T.C. Memo. 1997-513
UNITED STATES TAX COURT
MAURICE D. AND ELINOR TAYLOR, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5218-95. Filed November 17, 1997.
Paula M. Junghans and Caroline D. Klepper, for petitioners.
Richard A. Stone, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined the following
deficiencies, additions, and penalties with respect to petitioners'
Federal income taxes:
- 2 -
Additions to Tax & Penalties
Sec. Sec. Sec.
Year Deficiency 6651(a)(1) 6653(b)(1) 6663
1988 $178,198 --- $133,649 ---
1989 40,454 $10,114 --- $30,341
1990 36,405 9,101 --- 27,304
Respondent seeks, in the event the Court does not sustain the fraud
determination for 1988, additions to tax for negligence or
disregard of rules or regulations pursuant to section 6653(a)(1),
substantial understatement of tax pursuant to section 6661(a), and
failure to timely file a Federal tax return pursuant to section
6651(a)(1). Additionally, in the event the Court does not sustain
the fraud determinations for 1989 and 1990, respondent seeks
accuracy-related penalties pursuant to section 6662 for negligence
or disregard of rules or regulations or substantial understatement
of tax.
The 1988 deficiency arises from respondent's determination
that petitioners had unreported income from a grocery/convenience
store business, a jewelry business, a check-kiting scheme, an
individual retirement account distribution, and interest from bank
accounts. The 1989 deficiency arises from unreported income of the
grocery/convenience store business and from gambling, and the 1990
deficiency arises from unreported income of the grocery/convenience
store business, gambling winnings, and interest. For all 3 years
in issue, deficiencies were also determined for failure to report
self-employment taxes with respect to the unreported income from
petitioners' business activities.
- 3 -
After concessions,1 the following issues remain for decision:
(1) Whether Maurice D. Taylor (petitioner) received $280,698 (or
any lesser amount) of income from a check-kiting scheme in 1988;2
(2) whether petitioner is liable for the fraud addition to tax
pursuant to section 6653(b)(1) for 1988 and fraud penalties
pursuant to section 6663 for 1989 and 1990; (3) whether Elinor
Taylor (Mrs. Taylor) is entitled to innocent spouse relief pursuant
to section 6013(e) for each year in issue; and (4) in the event the
Court does not sustain respondent's determinations of the fraud
addition to tax or penalties, whether petitioners are liable for
additions to tax or accuracy-related penalties for negligence,
substantial understatement, and failure to file.
All section references are to the Internal Revenue Code as in
effect for the years in issue, unless otherwise indicated. All
1
The parties stipulate that petitioners had net income
from the grocery/convenience store business of $72,919 in 1988,
$102,370 in 1989, and $87,877 in 1990. Respondent concedes that
petitioners had no net income from the jewelry business and that
Mrs. Taylor is not liable for the fraud additions to tax and
penalties. Petitioners concede respondent's determinations with
respect to the individual retirement account distribution,
interest income, and gambling winnings. Petitioners further
concede that the net income from the grocery/convenience store
business is subject to self-employment taxes for each year in
issue. Finally, petitioners concede that they are liable for the
additions to tax for failure to timely file their 1989 and 1990
Federal income tax returns pursuant to sec. 6651(a)(1).
2
In the notice of deficiency, respondent determined
unreported income of $300,698 from a check-kiting scheme in 1988.
At trial, respondent conceded that $20,000 of the $300,698
related to attorney's fees and thus reduced the amount of
unreported income from the check-kiting scheme to $280,698.
- 4 -
Rule references are to the Tax Court Rules of Practice and
Procedure. All dollar amounts are rounded.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The
stipulation of facts and the attached exhibits are incorporated
herein by this reference.
Background
Petitioners, husband and wife, resided in Baltimore, Maryland,
at the time they filed their petition. They married in 1968 and
have three children. For over 25 years, petitioner operated
several small businesses in the Baltimore area, including a
grocery/convenience store. During the period in issue, Mrs. Taylor
remained at home and took care of the children.
Grocery/Convenience Store Business
In 1969 or 1970, petitioner began operating a "mom and pop"
grocery/convenience store under the name M&E, Inc. (Despite its
name, M&E, Inc., was a sole proprietorship of petitioner.) Many of
petitioner's business records were in disarray. Bills for
business expenses were kept in boxes, and daily gross receipts were
recorded on a calendar.
Mrs. Taylor began working in the store sometime in 1990 when
petitioner's criminal problems resulting from his check-kiting
scheme (discussed infra) overwhelmed him. Following petitioner's
incarceration in January 1991, Mrs. Taylor ran the store with one
- 5 -
of her sons 7 days a week, operating the cash register, taking
inventory, depositing receipts, and writing checks to pay the
store's creditors.
