Parrish v. Commissioner

T.C. Memo. 1997-474

UNITED STATES TAX COURT

DAVID D. PARRISH, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21508-95. Filed October 20, 1997.

Declan J. O'Donnell, for petitioner.

Loren B. Mark, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

FOLEY, Judge: Respondent determined the following

deficiencies, additions to tax, and accuracy-related penalties

relating to petitioner's Federal income taxes:

Additions to Tax Penalty
Year Deficiency Sec. 6651(a) Sec. 6653(a) Sec. 6662

1988 $25,257 $5,564 $1,263 --
1989 115,540 28,825 -- $23,108
 - 2 -

1990 55,238 13,738 -- 11,048

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. The issues for decision

are as follows:

1. Whether petitioner failed to report income. We hold

that he did.

2. Whether petitioner, pursuant to section 1366, is

entitled to deduct losses relating to M&L Business Machine Co.,

Inc. We hold that he is not so entitled.

3. Whether petitioner, pursuant to section 1401, is liable

for self-employment tax. We hold that he is liable to the extent

provided below.

4. Whether petitioner, pursuant to section 6651(a), is

liable for additions to tax for failing to file his tax returns

in a timely manner. We hold that he is liable.

5. Whether petitioner, pursuant to sections 6653(a) and

6662(a), is liable for an addition to tax and accuracy-related

penalties for negligence. We hold that he is liable.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

Petitioner resided in Kearney, Nebraska, at the time his petition

was filed.
 - 3 -

Petitioner is a psychiatrist. He earned his medical degree

in 1955 from the University of Nebraska and then served a 1-year

internship with the United States Public Health Service in New

York, New York. In 1975, petitioner cofounded the Boulder

Psychiatric Institute in Boulder, Colorado. In 1985, he sold his

interest in the hospital and became affiliated with M&L Business

Machine Co., Inc. (M&L).

M&L, an S corporation incorporated in Colorado, was formed

in the 1970's to repair office equipment. During the 1980's

Robert Joseph, Daniel Hatch, and petitioner acquired all of M&L's

stock. Petitioner was M&L's vice president of human resources

and served, with Mr. Hatch and Mr. Joseph, on M&L's board of

directors.

During the years in issue, M&L operated a ponzi scheme that

promised to pay interest to investors at rates ranging between 24

and 520 percent. M&L representatives told investors that funds

invested in the company would be used to purchase equipment for

resale. M&L used these funds, however, to pay interest to other

investors. M&L did not file Federal income tax returns relating

to the years in issue.

Petitioner withdrew funds from his bank accounts and

accounts that he held jointly with his parents, William and

Berdine Kotlarz, and invested these funds in M&L. In addition to

an annual salary of $28,000 and monthly payments of $1,000 which
 - 4 -

petitioner used to lease a Cadillac, M&L made monthly payments of

$6,000 to petitioner. Petitioner routinely reinvested portions

of these funds, and he borrowed funds from banks to make

additional investments in M&L. During his tenure with M&L,

petitioner made numerous solicitations to potential investors

(i.e., associates, friends, and relatives). These solicitations

resulted in over $1 million of investments in M&L. In return for

these investments, brokers, investors, and M&L paid petitioner

finder's fees of varying amounts.

In October of 1990, M&L filed a bankruptcy petition with the

U.S. Bankruptcy Court for the District of Colorado. On December

18, 1990, the bankruptcy court removed M&L as debtor in

possession and appointed a trustee. The trustee began a 3-month

investigation of M&L's financial activities that revealed M&L (1)

was operating ponzi and check-kiting schemes and (2) had no

inventory from which creditors' claims could be satisfied. On

July 17, 1991, petitioner filed a bankruptcy petition with the

U.S. Bankruptcy Court for the District of Colorado.

To recover funds for M&L creditors, the trustee commenced

adversarial proceedings against M&L investors and officers and

alleged that these investors and officers had received

preferential transfers or fraudulent conveyances. In August of

1991, the bankruptcy court assigned the accounting firm of

Patten, MacPhee & Associates, Inc. (the firm) to assist the
 - 5 -

trustee in determining who received funds from M&L during the 1-

year period (from October 1989 through October 1990) prior to the

filing of M&L's bankruptcy petition. The firm determined that

during this period M&L transferred $375,452.01 to petitioner and

that petitioner transferred $46,162 to M&L. The trustee then

filed suit to recover funds from petitioner. On February 8,

1994, the bankruptcy court entered a judgment for $375,534.01

against petitioner. Petitioner subsequently reached an agreement

requiring him to periodically remit 15 percent of his net income

to the trustee.

