Balabanian v. Commissioner

T.C. Memo. 1997-565

UNITED STATES TAX COURT

SARKIS N. AND BAKA S. BALABANIAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15947-95. Filed December 23, 1997.

Richard P. Slivka and Charles D. Henson, for petitioners.

Virginia L. Hamilton, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: Respondent determined a $189,212 income tax

deficiency and a $37,842 penalty under section 66621 for

1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the period under
consideration. Rule references are to this Court's Rules of
Practice and Procedure.
 - 2 -

petitioners' 1990 taxable year. The issues2 presented for our

consideration are: (1) Whether respondent correctly

reconstructed petitioners' income by use of the bank deposits

method, and (2) whether petitioners are liable for a penalty

under section 6662.

FINDINGS OF FACT3

Petitioners resided in Boulder, Colorado, at the time their

petition was filed in this case. Sarkis Balbanian (petitioner),

a jeweler since 1956, beginning in 1987 owned and operated a

retail jewelry business located in Northglenn, Colorado.

Petitioners used the cash method of accounting for financial and

tax reporting purposes.

Petitioner met Robert Joseph (Joseph) and, about 1983, began

manufacturing and/or selling jewelry to Joseph. Joseph operated

a Ponzi scheme under the name M&L Business Machine Co., Inc.

(M&L). Under the scheme, Joseph accepted currency from

individuals and promised them an extraordinary rate of return on

a monthly basis. The scheme was operated by Joseph’s paying

"investors" monthly interest funded by the currency received from

newer investors. At some point, Joseph turned to check kiting to

keep his Ponzi scheme afloat.

2
Petitioners conceded a third issue of whether their cost
of goods sold was overstated by $15,000 for 1990.
3
The parties’ stipulation of facts and attached exhibits
are incorporated by this reference.
 - 3 -

Beginning in 1988, petitioners became involved in a complex

and circuitous relationship with Joseph. Petitioners’

involvement with Joseph began with $30,000 and increased to over

$200,000 by July 1990. The monthly "interest" paid by Joseph was

either paid to petitioners or credited as an increase in their

investment. Petitioners did not report any interest from these

transactions on their Federal income tax returns, including the

1990 return. M&L also made payments totaling $10,000 toward

petitioners' purchase of a motor vehicle.

Also beginning sometime in 1988, petitioner became involved

with Joseph/M&L in a check exchanging arrangement that ultimately

became part of a check kiting scheme. M&L had cash-flow

problems, and the goal of the scheme was to obtain some "float"

in order to extend the time to pay commitments. The kiting also

made it appear that M&L had more cash because of the inflation

caused by the kiting activity. Under the arrangement, M&L would

draw a check in favor of petitioner, and petitioner, in turn,

would draw several checks totaling approximately the same amount

to M&L. For 1989 and 1990, M&L's checks to petitioner exceeded

petitioner's checks to M&L as follows:

1989 1990

Amount from M&L $5,866,328 $3,263,124
Amount to M&L 5,815,280 2,571,129
Excess received by
petitioner 51,048 691,995
 - 4 -

Petitioners did not report for 1989 or 1990 income from the check

exchanging arrangement. Also, during July 1990, M&L caused a

$207,000 check to be deposited in petitioners' Santa Barbara

Savings and Loan account.

Clara Spake (Spake) had been petitioners' tax return

preparer for about 15 years, and she prepared their 1990 return.

She was aware of the check exchanges with M&L, and she kept track

of them for a short time during 1988. Spake advised petitioner

that she did not know whether it was illegal, but if petitioner

came out ahead of M&L in any year, the difference would be

income. Petitioner encouraged several others, including Spake,

to invest with Joseph/M&L, and he received a "broker fee" for new

investors steered to M&L. Petitioner's broker fee was "paid" by

means of increases to his M&L investment. M&L filed for

bankruptcy during October 1990, and petitioners, in August 1993,

filed a $140,000 claim against the M&L bankrupt estate.

Spake performed the monthly bookkeeping and prepared

petitioners' annual tax returns, computing income on the basis of

the jewelry store register receipts and undocumented information

from petitioner. Petitioner, in addition to selling jewelry

through his store, manufactured and sold custom jewelry.

Numerous payments for custom jewelry received by petitioner were

not run through the jewelry store register and, instead, were

reported orally to Spake without documentation subject to

verification. Spake recorded petitioners' business bank deposits
 - 5 -

in a ledger, but she did not verify or check the amount of the

bank deposits in relation to the amount of recorded sales.

