COHEN v. COMMISSIONER

T.C. Memo. 2001-249

UNITED STATES TAX COURT

BRUCE DAVID COHEN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16641-96. Filed September 20, 2001.

Respondent determined deficiencies and additions
to tax for petitioner’s 1986, 1988, 1989, 1990, 1991,
and 1992 taxable years.

Held: Petitioner’s sole proprietorship earned net
income as redetermined herein for each of the 6 years
involved in this case.

Held, further, petitioner recognized capital gain
from the sale of stock in the amounts of $10,490 and
$9,227 in 1989 and 1990, respectively.

Held, further, petitioner’s filing status for 1992
was married filing separate.

Held, further, petitioner is entitled only to the
standard deduction in 1990.

Held, further, petitioner is liable for the sec.
6651(a)(1), I.R.C., addition to tax for failure timely
to file income tax returns for each of the years at
issue.
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Held, further, petitioner is liable for the sec.
6654, I.R.C., addition to tax for failure to pay
estimated tax for each of the 6 years under
consideration.

Bruce David Cohen, pro se.

Miles D. Friedman, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

NIMS, Judge: Respondent determined the following

deficiencies and additions to tax with respect to petitioner’s

Federal income taxes:

Taxable Income Tax Additions To Tax
Year Deficiency Sec. 6651(a)(1) Sec. 6654
1986 $94,940 $23,735 $4,594
1988 58,089 14,522 3,737
1989 70,535 17,634 4,770
1990 119,550 29,887 7,827
1991 70,516 17,629 4,030
1992 78,024 19,506 3,403

After concessions, the issues remaining for decision are:

(1) Whether petitioner’s sole proprietorship earned net

income in the amounts asserted by respondent for each of the 6

years involved in this case;

(2) whether petitioner recognized capital gain from the sale

of stock in 1989 and 1990 in the amounts asserted by respondent;
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(3) whether petitioner’s filing status was single or married

filing separate in 1992;

(4) whether petitioner is entitled to only the standard

deduction or, instead, to itemized deductions, in 1990;

(5) whether petitioner is liable for the section 6651(a)(1)

addition to tax for failure timely to file income tax returns for

each of the 6 years at issue; and

(6) whether petitioner is liable for the section 6654

addition to tax for failure to pay estimated tax for each of the

6 years involved.

Additional adjustments to petitioner’s self-employment taxes

and deduction for self-employment taxes are computational in

nature and will be resolved by our holdings on the foregoing

issues.

Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years at

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

To facilitate disposition of the foregoing issues, we shall

first make general findings of fact and then combine our findings

and opinion with respect to each issue.

I. General Findings of Fact

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

The stipulations of the parties, with accompanying exhibits, are
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incorporated herein by this reference. At the time the petition

was filed in this case, petitioner resided in Dana Point,

California.

From 1984 through 1999, petitioner operated a sole

proprietorship under the name of Dana Point Bicycle Sport

(Bicycle Sport). Bicycle Sport was an independent bicycle retail

store engaged primarily in the business of selling new bicycles

and bicycle-related products to consumers and of repairing

bicycles.

Petitioner failed to timely file Federal income tax returns

or to pay any estimated taxes for the years at issue. As a

result, a revenue agent with the Internal Revenue Service,

Darrell Cavender, contacted petitioner in 1994 in an attempt to

secure the delinquent returns. When petitioner failed to submit

the requested returns, notices of deficiency based on records

obtained from third parties were issued to petitioner for the

subject years on April 29, 1996.

Thereafter, on October 26, 1998, petitioner filed tax

returns for all 6 years. Through the information provided on

such returns and additional financial materials obtained,

respondent concluded that the amounts for which petitioner was

determined to be liable should be reduced. At initial hearings

in this case on March 20 and 27, 2000, respondent communicated to

the Court the following revised amounts in dispute:
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Taxable Income Tax Additions
Year Deficiency To Tax

1986 $11,062.00 $3,300.73
1988 3,927.00 1,234.37
1989 43,131.00 13,699.70
1990 20,276.00 6,396.52
1991 19,610.00 6,023.24
1992 9,182.00 2,695.96

Respondent also informed petitioner at the hearings that

further adjustments would be made if petitioner demonstrated

nontaxable sources of income and/or business expenses in excess

of those underlying respondent’s revised computations, provided

evidence of a cost basis in property generating capital gains, or

substantiated certain amounts claimed as itemized deductions.

