COHEN v. COMMISSIONER

T.C. Memo. 2003-42

UNITED STATES TAX COURT

BRADLEY M. COHEN AND KATHY A. COHEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9453-00. Filed February 24, 2003.

Robert C. Keller, for petitioners.

James N. Beyer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined a deficiency of $20,556

in petitioners’ Federal income tax for 1996. Respondent also

determined an addition to tax of $3,718 under section 6651(a)(1)

and a penalty of $3,505.20 under section 6662(a). Subsequently,

through an amendment to answer, respondent asserted an increased

deficiency of $135,120, addition to tax of $27,024, and penalty
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of $22,912.80. After concessions, the issues for decision are:

(1) Whether petitioners failed to report income reflected in bank

deposits controlled by them; (2) whether income reported on

Schedule C, Profit or Loss From Business, should be

recharacterized as wages and accompanying deductions disallowed;

(3) whether petitioners are liable for an addition to tax under

section 6651(a); and (4) whether petitioners are liable for an

accuracy-related penalty under section 6662(a).

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year 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 the stipulated

facts are incorporated in our findings by this reference. In

addition, because petitioners failed to comply with an order to

supplement their responses to respondent’s request for

admissions, some facts are deemed admitted pursuant to Rule 90.

Petitioners resided in Ottsville, Pennsylvania, at the time

they filed their petition.

Bradley Mark Cohen Enterprises, Inc.

Bradley M. Cohen (petitioner) was the sole shareholder and

sole corporate officer of Bradley Mark Cohen Enterprises, Inc.

(BMC), until its dissolution on December 31, 1994. During its
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existence, BMC elected to be treated as an S corporation. BMC

maintained a bank account with Corestates Bank (BMC account), and

petitioner deposited $59,609.62 into this account during 1996.

BMC did not file a 1996 Form 1120S, U.S. Income Tax Return for an

S Corporation, to report the $59,609.62 as gross receipts. The

deposits into the BMC account were not reported as income on

petitioners’ 1996 return or otherwise accounted for by

petitioners.

Nationwide Home Improvement Limited

Petitioner was also the sole shareholder and sole corporate

officer of Nationwide Home Improvement Limited (NHIL) during

1996. NHIL conducted remodeling services and aided customers in

securing financing for improvements. Petitioner filed a

Form 2553, Election by a Small Business Corporation, to change

the status of NHIL from a C corporation to an S corporation

effective as of January 1, 1996. The Internal Revenue Service

(IRS) approved the election in 1995.

During 1996, petitioner provided management services to

NHIL, working about 20 to 30 hours per week. These services

included petitioner’s meeting with clients and conducting sales

for NHIL. NHIL paid $20,680 to petitioner as compensation for

the management services provided. On NHIL’s return, the

preparer, Joseph M. Grey (Grey), treated this amount as

compensation paid to an officer.
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NHIL maintained a Meridian bank account (NHIL account), and

petitioners deposited $442,623.33 into the account in 1996. Of

these deposits, $8,800 were nontaxable insurance proceeds and

nontaxable transfers from other bank accounts controlled by

petitioners. NHIL filed a Form 1120, U.S. Corporation Income Tax

Return, for 1996. NHIL reported gross receipts of $247,743.79

and taxable income of $290.37. Thus, in 1996, NHIL had total

unexplained deposits of $186,079.54.

NHIL received four payments totaling $24,180 in 1996 from

Green Tree Financial Servicing Corp. (Green Tree income). These

payments were not deposited into the NHIL account or any other

account controlled by petitioners.

Personal Finances

On November 21, 1995, petitioners purchased a house for

$681,000 in Ottsville, Pennsylvania. Petitioners secured a

mortgage on the property through GE Capital Mortgage Corp. In

order to qualify for the mortgage, petitioners completed a

mortgage application, reporting a base monthly income of $14,860

from NHIL.

Petitioners maintained two accounts with Union National Bank

during 1996. One account was titled “Nationwide Home Remodelers

Group, Bradley Mark Cohen” (Nationwide account), and the second

was titled “Bradley Mark Cohen or Kathy Cohen” (Cohen account).

In 1996, petitioners deposited $16,017.50 into the Nationwide
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account. Of these deposits, $3,500 were nontaxable transfers

from bank accounts controlled by petitioners. Petitioners also

deposited $141,130.52 into the Cohen account during 1996. Of

these deposits, $74,857 represented nontaxable items.

