Gandy v. CIR

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT

_____________________

No. 98-60455
_____________________

DENNIS GANDY,

Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

--------------------

DENNIS GANDY; CAROLYN S. GANDY,

Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

_________________________________________________________________

Appeal from the Decision of the
United States Tax Court
(26018-93)
_________________________________________________________________

October 22, 1999

Before KING, Chief Judge, STEWART, Circuit Judge, and ROSENTHAL,
District Judge*.

PER CURIAM:**

*
District Judge of the Southern District of Texas, sitting
by designation.
**
Pursuant to 5TH CIR. R. 47.5, the court has determined
that this opinion should not be published and is not precedent
except under the limited circumstances set forth in 5TH CIR. R.
47.5.4.
 Petitioners-appellants Dennis and Carolyn Gandy appeal from

a decision of the United States Tax Court upholding tax

deficiencies and fraud penalties assessed by the Commissioner of

Internal Revenue, the Respondent-appellee. We affirm.

I.

From 1985 through 1987, Dennis Gandy and his wife, Carolyn

(the “Gandys” or “taxpayers”), operated the Dennis Gandy Nursery

(the “Nursery”), which sold trees throughout the southwest.

After the Gandys’ divorce in 1988, Dennis continued to operate

the Nursery. The Nursery grew most of its products and employed

laborers to work the fields. During the earlier years at issue,

taxpayers paid the laborers in cash. The laborers were

transported from Mexico by persons known as “coyotes” who charged

$500 to $1000 per laborer. The Nursery advanced the Mexican

laborers the coyote payments in cash and then deducted payments

from their wages to recover the advance. Beginning in mid-1987,

the workers were paid by check.

The Nursery’s customers included local “walk-in” customers

as well as large chain stores such as WalMart. The Nursery owned

its own delivery trucks and employed drivers to ship trees to its

chain store customers. Taxpayers gave their drivers cash

advances to pay for travel expenses, but the drivers were

required to bring back receipts. If a particular cash advance

exceeded a driver’s total receipts, the difference was deducted

from the driver’s paycheck. Eventually, drivers began using

credit or checks to pay for fuel, rather than cash.

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 Throughout the years in issue, taxpayers employed the same

office procedures. They generated invoices for the chain stores

from a computer and recorded these invoices in a set of ledgers

referred to as “deposits” or “chain store” ledger. The taxpayers

used hand-written or typed invoices for walk-in customers. These

invoices were not entered into the computer but were kept in a

ledger, the “walk-in” ledger, separate from the chain store

ledger. Gross receipts from the chain store ledger generally

were deposited into the Nursery’s bank account and reported on

the taxpayers’ income tax returns, while gross receipts from the

walk-in ledger generally were not deposited into the Nursery

account and not reported on the taxpayers’ returns. Each day,

one of the Nursery employees made deposits and cashed checks that

were usually associated with the walk-in ledger. Mrs. Gandy

instructed the employee to limit the checks cashed to an amount

less than $10,000 in order to avoid reports of currency

transactions to the Internal Revenue Service (“IRS”). The cash

proceeds from the walk-in ledger were turned over to the

taxpayers. Sometimes, Mr. Gandy made cash payments to the field

laborers out of these proceeds.

In 1985, taxpayers began lending money to individuals,

generally for the purchase or construction of residential

properties or commercial buildings. They used funds from the

Nursery receipts to make many of these loans. An attorney or

title company assisted in drawing up documents and conducting

settlement for some loans, but the taxpayers often disbursed the

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funds in cash or check directly to the borrowers. Taxpayers

maintained a bank account that was used primarily for conducting

these lending activities. All deposits to the account were made

in cash until 1987 when deposits began to include mortgage

payment checks from borrowers. All checks written on the account

were payable to mortgage borrowers, with the exception of one to

Mrs. Gandy and one to the Nursery.

Taxpayers maintained other personal accounts during the

years in issue. Each was primarily funded by checks from the

Nursery’s account. Dennis Gandy’s father, Burnice Gandy, also

maintained a personal account. During 1985 and 1986, deposits to

this account consisted almost exclusively of his social security

and Veterans’ disability benefits. In 1987, however, large sums

began to be deposited into his account consisting of checks

payable to the Nursery, checks written by taxpayers’ loan

borrowers, and cash. Equally large sums were withdrawn from

Burnice Gandy’s account and deposited into the Nursery’s account.

Taxpayers told their accountants that the funds drawn on this

account were loans from Burnice Gandy to Dennis Gandy.

In 1988, after taxpayers’ divorce, Dennis Gandy used

currency and Nursery gross receipts to open another personal

account styled “Burnice and Dennis Gandy.” Cash and checks

payable to the Nursery were deposited into the account during

1988 and 1989. Most of the amount deposited was withdrawn and

deposited into the Nursery’s account. Again, Dennis Gandy told

his accountant that the funds drawn on this account were loans

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from Burnice Gandy.