Petitioner did not do so, and respondent’s position regarding

petitioner’s tax liabilities remained substantially unchanged at

the time of trial on March 21, 2001. Petitioner appeared and

testified at trial but did not provide any further documentation

relating to his financial affairs. Subsequent to the

proceedings, respondent filed a posttrial brief; petitioner did

not.

II. Net Income From Proprietorship

The income of a sole proprietorship must be included in

calculating the income and tax liabilities of the individual

owning the business. Sec. 61(a)(2). The net profit or loss of
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such an enterprise is generally computed on Schedule C, Profit or

Loss From Business, by subtracting cost of goods sold and

ordinary and necessary business expenses from the gross receipts

of the venture. For the years at issue, respondent calculated

petitioner’s net income from Bicycle Sport through a combination

of accepting in whole or in part figures reported on petitioner’s

late-filed returns and of employing indirect methods to supply

missing or additional data.

Taxpayers are required to maintain records sufficient to

establish the existence and amount of all items reported on the

tax return, including both income and deductions therefrom. Sec.

6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd.

540 F.2d 821 (5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs.

In absence of books and records adequate to determine a

taxpayer’s proper tax liability, the Commissioner is authorized

to reconstruct income by any reasonable method which will clearly

reflect income. Sec. 446(b); Commissioner v. Hansen, 360 U.S.

446, 467 (1959); Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir.

1997); Petzoldt v. Commissioner, 92 T.C. 661, 686-687 (1989).

As a general rule, the Commissioner’s determinations are

presumed correct, and the taxpayer bears the burden of proving

error therein. Rule 142(a); cf. sec. 7491 (generally effective

with respect to examinations commencing after July 22, 1998).

However, the Court of Appeals for the Ninth Circuit, to which
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appeal in the instant case would normally lie, has indicated that

before the presumption of correctness will attach in an

unreported income case, the determination must be supported by at

least a “minimal” factual predicate or foundation of substantive

evidence linking the taxpayer to income-generating activity or to

the receipt of funds. Palmer v. IRS, supra at 1312-1313; see

also Rapp v. Commissioner, 774 F.2d 932, 935 (9th Cir. 1985);

Petzoldt v. Commissioner, supra at 687-689.

Here, the record clearly links petitioner to an income-

producing activity. Bicycle Sport, even according to

petitioner’s own returns, generated substantial gross sales in

each of the years at issue. Accordingly, respondent’s

reconstructions of the business’s profits, to the extent they

reveal unreported income, are supported by the requisite factual

predicate for placing the burden to show otherwise upon

petitioner.

A. 1986

On the Schedule C attached to petitioner’s 1986 Form 1040,

U.S. Individual Income Tax Return, gross receipts from Bicycle

Sport are shown as $311,159. After deductions, petitioner

reported a net loss from his business of $5,063. Respondent

accepted, and the parties stipulated, that gross sales in 1986

were $311,159. However, because petitioner provided no records

substantiating his claimed expenditures, respondent used industry
 - 8 -

statistics to reconstruct expenses. In this endeavor, respondent

relied on a financial survey prepared by the National Bicycle

Dealers Association entitled “The Cost of Doing Business for

Independent Bicycle Retailers”. The survey found that for the

average independent bicycle retailer with total revenue of

between $250,000 and $500,000 in 1993 and 1994: (1) The owner of

the business took a total salary or draws of 7.1 percent of total

revenues, and (2) the shop had a net financial income of 3.8

percent of total revenues. The parties then stipulated that in

1986 the average independent bicycle retailer with total revenue

in the $250,000 to $500,000 range also had owner salary or draws

of 7.1 percent and net financial income of 3.8 percent of total

revenues.