Petitioners had unexplained deposits into the two accounts in

1996 totaling $78,791.02.

During 1996, petitioners maintained a brokerage account with

Bear, Sterns & Co., Inc. (brokerage account). Petitioners

recognized short- and long-term capital gains of $18,521 in 1996.

Federal Tax Returns

Grey acted as petitioners’ accountant and filed both

business and personal returns for petitioners beginning in or

around 1983. Petitioners filed a joint Federal income tax return

for 1996 on July 18, 1997. They reported adjusted gross income

of $10,075.42, no taxable income, and self-employment tax of

$1,067.77. On their Schedule C, petitioners reported gross

receipts of $20,680, other income of $80, and expenses of

$13,202.96. Petitioners reported a net profit of $7,557.04 as

business income on their return. Grey prepared petitioners’

personal return and the Form 1120 for NHIL. Grey reviewed the

return with petitioners, who then signed the return.

On July 8, 1998, petitioners filed a Form 1040X, Amended

U.S. Individual Income Tax Return, for 1996. The only change

reported on this return was a claim by petitioners for the earned
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income tax credit for 1996. As a result of filing the amended

return, petitioners received a refund of tax in the amount of

$3,030.

Procedural Matters

The examination of petitioners’ income tax liability for

1996 arose out of an examination of NHIL’s employment tax

liability. During the examination, petitioners did not provide

any information to respondent’s revenue agent and failed to

produce bank records or documentation in support of their

position. Petitioners informed Grey, who represented petitioners

during the audit, that the records were missing or were not in

their possession.

The notice of deficiency was sent to petitioners on July 13,

2000, shortly prior to expiration of the period of limitations.

Third-party records received pursuant to summonses for various

bank accounts were received by the IRS subsequent to the notice

of deficiency and disclosed additional bank deposit income.

Respondent then amended his answer to allege an increased

deficiency, addition to tax, and penalty.

On July 12, 2001, petitioners answered respondent’s

interrogatories and request for admissions. The interrogatories

specifically asked petitioners to identify any nontaxable sources

of the deposits made into the Nationwide account, the Cohen

account, or the NHIL account. Petitioners responded that they
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could not identify any document showing a nontaxable source

because they were not in possession of their records. The

interrogatories asked petitioners to:

Provide the name, current address, current
telephone number, and occupation of all persons who
have any personal knowledge as to the non-taxable
sources of deposits into petitioner husband’s Union
National Bank account * * * [Nationwide account] for
the year 1996 and referred to above. Also provide a
description of their anticipated testimony and indicate
the persons’ relationship to petitioners.

Respondent used similar language to inquire about the Cohen

account and the NHIL account. Petitioners responded that they

were “not aware of anyone at present having any knowledge of

information mentioned in Respondent’s interrogatory”.

Petitioners used similar language in response to interrogatories

referring to the Cohen account and the NHIL account.

Respondent requested that petitioners produce documents

relating to deposits made into each of their accounts.

Specifically, respondent requested that petitioners “provide all

work papers, deposit slips, bank statements, and any other

documents showing the correct non-taxable transfers and the

nature of those non-taxable items” for the Nationwide account,

the Cohen account, the BMC account, and the NHIL account. On

July 12, 2001, petitioners responded to the request for

production of documents by stating “petitioners do not presently

have any record mentioned herein.”
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OPINION

I. Unreported Income From Bank Deposits

It is a taxpayer’s responsibility to maintain adequate books

and records sufficient to establish his or her income. See sec.

6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), affd. 959

F.2d 16 (2d Cir. 1992). When a taxpayer fails to maintain these

records, respondent may determine income under the bank deposits

method. Id. A bank deposit is prima facie evidence of income.

Id. at 868; Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). The

bank deposits method of reconstruction assumes that all money

deposited into a taxpayer’s account is taxable income, unless the

taxpayer can show a nontaxable source for the income. See DiLeo

v. Commissioner, supra at 868.

A. Income From BMC

Based on deposits made into the BMC account, respondent

determined in the notice of deficiency that petitioners had

unreported flowthrough income from the S corporation in the

amount of $59,609.62. Petitioners’ sole argument on this issue

is that BMC ceased to be in existence prior to 1996 because

petitioner submitted an “Out of Existence/Withdrawal Affidavit”

to the Commonwealth of Pennsylvania.

