T.C. Memo. 1997-323
UNITED STATES TAX COURT
CHENG C. AND SUSAN L. KAO, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 2982-94, 2983-94, Filed July 15, 1997.
6667-95.
Robert H. Solomon and Mark L. Quazzo, for petitioners.
Rebecca T. Hill and Bryce A. Kranzthor, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: Respondent determined the following
deficiencies, additions to tax, and accuracy-related penalties
with respect to petitioners' Federal income taxes:
1
Cases of the following petitioners are consolidated
herewith: Kolyn Enterprises Corp., docket No. 2983-94; and KCW
Associates, Inc., docket No. 6667-95.
- 2 -
Cheng C. and Susan L. Kao, docket No. 2982-94
Additions to Tax Penalty
Year Deficiency Sec. 6653(a)(1) Sec. 6661 Sec. 6662(a)
1988 $186,609 $9,330 $46,652 --
1989 975,338 -- -- $195,068
1990 663,670 -- -- 132,734
1991 347,457 -- -- 69,491
Kolyn Enterprises Corp., docket No. 2983-94
Additions to Tax Penalty
Year Deficiency Sec. 6653(a)(1) Sec. 6661 Sec. 6662(a)
1988 $ 182,456 $9,123 $45,614 --
1989 1,125,870 -- -- $225,174
1990 733,023 -- -- 146,605
1991 266,566 -- -- 53,313
KCW Associates Inc., docket No. 6667-95
Penalty
Year Deficiency Sec. 6662(a)
1990 $97,350 $19,470
1991 1,962 392
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. All dollar amounts
are rounded to the nearest dollar. After concessions, the issues
for decision are as follows:
1. Whether petitioners failed to report income. We hold
that they did to the extent provided below.
2. Whether petitioners are liable for additions to tax and
accuracy-related penalties. We hold that they are.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At
the time the petitions were filed, Cheng and Susan Kao resided,
- 3 -
and Kolyn Enterprises Corp. and KCW Associates, Inc., each had
their principal place of business, in Los Altos, California.
Petitioners Cheng and Susan Kao were born and raised in
Taiwan. In 1964, Cheng Kao moved to the United States to pursue
graduate studies in applied physics at Harvard University. In
1969, he received a Ph.D. In 1968, Susan Kao moved to the United
States to pursue graduate studies in chemistry at the University
of Rochester. She married Dr. Kao in 1970, and they have three
children. During the years in issue, Mrs. Kao was employed as an
engineer at Intel Corp., and Dr. Kao was employed as president of
Kolyn Enterprises Corp. (Kolyn) and as vice president of KCW
Associates, Inc. (KCW). Dr. Kao has five younger siblings, four
of whom reside in the United States. His sister, Yu-Hsia Kao Tu,
resides in Taiwan.
Kolyn is a closely held corporation that trades in
electronic goods, invests in real estate, and advises Asian
electronics companies. Dr. and Mrs. Kao together own 52 percent,
and their three children each own 16 percent, of Kolyn's stock.
KCW is a closely held corporation that trades in electronic goods
and invests in real estate. KCW's stock is held by Dr. Kao and
his relatives.
During the years in issue, petitioners filed their Federal
income tax returns in a timely manner. Kolyn's returns, on
Schedule L, reported increases in long-term liabilities. On
their 1991 returns, the Kaos and Kolyn disclosed, on Forms 8275,
- 4 -
that Kolyn received $790,000. The disclosures stated that these
funds were not taxable to either Kolyn or the Kaos. In 1992, the
Internal Revenue Service conducted an audit of Kolyn's 1988,
1989, and 1990 returns. Agent Jimmy Chan was assigned to the
case. On January 14, 1992, Agent Chan met with Dr. Kao for
approximately 7 hours to review Kolyn's corporate records.
During the interview, Agent Chan discovered numerous deposits in
Kolyn's accounts. In response to Agent Chan's questions, Dr. Kao
explained that these deposits were cash gifts from his father.
Dr. Kao refused, however, to provide Agent Chan with any records
to corroborate his explanation.
Because Dr. Kao failed to provide records to corroborate his
explanation for these and other deposits in petitioners'
accounts, respondent used the bank deposits method to reconstruct
petitioners' income for the years in issue. After completing
this analysis, respondent issued notices of deficiency to
petitioners and determined for the years in issue that: (1) KCW
received unreported income of $121,857; (2) the Kaos received
unreported income of $905,502; and (3) Kolyn received unreported
income of $6,777,319, and this amount was taxable to both Kolyn
and the Kaos. Respondent has subsequently conceded that a
$300,000 deposit into Cheng and Susan Kao's checking account, as
well as funds deposited into two other accounts at World Savings
and Loan, are not taxable to the Kaos.
OPINION
- 5 -
I. Unreported Income
Gross income includes all income from whatever source
derived. Sec. 61(a). Every taxpayer is required to maintain
adequate records of taxable income. Sec. 6001. If a taxpayer
fails to maintain such records, the Commissioner may reconstruct
income in accordance with a method that clearly reflects the full
amount of income received. Sec. 446(b); Meneguzzo v.
Commissioner, 43 T.C. 824, 831 (1965).
Respondent used the bank deposits method to reconstruct
petitioners' income for the years in issue. Bank deposits are
prima facie evidence of income, Tokarski v. Commissioner, 87 T.C.
74, 77 (1986), and under the bank deposits method, all money
deposited into a taxpayer's bank account during a given period is
assumed to be taxable income, DiLeo v. Commissioner, 96 T.C. 858,
868 (1991), affd. 959 F.2d 16 (2d Cir. 1992). Respondent's
determinations are presumed to be correct, and petitioners bear
the burden of proving that respondent's bank deposits analysis is
erroneous. Rule 142(a); Parks v. Commissioner, 94 T.C. 654, 658
(1990).