Based on these percentages, respondent computed Bicycle

Sport’s net profit for tax purposes to be $33,916. This number

comprises owner draws of $22,092 (.071 x $311,159), a

nondeductible outlay in this context, and net financial income of

$11,824 (.038 x $311,159). Stated differently, the survey showed

that the average bicycle retailer earned net income for tax

purposes of 10.9 percent of sales (7.1 percent + 3.8 percent) and

incurred deductible or offsetting expenditures of 89.1 percent

(100 percent - 10.9 percent) of sales. Accordingly, here Bicycle
 - 9 -

Sport was determined to have net income of $33,916 after

subtracting expenses of $277,243 (.891 x $311,159) from the

stipulated gross sales.

Petitioner has offered no concrete evidence to establish

either that his business diverged from that of the average

bicycle retailer or that he incurred specific costs in excess of

those taken into account by respondent’s method of

reconstruction. Rather, petitioner has offered testimony,

tangential at best, regarding his standard of living, on the

premise that “My standard of living did not, has not, never has

reflected the amount of income that they alleged, either

originally or now”. He has also relied on unsupported assertions

that his business operated at a loss, such as that in the

following brief colloquy:

THE COURT: All right. You went for 6 years
without making any money? Is that what you’re saying?

MR. COHEN: Yes, sir, absolutely.

In these circumstances, we conclude that respondent has

employed a reasonable method for reconstructing petitioner’s

Schedule C income for 1986 and that petitioner has failed to

carry his burden of showing such method to be in error. As the

Court of Appeals for the Ninth Circuit has expressly stated:

“Courts have long held that the IRS may rationally use statistics

to reconstruct income where taxpayers fail to offer accurate
 - 10 -

records.” Palmer v. IRS, 116 F.3d at 1312. Petitioner must

report business income from Bicycle Sport of $33,916 for the 1986

taxable year.

B. 1988, 1990, and 1992

For the 1988, 1990, and 1992 taxable years, the Schedules C

submitted by petitioner reflected gross sales from Bicycle Sport

of $584,120, $731,881, and $617,273, respectively. After offsets

and deductions, petitioner reported a net loss of $78,316 in

1988, a net profit of $15,380 in 1990, and a net loss of $7,105

in 1992. Petitioner has at no time provided books and records to

document the calculation of these amounts.

With respect to these years, respondent was able to obtain

the financial records necessary to perform a bank deposits

analysis. The use of the bank deposits method for computing

unreported income has long been sanctioned by the courts. Factor

v. Commissioner, 281 F.2d 100, 116 (9th Cir. 1960), affg. T.C.

Memo. 1958-94; Clayton v. Commissioner, 102 T.C. 632, 645 (1994);

DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16

(2d Cir. 1992). Underlying this method is the principle that

bank deposits constitute prima facie evidence of income. Clayton

v. Commissioner, supra at 645; DiLeo v. Commissioner, supra at

868; Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). A bank

deposits analysis must generally encompass the following: (1) A

totaling of bank deposits; (2) the elimination from such total of
 - 11 -

any amounts derived from duplicative transfers or nontaxable

sources of which the Commissioner has knowledge; (3) the further

reduction of the adjusted total by any deductible or offsetting

expenditures of which the Commissioner is aware. Clayton v.

Commissioner, supra at 645-646; DiLeo v. Commissioner, supra at

868.

As previously indicated, the burden here rests on petitioner

to show error in respondent’s analysis, either by proving a

nontaxable source for deposits or by substantiating allowable

expenditures. Rule 142(a); Clayton v. Commissioner, supra at

645; Estate of Mason v. Commissioner, 64 T.C. 651, 656-657

(1975), affd. 566 F.2d 2 (6th Cir. 1977). In some circumstances

(e.g., fraud cases), the Commissioner may be expected to

investigate leads of nontaxable sources that are “reasonably

susceptible of being checked.” Holland v. United States, 348

U.S. 121, 135-136 (1954); see also Tunnell v. Commissioner, 74

T.C. 44, 57-58 (1980), affd. 663 F.2d 527 (5th Cir. 1981).

However, this “lead-check rule” has been held inapplicable where

the taxpayer bears the burden of proof or where purported leads

are vague and unsupported by any evidence. Tunnell v.