Petitioners bear the burden of showing that the deposits

made into an account that they control represent nontaxable

income. The burden does not shift to respondent under section
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7491, because petitioners failed to introduce credible evidence

of the nontaxable nature of the deposits and petitioners failed

to maintain adequate records to support their position. By using

the bank deposits method, respondent has made a prima facie case

that petitioners have received income. In any event, petitioners

have stipulated to the amount of the deposits made into the BMC

account and have offered no argument as to the nontaxable nature

of the amounts. Petitioners’ argument that BMC was not in

existence is irrelevant to this issue because petitioners

remained in control of the BMC account during 1996. We therefore

conclude that the $59,609.62 represents additional unreported

income to petitioners.

B. Unreported Self-Employment Income and Flowthrough
Income From NHIL

Respondent asserts that petitioners received $78,791.02 of

self-employment income based on unexplained bank deposits made

into the Nationwide account and the Cohen account. Respondent

also asserts that petitioners received flowthrough income from

NHIL of $210,549.91 based on unexplained deposits of $186,079.54

made into the NHIL account, the Green Tree income of $24,180, and

NHIL’s taxable income of $290.37 erroneously reported on

Form 1120. Petitioners have admitted receipt of the Green Tree

income and have not shown that the S corporation election made by

them for 1996 was not effective. We focus then on the treatment
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of the unexplained deposits into all three of the accounts

totaling $264,870.56.

The burden of proof with respect to the unreported income

still in dispute is on respondent because he asserted the

increased deficiencies in his amendment to answer. Rule 142(a).

Because petitioners failed to maintain adequate records of their

business activities for 1996, the IRS secured petitioners’

records to determine income under the bank deposits method.

Based on the bank records for the Nationwide account, the Cohen

account, and the NHIL account and on the stipulated facts

concerning deposits into those accounts, respondent determined

that petitioners had unreported income. Respondent has met his

burden, and petitioners must show that the deposits arose from

nontaxable sources.

Petitioners dispute respondent’s computation by combining

all of the unreported income into a total of $289,341, including

the deposits, the Green Tree income, and NHIL’s income. Of this

amount, petitioners “admit to unreported income of $121,722.45”

and dispute only $167,618.55.

Petitioners assert that $47,618.55 represents “gross

proceeds from the sale of capital assets which were deposited

into various accounts under the control of the Petitioners.”

Petitioners raised this argument in their reply brief.

Although petitioners’ argument is somewhat unintelligible, they
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appear to claim that this amount should be considered as

additional nontaxable income because it was transferred from

another account under petitioners’ control. However, petitioners

stipulated prior to trial to the amount of the deposits that

represented nontaxable amounts, and we are not persuaded that

respondent did not already consider sales proceeds in determining

nontaxable transfers, in part because the amounts stipulated as

nontaxable exceeded the sales proceeds. Petitioners failed to

identify or prove specific deposits made into their bank accounts

from their brokerage account that coincide in time or amount to

the sales of capital assets. Petitioners are raising a belated

argument based on speculation that lacks credibility.

Petitioners dispute the remaining $120,000, claiming that

this amount represented a loan from petitioner’s deceased father.

Prior to trial, during examination of their return and in

response to discovery requests, petitioners did not mention any

loan from petitioner’s father. At trial, petitioner testified

that he received a loan from his father in 1996 of $140,000 that

was paid to him over time, in various increments, in both cash

and wire transfers. Petitioner stated that about $50,000 or

$60,000 was lent to him in cash and was deposited in various bank

accounts maintained by petitioners. Petitioner stated that he

repaid about $6,000 of the loan prior to his father’s death.

Petitioners claim in their reply brief that $120,000 of the loan
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was actually deposited into their accounts and that the remaining

$20,000 was used to “pay expenses”.

