T.C. Memo. 1999-343
UNITED STATES TAX COURT
MICHAEL F. LAMBAISO AND JODY D. LAMBAISO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11489-98. Filed October 14, 1999.
Mario A. Venditti, for petitioners.
Dustin M. Starbuck, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined the following
deficiencies and accuracy-related penalties with respect to
petitioners' Federal income taxes:
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Accuracy-Related Penalty
Year Deficiency Sec. 6662
1991 $600 $120
1992 20,285 4,057
1993 20,919 4,170
Following concessions by each party, the primary issue for
decision is whether petitioners understated their 1991, 1992, and
1993 income by $2,165, $69,187, and $54,661, respectively.
Resolution of this issue turns upon the correctness of respondent's
revenue agent's use of the markup method to reconstruct the gross
sales of alcoholic beverages of a bar/restaurant (Classic Pub) in
Virginia Beach, Virginia, operated by Classic Pub, Inc., an
electing S corporation, during the 3 years in question.
Petitioners owned 28.98 percent of Classic Pub, Inc.'s stock in
1991 and all of its stock in 1992 and 1993.
In computing Classic Pub's gross sales of alcoholic beverages,
the revenue agent first determined the potential number of drinks
that could be sold from the amount of liquor available for
consumption. Petitioners agree with the revenue agent's
computation of Classic Pub's potential gross sales of alcoholic
beverages before an allowance for drinks sold at discount prices,
as well as his computation for spillage, breakage/waste, and theft
of alcoholic beverages. However, they posit that (1) the revenue
agent arbitrarily and erroneously used the markup method to
reconstruct Classic Pub's income for the years in issue, and (2)
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the revenue agent erred in computing the amount of sales of
alcoholic beverages sold at discounted prices during "happy hours".
The other remaining issues are (1) whether petitioners are
entitled to deduct 1991 unreimbursed automobile expenses allegedly
incurred in connection with Classic Pub's operation, and (2)
whether petitioners are liable for the section 6662(a) accuracy-
related penalty for 1991, 1992, and 1993.
All section references are to the Internal Revenue Code in
effect for the years under consideration. All 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
At the time Michael F. and Jody D. Lambaiso (petitioners),
husband and wife, filed their petition, they resided in Virginia
Beach, Virginia. They filed joint Federal income tax returns for
all years in issue.
Classic Pub
Classic Pub, Inc. is a Virginia corporation. In 1990, it
elected S corporation status for Federal tax purposes;
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consequently, its income and losses passed through to its
shareholders during each of the years at issue.
Michael Lambaiso (petitioner) owned 200 shares of Classic Pub,
Inc. stock, while Jenro and Evelyn Lambaiso, petitioner's parents,
each owned 400 shares. On November 22, 1991, petitioners purchased
Jenro and Evelyn Lambaiso's 800 shares of Classic Pub, Inc. stock.
Accordingly, the parties have stipulated that the income and losses
from Classic Pub should be allocated to petitioners as 28.98
percent for 1990, 100 percent for 1991, and 100 percent for 1992.
Classic Pub was licensed to serve alcohol by the Virginia
Alcoholic Beverage Control Board (VABCB). It operated 16 hours a
day, from 10 a.m. to 2 a.m., 7 days a week. Classic Pub ran some
form of discounted beverage specials each day of the week. The
greatest number of discounted beverage sales occurred during the
Wednesday and Friday night "happy hours" from 7 p.m. to 9 p.m. It
had a maximum seating capacity of 144 persons.1 Classic Pub
usually had two bartenders tending the bar at any given time and a
"bar back" person in order to relieve the bartenders from
miscellaneous tasks. Sales were rung up on the bar/restaurant's
cash register.
Classic Pub submitted Mixed Beverage Annual Review (MBAR)
reports to VABCB, indicating the dollar amounts of its sales of
1
During the years at issue, the actual number of seats
was for 130 persons.
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food, mixed alcoholic beverages (mixed drinks), beer, and wine.