Petitioners contend that the funds deposited into their
accounts are not taxable income. Their contentions are based
primarily on the testimony of Dr. Kao, Ms. Tu, and Jin Cheng Kao
(Dr. Kao's uncle). Their testimony, however, was vague, evasive,
and otherwise unpersuasive. Petitioners, in an attempt to
corroborate this testimony, presented dubious documentation,
- 6 -
including notes, letters, and records prepared by Dr. Kao or Ms.
Tu. Some of the documents are not reliable and do not contain
any credible indicia of contemporaneous communications (e.g.,
postmark dates). Other documents either do not support
petitioners' contentions (e.g., bank records do not establish the
source of funds) or, in some cases, contradict petitioners'
testimony (e.g., bank records indicate that Dr. Kao transferred
funds from overseas to Kolyn, while he testified to the
contrary). In short, petitioners have failed to meet their
burden of proof.
We disagree with respondent, however, with respect to
$6,777,319 attributed to the Kaos based on a bank deposits
analysis of Kolyn's accounts. Respondent's bank deposits
analysis of Kolyn's accounts is not persuasive evidence of the
Kaos' receipt of income. Respondent has not provided substantive
evidence or a plausible theory to establish that the Kaos
received these funds. As a result, we reject respondent's
determination that $6,777,319 deposited into Kolyn's accounts is
taxable to the Kaos. Cf. Weimerskirch v. Commissioner, 596 F.2d
358, 362 (9th Cir. 1979), revg. 67 T.C. 672 (1977) (holding that
the Commissioner's determination was arbitrary and erroneous,
because the Commissioner did not provide "substantive evidence"
linking the taxpayer with the receipt of income).
II. Additions to Tax and Accuracy-Related Penalties
- 7 -
For the 1988 tax year, respondent determined that
petitioners, pursuant to sections 6653(a)(1) and 6661, were
liable for additions to tax for negligence and substantial
understatements. For the 1989 through 1991 tax years, respondent
determined that petitioners, pursuant to section 6662(a), were
liable for accuracy-related penalties based on either negligence
or substantial understatements. As with the deficiencies,
petitioners bear the burden of proving that these determinations
are erroneous. See Rule 142(a); Bixby v. Commissioner, 58 T.C.
757, 791 (1972).
A. Additions to Tax for Negligence
Section 6653(a)(1), applicable to petitioners' 1988 tax
year, provides that if any part of any underpayment of tax
required to be shown on a return is due to negligence, there
shall be added to the tax an amount equal to 5 percent of the
underpayment. The term "negligence" is defined as the failure to
exercise the care that a reasonable and ordinarily prudent person
would exercise under the circumstances. Zmuda v. Commissioner,
731 F.2d 1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982);
Neely v. Commissioner, 85 T.C. 934, 947 (1985).
Petitioners offered no plausible explanation for their
failure to report significant amounts of income. As a result, we
conclude that they are liable for the section 6653(a) additions
to tax.
B. Additions to Tax for Substantial Understatement
- 8 -
Section 6661(a), applicable to petitioners' 1988 tax year,
provides for an addition to tax in the amount of 25 percent of
the amount of any underpayment attributable to a substantial
understatement. The amount of the understatement generally is
reduced by the portion of the understatement attributable to (1)
the tax treatment of an item if there was substantial authority
for such treatment, or (2) any item with respect to which the
relevant facts affecting the item's tax treatment are adequately
disclosed in the return or in a statement attached to the return.
Sec. 6661(b)(2)(B). The requirements of adequate disclosure can
be satisfied by providing, on the return, information sufficient
to enable the Commissioner to identify the potential controversy
involved. Schirmer v. Commissioner, 89 T.C. 277, 285-286 (1987).
Kolyn's 1988 return reported, on Schedule L, increases in
Kolyn's long-term liabilities. Petitioners contend that this
information adequately disclosed the funds Kolyn received. We
conclude that the mere disclosure of an increase in long-term
liabilities was insufficient to enable respondent to identify the
potential controversy (i.e., whether petitioners failed to report
income). Accordingly, petitioners are liable for the section
6661(a) additions to tax.
C. Accuracy-Related Penalties
Section 6662(a), applicable to petitioners' 1989 through
1991 tax years, imposes an accuracy-related penalty in an amount
equal to 20 percent of the portion of any underpayment to which
- 9 -
the section applies. The section applies to, among other items,
the portion of an underpayment attributable to (1) negligence or
disregard of rules or regulations, or (2) any substantial
understatement of income tax. Sec. 6662(b). Negligence includes
the failure to make any reasonable attempt to comply with the
Internal Revenue Code. Sec. 6662(c). No penalty may be imposed
on any portion of an underpayment that is attributable to
negligence if the position is adequately disclosed, the position
is not "frivolous", and the taxpayer has adequate books and
records and has substantiated items properly. Sec. 1.6662-3(c),
Income Tax Regs. A "frivolous" position is one that is "patently
improper." Sec. 1.6662-3(b)(3), Income Tax Regs.
Petitioners offered no plausible explanation for their
failure to report significant amounts of income. While the Kaos
and Kolyn disclosed, on Forms 8275, that Kolyn received $790,000
in 1991, they failed to produce adequate books and records and to
substantiate items properly. As a result, we sustain
respondent's determinations on this issue.
We have considered all other arguments made by the parties
and found them to be either irrelevant or without merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.