Check-Kiting Scheme
In late 1980 or early 1981, petitioner began a check-kiting
scheme. Check kiting involves writing checks on a bank account
that has insufficient funds and depositing those checks into an
account at another bank (the second bank). The credit received at
the second bank for the deposited checks is then used to issue
checks from the account at the second bank. The check kiter relies
on the time (the "float time") it takes a bank (the second bank) to
process checks for deposit and payment. The check kiter uses the
float time (normally 3 days) to cover the "bad" checks. In the
case at hand, petitioner's check-kiting scheme primarily involved
accounts at Irvington Federal Savings & Loan (Irvington Federal)3
and Commercial & Farmers Bank (Commercial & Farmers). During the
years at issue, petitioner kited as much as $60,000 in checks per
day.
Occasionally petitioner used check-cashing services to obtain
cash needed to keep his check-kiting scheme afloat. In general,
these services charged 2-1/2 percent of the amount of the check.
At other times, in order to obtain cash, petitioner wrote checks
3
Irvington Federal Savings & Loan accounts were taken
over by the Resolution Trust Corporation in February 1992.
- 6 -
to purchase gold Krugerrand coins at a premium, then sold the coins
to a dealer at a discount of 5 to 8 percent.
Petitioner was aware of the requirement that banks report
deposits of $10,000 or more and often made efforts to evade making
deposits in those amounts.
To support his check-kiting scheme and to pay off debts,
petitioner borrowed funds. He borrowed approximately $100,000 from
his father-in-law, of which Mrs. Taylor was unaware, and from
several other individuals. Petitioner was unable to repay all of
his debts and often used funds borrowed from one person to pay what
he owed to others.
In July 1988, after a Commercial & Farmers bank officer
notified petitioner that his account at that bank would be frozen,
and that his checks would no longer be honored, petitioner knew
that his check-kiting scheme was on the verge of collapse.
Petitioner then, for the first time, informed Mrs. Taylor of his
check-kiting activities. The Taylors went to Irvington Federal to
liquidate both the family checking account and Mrs. Taylor's
savings account. Petitioner then went (without Mrs. Taylor) to the
Irvington Federal branch where the president of the bank, William
Ottey, maintained his office. Petitioner informed Mr. Ottey of his
check-kiting activities and the action taken by Commercial &
Farmers with regard to petitioner's account. Petitioner told Mr.
Ottey that as a result of Commercial & Farmers' decision to freeze
- 7 -
his account, Irvington Federal would be left holding a number of
dishonored checks.4 Petitioner showed Mr. Ottey a spreadsheet that
detailed petitioner's check-kiting activity and told him that
Commercial & Farmers checks worth approximately $163,000 were going
to bounce.
Several days later, petitioner and Mrs. Taylor executed two
confessed judgment promissory notes totaling $170,000 (one in the
name of M&E, Inc., and one in petitioners' names, each dated July
21, 1988) to repay Irvington Federal for the bounced checks. To
secure the repayment of these notes, petitioners executed mortgages
against their home and two business properties. No evidence was
presented as to petitioners' equity in the properties upon which
the mortgages were given.
Although Mr. Ottey considered the $170,000 to be partial
restitution for the losses incurred by Irvington Federal as a
result of petitioner's check-kiting scheme, petitioners' payments
pursuant to the notes were structured by Mr. Ottey as payments
pursuant to a line of credit. The line of credit statement
4
These checks were drawn on petitioner's Commercial &
Farmers account and deposited into his Irvington Federal account
in order to create a positive balance which petitioner used in
turn to draw checks on his Irvington Federal account. Because
Commercial & Farmers froze petitioner's account, Irvington
Federal could not present the Commercial & Farmers checks, which
were deposited into petitioner's Irvington Federal account, for
payment. Thus, Irvington Federal was left holding worthless
Commercial & Farmers checks which Irvington Federal had already
cleared for payment.
- 8 -
indicated that the line of credit was for $280,698; interest at 2
percent above prime would be charged; and no monthly fixed payments
were required. (Petitioners disputed the amount of liability
($280,698) Irvington Federal claimed petitioner owed it.)
In March 1990 as part of a plea agreement with the U.S.
Attorney's Office, petitioner pled guilty to one count of
structuring cash transactions to circumvent the $10,000 cash
deposit reporting requirements. Judgment was entered in November
1990, and petitioner was sentenced to 12 months' incarceration. He
served 6 months in the Federal prison in Allenwood, Pennsylvania
(from January through June 1991), and was thereafter transferred to
a halfway house to serve the remainder of his sentence on work
release.
The plea agreement with the U.S. Attorney's Office stipulated
that the check-kiting scheme caused Irvington Federal to suffer a
loss of $170,000 to $280,000, and that Mr. Taylor agreed to make
restitution. Pursuant to the judgment entered by the U.S. District
Court for the District of Maryland, petitioner agreed to file any
delinquent Federal and State income tax returns.
Petitioners' Lifestyle
Throughout the years in issue, petitioners maintained a modest
lifestyle. They resided in the house they purchased in 1977; the
mortgage payments were approximately $400 per month. Petitioners
owned two cars, a 1983 or 1984 pickup truck and a late-1970's model
- 9 -
Ford station wagon, both of which were financed. Also, petitioners
coowned a beach house in Annapolis, Maryland, which was sold in
1984 or 1985.