Petitioners recorded Classic Pub's sales of food, beer, wine, and
mixed drinks in handwritten monthly sales journals. These monthly
sales journals were provided to petitioners' accountant, who
prepared monthly profit and loss statements.
Tax Returns
Petitioners filed joint Federal income tax returns for the
years in issue reporting the following:
Classic Pub
Year Wages Sch. E Loss Taxable Income
1
1991 $31,119 $6,673 $10,024
1992 30,200 3,104 20,471
2
1993 37,800 23,056 41,507
During these years, Classic Pub, Inc. filed U.S. Income Tax Returns
for an S Corporation (Forms 1120S), reporting the following:
Cost of Total Total Ordinary
Year Gross Sales Goods Sold Income Deductions Income (Loss)
1
1991 $294,214 $147,167 $147,276 $180,643 ($33,367)
1992 403,214 228,603 175,076 171,972 3,104
2
1993 414,649 203,864 226,633 205,677 20,956
1
For 1991, petitioners reported 20 percent of Classic Pub,
Inc.'s losses. The record does not reveal why petitioners reported
20 percent rather than 28.98 percent of Classic Pub Inc.'s losses.
2
The record does not reveal why for 1993 petitioners reported
$23,056 of income, rather than $20,956, as reflected on the K-1
from Classic Pub, Inc.
These amounts were based upon the bar/restaurant's monthly profit
and loss statements of income and expenses, which, in turn, were
based upon Classic Pub's handwritten sales journals.
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The Audit and Respondent's Reconstruction of Gross Sales
Revenue Agent William Bixler was assigned to audit
petitioners' 1991, 1992, and 1993 tax years. During that audit, he
discovered that for 1991 Classic Pub's monthly gross sales reported
on its MBAR were less than the State average for similar
establishments. Further investigation by Revenue Agent Bixler
revealed that Classic Pub, Inc. reported differing amounts of gross
sales on its Federal income tax returns, MBARs, State sales tax
returns, and profit and loss statements, and that none of the
reported gross sales were consistent with Classic Pub's daily sales
journals. The varying amounts of gross sales as reported in these
documents are reflected in the following table:
Documents on Which Gross Sales Were Reported
State Profit & Monthly Journals
Form Sales Tax Loss Sales Including Sales
Without Year 1120S MBAR Return Statement 9% Sales Tax 9%
Sales Tax
1991 $294,214 $313,667 $296,132 $291,656 $314,682 $288,699
1992 403,213 418,213 388,387 400,249 416,928 382,503
1993 414,649 441,717 --- 414,649 --- ---
Because of the lack of internal controls for income reporting
purposes and the inconsistencies between Classic Pub, Inc.'s Forms
1120S, MBARs, State sales tax returns, and profit and loss
statements, Revenue Agent Bixler decided to reconstruct Classic
Pub's sales of mixed drinks, beer, and wine. In doing so, he
employed an indirect method to determine Classic Pub's gross sales,
utilizing information and calculations provided to him by
petitioners, including Classic Pub's purchases of alcohol, prices
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and content of mixed drinks, beer, and wine, happy hour and
promotional prices, and hours of operation.2 Revenue Agent Bixler
subsequently subtracted the gross sales reported on Classic Pub
Inc.'s tax returns from the figures he determined Classic Pub, Inc.
should have reported on the returns; the difference represented
Classic Pub's understated sales for each year in issue.
Specifically, Revenue Agent Bixler computed Classic Pub's total
gross sales of mixed drinks for 1992 and 1993 by: (1) Determining
the potential number of drinks that could be sold from the amount
of liquor available for consumption based upon Classic Pub's
documented liquor purchases; (2) reducing the potential number of
drinks sold by 10 percent to allow for spillage; (3) multiplying
the adjusted potential number of drinks sold by Classic Pub's
published price list in a ratio of 69 percent for the lower day
prices and 31 percent for the higher evening prices (the lower day
prices were in effect for 11 of Classic Pub's 16 hours of operation
while the higher evening prices were in effect for the remaining
hours of operation) to arrive at tentative gross sales; (4)
increasing the tentative gross sales to reflect beverages that were
sold for an extra charge; (5) reducing the tentative gross sales by
20 percent to account for discounted mixed drink prices (happy hour
2
Revenue Agent Bixler considered the entire week's
discounted beverage prices (rather than solely the Wednesday and
Friday happy hours) in formulating a discount allowance for mixed
drinks, wine, and beer.