Petitioner filed his 1988 and 1989 Federal income tax

returns on April 26, 1991, and his 1990 return on December 28,

1992. In October of 1993 Gudrun Stacks, the IRS agent assigned

to audit petitioner's returns, asked petitioner to provide bank

and other records relating to M&L investments. On several other

occasions Agent Stacks requested such records, but petitioner did

not provide them. Other sources subsequently provided Agent

Stacks with copies of M&L checks made payable to petitioner and

petitioner's bank records. Agent Stacks analyzed bank records

relating to petitioner's 1988 and 1989 tax years and examined M&L

checks issued to petitioner during his 1990 tax year. Upon

completing her analysis, Agent Stacks determined that petitioner

had unreported income of $72,415, $386,663, and $165,822 for

1988, 1989, and 1990, respectively.
 - 6 -

Based on the results of Agent Stacks' audit, respondent on

July 20, 1995, issued a notice of deficiency to petitioner.

Respondent subsequently conceded that Agent Stacks made an error

in the analysis relating to petitioner's 1989 tax year and now

contends that the correct amount of unreported income for 1989 is

$238,834.27 rather than the $386,663 earlier determined.

OPINION

Respondent's determinations are presumed to be correct, and

petitioner bears the burden of proving them erroneous. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Mattingly

v. United States, 924 F.2d 785, 787 (8th Cir. 1991).

I. Unreported Income

Gross income includes all income from whatever source

derived. Sec. 61(a). If a taxpayer fails to maintain adequate

records of taxable income, the Commissioner may reconstruct

income in accordance with a method that clearly reflects the full

amount of income received. Sec. 446(b); Rowell v. Commissioner,

884 F.2d 1085, 1087 (8th Cir. 1989), affg. T.C. Memo. 1988-410;

Meneguzzo v. Commissioner, 43 T.C. 824, 831 (1965).

Respondent used the bank deposits method to reconstruct

petitioner's income for 1988 and 1989. 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
 - 7 -

assumed to be taxable income, DiLeo v. Commissioner, 96 T.C. 858,

868 (1991), affd. 959 F.2d 16 (2d Cir. 1992). Respondent used

the specific items method to reconstruct petitioner's income for

1990. This method requires proof of specific items of income

that were omitted from the taxpayer's return. United States v.

Merrick, 464 F.2d 1087, 1092 (10th Cir. 1972).

Petitioner acknowledges that he received, but did not

report, monthly payments of $1,000 which petitioner used to lease

a Cadillac. He also acknowledges that he received finder's fees

of varying amounts but has not offered any explanation for his

failure to report these funds. Petitioner contends that the

remaining unreported funds are, pursuant to the open transaction

doctrine, a return of principal.

The open transaction doctrine, which applies in rare and

extraordinary circumstances, see McShain v. Commissioner, 71 T.C.

998, 1004 (1979), permits an investor to recover capital prior to

recognizing gain. The Supreme Court in Burnet v. Logan, 283 U.S.

404, 413 (1931), established that this doctrine applies to

deferred payment transactions where the realization of income is

uncertain or contingent. The doctrine has also been applied to

the purchase of notes at a discount where, at the time of

acquisition, the investor was not reasonably certain that he

would recover his cost and a major portion of the discount.

Underhill v. Commissioner, 45 T.C. 489, 495 (1966).
 - 8 -

Petitioner has failed to establish that the open transaction

doctrine is applicable. Petitioner, on brief, contends that he

loaned over $334,500 to M&L. This contention is based primarily

on petitioner's testimony, which was vague, evasive, and

otherwise unpersuasive. In an attempt to corroborate this

testimony, petitioner presented scant and dubious documentation.

Even if petitioner could establish that he loaned M&L these

funds, the open transaction doctrine is not applicable, because

petitioner did not have the requisite uncertainty relating to the

recovery of his principal. Indeed, petitioner routinely received

monthly payments from M&L and reinvested them in the company.

Moreover, he encouraged friends and family to make investments in

M&L.

Petitioner also contends that the payments he received from

M&L should be treated as a return of principal because they were

made to conceal a fraud. Petitioner relies on Greenberg v.

Commissioner, T.C. Memo. 1996-281. In Greenberg, the taxpayers

transferred funds to a ponzi scheme that purported to be a

legitimate mortgage company. The taxpayers were passive

investors and were paid monthly payments from the company's bank

account. The Court was presented with sufficient evidence to

determine the amount of funds paid and received by the taxpayers,

and it held that the payments the taxpayers received were not

interest because they were not compensation for the use or
 - 9 -

forbearance of money. Instead, the Court found that the payments

were made to conceal the fraudulent misappropriation of the

taxpayers' investment.

