Smith v. Commissioner

T.C. Memo. 1998-143

UNITED STATES TAX COURT

ROBERT A. & GERRI M. SMITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2369-97. Filed April 16, 1998.

George B. Smith and Carolyn A. Truby, for petitioners.

George D. Curran, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

FOLEY, Judge: Respondent determined the following

deficiencies, additions to tax, and accuracy-related penalties

for 1990 through 1993:

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)

1990 $45,031 $11,258 $9,006
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1991 61,687 15,422 12,337
1992 98,291 24,573 19,658
1993 175,247 43,811 35,049

After concessions, the issues for decision are:

1. Whether respondent's determinations are entitled to the

presumption of correctness. We hold that they are.

2. Whether petitioners demonstrated that respondent's

determinations were erroneous. We hold that they did to the

extent provided below.

3. Whether petitioners are liable for additions to tax for

failure to file their tax returns in a timely manner. We hold

that they are.

4. Whether petitioners are liable for accuracy-related

penalties for substantial understatements. We hold that they are

to the extent provided below.

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.

FINDINGS OF FACT

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

Robert and Gerri Smith resided in Felton, Delaware, at the time

they filed their petition. At all relevant times, petitioners

owned and operated: Guns & Goodies, a retail sporting goods

store located in Dover, Delaware, and National Distributors, an

ammunition wholesale business. Mrs. Smith managed Guns &
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Goodies, which sold a wide variety of hunting and fishing goods,

while Mr. Smith managed National Distributors, which sold

ammunition at gun shows. Petitioners also owned three

residential rental properties. Petitioners did not maintain any

personal bank accounts but did maintain two business accounts: a

general checking account into which they deposited business and

rental receipts and a payroll checking account.

During each year in issue, Guns & Goodies and National

Distributors had total gross receipts of approximately $1

million, 60 percent to 70 percent of which were in cash.

Petitioners regularly deposited most of their business receipts

into their general checking account. Some of petitioners'

business receipts, however, were never deposited and were used to

pay petitioners' personal living expenses. Petitioners did not

maintain records of the cash that they received but did not

deposit, and they regularly disposed of cash register tapes and

deposit slips. They did not maintain inventory records, except

for 1993 ending inventory, or sales receipts. Petitioners

retained monthly bank statements and maintained a firearms log

which recorded the identity of the purchaser and serial number of

every gun purchased.

Petitioners failed to pay taxes relating to their employees

and, as a result, on December 23, 1993, the Internal Revenue

Service (IRS) seized Guns & Goodies. The IRS informed
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petitioners that they would not be allowed to reopen their

business until they paid their payroll tax delinquencies and

filed their 1990, 1991, and 1992 Federal income tax returns.

The accounting firm of Faw, Casson, & Co., LLP (Faw),

prepared petitioners' 1990, 1991, and 1992 returns and filed them

on January 5, 1994. On each return, the activities of both

businesses are combined and reported under the name National

Distributors; accrual is designated as the method of accounting;

and cost is designated as the method of valuing closing

inventory. Petitioners failed to provide Faw with sufficient

information to calculate accurately gross receipts and cost of

goods sold. As a result, the return entries were based largely

on estimates (e.g., gross receipts were ascertained by analyzing

bank deposits). Each return contains the following statement:

Amounts contained in this return were obtained from the
best available information. In certain cases this
includes estimates. As additional / better information
becomes available this return may be amended.