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and other drink specials); and (6) subtracting an additional 6
percent to account for losses due to theft. Using this method, he
calculated that Classic Pub's gross sales from mixed drink sales
for 1992 and 1993 were understated by $21,888 and $28,313,
respectively. (Step (5) of his computation is at issue herein.)
Revenue Agent Bixler reconstructed the gross sales of Classic
Pub's beer and wine in a manner similar to his reconstruction of
mixed drink sales, with a few modifications.3 He reduced the
tentative gross sales by 10 percent to account for discounted wine
and beer prices. Utilizing this method, he calculated that Classic
Pub's income from beer and wine sales for 1991, 1992, and 1993, was
understated by $6,361, $33,257, and $38,147, respectively.
In determining an appropriate discount to apply to gross sales
for mixed drinks, wine, and beer sold at discount prices, Revenue
Agent Bixler discovered that in VABCB's audits of bars/restaurants,
VABCB discounted drink prices by reducing gross sales by 5 percent.
3
This reconstruction involved: (1) Determining the
potential amount of beer and wine that could be sold based upon
Classic Pub's documented purchases of beer and wine; (2) reducing
the potential draft beer and wine sold by 10 percent to allow for
spillage, and bottled beer by 5 percent for breakage; (3)
multiplying the adjusted potential amount sold by Classic Pub's
published prices in a ratio of 69 percent for the lower day
prices and 31 percent for the higher evening prices to arrive at
a tentative gross sales figure; (4) reducing the tentative gross
sales by 10 percent to account for discounted wine and beer
prices (happy hour and other drink specials); and (5) subtracting
an additional 6 percent to account for losses due to theft.
(Step (4) of his computation is at issue.)
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Initially, he relied upon VACBC's 5-percent allowance in
reconstructing the gross sales of Classic Pub's mixed drinks, beer,
and wine. However, after learning from petitioners that Classic
Pub ran more discounted drink specials than an average
bar/restaurant, he raised the allowance to 20 percent for
discounted mixed drinks, and 10 percent for discounted beer and
wine sales.
In light of Classic Pub, Inc.'s status as an S corporation,
respondent determined that Classic Pub's understatement of mixed
drinks, beer, and wine sales for the years in issue flowed through
to petitioners as unreported taxable income as follows:
1991 1992 1993
Classic Pub's
income on Form ($33,367) $3,104 $20,956
1120
Classic Pub's
mixed drink
understatement --- 21,888 28,313
Classic Pub's
beer & wine
understatement 6,361 33,257 38,147
Adjustments/
concessions 11,449 14,042 (9,699)
Corrected income/loss
available for distribution (15,557) 72,291 77,717
Allocation of
income/losses 28.98% 100% 100%
Corrected Classic Pub
income/loss distributed to
petitioners (4,508) 72,291 77,717
Income/losses from
Classic Pub reported on
Form 1040 (6,673) 3,104 23,056
Petitioners' understatement 2,165 69,187 54,661
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Automobile Expenses
Petitioners maintain that they are entitled to deduct $1,581
in unreimbursed automobile expenses incurred during 1991 in
connection with Classic Pub's operation. These expenses were not
claimed on their tax return.
Notice of Deficiency
In the notice of deficiency mailed to petitioners regarding
their 1991, 1992, and 1993 tax years, respondent revised
petitioners' allowable losses and income from Classic Pub, as
described above. Respondent also determined a section 6662(a)
accuracy-related penalty for each of the years in issue.
OPINION
Issue 1. Determination of Classic Pub's Gross Sales
The primary issue before us is whether petitioners had
unreported income arising from Classic Pub during the years in
issue. In resolving this issue, we must determine whether Revenue
Agent Bixler's use of the percentage markup method in
reconstructing Classic Pub's gross sales was proper and whether
discounts4 he applied in computing the amount of sales of
discounted mixed drinks, wine, and beer were correct.