During October 1992, M&L's bankruptcy trustee filed a

complaint against petitioners to recover any funds they held that

may have belonged to the bankruptcy estate. Petitioners were

represented by Kevin Allen (Allen) in the bankruptcy matter. The

trustee was seeking amounts approaching $5 million from

petitioners on the theory of preferential transfers and

fraudulent conveyances. Petitioners contended that they held no

funds or assets of M&L, and they also disputed whether the

asserted legal theories applied to them. A settlement was

reached, and petitioners paid the bankruptcy estate $280,000

($220,000 in 1993 and $60,000 in 1994).

Respondent's agent, Monty Careswell (Careswell), a certified

public accountant with a master’s degree in taxation, began an

examination of M&L and related individuals, including

petitioners. Initially, Careswell examined petitioners'

involvement with M&L and attempted to reconstruct petitioners'

income using a check exchange analysis, but he found that the

payments from M&L for jewelry and those for the check exchanges

could not be distinguished. Additionally, Careswell could not

reconcile or verify the gross jewelry sales reported by

petitioners. Careswell concluded that petitioners' records were

inadequate, and he prepared a bank deposits reconstruction of

petitioners' income.
 - 6 -

Careswell performed the following steps in his bank deposits

analysis for petitioners' 1990 taxable year: He calculated total

deposits of $4,898,961 from four different accounts, including

Colorado National Bank, Bank of Boulder, Santa Barbara Savings

and Loan, and Merrill Lynch. From that amount he subtracted

nontaxable deposits of $1,148,549 and income reported by

petitioners of $594,374, and he added cash and other income items

of $34,646, to arrive at unexplained deposits not reported of

$3,190,684. Careswell then made a further reduction of

$2,571,129, representing the transfers from petitioners to M&L,

thereby arriving at $619,555 of unreported income for 1990.

Careswell did a similar analysis for 1989 and determined

unreported income of $106,104.

OPINION

Respondent, by means of a bank deposits analysis,

reconstructed petitioners' 1990 income. Petitioners do not

disagree with respondent's bank deposits mathematics. Instead,

petitioners question respondent's use of the bank deposits

analysis over the check spread analysis. In addition,

petitioners argue whether they should have to recognize the

portions of the bank deposits attributable to the check exchange

scheme with M&L. Petitioners assert that they were not entitled

to any portion of the income attributable to the check exchanges

until the resolution of the bankruptcy proceedings in 1993.

Accordingly, we must consider whether respondent's use of the
 - 7 -

bank deposits method was reasonable and whether petitioners must

recognize any portion of the income attributable to the check

exchanges in 1990.

The Commissioner may use a method to clearly reflect income

if a taxpayer does not maintain adequate records. Sec. 446(b);

Holland v. United States, 348 U.S. 121 (1954); sec. 1.446-

1(b)(1), Income Tax Regs. A bank deposits reconstruction of

income is one method the Commissioner may use to determine

income. DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), affd.

959 F.2d 16 (2d Cir. 1992). The bank deposits analysis is

conducted by examining deposits into an individual's bank

account. Reported income and any nontaxable items are subtracted

from total deposits in order to determine unreported income.

Unexplained bank deposits are prima facie evidence of income

where a taxpayer has failed to maintain adequate records.

Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). The evidence

here shows that petitioners' records were inadequate and that

there were sources of income petitioners did not report.

Therefore, respondent's use of the bank deposits analysis was

justified by the circumstances.

When using the bank deposits method, the Commissioner is not

required to show that each deposit or part thereof constitutes

income, Gemma v. Commissioner, 46 T.C. 821, 833 (1966), or that

it came from a likely or particular source. Clayton v.

Commissioner, 102 T.C. 632, 645 (1994); Estate of Mason v.
 - 8 -

Commissioner, 64 T.C. 651, 656-657 (1975), affd. 566 F.2d 2 (6th

Cir. 1977).

The parties stipulated that Agent Careswell's bank deposits

analysis is correctly computed. Normally, when the

Commissioner's agents have performed such an analysis, taxpayers

attempt to show that the bank deposits analysis is faulty by

identifying nontaxable deposits. By stipulating to the

mathematical correctness of respondent's bank deposits analysis,

petitioners are left with the option of either showing a method

that more correctly reflects income or explaining why particular

deposits are nontaxable.