Mrs. Taylor handled the family finances. She maintained the
family checking account and paid the household expenses out of the
weekly $500 given to her by petitioner.
Petitioners' three children attended public schools in
Baltimore County and were members of a local swim club.
Occasionally, petitioners went on short family vacations to Ocean
City, Maryland.
Petitioner did not purchase any jewelry, furs, or similar
luxury items for Mrs. Taylor during the years in issue.
Filing of Federal Tax Returns
In January 1992, following petitioner's release from the
halfway house, petitioner and his accountant, Daniel Mules, met
with Revenue Officer Mario Scilipoti to discuss the filing of
delinquent returns for both the grocery/convenience store and
petitioners. Petitioner informed Revenue Officer Scilipoti that he
believed the grocery/convenience store suffered losses during the
years in issue. Petitioner further informed Revenue Officer
Scilipoti that although the records for the grocery/convenience
store were in disarray, he had some documents that he could use for
filing the returns. Petitioner also informed Revenue Officer
- 10 -
Scilipoti of his criminal conviction relating to his check-kiting
scheme.
Revenue Officer Scilipoti told petitioner and Mr. Mules to
prepare the delinquent returns from information available and that
if all the records were not complete, to file amended returns when
the necessary information became available.
Petitioner provided Mr. Mules with records for preparing
petitioners' delinquent returns for 1988, 1989, and 1990, which did
not include records regarding the grocery/convenience store
business. Petitioner did not ask Mr. Mules about the tax
consequences of the check-kiting scheme. After preparing and
signing the joint returns, Mr. Mules hand-delivered them to
petitioner. Mr. Mules never discussed the preparation of the
returns with Mrs. Taylor. Mr. Mules did not expect to prepare
amended returns for petitioners if and when the grocery/convenience
store business records were discovered, and petitioner told Mr.
Mules that he would hand-deliver the original returns to Revenue
Officer Scilipoti.
Rather than delivering the signed returns to Revenue Officer
Scilipoti, petitioners mailed joint Federal tax returns for 1988,
1989, and 1990 to the Internal Revenue Service (IRS) Center in
Philadelphia. The returns were received on January 29, 1992. The
1988 return reported gross income before adjustments of $13,298.
The 1989 return reported gross income before adjustments of $8,842.
- 11 -
The 1990 return reported gross income before adjustments of $5,791.
Petitioners never filed amended returns.
Mrs. Taylor knew that petitioners had not filed tax returns
for the years in issue. In January 1992, when she signed the
delinquent returns, Mrs. Taylor knew about the existence of
petitioner's check-kiting scheme. She also knew about the
grocery/convenience store business but never questioned why income
from that business was not reported on the delinquent returns.
Notice of Deficiency
In the notice of deficiency, respondent determined unreported
net income from the grocery/convenience store business through an
analysis of the bank deposits, ledger notations, Department of
Treasury statistics, and industry guidelines. The unreported net
income was determined to be $72,919 for 1988, $102,370 for 1989,
and $87,877 for 1990. Respondent further determined petitioners
had unreported income in 1988 from petitioner's check-kiting scheme
in the amount of $300,698.5
Respondent determined that petitioners were liable for the
fraud addition to tax for 1988, or in the event respondent's fraud
determination is not sustained, an addition to tax for negligence
or disregard of rules or regulations, an addition to tax for
substantial understatement of tax, and an addition to tax for
failure to timely file a Federal tax return. For 1989 and 1990,
5
See supra note 2.
- 12 -
respondent determined that petitioners were liable for the fraud
penalties, and in the event respondent's fraud determinations are
not sustained, accuracy-related penalties pursuant to section 6662
for negligence or disregard of rules or regulations or substantial
understatement of tax.
OPINION
Issue 1. 1988 Check-Kiting Income
The first issue for decision is whether petitioners must
recognize $280,698 (or any lesser amount) of income for 1988 as a
result of petitioner's check-kiting scheme. Petitioners assert
that Irvington Federal's shortfall from the check-kiting scheme was
$170,000, not $280,698, and that because the shortfall was
converted to a loan upon the execution of the confessed judgment
promissory notes and mortgages in July 1988, the proceeds from the
scheme are not taxable. Respondent counters that the notes and
mortgages represented restitution, not a loan.
Gross income means income from whatever source derived,
including income from illegal sources. Sec. 61; James v. United
States, 366 U.S. 213 (1961); Rutkin v. United States, 343 U.S. 130
(1952); United States v. Rosenthal, 470 F.2d 837 (2d Cir. 1972);
Moore v. United States, 412 F.2d 974 (5th Cir. 1969); Peters v.