On November 8, 1994, petitioners filed amended returns for

1990, 1991, and 1992. Each amended return contains the following

statement:

Taxpayers' original Form 1040 was prepared using
estimates where data was not available. Missing
information has been obtained and reviewed and the
original figures have been adjusted accordingly. * * *

Petitioners, on their amended returns, designated accrual as the

method of accounting and cost as the inventory method. On June
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5, 1995, petitioners filed their 1993 return, on which they

designated cash as the method of accounting and marked the "Does

not apply" box when asked to identify the inventory method. Most

of the entries on the 1990, 1991, and 1992 amended returns and on

the 1993 return were estimates based on Faw's work papers. In

April of 1995, respondent assigned petitioners' case to Revenue

Agent Eric Brown. Agent Brown issued Information Document

Requests for a variety of documents and work papers, including

financial statements, general ledgers, books of original entry,

inventory records, bank statements, canceled checks, deposit

slips, cash register tapes, and purchase invoices. Petitioners

did not provide financial statements, contemporaneous books of

original entry (other than for 1993 ending inventory), deposit

slips, or cash register tapes. Petitioners did provide copies of

bank statements, canceled checks, a disorganized assortment of

purchase invoices, and work papers that Faw prepared. Agent

Brown requested information from vendors that sold goods to

petitioners, but received only documents relating to guns sold to

petitioners in 1992 and 1993.

After reviewing the documents that petitioners maintained

and that Faw created to prepare petitioners' returns, Agent Brown

requested a clarification of how petitioners arrived at the

ending inventory figure on petitioners' 1993 return. In a letter
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prepared by Faw, signed by Mrs. Smith, and dated November 10,

1995, petitioners responded:

Inventory was counted at retail (market price). After
all inventory was counted and totaled, guns were marked
down 15% to cost (by multiplying retail price by 85%)
and other inventory was marked down 40% to cost (by
multiplying retail price by 60%). This method of
deriving the year-end inventory valuation has been used
by me since the inception of the business,
approximately 30 years ago.

After reading the letter, Agent Brown determined that petitioners

had a 15-percent gross profit on guns and a 40-percent gross

profit on other goods. Mrs. Smith intended, however, for the

percentages stated in her letter to reflect markup, rather than

gross profit percentages. A markup percentage is profit divided

by cost while a gross profit percentage is profit divided by

sales. For example, an item that costs $100 and sells for $118

has an 18-percent markup (i.e., $18 profit divided by $100 cost)

and a 15-percent gross profit (i.e., $18 profit divided by $118

sales). Accordingly, a 15-percent gross profit is equal to an

18-percent markup, and a 40-percent gross profit is equal to a

67-percent markup.

With the information from petitioners and third parties,

Agent Brown adjusted petitioners' cost of goods sold and

reconstructed their gross receipts as follows:
1990 1991
original amended adjusted original amended adjusted

Gross Receipts $916,099 $881,353 $1,001,017 $999,482 $992,372 $1,177,850
Cost of Goods Sold 667,606 711,496 622,769 728,371 797,224 729,929
Beginning Inventory 131,250 131,250 131,250 131,250 88,014 131,250
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Purchases 667,606 668,260 622,769 728,371 763,995 729,929
Ending Inventory 131,250 88,014 131,250 131,250 54,785 131,250

1992 1993
original amended adjusted original adjusted

Gross Receipts $887,837 $1,125,400 $1,412,380 $1,308,700 $1,750,539
Cost of Goods Sold 645,550 912,465 884,197 1,061,858 1,088,859
Beginning Inventory 131,250 54,785 131,250 93,817 131,250
Purchases 645,550 951,497 884,197 1,122,691 1,108,576
Ending Inventory 131,250 93,817 131.250 154,650 165,082

To determine gross receipts, Agent Brown first allocated cost of

goods sold between guns and other goods. He determined that each

beginning and ending inventory figure for 1990 through 1993

consisted of 28.2 percent guns and 71.8 percent other goods

(i.e., this allocation was consistent with petitioners' 1993

inventory records). He accepted as correct the purchase amounts

from Faw's work papers, used information received from vendors to

determine the amount of purchases attributable to gun purchases,

and subtracted gun purchases from total purchases to determine

the amount of purchases attributable to other goods. Agent Brown

did not have sufficient information to categorize the 1990 and

1991 purchases. After allocating cost of goods sold between guns

and other goods, Agent Brown applied the gross profit percentages

to determine gross receipts. For 1992 and 1993, he applied a

gross profit of 15 percent to the cost of guns (i.e., he

multiplied cost by 118 percent) and 40 percent to the cost of

other goods (i.e., he multiplied cost by 167 percent). He did

not have sufficient information to allocate between the cost of

guns and the cost of other goods sold in 1990 and 1991, so he
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determined gross receipts by applying a 37-percent "weighted

gross profit percentage", which was based on his analysis of 1992

and 1993 gross profit percentages, to the total cost of goods

sold for 1990 and 1991.