An alleged loan agreement between petitioner and his father

was presented at trial but was not received into evidence because

petitioners had failed to comply with the Court’s standing

pretrial order concerning exchange of documents. The late

production of the document prejudiced respondent’s ability to

test its authenticity. In any event, there was no reliable

evidence of funds actually transferred to petitioner from his

father. Petitioners failed to file a trial memorandum required

by the Court’s standing pretrial order, but at the calendar call

petitioners’ counsel represented to the Court that petitioner’s

mother would be a witness. She was never called to testify,

leaving petitioner’s testimony uncorroborated. The

uncorroborated testimony offered by petitioner lacks credibility

and contradicts the stipulations, and we decline to accept

petitioners’ belated explanation as proof of nontaxable deposits.

See, e.g., Tokarski v. Commissioner, 87 T.C. at 76-77.

Petitioner testified at trial that about $27,000 of NHIL’s

receipts were deposits from customer accounts that were later

refunded or returned to the customers. Petitioners failed to

provide any documentation of these refunds until the day before

trial occurred and have not shown that they represented items

included in their reported receipts. Petitioners also failed to
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identify these refund amounts in response to discovery requests.

We are not persuaded that these amounts should be offset against

petitioners’ unreported income from NHIL.

II. Employment Status

Respondent determined in the notice of deficiency that

$20,760 reported on petitioners’ Schedule C as income from NHIL

should be recharacterized as wages and that the business

deductions claimed by petitioners on Schedule C should be

disallowed for lack of substantiation or claimed only as employee

expenses on Schedule A, Itemized Deductions. Respondent argues

that petitioner was an employee of NHIL because he was an officer

who performed substantial services for NHIL.

Petitioner asserts that he was not an employee of NHIL.

Petitioners rely on several arguments that have been rejected in

analogous circumstances.

Under section 3121(d)(2), the term “employee” includes any

individual who has the status of an employee under the common

law. Paragraphs (1), (3), and (4) of section 3121(d) describe

other individuals who are considered employees regardless of

their status under the common law. Individuals described within

those paragraphs are commonly referred to as “statutory”

employees. See Joseph M. Grey Pub. Accountant, P.C. v.

Commissioner, 119 T.C. 121, 126 (2002).
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One category of statutory employee is defined as “any

officer of a corporation”. Sec. 3121(d)(1). Regulations clarify

the scope of section 3121(d) in determining the employee status

of corporate officers as follows:

Generally, an officer of a corporation is an employee
of the corporation. However, an officer of a
corporation who as such does not perform any services
or performs only minor services and who neither
receives nor is entitled to receive, directly or
indirectly, any remuneration is considered not to be an
employee of the corporation. * * * [Sec. 31.3121(d)-
1(b), Employment Tax Regs.]

Consequently, if an officer performs substantial services for a

corporation, and receives remuneration for those services, that

officer is an employee. See Veterinary Surgical Consultants,

P.C. v. Commissioner, 117 T.C. 141 (2001), affd. sub nom. Yeagle

Drywall Co. v. Commissioner, 54 Fed. Appx. 100 (3d Cir. 2002).

In this case, petitioner falls within the definition of an

employee because he was an officer of NHIL who provided

substantial services. Petitioner worked about 20 to 30 hours a

week for NHIL throughout the year; he ran the company; he was the

only individual who provided management services; and he received

compensation for those services.

Petitioners argue that respondent has disregarded the

employer and employee relationship under common law in

determining petitioner’s status. Petitioners focus on the

argument that respondent disregards the “question of fact as to

whether the corporation exercises any control over its officer.”
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They argue that “an employer cannot be his own employee” and that

no other person controlled petitioner in his work for NHIL. To

accept petitioners’ contentions that there was a lack of control

over petitioner would be the equivalent of disregarding the

corporate form in which petitioner chose to conduct his business.

Caselaw does not permit a taxpayer to use his or her dual role as

a shareholder of and service provider to a corporation as grounds

for ignoring the legal ramifications of the business form he

selected. See Moline Props., Inc. v. Commissioner, 319 U.S. 436,

438-439 (1943); Joseph M. Grey Pub. Accountant, P.C. v.

Commissioner, supra at 129.

Respondent properly recharacterized petitioner’s income as

wages and disallowed petitioners’ Schedule C deductions.

Petitioners claim that they are entitled to deductions not

previously claimed for business expenses, mortgage interest, and

real estate tax payments for 1996. Respondent has conceded

petitioners’ deductions for mortgage interest and real estate

taxes.