Commissioner, 51 T.C. 226 (1968); McSpadden v. Commissioner, 50
T.C. 478 (1968). Generally, check kiting does not produce taxable
income because it merely involves a "merry-go-round" of funds from
- 13 -
one account to another. Teichner v. Commissioner, 453 F.2d 944 (2d
Cir. 1972), revg. and remanding on other grounds T.C. Memo. 1970-
311; Forster v. Commissioner, T.C. Memo. 1961-281. However, when
the check-kiting scheme results in bounced checks of the taxpayer
and creates a loss to the financial institutions whose funds were
drawn upon in the scheme, income from the check-kiting scheme is
includable by the taxpayer. Romer v. Commissioner, T.C. Memo.
1996-287; Bradshaw v. Commissioner, T.C. Memo. 1996-123.
Petitioner concedes that he was engaged in a check-kiting
scheme through July 1988 when it collapsed due to Commercial &
Farmers' refusal to honor future checks presented by petitioner for
deposit. But petitioner contends that the check-kiting scheme was
converted to a loan arrangement in July 1988 when petitioners
executed promissory notes and mortgages in favor of Irvington
Federal. Hence, petitioners assert that the proceeds from the
check-kiting scheme do not constitute taxable income. Respondent
argues that the agreement reached between petitioner and Irvington
Federal in July 1988 cannot be characterized as a loan, but rather
as a plan of restitution. Alternatively, respondent argues that
even if the agreement between Irvington Federal and petitioner
could be characterized as a loan, that agreement cannot alter the
taxability of the diverted funds to petitioner, i.e., inclusion of
the amount of such funds as income, because the agreement was made
- 14 -
after the check-kiting scheme collapsed and the bank incurred
losses.
For a transaction to be deemed a loan (and thus nontaxable),
the parties must have intended, at the time the transaction was
entered, that the money advanced be repaid. Moore v. United
States, supra at 978; Commissioner v. Makransky, 321 F.2d 598, 600
(3d Cir. 1963), affg. 36 T.C. 446 (1961); Leaf v. Commissioner, 33
T.C. 1093, 1096 (1960), affd. 295 F.2d 503 (6th Cir. 1961); Kreimer
v. Commissioner, T.C. Memo. 1983-672. The converse is also true:
When a taxpayer acquires earnings, lawfully or
unlawfully, without the consensual recognition, express
or implied, of an obligation to repay and without
restriction as to their disposition, "he has received
income which he is required to return, even though it may
still be claimed that he is not entitled to retain the
money, and even though he may still be adjudged liable to
restore its equivalent."
James v. United States, supra at 219 (quoting North Am. Oil Consol.
v. Burnet, 286 U.S. 417, 424 (1932)).
With respect to the case at hand, from the inception of
petitioner's check-kiting scheme in 1980 or 1981 through the day
the scheme collapsed in July 1988, Irvington Federal never
consented to petitioner's overdraws. See Romer v. Commissioner,
supra. Indeed, Mr. Ottey, Irvington Federal's president, testified
that neither he nor the bank was aware of the check-kiting scheme
until petitioner notified them of it in July 1988. And no evidence
was introduced to contradict this testimony. Thus, it is clear
that no loan agreement was made between petitioner and Irvington
- 15 -
Federal with respect to the check-kiting scheme before July 1988.
And at that time, it was apparent that Irvington Federal would
suffer a loss as a result of petitioner's check-kiting scheme.
In Buff v. Commissioner, 58 T.C. 224, 232 (1972), revd. 496
F.2d 847 (2d Cir. 1974), we held that where a taxpayer embezzled
funds and "there is a 'consensual recognition' of indebtedness
within the same taxable year, formalized by a confession of
judgment," the embezzled funds are not included in income. The
facts in Buff were as follows: The taxpayer embezzled funds from
his employer. Upon discovery of the embezzlement, the taxpayer
immediately admitted the embezzlement. He signed confessed
judgments "for a debt justly due to the plaintiff [employer]". Id.
at 225. The taxpayer further agreed to continue working for the
employer and to pay $25 per week for repayment of the debt. He
also borrowed $1,000 which he used to repay part of the debt.
We recognized in Buff that parties to a transaction, dealing
at arm's length, may alter, amend, or revoke a transaction so as to
change its character for tax purposes if their action takes place
within the same taxable year. We thus held therein that a
consensual recognition of indebtedness existed such that the
embezzled funds were not includable in the taxpayer's income.
The facts in Buff are distinguishable from those herein.
First, Irvington Federal never agreed to treat the repayment of the
check-kiting scheme losses as a debt. Mr. Ottey testified that he
- 16 -
considered the repayments restitution for the losses Irvington
Federal incurred, not a loan. The line of credit format employed
by Mr. Ottey was solely for the bank's internal accounting use.
Further, the confessed judgments signed by petitioners do not
characterize the repayments as "debt" as in Buff, but only as
"advances" (namely, the overdrawn funds). Moreover, we are
cognizant of the fact that petitioner's plea agreement with the
U.S. Attorney's Office with respect to his cash structuring charge
required petitioner to make restitution to Irvington Federal.