On December 26, 1996, respondent issued a notice of

deficiency to petitioners for their 1990 through 1993 tax years.

On February 6, 1997, petitioners filed their petition, and on

February 19, 1997, they submitted a second amended return for

1992.

OPINION

I. Respondent's Presumption of Correctness

We must first ascertain whether respondent's determinations

are presumed correct. Anastasato v. Commissioner, 794 F.2d 884,

886 (3d Cir. 1986), vacating and remanding T.C. Memo. 1985-101;

see Welch v. Helvering, 290 U.S. 111, 115 (1933). For the

presumption to attach respondent must link petitioners to a tax-

generating activity. Anastasato v. Commissioner, supra at 887.

Respondent has linked petitioners to two tax-generating

activities--Guns & Goodies and National Distributors.

Petitioners contend, however, that respondent's determinations

were arbitrary.

First, petitioners contend that they kept adequate records

and, therefore, respondent did not have the authority to

reconstruct gross receipts. To support their contention,
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petitioners note that respondent accepted as correct most of the

information that petitioners provided and that maintenance of the

records that petitioners did not provide (e.g., cash register

receipts) is not required. The fact that petitioners' own

accountants had to resort to estimates and reconstruction methods

to prepare the original and amended returns, however, belies

petitioners' contention. It is well settled that taxpayers have

a duty to maintain records that enable them to file correct

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

959 F.2d 16 (2d Cir. 1992); sec. 1.446-1(a)(4), Income Tax Regs.,

and that in the absence of such records respondent has the

authority to reconstruct a taxpayer's income, Petzoldt v.

Commissioner, 92 T.C. 661, 686-687 (1989). Petitioners' records

for National Distributors were nonexistent, and their records for

Guns & Goodies were, at best, scant. In addition, they routinely

disposed of important source documents such as cash register

tapes and sales slips. Cf. Kikalos v. Commissioner, T.C. Memo.

1998-92 (finding that failure to maintain source documents,

particularly cash register tapes, justified respondent's use of

an indirect method of reconstruction); Edgmon v. Commissioner,

T.C. Memo. 1993-486 (finding that the absence of source documents

such as cash register tapes and sales slips amounted to

inadequate records). Therefore, we reject petitioners'

contentions.
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Second, petitioners contend that respondent could only

resort to an indirect method of reconstruction (i.e., the gross

profit percentage method) if the direct methods of reconstruction

(e.g., bank deposit method, net worth method, etc.) were

infeasible. Contrary to petitioners' assertion, respondent may

use the gross profit percentage method as long as such method is

reasonably implemented. See Schroeder v. Commissioner, 40 T.C.

30, 33 (1963) (stating that respondent is not limited to any

particular method of reconstruction and may use any method that

is reasonable in light of the surrounding facts and

circumstances); Bollella v. Commissioner, T.C. Memo. 1965-162,

affd. 374 F.2d 96 (6th Cir. 1967). Respondent's use of the gross

profit percentage method was both appropriate and reasonable in

light of the information that petitioners provided (e.g.,

petitioners' letter to respondent).

Third, petitioners contend that respondent's determination

was arbitrary because respondent had no authority or factual

basis to adjust cost of goods sold or to change petitioners'

method of accounting. Respondent may change a taxpayer's method

of accounting whenever the taxpayer's method of accounting does

not clearly reflect income. Sec. 446(b); Thor Power Tool Co. v.