Petitioners argue that a check exchange analysis rather

than a bank deposits analysis should be used to determine

petitioners' taxable income. Petitioners, however, do not

precisely explain how the bank deposits analysis should be

adjusted to account for their theory. In particular, they do not

account for the possibility that other likely and demonstrated

sources of unreported income may be more accurately reflected by

the bank deposits analysis. It is petitioners' obligation to

show that particular deposits or amounts should be subtracted

from the deposits computed by respondent. Parks v. Commissioner,

94 T.C. 654, 658 (1990). This petitioners have not done.

Petitioners contend that we should rely on a modified

version of the bank deposits analysis that was performed by Agent

Careswell. Careswell prepared a check spread to analyze
 - 9 -

petitioners' check exchange involvement with M&L. Careswell was

unable to reconcile petitioners' deposits with their records and

found that the records were inadequate. Therefore, Careswell

turned to a bank deposits analysis to reconstruct petitioners'

income from all sources, including the involvement with M&L and

the jewelry business.

Using the bank deposits analysis, Careswell calculated total

deposits of $4,898,961 and subtracted nontaxable deposits of

$1,148,549 and the income reported by petitioners of $594,374.

To that amount he added cash and other income items of $34,646 to

arrive at taxable deposits not reported of $3,190,684. Careswell

then made a further reduction of $2,571,129, representing

petitioners' payments and transfers to M&L under the check kiting

scheme. This resulted in net unexplained bank deposits of

$619,555 for 1990.

The $2,571,129 amount by which Careswell reduced the

unexplained bank deposits was determined from his check spread

analysis of check exchanges with M&L. Careswell's analysis

reflects $3,263,124 remitted by M&L to petitioners and $2,571,129

remitted by petitioners to M&L for a net excess to petitioners of

$691,995 for 1990. Petitioners argue that their unreported

taxable income should be determined using the net difference from

the check spread analysis reduced for certain adjustments

asserted by petitioners.
 - 10 -

First, petitioners assert that Careswell's analysis

overstates the net difference by approximately $75,000. In part,

the difference between Careswell's analysis and petitioners' is

that Careswell analyzed the check exchanges on an annualized

basis, and petitioners' analysis is for a continuum beginning

January 2, 1989, through October 3, 1990. Petitioners then

further reduced the net excess from the check exchanges by

amounts of alleged jewelry sales to M&L in the approximate

amounts of $126,000 for 1989 and $176,000 for 1990. In addition,

petitioners deducted the $280,000 settlement paid by them to the

bankruptcy trustee in 1993 and 1994. By ignoring annual

accounting principles and by means of the other reductions from

Careswell's analysis, petitioners attempt to reduce the amount of

the net difference between M&L's and their check payments to

approximately $161,000, as opposed to the $691,995 developed in

Careswell's check exchange analysis.

Respondent contends that the reductions proposed by

petitioners are improper. For example, some of petitioners'

reductions are based on the presumption that Careswell included

in his check exchange analysis amounts that should have been

attributed to jewelry sales from petitioners to M&L. Respondent

contends that petitioners' financial records were inadequate to

permit accurate delineation between jewelry sales and M&L check

exchanges. In that regard it cannot be determined whether any of

those jewelry sales occurred and/or were included in part or
 - 11 -

whole in the sales reported on petitioners' 1990 return. Because

respondent has given credit for the sales petitioners reported,

the reductions proposed by petitioners may be duplications.

Since petitioners have failed to distinguish adequately between

the jewelry sales and M&L check exchanges, respondent's

determination stands.

We also note that petitioners have not shown how their

adjustments to Careswell's check exchange analysis can be

integrated with the bank deposits analysis. In addition,

petitioners have not shown that the check exchange analysis

performed by Careswell and/or the modified version advanced by

petitioners would more accurately reflect income than the bank

deposits method used by respondent. The record reflects more

than one potential source of unreported income, and the check

exchange analysis would only partially address that aspect,

whereas the bank deposits analysis would include all deposited

and identified income from all sources.

Petitioners’ final argument is an attempt to attack

indirectly the bank deposits analysis by arguing that any income

from the check exchanges was either not known or not reportable

until after the 1990 taxable year. Relying on the includability

rule of section 451 and cases4 addressing whether there is a

4
Some of the cases cited by petitioners include Estate of
Whitaker v. Commissioner, 259 F.2d 379, 382 (5th Cir. 1958),
affg. 27 T.C. 399 (1956); Penn v. Robertson, 115 F.2d 167, 173
(continued...)
 - 12 -

"fixed or unconditional right to receive" income, petitioners

argue that they were not required to report any income they may

have had from the check exchanges until the matter was finally

resolved during 1993 in the bankruptcy proceeding. Petitioners'

argument is premised on their contention that the check exchanges

represent the heart of respondent's bank deposits analysis and

that the analysis would be defective if any income from the

exchanges were not taxable for 1990. Respondent argues that

under the claim of right doctrine petitioners should report the

excess of M&L payments over their payments to M&L. We agree with

respondent.