Second, there is no evidence that petitioners would have
qualified for a loan from Irvington Federal. See Quinn v.
Commissioner, 62 T.C. 223, 229 (1974), affd. 524 F.2d 617 (7th Cir.
1975) (holding that no loan transaction occurred and embezzled
funds were includable in income where the savings and loan could
not make a loan to the taxpayer under State law). There is no
evidence that the bank conducted a check of petitioners' credit-
worthiness before the confessed judgments and mortgages were
executed. Additionally, there is no evidence of a continued
relationship between petitioners and Irvington Federal outside of
the restitution payments, whereas in Buff the taxpayer continued to
work for the employer for 1 month.
We do not believe petitioners' July 1988 execution of
confessed judgment notes and mortgages to cover the bank's losses
was intended by the parties to create a consensual loan between
- 17 -
Irvington Federal and petitioners so as to convert the check-kiting
scheme to a debt arrangement. Consequently, we hold that the amount
of the bounced checks--the amount of the loss Irvington Federal
sustained--must be included in petitioners' income.
We now turn to the amount that must be included in
petitioners' income; i.e., the amount of the bank's loss.
Petitioners assert that Irvington Federal suffered approximately
$170,000 in losses from petitioner's check-kiting scheme.
Respondent claims that the losses totaled $280,698. These amounts
are at the opposite ends of the range stipulated in petitioner's
plea agreement with the U.S. Attorney's Office with respect to the
cash-structuring charge.
Petitioner claims that $170,000 is the correct amount because
that is the amount reflected in the confessed judgment promissory
notes and mortgages executed by the parties in July 1988.
Additionally, petitioner testified that when he presented Mr. Ottey
with the spreadsheet of his check-kiting activity, he told Mr.
Ottey that the total losses were approximately $163,000.
Mr. Ottey testified that Irvington Federal suffered a $280,000
loss and that $170,000 represented the maximum Irvington Federal
could secure from petitioners' assets on foreclosure. Mr. Ottey
claimed that the balance of the losses, $110,000, was written off
by the bank and placed in a loss reserve account.
- 18 -
Mr. Ottey's testimony failed to persuade us that Irvington
Federal suffered a $280,000 loss. Based on the record, we find
that the bank's loss from petitioner's check-kiting scheme was
$183,229. This amount represents the total Irvington Federal
checks that Commercial & Farmers dishonored on July 13, 1988.
After reducing the $183,229 by $20,000 to reflect attorneys' fees
conceded by respondent, we hold that petitioners had unreported
income of $163,229 in 1988 from petitioner's check-kiting scheme.
Petitioners are entitled to relief for repayments to Irvington
Federal with regard to the dishonored checks. See James v. United
States, 366 U.S. at 219-220. Taxpayers are permitted to deduct
from income the amount of actual repayments made to the embezzled
party in the year of repayment. Ianniello v. Commissioner, 98 T.C.
165, 174 (1992).6 The character of the repayments as a loan or
restitution here is irrelevant. If the taxpayer proves the actual
repayment of the embezzled funds, he is entitled to treat those
repayments as losses under section 165(c)(2).7 Mais v.
6
There is no evidence to suggest that petitioners were
not cash basis taxpayers. Consequently, any amount repaid is
deductible in the year of repayment. See Whitaker v.
Commissioner, 259 F.2d 379, 382 (5th Cir. 1958), affg. 27 T.C.
399 (1956).
7
SEC. 165. LOSSES.
(a) General Rule.--There shall be
allowed as a deduction any loss sustained
during the taxable year and not compensated
for by insurance or otherwise.
(continued...)
- 19 -
Commissioner, 51 T.C. 494, 497-498 (1968); Rev. Rul. 65-254, 1965-2
C.B. 50.8
Petitioner made repayments of at least $11,942 in 1988,
$33,693 in 1989, and $19,029 in 1990. These amounts were reported
on Forms 1098 sent to the IRS and petitioners by Irvington Federal.
The forms indicate that they are interest payments made pursuant to
the line of credit set up by Mr. Ottey to recover the losses from
the check-kiting scheme. Mr. Ottey, however, testified that the
line of credit structure was only a bookkeeping mechanism to keep
track of both petitioner's restitution payments and Irvington
Federal's loss of interest income. Mr. Ottey claims that his loan
officer mistakenly sent out the Forms 1098, and that the bank did
not report interest income to itself from any of petitioners'
payments. Further, petitioner testified that he never agreed to a
7
(...continued)
* * * * * * *
(c) Limitation on Losses of
Individuals.--In the case of an individual,
the deduction under subsection (a) shall be
limited to--
* * * * * * *
(2) losses incurred in any
transaction entered into for
profit, though not connected with a
trade or business * * *
8
A revenue ruling reflects the Commissioner's position
on an issue and is not binding on the Court. See Stark v.
Commissioner, 86 T.C. 243, 250-251 (1986).
- 20 -
line of credit format and that he never designated the payments as
principal or interest.
