returns leads to a finding that petitioners intended to evade Federal income tax. Instead, as similarly discussed above, it appears more likely that the underpayments in these cases were due to the Rowells' attempt to file petitioners' tax returns without properly and sufficiently reviewing petitioners' records and to Mr. Rowell's belief that PLC's unrecovered advanced client costs and Knutsen's inventory purchases, each of which was substantial in amount, would sufficiently offset PLC's and Knutsen's income for those years. Third, we disagree with respondent's view that petitioners *115 failed to maintain adequate records with an intent to evade Federal income tax. Petitioners maintained their records in Quicken, their computerized accounting system, but they failed to maintain sufficient documentation to support their entries into the Quicken database. The Rowells also did not maintain sufficient records to allow them to ascertain the expenses incurred by them and by each of the corporate entities. The Rowells had themselves and two other taxpayers to account for, and they failed to respect the separate status of each of the subject corporations. Under the facts at hand, however, we are not clearly convinced that petitioners' recordkeeping deficiencies in these cases were attributable to fraud as respondent asserts. It appears more likely, as we find, that petitioners' recordkeeping deficiencies are the result of negligence as petitioners concede. Fourth, we disagree with respondent's view that the Rowells failed to cooperate with respondent during the audit in a further attempt to evade Federal tax. By the agent's own admission, respondent's determination of fraud was spearheaded by the slow pace at which Mr. Rowell was allowing the agent to complete the audit. While *116 Mr. Rowell did in fact reschedule many appointments with the agent because of conflicts with his work schedule, and he was slow to get documents to the agent as requested, Mr. Rowell eventually met with the agent on various occasions and he repeatedly provided the agent with documents and with answers. On one occasion, for example, at the beginning of the audit, the agent demanded of Mr. Cutter that Mr. Rowell appear in person by the end of the day. Mr. Rowell complied with that demand, almost immediately abandoning his work commitments to appear before the agent shortly thereafter and to allow the agent to interview him at length. Mrs. Rowell also met with and allowed herself to be interviewed by the agent. Mr. Rowell also tried earnestly on the basis of the limited information he had to provide a solid foundation to respondent to support the deductions claimed on petitioners' returns. Mr. Rowell, on behalf of petitioners, also agreed with respondent's requests to extend the applicable periods of limitation for assessment so that a more complete audit could be performed. While it appears that Mr. Rowell may have made some inconsistent statements to the agent during the audit and provided *117 to the agent some documents which were facially inconsistent with each other, we do not conclude in the setting of the record as a whole that he consciously did so to hinder the audit. *118 the payments were loans from the subject corporations to their shareholders (or repayments of such loans). *119 he received from the Cheong firm given that the firm had reported that amount to both Mr. Rowell and to the Internal Revenue Service. For the same reason, we also do not believe that PLC's failure to report its interest income correctly was a conscious attempt to conceal its receipt of that income. Nor do we believe that PLC's isolated deposits into the Rowells' personal bank account of the $8,220 in legal fees and the $27,073 in chess winnings evidences that intent. Conclusion After our detailed review of the facts and circumstances of these cases, in conjunction with our analysis of the applicable badges of fraud, we conclude that respondent has not clearly and convincingly proven a fraudulent intent on the part of any petitioner. We hold that none of petitioners is liable for a fraud penalty under All of the parties' arguments have been considered. We have rejected those not discussed *120 herein as meritless. Accordingly,Addition to Tax Fraud Penalty Year Deficiency 2000 $406,529 $20,343 $304,897 2001 340,485 51,344 255,364 2002 182,000 -0- 135,500 2001 2002 Listing fees $4,678 $3,172 Outside services 5,984 2,885 Rent 2,234 4,533 Research 13,812 13,390 Shared residuals 293 1,443 Dues -0- 3,608 Postage 102 123 Supplies 301 100 Telephone 375 203 Bank service fees 57 20 Utilities 73 136 Computer maintenance -0- 276 Accounting 720 -0- Taxes 1,600 -0- Total 30,229 29,889 Year Doll Business Screenwriting Business Total 2001 $18,055 $174,622 $192,677 2002 23,602 18,339 41,941 Year Total Income Reported Total Deductions Claimed 1999 $355,560 $355,896 2000 487,235 481,954 2001 107,941 108,105 2002 287,735 287,735 Year Total Income Reported Total Deductions Claimed 2001 $53,679 $53,800 2002 69,084 68,514 Year Per Examination Per Return Difference 1999 $833,080 $649,033 $184,047 2000 1166,763 115,111 51,652 2001 299,090 39,058 60,032 2002 31,389 26,640 4,749 Year Advanced Client Costs Bad Debt Total 1999 $338,639 $75,286 $413,925 2000 17,996 72,999 90,995 2001 5,063 49,199 54,262 2002 37 21,381 21,418 Year Per Examination1 Per Return Difference 2001 $181,466 $219, 859 $38,393 2002 20,472 83,184 62,712 Year Per Examination Per Return Difference 2001 $219,859 $219,859 -0- 2002 83,184 83,184 -0- Expense Item 2001 2002 Cost of goods sold $166,241 $14,100 Repairs and maintenance 13,272 -0- Rents 5,400 4,533 Taxes and licenses 1,488 80 Advertising 375 1,833 Other deductions 30,584 58,005 Return of Year Distributions Dividends Capital Capital Gain 2000 $225,678 $225,678 -0- -0- 2001 224,362 124,967 $1,000 $98,395 2002 92,487 92,487 -0- -0- Return of Year Distributions Dividends Capital Capital Gain 2001 $163,425 $163,425 -0- -0- 2002 35,752 31,258 $1,000 $3,494 Return of Year Distributions Dividends Capital Capital Gain 2000 $225,678 $225,678 -0- -0- 2001 387,788 288,393 $1,000 $98,395 2002 128,239 123,745 1,000 3,494 AGI State Tax State Tax Originally Originally AGI on Amended on Amended Year Reported Reported California Returns California Returns 2000 $77,950 $291 $867,237 $75,204 2001 26,110 -0- 598,291 50,067 2002 12,243 -0- 362,249 25,327
1. Cases of the following petitioners are consolidated herewith: John D. Rowell, Professional Law Corporation, docket No. 27628-07; and John D. & Kathleen K. Rowell, docket No. 27629-07.↩
2. Unless otherwise indicated, section references are to the applicable versions of the Internal Revenue Code, and Rule references are to the Tax Court Rules of Practice and Procedure. Dollar amounts are rounded. The term "years in issue" refers collectively to 1999 through 2002. The term "subject corporations" refers collectively to PLC and Knutsen.