Commissioner, supra at 57-58.

During 1988, petitioner maintained a single business bank

account in the name of Bicycle Sport at the Dana Niguel Bank. A

second business bank account was opened in the name of Bicycle
 - 12 -

Sport on October 18, 1989, at Monarch Bank. After a period of

inactivity, the Dana Niguel Bank account was closed on June 8,

1990, with a final withdrawal of $2,388.87. Using records for

these accounts, respondent determined petitioner’s net income

from Bicycle Sport as follows:

1988 1990 1992
Total Deposits $783,228.10 $741,074.36 $674,278.00
Less: Transfers 0.00 2,388.37 0.00
Subtotal 783,228.10 738,685.99 674,278.00
Less: Checks & Debits 777,215.48 760,520.95 679,358.26
Subtotal 6,012.62 -21,834.96 -5,080.26
Plus: Owner Draws 10,640.00 64,400.00 52,200.00
Subtotal 16,652.62 42,565.04 47,119.74
Plus: Additional Draws 0.00 8,500.00 0.00
Subtotal 16,652.62 51,065.04 47,119.74
Less: Gifts, Loans, Etc. 0.00 0.00 0.00
NET INCOME $16,652.62 $51,065.04 $47,119.74

We consider the sustainability of respondent’s analysis

first by addressing whether petitioner has shown entitlement to

further offsetting or deductible expenditures and, second, by

deciding whether petitioner has proven nontaxable sources for the

deposits in the Bicycle Sport accounts.

In performing the above calculations, respondent treated as

deductible business expenses all checks drawn on the Bicycle

Sport accounts except for those determined to be owner draws.

For the majority of these sums characterized as nondeductible

draws, the record contains copies of checks which are made
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payable to petitioner, have the word “Draw” written in the space

for “Description”, and specify a check amount in round hundred-

dollar increments. Petitioner does not dispute that these and

similar checks totaled $10,640, $64,400, and $52,200 for 1988,

1990, and 1992, respectively. However, for December of 1990, no

copies of the checks drawn on Bicycle Sport’s account were made

available to respondent. Because the bank statements for

December showed two checks in even amounts similar to those

identified as draws, respondent concluded that these, too,

represented nondeductible draws of an additional $8,500.

Petitioner has offered no evidence establishing that the

amounts treated as draws should in fact be characterized as

deductible expenditures. Rather, petitioner’s testimony at trial

seems to indicate that these sums were in fact owner draws but

that petitioner holds a misguided interpretation of the income

tax consequences thereof. For instance, the discussion set forth

below illustrates petitioner’s apparent position.

MR. COHEN: I’m saying that some of those came--
some of that came from--as a draw on equity, which I’m
legally entitled to do as a nontaxable event. If I
have that money that I’ve put into the business, then
I’m allowed to take that back out and not declare that
as--that doesn’t have to necessarily be a taxable
event.

* * * * * * *
 - 14 -

MR. COHEN: Not only that, but I’m saying that
some of the money that I started the business with, if
I started the business with x number of dollars, I’m
allowed to draw that x number of dollars out, without
it being income.

THE COURT: Well, that’s your version. You can
draw it out, but it’s subject to income tax. The
business has to pay--

* * * * * * *

THE COURT: I mean, you don’t just arbitrarily
draw money out of a business account and say, well,
this is equity, I don’t have to worry about the tax due
on it. You can’t--that’s just not the way things
operate.

Given this testimony, we have no basis on which to conclude

that the amounts treated as draws in respondent’s bank deposits

analysis represent deductible expenditures. Petitioner has not

so much as alleged any specific business expenses that were

omitted from respondent’s calculations. Hence, petitioner has

failed to prove his entitlement to any reduction in the net

business income determined by respondent on account of additional

costs incurred by Bicycle Sport.

We next turn to whether such net income should be decreased

to reflect nontaxable sources for the funds deposited in the

Bicycle Sport accounts. On several occasions during the

examination and at trial, petitioner alluded to potential

nontaxable sources in the form of inheritances, gifts, and loans

from family members and a friend, Anthony Turley. However, none

of these receipts have been substantiated. The minimal record
 - 15 -

which relates thereto is vague as to both timing and amount. Mr.