Petitioner asserts that he paid as much $1,000 per week to
Irvington Federal, with a $25,000 initial payment. Mr. Ottey
acknowledged that at times petitioner paid as much as $1,000 a week
and in 1988 petitioner paid "a total of maybe $50,000". Mr. Ottey
further acknowledged that as of the date of petitioner's sentencing
(November 20, 1990), petitioner had repaid $91,804 to Irvington
Federal.
On the basis of the record, we conclude that petitioner made
restitution to Irvington Federal as follows: $39,082 in 1988,
$33,693 in 1989, and $19,029 in 1990. Consequently, we hold that
petitioners are entitled to reduce their income for each of the
years in issue by those respective amounts.
Issue 2. Fraud Addition to Tax and Penalties
The second issue for decision is whether petitioner is liable
for the fraud addition to tax or penalties for each year in issue.
Respondent determined the fraud addition to tax for 1988 pursuant
to section 6653(b)(1) and fraud penalties for 1989 and 1990
pursuant to section 6663. Petitioner asserts that he lacked the
necessary intent to evade taxes.
Respondent has the burden of proving fraud by clear and
convincing evidence. Sec. 7454(a); Rule 142(b). Respondent must
show that the taxpayer intended to evade taxes known to be owing by
- 21 -
conduct intended to conceal, mislead, or otherwise prevent the
collection of such taxes. Rowlee v. Commissioner, 80 T.C. 1111,
1123 (1983). Fraud can never be presumed. Beaver v. Commissioner,
55 T.C. 85, 92 (1970). Fraud may be proven by circumstantial
evidence, Stone v. Commissioner, 56 T.C. 213, 223-224 (1971), and
the Court may consider the taxpayer's entire course of conduct,
Rowlee v. Commissioner, supra at 1123.
To prove fraud, respondent relies primarily on petitioners'
failure to report the income from the grocery/convenience store
business, as well as the check-kiting scheme, on their original
delinquent returns or on amended returns. Respondent asserts that:
(1) Petitioner did not file the delinquent returns with Revenue
Officer Scilipoti in order to hide the fact that no income was
reported from the grocery/convenience store business; (2)
petitioner had sufficient records from his calendar of daily gross
receipts and boxes of bills to calculate his net income from the
grocery/convenience store business; (3) petitioner knew from his
lifestyle that he had earned substantial profits from his
grocery/convenience store business; and (4) petitioner knew he had
income from his check-kiting scheme.
Respondent's assertions are not supported by the evidence.
First, we find credible petitioner's belief that he had no profits
from the grocery/convenience store business and that his lack of
adequate books and records prevented him from establishing
- 22 -
otherwise. Petitioner's testimony that the records were in
disarray is also credible. The lack of organized records, given
petitioner's criminal problems during the years in issue, does not
reflect an intent to evade taxes. See Marinzulich v. Commissioner,
31 T.C. 487 (1958); Ouellette v. Commissioner, T.C. Memo. 1971-98.
Second, we believe petitioner never understood that he was supposed
to file the delinquent returns directly with Revenue Officer
Scilipoti, as respondent contends. In this regard, Revenue Officer
Scilipoti testified only that it was his standard operating
procedure to ask taxpayers to submit delinquent returns directly to
him. Revenue Officer Scilipoti did not testify that he
specifically told petitioner to hand-deliver petitioners' tax
returns to him. Additionally, there was never any clear
understanding about the filing of amended returns. Mr. Mules
testified that he did not expect to prepare them, and petitioner
testified that he was not aware of his obligation to file amended
returns. The failure to file amended returns does not evince an
intent to evade taxes. Broadhead v. Commissioner, T.C. Memo. 1955-
328.
Third, apparently relying on the notes and mortgages executed
in favor of Irvington Federal, petitioner did not know that the
check-kiting scheme resulted in taxable income, and apparently
Revenue Officer Scilipoti did not recognize the issue either. The
lack of knowledge that ill-gotten gains are taxable tends to show
- 23 -
lack of intent to evade taxes. Cipparone v. Commissioner, T.C.
Memo. 1985-234; Hauser v. Commissioner, T.C. Memo. 1970-207.
We also find significant petitioner's attempt to promptly
resolve his tax problems following his release from Federal prison
and the halfway house. He did not evade Revenue Officer
Scilipoti's request to meet; moreover, in less than 2 weeks after
the meeting, petitioners filed their delinquent returns.
On the basis of all the facts and circumstances, we hold that
respondent has failed to prove by clear and convincing evidence
that petitioner intended to evade taxes and defraud the Government
for the years in issue.
Issue 3. Innocent Spouse Relief
The third issue for decision is whether Mrs. Taylor is
entitled to innocent spouse relief pursuant to section 6013(e).
Mrs. Taylor claims that she is entitled to such relief for each
year in issue. Respondent contends that Mrs. Taylor fails two of
the four requirements for relief.