The principle of the doctrine is explained in the following

quotation from Healy v. Commissioner, 345 U.S. 278, 281-282

(1953):

Not infrequently, an adverse claimant will contest
the right of the recipient to retain money or property,
either in the year of receipt or subsequently. In
North American Oil v. Burnet, 286 U.S. 417 (1932), we
considered whether such uncertainty would result in an
amount otherwise includible in income being deferred as
reportable income beyond the annual period in which
received. That decision established the claim of right
doctrine "now deeply rooted in the federal tax system."
The usual statement of the rule is that by Mr. Justice
Brandeis in the North American Oil opinion: "If a
taxpayer receives earnings under a claim of right and
without restriction as to its disposition, he has
received income which he is required to * * * [report],
even though it may still be claimed that he is not
entitled to retain the money, and even though he may

4
(...continued)
(4th Cir. 1940); H. Liebes & Co. v. Commissioner, 90 F.2d 932,
938 (9th Cir. 1937), affg. 34 B.T.A. 677 (1936).
 - 13 -

still be adjudged liable to restore its equivalent."
286 U.S., at 424.
The phrase "claim of right" is a term known of old
to lawyers. * * * There is a claim of right when
funds are received and treated by a taxpayer as
belonging to him. The fact that subsequently the claim
is found to be invalid by a court does not change the
fact that the claim did exist. * * * [Citation
omitted; fn. refs. omitted.]

Petitioners, on the cash basis, had an excess of receipts

over payments for the 1990 taxable year in their exchanges with

M&L. Petitioners claimed as their own that excess and did not

make any claim in the bankruptcy estate until 1993.

Additionally, they resisted and denied any liability in

connection with the trustee's claim against them. Petitioners

were made aware by their bookkeeper that if they were ahead of

M&L at the close of the taxable year, they were liable for

reporting the same as income. Even though petitioners have

argued that they were engaged in the check exchanges with M&L as

a convenience, the record supports our finding that they expected

to be and were compensated for assisting M&L in maintaining float

and for their participation in the kiting scheme. After the

fact, the bankruptcy trustee sought a substantial amount from

petitioners, and petitioners made a $140,000 claim against the

bankrupt's estate. Ultimately, however, petitioners settled the

dispute by their payment to the bankruptcy estate of $280,000,

part in 1993 and the remainder in 1994. Petitioners could have

accounted for the exchanges with M&L and known the amount they

were ahead or behind, but they chose not do so and did not
 - 14 -

require their bookkeeper to do so, even though she, in the

initial stages, had done so. Petitioners are required to report,

as income, the amount of the excess in their check exchanges with

M&L.

Respondent also determined that petitioners are liable for

substantial understatement penalties under section 6662.

Petitioners bear the burden to show they are not liable for the

penalty. Rule 142(a); Bixby v. Commissioner, 58 T.C. 757, 791-

792 (1972). Section 6662 imposes the penalty on any portion of

an underpayment of tax required to be shown on a return if, as

pertinent here, there is any substantial understatement of income

tax. Sec. 6662(b)(2). A substantial understatement exists if

the amount of the understatement for the taxable year exceeds the

greater of 10 percent of the amount of tax required to be shown

on the return or $5,000. Sec. 6662(d)(1). A substantial

understatement may be reduced for any item reported for which

there was substantial authority or for which there was adequate

disclosure of the facts. Sec. 6662(d)(2)(B). Substantial

authority requires a showing that the weight of authorities

supporting a taxpayer's position is substantial in relation to

those supporting a contrary view. Antonides v. Commissioner, 91

T.C. 686, 702 (1988), affd. 893 F.2d 656 (4th Cir. 1990). In

addition, no penalty will be applied to any portion of an

underpayment if there was a reasonable cause for such portion and

the taxpayer acted in good faith. Sec. 6664(c)(1).
 - 15 -

Petitioners argue that they should not be liable for the

penalty because "They held a good faith belief that the check

exchange did not involve income to them." The facts of this case

belie any claim of good faith on petitioners’ part. Their

bookkeeper/tax return preparer advised petitioners that any

excess in their favor at the end of the year was taxable income.

Also, petitioners failed to report any of the interest and/or

broker fees either paid or credited to them by M&L. Finally,

petitioners did not keep adequate books and records, and the bank

deposits analysis shows a substantial understatement of income.

Accordingly, we hold that the entire underpayment is subject to

the section 6662 penalty.

To reflect the foregoing,

Decision will be entered for

respondent.