Cavender inquired during the examination of petitioner’s parents

regarding alleged loans and/or gifts, but petitioner’s parents

could not recall when or how much was remitted to petitioner.

Mr. Turley likewise admitted that he was unsure of the dates when

any particular loans were made. When questioned at trial

regarding a claimed 1987 inheritance from his grandmother,

petitioner indicated that the funds were used at least in part to

buy a condominium. Similarly, an alleged loan from petitioner’s

sisters was linked to the purchase of a home. Significantly,

petitioner never asserted that these nontaxable sums were

deposited in Bicycle Sport’s accounts.

We conclude that petitioner has not proven any of the

deposits into the Bicycle Sport accounts, other than the single

transfer identified by respondent, to be attributable to

nontaxable sources. (We also note, for the sake of completeness

and because the parties have made assertions with respect

thereto, that this record reveals no reasonably definitive leads

which respondent failed to check.) We hold that petitioner must

report business income from his sole proprietorship in the

amounts of $16,652.62, $51,065.04, and $47,119.74 for the years

1988, 1990, and 1992, respectively, in accordance with

respondent’s bank deposits analysis.
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C. 1989 and 1991

For the 1989 and 1991 taxable years, the Schedules C

submitted by petitioner reported gross sales in the respective

amounts of $711,728 and $541,005. After reduction for costs and

expenses, Bicycle Sport was shown as having earned a net profit

of $124,325 in 1989 and $77,258 in 1991. Respondent has accepted

these figures as representing petitioner’s net business income

for such years, due in part to a lack of complete records for

performance of a bank deposits analysis. Since petitioner has

never specifically addressed these years in his generalized

arguments to the Court, we likewise hold petitioner to the

amounts stated on his own returns.

III. Capital Gain

As a general rule, a taxpayer is required on the disposition

of property to report as capital gain the excess of the amount

realized on disposition over his or her adjusted basis in the

property. Sec. 1001. On petitioner’s 1989 and 1990 returns, he

reported capital gain from the sale of stock in the amounts of

$10,490 and $9,227, respectively. The attached Schedules D,

Capital Gains and Losses, each show a sales price equal to the

full amount reported as gain and neither reflect nor deduct

therefrom any “Cost or other basis”. At trial, however,

petitioner seemed to contend, albeit rather obliquely, that he

was entitled to offset his reported gains by some amount other
 - 17 -

than a zero basis. Nonetheless, he did not offer any specific

figures in his testimony and did not produce any documentation

regarding how, when, or at what prices he obtained the shares.

Thus, absent any data in the record which would support a

recalculation of petitioner’s capital gains, we hold petitioner

to the $10,490 and $9,227 figures stated on his returns.

IV. Filing Status

The filing status of an individual for income tax purposes

is determined as of the close of the taxable year. Sec.

7703(a)(1). In applying this rule, however, an individual

legally separated from his or her spouse will not be considered

as married. Sec. 7703(a)(2). Here there appears to be a dispute

between the parties regarding whether petitioner’s filing status

for 1992 should be single or married filing separate.

The parties have stipulated that petitioner was married on

August 19, 1990; that he and his wife separated on January 15,

1993; and that the couple did not file joint returns in 1990,

1991, or 1992. Accordingly, respondent has acknowledged on brief

that petitioner’s filing status was single for tax years prior to

1990. In addition, the parties have stipulated that petitioner’s

filing status was married filing separate in 1990 and 1991. It

is respondent’s position that married filing separate is the

appropriate status for 1992 as well. Petitioner, on the other

hand, has refused to agree to a stipulation to such effect. Yet
 - 18 -

he has also declined to provide any argument whatsoever related

to his filing status and relationship with his wife. Therefore,

since there is no evidence in the record that petitioner and his

wife were separated before January of 1993, we hold that

petitioner’s status for 1992 is married filing separate.