Spouses who file a joint income tax return generally are
jointly and severally liable for its accuracy and the tax due,
including any additional taxes, interest, or penalties determined
on audit of the return. Sec. 6013(d)(3). However, pursuant to
section 6013(e), a spouse (commonly referred to as an innocent
spouse) can be relieved of tax liability if that spouse proves: (1)
A joint income tax return was filed; (2) the return contained a
- 24 -
substantial understatement of tax attributable to grossly erroneous
items of the other spouse; (3) in signing the return, the spouse
seeking relief did not know, and had no reason to know, of the
substantial understatement; and (4) under the circumstances it
would be inequitable to hold the spouse seeking relief liable for
the understatement. Sec. 6013(e). The spouse seeking relief bears
the burden of proving that each of the four elements of the statute
has been satisfied, and failure to satisfy any one of the elements
will prevent innocent spouse relief. Purcell v. Commissioner, 826
F.2d 470, 473 (6th Cir. 1987), affg. 86 T.C. 228 (1986); Bokum v.
Commissioner, 94 T.C. 126, 138-139 (1990), affd. 992 F.2d 1132
(11th Cir. 1993).
Respondent concedes that Mrs. Taylor has satisfied the first
two statutory requirements for innocent spouse relief.
Mrs. Taylor asserts that she did not know, nor had reason to
know, of the substantial understatement of income. To establish
this claim, Mrs. Taylor must prove that she was unaware of the
circumstances that gave rise to the omission of income. See
Purcell v. Commissioner, 86 T.C. at 238. She must demonstrate lack
of both actual and constructive knowledge of the omission such that
a reasonable person could not have been expected to know that the
tax liability stated was erroneous or that further inquiry was
necessary. See Stevens v. Commissioner, 872 F.2d 1499, 1504-1505
(11th Cir. 1989), affg. T.C. Memo. 1988-63.
- 25 -
The record is clear that Mrs. Taylor knew of the substantial
understatement of income from both petitioner's check-kiting scheme
and the grocery/convenience store business. Mrs. Taylor admitted
at trial that she was told by petitioner of the check-kiting scheme
in July 1988, approximately 3-1/2 years prior to the filing of the
delinquent returns. This fact prevents Mrs. Taylor from obtaining
innocent spouse relief with respect to the check-kiting income in
1988. See Krause v. Commissioner, T.C. Memo. 1991-13; Newton v.
Commissioner, T.C. Memo. 1990-606; Bents v. Commissioner, T.C.
Memo. 1990-487. Although Mrs. Taylor may not have known the tax
consequences of the check-kiting scheme, that ignorance is no basis
for relief. See Krause v. Commissioner, supra; Newton v.
Commissioner, supra; Trimmer v. Commissioner, T.C. Memo. 1983-131.
With respect to the grocery/convenience store business, Mrs.
Taylor was fully aware that this business existed during 1988,
1989, and 1990, and she even worked in the store for a short period
during 1990 and much of 1991. Although Mrs. Taylor may have
believed from her conversations with petitioner that the
grocery/convenience store was operating at a loss during the years
in issue, she knew from her participation in the business that the
grocery/convenience store was generating gross receipts. Mrs.
Taylor made deposits of cash receipts and wrote checks to creditors
while working at the store. She testified, however, that she did
not review the joint returns she signed, and thus she never had
- 26 -
reason to know that the grocery/convenience store income was not
reported.
Taxpayers have an obligation to review tax returns before
signing them, and they are ordinarily charged with constructive
knowledge of the contents of the returns if they do not review
them. Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d Cir. 1993),
affg. T.C. Memo. 1992-228. Taxpayers generally cannot turn a blind
eye to what is disclosed on the tax return and plead ignorance.
Edmondson v. Commissioner, T.C. Memo. 1996-393; Cohen v.
Commissioner, T.C. Memo. 1987-537.
Mrs. Taylor's knowledge of, and involvement in, the
grocery/convenience store business put her on notice of the
unreported income, even though petitioner may have suggested to her
that the business was losing money. See Alberts v. Commissioner,
T.C. Memo. 1986-483. When that income was omitted from the joint
returns, Mrs. Taylor had a duty to inquire of petitioner as to the
reporting of that income. See Zimmerman v. Commissioner, T.C.
Memo. 1996-223. Petitioner's financial and criminal problems
should have also prompted Mrs. Taylor to review the joint returns.
See Starr v. Commissioner, T.C. Memo. 1995-190, affd. without
published opinion 99 F.3d 1146 (9th Cir. 1996).
Mrs. Taylor presented no evidence supporting her innocent
spouse claim with respect to the other items of income (which
- 27 -
petitioners conceded, see supra note 1) and thus failed to meet her
burden of proof with respect to those items. Rule 142(a).
Thus, we hold that Mrs. Taylor is not entitled to innocent
spouse relief and is liable for the deficiencies for the years in
issue.