4
A higher discount percentage for items sold at
discounted prices benefits petitioners because it results in
lower total gross sales.
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Section 6001 requires taxpayers to maintain adequate records
to determine their correct tax liabilities. Absent adequate
records, or if the records that are kept do not accurately reflect
income, the Commissioner may determine the existence and amount of
a taxpayer's income by using any method that clearly reflects
income.5 Sec. 446(b); United States v. Johnson, 319 U.S. 503
(1943); Burka v. Commissioner, 179 F.2d 483 (4th Cir. 1950).
Petitioners bear the burden to prove that respondent's method does
not clearly reflect income. Rule 142(a); see sec. 446.
The indirect method used to calculate income must be
reasonable. See, e.g., Holland v. United States, 348 U.S. 121
(1954). The percentage markup method is well recognized as a
reasonable means of reconstructing income, see Bollella v.
Commissioner, 374 F.2d 96 (6th Cir. 1967), affg. T.C. Memo. 1965-
162, particularly when cash businesses are involved, see Webb v.
Commissioner, 394 F.2d 366 (5th Cir. 1968), affg. T.C. Memo. 1966-
81; Edgmon v. Commissioner, T.C. Memo. 1993-486. Pursuant to this
method, gross sales are determined by adding a predetermined
percentage to cost of goods sold. See, e.g., Cebollero v.
Commissioner, 967 F.2d 986 (4th Cir. 1992), affg. T.C. Memo. 1990-
5
Even if a taxpayer's books and records appear adequate,
the Commissioner may test the adequacy of the information
contained therein by any reasonable method which properly
reflects the taxpayer's income. See, e.g., Michas v.
Commissioner, T.C. Memo. 1992-161.
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618; Bernstein v. Commissioner, 267 F.2d 879, 880 (5th Cir. 1959),
affg. T.C. Memo. 1956-260.
Because Classic Pub's records reflected inconsistent amounts
of gross sales for the years in issue, Revenue Agent Bixler
reasonably and justifiably reconstructed the bar/restaurant's gross
receipts using a form of the percentage markup method. See, e.g.,
Rungrangsi v. Commissioner, T.C. Memo. 1998-391; DiLando v.
Commissioner, T.C. Memo. 1975-243; Jurkiewicz v. Commissioner, T.C.
Memo. 1955-318. In performing this reconstruction, he used
petitioners' own records and calculations regarding liquor
purchases, prices, and quantities. See, e.g., Gasper v.
Commissioner, 225 F.2d 284 (6th Cir. 1955). Petitioners failed to
present any competent evidence that would cause us to question
Revenue Agent Bixler's reconstruction.
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We are unpersuaded by any of petitioners' arguments.6
Petitioners argue that the notice of deficiency was arbitrary
because of Revenue Agent Bixler's purported inaccurate conclusions
about Classic Pub's business and record keeping. We disagree. Not
only did petitioners fail to prove that Revenue Agent Bixler's
conclusions (which are the basis of respondent's determinations)
are arbitrary, but on the basis of the record before us, we are
satisfied that they are "reasonable in light of all surrounding
facts and circumstances". See, e.g., Schroeder v. Commissioner, 40
T.C. 30, 33 (1963). We found Revenue Agent Bixler's testimony
credible. We therefore conclude that the reconstruction of Classic
Pub's income through the use of the percentage markup method was
proper and that the allowance for alcoholic beverages, wine, and
beer sold at discount prices was realistic.
6
We mention two additional arguments made by
petitioners. First, petitioners contend that they overstated
Classic Pub's 1991 and 1992 gross sales (on the Forms 1120S) by
erroneously including State sales tax. Although respondent
acknowledges that, for income tax purposes, State sales tax
should not be includable in gross sales, petitioners have not
established that they actually overstated Classic Pub's gross
sales by including State sales tax. Petitioners failed to
reconcile the amounts of State sales tax allegedly included in
reported gross sales with the stipulated amounts reflected in
Classic Pub's various records.