Commissioner, 439 U.S. 522 (1979). For 1990, 1991, and 1992,

petitioners kept virtually no records, yet they reported their

income on the accrual method--a method that demands strict
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accounting. For 1993, petitioners changed to the cash method

without the Commissioner's permission to do so, and they used a

method of valuing inventory that fails to comport with any

recognized method. Respondent, in essence, placed petitioners on

the cash method of accounting and the retail method of valuing

inventory, which is the method that most closely resembles

petitioners' inventory method. Given respondent's broad

authority pursuant to section 446, the paucity of information

that petitioners maintained with respect to cost of goods sold,

and the fact that petitioners did not have a valid method of

accounting for reporting inventories, we reject petitioners'

contention.

Accordingly, respondent's determinations were not arbitrary

and petitioners must prove the correct amount of their tax

liability by a preponderance of the evidence.

II. Adjustments to Respondent's Determinations

The Court may redetermine petitioners' tax liability if and

to the extent that petitioners demonstrate by a preponderance of

the evidence that respondent's determination is wrong.

Anastasato v. Commissioner, supra at 888; Miller v. Commissioner,

237 F.2d 830, 838 (5th Cir. 1956), affg. in part, revg. in part

and remanding T.C. Memo. 1955-112. With respect to cost of goods

sold, to the extent the cost of hunting and fishing licenses was

included in purchases for the years in issue, such costs should
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be subtracted from purchases and deducted as business expenses.

With respect to gross receipts, two adjustments are warranted.

First, the cost of goods sold used in the calculations of gross

receipts should be adjusted pursuant to the previous sentence.

Second, instead of applying gross profits of 15 percent (i.e., a

markup of 18 percent) to guns and 40 percent (i.e., a markup of

67 percent) to other goods, the cost of guns and other goods

should be marked up by 15 percent and 40 percent, respectively

(i.e., cost of guns should be multiplied by 115 percent and cost

of other goods should be multiplied by 140 percent).

In all other respects that have not been specifically

addressed, we conclude that respondents' deficiency determination

is correct.

III. The Additions to Tax

Respondent determined additions to tax pursuant to section

6651(a)(1) for each of the years in issue. Section 6651 provides

an addition to tax for failure to file a tax return in a timely

manner, unless such failure was due to reasonable cause and not

due to willful neglect. Petitioners concede liability for 1990,

1991, and 1992 and have the burden of proving that their 1993

return was timely. See Welch v. Helvering, 290 U.S. at 115.

They contend that they filed their 1993 return in a timely manner

but they failed to present any credible evidence supporting their
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contention. Accordingly, petitioners are liable for the section

6651(a)(1) additions to tax.

IV. The Accuracy-Related Penalties

Respondent also determined that for 1990 through 1993

petitioners were liable, pursuant to section 6662(a), for

substantial understatements of tax penalties. Section 6662(a)

imposes a penalty equal to 20 percent of the amount of any

underpayment attributable to a substantial understatement of

income tax. Pursuant to section 6662(d), an understatement is

the amount by which the correct tax exceeds the tax reported on

the return. The understatement is substantial if it exceeds the

greater of $5,000 or 10 percent of the correct tax. Sec.

6662(d)(1)(A).

Respondent calculated petitioners' understatement by

subtracting the tax reported on their originally filed returns

from the tax that should have been reported on those returns.

Petitioners contend that the amount of any understatement should

be based on the tax reported on the amended returns for 1990,

1991, and 1992 instead of the original returns for those years.

We reject petitioners' contention. Petitioners filed their

returns only upon the demand of the IRS collection officer that

seized their retail store. Under these circumstances, we

conclude that it was appropriate for respondent to use the amount

reported on petitioners' original returns. See sec. 1.6662-
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4(b)(4), Income Tax Regs. (cross-referencing sec. 1.6664-2(c),

Income Tax Regs.). Accordingly, if the recomputed deficiencies

satisfy the statutory percentage or amount, petitioners will be

liable for such penalty.

All other contentions raised by the parties are either

irrelevant or without merit.

To reflect the foregoing,

Decision will be entered

pursuant to Rule 155.