On November 1, 1989, the IRS conducted a search, pursuant to

a warrant, of the Nursery and a consensual search of taxpayers’

residence. Both taxpayers were indicted for willfully making and

subscribing false tax returns for 1985, 1986, and 1987. On

September 4, 1992, each taxpayer pleaded guilty and was convicted

of subscribing a false tax return for 1987.

On September 21, 1993, the Commissioner of Internal Revenue

(“Commissioner”) mailed a notice of deficiency to Dennis and

Carolyn Gandy for the years 1985 through 1987. He determined

federal income tax deficiencies, as well as additions to tax

under I.R.C. § 6653(b), for fraud, and under I.R.C. § 6661, for

substantial understatement of tax liability. On the same date,

the Commissioner mailed a notice of deficiency to Dennis Gandy

for the years 1988 and 1989. He determined tax deficiencies, as

well as additions to tax under I.R.C. § 6653(b) and § 6663,1 for

fraud, and under I.R.C. § 6661, for substantial understatement of

tax liability.

Dennis and Carolyn Gandy filed a timely petition in the

United States Tax Court seeking redetermination of the

deficiencies and additions to tax for 1985 through 1987, and

Dennis Gandy filed a petition seeking redetermination of the

deficiencies and additions to tax for 1988 and 1989. The Tax

Court consolidated the petitions and tried the case over a period

1
The fraud penalty under I.R.C. § 6653(b) was recodified at
I.R.C. § 6663 for returns due after December 31, 1988.

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of three days. The presiding judge, Edna Parker, died before

rendering an opinion. The case was reassigned to Chief Judge

Mary Ann Cohen to be resolved on either the evidence in the

record or after a new trial. The parties unconditionally

consented in writing to the submission of the consolidated cases

on the record.

On December 1, 1997, the court issued a careful, thorough

opinion finding that the Commissioner had proved the existence of

an underpayment for each of the years at issue and that each

underpayment was due to the taxpayers’ fraud. The Tax Court

found that the taxpayers knew their bookkeeping methods would

result in underreporting of income and that their use of cash was

intended to conceal income and assets. Further, the Tax Court

rejected taxpayers’ contention that a substantial portion of the

cash was used for deductible labor and transportation expenses,

expenses that they did not try to claim until trial. The court

upheld much of the Commissioner’s deficiency determinations but,

despite its skepticism, allowed taxpayers an additional $100,000

deduction for labor expenses in 1985 and in 1986 and an

additional $50,000 deduction for labor expenses in 1987. The

taxpayers filed a timely notice of appeal.

II.

We review the Tax Court’s determinations of law de novo and

its findings of fact for clear error. See Stanford v.

Commissioner, 152 F.3d 450, 455 (5th Cir. 1998). It is well

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settled that “[a] finding is ‘clearly erroneous’ when although

there is evidence to support it, the reviewing court on the

entire record is left with the definite and firm conviction that

a mistake has been committed.” Anderson v. City of Bessemer

City, 470 U.S. 564, 573 (1985) (quoting United States v. United

States Gypsum Co., 333 U.S. 364, 395 (1948)).

The Commissioner bore the burden of proving by clear and

convincing evidence (1) that underpayments existed for each year

in issue and (2) that each underpayment was due to fraud. See

I.R.C. §§ 7454(a), 6501(c)(1); Toussaint v. Commissioner, 743

F.2d 309, 312 (5th Cir. 1984). With respect to the

Commissioner’s first burden, taxpayers admitted to having

unreported income for the years in issue. The Commissioner

reconstructed their income for those years to determine the

amount that was unreported. Based on these reconstructions, the

Commissioner determined the tax deficiencies. Taxpayers

challenged the determinations, contending that they had

additional unclaimed deductions for labor and transportation

expenses, which were paid in cash and substantially offset their

unreported income. To the extent their unreported income and use

of cash were intertwined with the allegations of fraud, taxpayers

claim error in the Tax Court’s treatment of the issue of expense

deductions.

First, taxpayers argue that, once the Commissioner presented

evidence of unreported receipts, the Tax Court improperly shifted

the burden of proof to them to explain the receipts. Instead,

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they contend, the Commissioner retains the burden of uncovering

their unclaimed deductions and the Commissioner discharges this

duty by following any lead the taxpayers might have provided.

This is incorrect.