3. The Rowells filed amended California income tax returns for 2000, 2001, and 2002 (amended California returns) reporting income in amounts greater than the amounts reported for Federal income tax purposes. The increased deficiencies (and related amounts) result mainly from respondent's assertions that the Rowells' income for 2000, 2001, and 2002 includes the additional amounts of income reported on the amended California returns. The increased deficiency (and related amount) for 2002 also results from respondent's assertion that the Rowells failed to include in their income (as a constructive dividend) a $100,000 transfer that PLC made on Mr. Rowell's behalf.↩
4. The single exception is that the Rowells reported $109,000 of those funds as wages that PLC paid Mr. Rowell in 2000.↩
5. PLC's 1999 return reported $280,234 of loans from Mr. Rowell at the beginning of the year.↩
6. In addition to unreported gross receipts determined through the bank deposits analysis, respondent determined that PLC failed to report income from the Cheong firm of $84,546 ($92,120 -$7,574 $84,546) and failed to report interest income of $197 and $1,196 for 2000 and 2002, respectively. Petitioners concede these other adjustments.↩
7. This superseding computation also includes Knutsen's receipts from doll sales.↩
8. Respondent determined that during 2001 and 2002 the Rowells respectively took $250,511 and $118,029 of Knutsen funds for their personal use and that the respective constructive distributions were $163,425 and $35,752. We find that $27,640 and $20,354 of the respective amounts for 2001 and 2002 were spent in Knutsen's doll business and do not include those amounts in the amounts that the Rowells took for their personal use. Consequently, the constructive distributions are reduced to $135,785 for 2001 and $15,398 for 2002.↩
9. A $1 discrepancy is attributable to rounding.↩
10. While
11. Nor have petitioners established that a $7,773 deposit in 2000 represents nontaxable income. They have established, however, that a $23,980 deposit in 2001 is not taxable income in that it was a repayment of a loan to a client.↩
12. Payees included, for example, the Rowells' housekeeper, gardener, grocers, tailor, hair stylist, insurer, pool cleaner, utility providers, and medical care providers.↩
13. While PLC reported significant amounts of outstanding shareholder loans at the end of 2000, 2001, and 2002 and Knutsen reported significant amounts of outstanding loans at the end of 2001 and 2002, respondent determined that neither subject corporation had any outstanding shareholder loan as of those dates. Petitioners have failed to prove that determination wrong. We note in this regard that petitioners have effectively conceded that the subject corporations substantially overstated the amounts of the shareholder loans reported on the returns in issue and have introduced no credible evidence that allows the Court to find amounts that are different from those respondent determined.
14. We have no doubt that a shareholder and his or her closely held corporation can enter into regular loans with each other or can enter into an agreement whereby the corporation pays for all of the shareholder's personal expenses and the amounts of those payments are considered to be loans between the two. We believe, however, that such an agreement must be accompanied by reliable outward manifestations of debt, given the close relationship between the shareholder and the corporation and the risk of abuse, and we do not find that the distributions at hand have sufficient manifestations or specificity of debt other than as established through the bald assertions of Mr. Rowell.↩
15. Petitioners also do not dispute respondent's determination that each of the Rowells had a $1,000 basis in the stock of his or her corporation. We sustain that determination as well.↩
16. Of course, the treatment of the $100,000 must take account of
17. Respondent also argues that the Rowells, rather than Knutsen, conducted the doll business. The facts at hand establish to the contrary, e.g., that Knutsen (as opposed to the Rowells) realized revenue from the doll business and paid the expenses of that business.↩
18. In relevant part, (a) Imposition of Penalty.—If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud. (b) Determination of Portion Attributable to Fraud.—If the Secretary establishes that any portion of an underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud, except with respect to any portion of the underpayment which the taxpayer establishes (by a preponderance of the evidence) is not attributable to fraud.↩
19. Respondent also asserts that the Rowells failed to cooperate in the audit in that they did not inform the agent they had filed the amended California returns and did not volunteer information or documents on their and their corporations' financial holdings. We do not believe that the matter in those assertions is indicia of fraud in the setting of these cases.↩
20. This explains to our satisfaction why the Rowells did not report all of the constructive distributions as income.↩
21. Respondent also finds fraud in the Rowells' misrepresentation of their income to a proposed mortgagee and to the State of California. While we do not condone that practice, we do not view these actions as clear and convincing evidence of the requisite fraudulent intent.↩
William H. And Avilda L. Edwards v. Commissioner of ... , 680 F.2d 1268 ( 1982 )
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United States v. Harvey Stone , 770 F.2d 842 ( 1985 )
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