Greenberg v. Commissioner, supra, however, is

distinguishable from this case. Petitioner was not a passive

investor but was a director and officer of M&L who encouraged

investors to transfer over $1 million to M&L. Moreover,

petitioner failed to provide sufficient evidence to establish the

amount of funds that he allegedly loaned to, or the amount of

funds he received from, M&L. Accordingly, we hold that

petitioner failed to report income.

II. Losses Relating to M&L

Petitioner contends that, in his capacity as an S

corporation shareholder, he is entitled to deduct 20 percent of

M&L's losses for the years in issue. See sec. 1366(a)(1); see

also sec. 1366(d)(1) (limiting such deductions to the

shareholder's adjusted basis in the corporate stock). While

petitioner bears the burden of establishing that M&L actually

incurred losses for the years in issue, Burke v. Commissioner,

T.C. Memo. 1995-608, he has failed to produce sufficient evidence

to substantiate such losses. Nevertheless, he contends that this

Court should apply the rule of Cohan v. Commissioner, 39 F.2d

540, 543-544 (2d Cir. 1930), which provides that when taxpayers

establish that they incurred an expense, the Court may estimate
 - 10 -

the amount of the expense. M&L did not file Federal income tax

returns for the years in issue. Moreover, petitioner did not

present sufficient evidence to establish his basis in M&L or

estimate the amount of M&L's losses. Under such circumstances, a

deduction based on the Cohan rule would be "'unguided largesse.'"

Epp v. Commissioner, 78 T.C. 801, 807 (1982) (quoting Williams v.

United States, 245 F.2d 559, 560 (5th Cir. 1957). Accordingly,

we conclude that petitioner has failed to meet his burden of

proof and hold that he is not entitled to claim losses relating

to M&L.

III. Self-Employment Tax

Section 1401(a) imposes a tax on the self-employment income

of every individual. Self-employment income consists of the net

earnings from a trade or business carried on by an individual

through a sole proprietorship or as a partner. Sec. 1.1401-1(c),

Income Tax Regs.

Respondent determined that during the years in issue M&L

paid petitioner $477,071.27 that is subject to self-employment

tax. We conclude that $216,000 of the $477,071.27 received is

appropriately characterized as either interest or dividends

(i.e., the total amount of $6,000 monthly payments) and $36,000

is appropriately characterized as salary (i.e., the total amount

of $1,000 monthly payments which petitioner used to lease a

Cadillac). Therefore, $252,000 (i.e., $216,000 + $36,000) is not
 - 11 -

subject to self-employment tax. See secs. 1402(a)(2),

1402(c)(2), 3121(d)(1). Petitioner, however, failed to establish

that the remaining $225,071.27 (i.e., $477,071.27 - $252,000) was

not net earnings from a trade or business carried on by him in

his individual capacity. Indeed, petitioner acknowledged that he

received an undetermined amount of finder's fees from M&L

investors and brokers. Accordingly, we hold that he is liable

for self-employment tax on $225,071.27.

IV. Additions to Tax and Accuracy-Related Penalties

Respondent determined that petitioner was liable for

additions to tax for failing to file his Federal income tax

returns in a timely manner as well as an addition to tax and

accuracy-related penalties for negligence.

Section 6651(a) imposes an addition to tax for failure to

file Federal income tax returns in a timely manner. Petitioner

introduced no evidence relating to this issue. Accordingly, we

hold that he is liable for the section 6651(a) additions to tax.

Section 6653(a), which is applicable to petitioner's 1988

tax year, imposes an addition to tax if any part of an

underpayment is attributable to negligence or disregard of rules

or regulations. Section 6662, which is applicable to

petitioner's 1989 and 1990 tax years, imposes an accuracy-related

penalty on the portion of an underpayment that is attributable to

negligence or disregard of rules or regulations. Negligence is
 - 12 -

the "lack of due care or failure to do what a reasonable and

ordinarily prudent person would do under the circumstances."

Neely v. Commissioner, 85 T.C. 934, 947 (1985). Section 6001

provides that a taxpayer has an obligation to maintain adequate

books and records.

Petitioner did not maintain adequate books and records and

failed to exercise due care in reporting his income.

Accordingly, we hold that he is liable for the section 6653(a)

addition to tax and section 6662 accuracy-related penalties.

All other arguments raised by the parties are either

irrelevant or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.