When the Commissioner uses circumstantial evidence and

approximations to prove that income was not reported, as with the

net-worth method, the Commissioner has a duty to investigate

reasonable leads that might more accurately establish the figures

upon which the indirect method is based. See Holland v. U.S.,

348 U.S. 121, 135-37, 137 (1954); Yoon v. Commissioner, 135 F.3d

1007, 1012 (5th Cir. 1998); Fairchild v. Commissioner, 240 F.2d

944, 947 (5th Cir. 1957). The Commissioner has no such duty when

proof of unreported income is directly established by reference

to specific, unreported items in the taxpayer’s records. See

United States v. Suskin, 450 F.2d 596, 598 (2d Cir. 1971); United

States v. Shavin, 320 F.2d 308, 311 (7th Cir. 1963) (citing

Swallow v. United States, 307 F.2d 81 (10th Cir. 1962)); United

States v. Stayback, 212 F.2d 313, 317 (3d Cir. 1954).

The Gandys claim to have incurred deductible labor and

transportation expenses in 1985, 1986, and 1987. The

Commissioner used the specific-items method to reconstruct their

income for these years and, therefore, had direct evidence of the

taxpayers’ unreported receipts. That evidence satisfied the

Commissioner’s burden of proving an underpayment. The Tax Court,

then, properly placed the burden on the taxpayers to explain

those receipts, applying the settled rule: “[E]vidence of

8
unexplained receipts shifts to the taxpayer the burden of coming

forward with evidence as to the amount of offsetting expenses, if

any.” Siravo v. United States, 377 F.2d 469, 473 (1st Cir.

1967).

Second, taxpayers contend that the Tax Court erred by

discounting their evidence regarding profit margins, labor costs,

and transportation expenses. They allege that the Commissioner

overstated their profit margins for the years 1985 through 1987.

Evidence to this effect, they argue, indicates the existence of

their deductible travel and labor expenses for those years.

Taxpayers’ evidence that their profit margins were overstated

included the testimony of three of their competitors in the

nursery business. These witnesses were not certified as experts,

spoke only to profits and expenses in their own businesses, and

admitted they had never examined the Gandys’ records. As stated

above, it was the taxpayers’ burden to establish the amount of

their offsetting expenses. Evidence of other people’s records

does not satisfy that burden, and the Tax Court was not in error

for concluding as much.

Taxpayers challenge the profit margin determination on

another ground. They argue that the Commissioner should have

corroborated the numbers by resort to another method of

reconstruction. Doing so, they maintain, would have proven that

the profit margin was overstated. Upon finding that the profit

margin was overstated, the Commissioner should have followed that

“lead” to conclude that taxpayers must have had additional

9
unclaimed expenses. This contention is wholly without merit.

When a taxpayer’s books and records are incomplete or do not

accurately reflect income, the Commissioner is authorized to use

any method deemed appropriate to reconstruct the taxpayer’s

income. See I.R.C. § 446(b); Webb v. Commissioner, 394 F.2d 366,

371-72 (5th Cir. 1968). Further, the Commissioner is not

required to corroborate these results by using several methods.

See Gordon v. Commissioner, 63 T.C. 51, 78 (1974), modified, 63

T.C. 501 (1975), rev’d in part on other grounds, 572 F.2d 193

(9th Cir. 1977). And, again, the Commissioner established a

prima facie case of underpayment with evidence of unreported

income. It was then the taxpayers’ duty to follow their own

“leads.”2

With respect to the Commissioner’s second burden, taxpayers

contend that the Tax Court’s finding of fraudulent intent was

clearly erroneous. They argue that they were unsophisticated,

they relied on their accountants, they were merely negligent,

and, although they wore several “badges of fraud,” they failed to

wear others. We have reviewed the record and the Tax Court’s

opinion, and we note that these same contentions were ably

addressed below. On appeal, moreover, taxpayers have again

failed to specify error in the more damaging indicia of fraud

found by the Tax Court. We think it unnecessary to recount these

2
In a display of unusual generosity, the Tax Court did
permit deductions for the years 1985 through 1987, despite the
taxpayers’ inability to proffer concrete evidence regarding their
expenses. Taxpayers’ dissatisfaction with the numbers adds
little to merit reversal.

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findings, since they too were ably addressed below, but we

conclude that they are not clearly erroneous.

Finally, taxpayers assert that Judge Cohen’s opinion was

based on a clearly erroneous interpretation of the original

record. Their claim of error is twofold. First, they contend

that Judge Cohen mischaracterized the evidence in the record and

such mischaracterization indicates that she did not base her

opinion on the record. We too have examined the record and

conclude that it more than adequately supports her opinion. Her

characterizations of the evidence were not clearly erroneous.

Second, taxpayers maintain that Judge Cohen’s interpretation

of the record was erroneous because she failed to recall

witnesses and, instead, made credibility determinations based on

the record alone. This argument is without merit. Taxpayers

filed an unqualified consent to submission on the record,

choosing to forego the option of a new trial. They cannot now

claim error because the opinion was based on the record rather

than live testimony.

III.

For the foregoing reasons, we AFFIRM the judgment of the Tax

Court.

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