V. Standard Deduction or Itemized Deductions

An individual who does not elect to itemize his or her

deductions is entitled to the standard deduction specified for

his or her filing status. Sec. 63(b) and (c). Petitioner did

not elect to itemize on his 1986, 1988, or 1989 returns, and

respondent does not disagree with such treatment. For 1990,

1991, and 1992, petitioner claimed itemized deductions of

$22,710, $25,143, and $24,663, respectively, attributable solely

to alleged home mortgage interest. Because respondent has

conceded that petitioner is entitled to deduct the interest

reported for 1991 and 1992, subject to computational statutory

limits thereon, only the 1990 deductions remain at issue.

Respondent asserts that petitioner has not substantiated his

interest payments for 1990, and once again the record is devoid

of any evidence provided by petitioner on this matter. We

sustain respondent’s position in affording petitioner only the

standard deduction for 1990.
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VI. Section 6651(a)(1) Addition to Tax

Section 6651(a)(1) imposes an addition to tax for

delinquency in filing returns and provides in relevant part as

follows:

SEC. 6651. FAILURE TO FILE TAX RETURN OR TO PAY TAX.

(a) Addition to the Tax.--In case of failure–

(1) to file any return required under
authority of subchapter A of chapter 61 * * * , on
the date prescribed therefor (determined with
regard to any extension of time for filing),
unless it is shown that such failure is due to
reasonable cause and not due to willful neglect,
there shall be added to the amount required to be
shown as tax on such return 5 percent of the
amount of such tax if the failure is for not more
than 1 month, with an additional 5 percent for
each additional month or fraction thereof during
which such failure continues, not exceeding 25
percent in the aggregate.

The Supreme Court has characterized the foregoing section as

imposing a civil penalty to ensure timely filing of tax returns

and as placing on the taxpayer “the heavy burden of proving both

(1) that the failure did not result from ‘willful neglect,’ and

(2) that the failure was ‘due to reasonable cause’”, in order to

escape the penalty. United States v. Boyle, 469 U.S. 241, 245

(1985). “Willful neglect” denotes “a conscious, intentional

failure or reckless indifference.” Id. “Reasonable cause”

correlates to “ordinary business care and prudence”. Id. at 246

& n.4; sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
 - 20 -

Section 6012(a)(1)(A) further delineates that an individual

is required to file a tax return for any year in which his or her

gross income exceeds the sum of the applicable exemption amount

and standard deduction for such taxpayer. In this context, gross

income includes “Gross income derived from business”, sec.

61(a)(2), which in turn is defined as “total sales, less the cost

of goods sold,” plus certain other items, sec. 1.61-3(a), Income

Tax Regs. Business expenses, as distinct from cost of goods

sold, are not subtracted in ascertaining gross business income.

Id.

Here, petitioner did not file tax returns for 1986, 1988,

1989, 1990, 1991, and 1992 until October of 1998. Such returns

were untimely by a large margin. See sec. 6072(a). Furthermore,

the returns, even as filed, reflect substantial gross income

derived from Bicycle Sport and thus clearly place petitioner over

the filing threshold.

Petitioner, however, has fallen far short of establishing

reasonable cause for his repeated failure to file timely tax

returns. Other than vague references to loss of records and

perhaps the misguided belief that he owed no taxes, petitioner

has not offered any explanation for his delinquency. We

therefore hold that petitioner is liable for the section

6651(a)(1) addition to tax for each of the taxable years at

issue.
 - 21 -

VII. Section 6654 Addition to Tax

Section 6654(a) provides for an addition to tax in the case

of any underpayment of estimated tax by an individual. Where

payments of tax, through either withholding or the making of

estimated quarterly tax payments, do not equal the percentage of

total liability required under the statute, imposition of the

addition is automatic and mandatory, unless one of the statutory

exceptions enumerated in section 6654 is shown by the taxpayer to

apply. Sec. 6654(a)-(e), (g); Grosshandler v. Commissioner, 75

T.C. 1, 20-21 (1980). Since petitioner paid no estimated taxes

and has offered no evidence indicating any of the exceptions to

be applicable here, we sustain respondent on this issue for each

of the taxable years under consideration.

To reflect the foregoing and the parties’ concessions,

Decision will be entered

under Rule 155.