Petitioners claim that checks were written from their

accounts for various expenses that would have been deductible if

they had itemized their deductions at the time of filing their

return. Petitioners argue that respondent should have provided

these checks to the Court. However, petitioners bear the burden

of showing their entitlement to deductions. Rockwell v.
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Commissioner, 512 F.2d 882 (9th Cir. 1975), affg. T.C. Memo.

1972-133. Under section 6001, petitioners bear the sole

responsibility for maintaining their business records. They have

neither identified nor proven any additional deductions to which

they are entitled. The categories duplicate those claimed on

NHIL’s return and appear questionable as employee expenses. No

deductions may be allowed on this record.

Addition to Tax and Penalty

Respondent determined an addition to tax for failure to

file timely under section 6651(a)(1) and an accuracy-related

penalty for substantial understatement under section 6662(a).

Respondent has the burden of production under section 7491(c) for

the addition to tax and the penalty and must come forward with

sufficient evidence that it is appropriate to impose the penalty.

See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).

Respondent determined the addition to tax for late filing

because petitioners did not file until July 18, 1997. Section

1.6081-4, Income Tax Regs., provides for an automatic 4-month

extension if the taxpayer files an application for extension on

Form 4868, Application for Automatic Extension of Time to File

U.S. Individual Income Tax Return, on or before the due date for

filing the return if certain requirements are met. There is no

evidence that petitioners applied for an extension of time to
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file their return. Respondent has met his burden under section

7491(c) by establishing petitioners’ late filing.

To avoid the addition to tax for filing a late return,

petitioners have the burden of proving that the failure to file

did not result from willful neglect and that the failure was due

to reasonable cause. See United States v. Boyle, 469 U.S. 241,

245 (1985). To prove reasonable cause, a taxpayer must show that

he or she exercised ordinary business care and prudence but

nevertheless could not file the return when it was due. See

Crocker v. Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.

Petitioners argue against the imposition of the addition to

tax by claiming that they were not in possession of the records

and that they “suffered tragedies in the loss of close

relatives.” Although petitioner testified that his father died

in 1997 and that his mother-in-law and sister-in-law had both

died, it is unclear from the record exactly when these events

occurred. In any event, petitioner continued to carry on a

business throughout the tax year, making a considerable income

from the business. A taxpayer's selective inability to perform

his or her tax obligations, while performing regular business,

does not excuse failure to file. See, e.g., Watts v.

Commissioner, T.C. Memo. 1999-416; Wright v. Commissioner, T.C.

Memo. 1998-224, affd. 173 F.3d 848 (2d Cir. 1999). Petitioners’
 - 18 -

failure to retain their files does not excuse them from their tax

obligations because it is their responsibility to retain those

records. Respondent's determination with respect to the addition

to tax under section 6651(a)(1) is sustained.

Under section 6662(a), a taxpayer may be liable for a

penalty of 20 percent on the portion of an underpayment of tax

attributable to a substantial understatement of tax or due to

negligence or disregard of rules or regulations. Sec. 6662(b).

Whether the penalty is applied because of a substantial

understatement of tax or negligence or disregard of the rules or

regulations, the accuracy-related penalty is not imposed with

respect to any portion of the understatements as to which the

taxpayer acted with reasonable cause and in good faith. Sec.

6664(c)(1); Higbee v. Commissioner, supra at 448-449. The

decision as to whether the taxpayer acted with reasonable cause

and good faith depends upon all the pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant

factors include the taxpayer’s efforts to assess his proper tax

liability, including the taxpayer’s reasonable and good faith

reliance on the advice of a tax professional. See id.

The term "understatement" is defined as the excess of the

amount of tax required to be shown on the return for the taxable

year over the amount of tax shown on the return for the taxable

year. Sec. 6662(d)(2)(A). Based on petitioners’ concessions of
 - 19 -

unreported income of $121,722.45, without even considering our

conclusion that they had additional substantial amounts of

income, a prima facie case exists for imposition of the penalty.

The record in this case negates any mitigation by reasonable

cause, and petitioners have not shown good faith or reasonable

reliance on Grey. Their failure to maintain adequate books and

records constitutes negligence, particularly when that failure

resulted in substantial underreporting of income. See sec.

6662(c). The penalty determined by respondent is sustained.

To reflect the foregoing and the concessions of the parties,

Decision will be entered

under Rule 155.