Issue 4. Negligence, Substantial Understatement, and Failure To
File
The final issue for decision is whether petitioners are liable
for additions to tax for negligence or disregard of rules or
regulations pursuant to section 6653(a)(1), substantial
understatement of tax pursuant to section 6661(a), and failure to
file their Federal tax return pursuant to section 6651(a)(1) for
1988; and whether petitioners are liable for accuracy-related
penalties pursuant to section 6662 for negligence or disregard of
rules or regulations, or substantial understatement of tax for 1989
and 1990. Respondent made these determinations as an alternative
to the fraud addition to tax and penalties.
For 1988, section 6653(a)(1) imposes an addition to tax equal
to 5 percent of the underpayment if any part of the underpayment is
attributable to negligence or disregard of rules or regulations.
"Negligence" means any failure to make a reasonable attempt to
comply with the Internal Revenue Code, and "disregard" includes any
careless, reckless, or intentional disregard. Sec. 6653(a)(3).
For 1988, section 6661(a) imposes an addition to tax equal to 25
percent of the amount of any underpayment attributable to a
- 28 -
substantial understatement of income tax. A substantial
understatement means an understatement which exceeds the greater of
10 percent of the tax required to be shown on the return or $5,000.
Sec. 6661(b)(1). Finally, section 6651(a)(1) imposes an addition
to tax of 5 percent of the tax required to be shown on the return
for each month or fraction thereof for which a return is not filed,
not to exceed 25 percent. An exception is made where the failure
to file the return is due to reasonable cause not the result of
willful neglect.
For 1989 and 1990, section 6662(a) imposes an accuracy-related
penalty of an amount equal to 20 percent of the portion of the
underpayment attributable to negligence or disregard of rules or
regulations, or to a substantial understatement of tax.
Negligence is defined as a lack of due care or failure to do
what a reasonable person would do under the circumstances. Neely
v. Commissioner, 85 T.C. 934, 947 (1985). A taxpayer is not liable
for negligence or disregard of rules or regulations, or substantial
understatement of tax, if he shows that he acted with reasonable
cause and in good faith with respect to the underpayment in issue.
Sec. 6664(c). The most important factor in determining reasonable
cause is the extent of the taxpayer's effort to assess the proper
tax liability. Sec. 1.6664-4(b), Income Tax Regs. The reasonable
cause exception applies only to returns due after December 31, 1989
(without regard to extensions). Omnibus Budget Reconciliation Act
- 29 -
of 1989 (OBRA), Pub. L. 101-239, sec. 7721(a), 103 Stat. 2106,
2395.
Petitioners assert that they are not liable for the addition
to tax and accuracy-related penalties for negligence or disregard
of rules or regulations, or substantial understatement of tax,
because of their state of upheaval during the investigation and
prosecution of petitioner for his check-kiting activity.
With respect to 1988, the reasonable cause exception does not
apply. OBRA sec. 7721(a). Thus for 1988, petitioners are liable
for the addition to tax for negligence pursuant to section
6653(a)(1) and the addition to tax for substantial understatement
of tax pursuant to section 6661(a). Petitioners presented no
evidence with respect to the failure to timely file their 1988
Federal tax return, and thus they are liable for the addition to
tax pursuant to section 6651(a)(1). Rule 142(a).
With respect to 1988, 1989, and 1990, petitioners made an
inadequate effort to determine their proper tax liability.
Although their business records were generally in disarray,
petitioners had some grocery/convenience store records that could
have been presented to their accountant, Mr. Mules, or to Revenue
Officer Scilipoti, including the box of bills and the calendar
reflecting daily gross receipts. These records were presented to
petitioners' attorney and to the IRS in the course of the IRS's
audit. Petitioner's preoccupation with his criminal problems does
- 30 -
not excuse the failure to report income from the
grocery/convenience store business or any other item. See Kenroy,
Inc. v. Commissioner, T.C. Memo. 1984-232. The failure to keep
adequate records, in contravention of section 6001, supports the
imposition of the negligence addition to tax and the accuracy-
related penalty. See Maguire v. Commissioner, T.C. Memo. 1996-145;
Tabbi v. Commissioner, T.C. Memo. 1995-463; Simonelli v.
Commissioner, T.C. Memo. 1985-12.
Finally, petitioners made no efforts to obtain professional
advice to determine the tax consequences of the check-kiting scheme
before filing their tax returns. They never asked either their
accountant or a tax attorney about how to report those activities.
Given their lack of knowledge of the tax law, petitioners should
have sought advice about the tax implications of the check-kiting
scheme. Cf. Krause v. Commissioner, T.C. Memo. 1991-13.
Thus, for 1988, we hold that petitioners are liable for
additions to tax for negligence or disregard of rules or
regulations pursuant to section 6653(a)(1), substantial
understatement of tax pursuant to section 6661(a)(1), and failure
to timely file their return. For 1989 and 1990, we hold that
petitioners are liable for the accuracy-related penalties for
negligence or disregard of rules or regulations pursuant to section
6662.
- 31 -
To reflect the foregoing and the concessions of the parties,
Decision will be entered
under Rule 155.