Moreover, petitioners posit that two bartenders can pour
2,880 shots of liquor during a 2-hour period. In attempting to
prove this point, petitioners played a videotape (that they
prepared the night before trial) for the Court, in which two
Classic Pub bartenders poured shots of liquor. However, no
evidence was presented as to how many shots of discounted liquor
were actually poured and served on any given night.
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Petitioner testified that based upon an examination of Classic
Pub's cash register tapes, the bar/restaurant sold an average of
700 drinks/shots during the Wednesday and Friday happy hours.
However, petitioners neither introduced the cash register tapes
into evidence nor quantified how selling 700 drinks/shots during a
Wednesday or Friday happy hour would alter the reasonableness of
respondent's reduction for discounted mixed beverage sales.
In sum, we sustain respondent's use of the percentage markup
method and respondent's determination of a 20-percent discount with
regard to Classic Pub's discounted mixed drink sales and a 10-
percent discount for discounted beer and wine sales. Petitioners
offered no reliable evidence to contradict respondent's
determinations. We conclude that Classic Pub's gross sales of
mixed drinks during 1992 and 1993 were understated by $21,888 and
$28,313, respectively, and that its gross sales of beer and wine
during 1991, 1992, and 1993, were understated by $6,361, $33,257,
and $38,147, respectively. Consequently, we hold that petitioners
understated their 1991, 1992, and 1993 taxable income by $2,165,
$69,187, and $54,661, respectively.
Issue 2. Business Automobile Expenses
The next issue is whether petitioners are entitled to deduct
$1,581 of unreimbursed automobile expenses they purportedly
incurred during 1991 in operating Classic Pub.
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Deductions are a matter of legislative grace. See New
Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers
bear the burden of establishing that they are entitled to the
claimed deductions. See Rule 142(a); Welch v. Helvering, 290 U.S.
111, 114 (1933). This includes the burden of substantiating the
amount and purpose of the item claimed. See sec. 6001; Hradesky v.
Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d 821
(5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs.
Petitioners failed to substantiate the amount or business
purpose of the automobile expenses. The only evidence presented
was a list of automobile expenses prepared by petitioners' counsel
on the basis of petitioner's memory and not prepared
contemporaneously with the use of the automobile. Accordingly, we
sustain respondent on this issue.
Issue 3. Section 6662(a) Accuracy-Related Penalty
The final issue is whether petitioners are liable for the
section 6662(a) accuracy-related penalties for the years in issue
for negligence or disregard of rules or regulations or substantial
understatement of tax. Petitioners generally assert a reasonable
cause defense.
Section 6662 imposes a penalty equal to 20 percent of the
amount of the underpayment attributable to negligence or disregard
of rules or regulations or substantial understatement of tax.
"Negligence" means any failure to make a reasonable attempt to
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comply with the provisions of the Internal Revenue Code, and
"disregard" means any careless, reckless, or intentional disregard.
See sec. 6662(c). A substantial understatement of tax means an
understatement of tax that exceeds the greater of 10 percent of the
tax required to be shown on the tax return or $5,000. See sec.
6662(d)(1)(A).
No accuracy-related penalty is imposed with respect to any
portion of the understatement as to which the taxpayer acted with
reasonable cause and in good faith. Sec. 6664(c)(1).
Petitioners failed to establish that they were not negligent
in preparing their returns. In fact, the record establishes that
petitioners failed to maintain adequate books and records for their
bar/restaurant. Revenue Agent Bixler's reconstruction establishes
that Classic Pub's books and records were unreliable and
understated its income.
In sum, we hold that petitioners failed to exercise reasonable
care both in reporting Classic Pub's gross sales and in ensuring
the accuracy of their individual tax returns. Accordingly, we
sustain the section 6662(a) accuracy-related penalties with respect
to the years in issue.
In reaching our conclusion, we have considered all of
petitioners' arguments and, to the extent not discussed, conclude
that each of them is without merit.
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To reflect the foregoing and the concessions of the parties,
Decision will be entered
under Rule 155.