T.C. Memo. 2006-169
UNITED STATES TAX COURT
RICHARD D. IRVING AND CYNTHIA A. BURROUGH IRVING, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1096-05. Filed August 16, 2006.
Richard D. Irving and Cynthia A. Burrough Irving, pro sese.
Miriam C. Dillard, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: Respondent determined the following
deficiencies, additions to tax, and penalties with respect to
petitioners’ 2000 and 2001 tax years:
Addition to tax Penalty
Year Deficiency Section 6651(a)(1) Section 6662(a)
2000 $32,133.00 $7,473.75 $6,426.60
2001 43,431.65 -- 8,634.19
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Unless otherwise indicated, all section references are to the
Internal Revenue Code, as amended, and all Rule references are to
the Tax Court Rules of Practice and Procedure. The issues to be
decided are: (1) Whether petitioners properly reported the gross
receipts of their business; (2) whether petitioners are entitled
to the business expense deductions they claimed on their returns;
(3) whether petitioners are liable for tax on self-employment
income pursuant to section 1401; (4) whether petitioners are
liable for an addition to tax for failure to file timely pursuant
to section 6651(a)(1); and (5) whether petitioners are liable for
accuracy-related penalties pursuant to section 6662.
FINDINGS OF FACT
Some of the facts in this case have been stipulated. The
stipulated facts and accompanying exhibits are incorporated
herein by this reference.
Petitioners are husband and wife. We hereinafter refer to
Richard D. Irving, individually, as petitioner. At the time of
the filing of the petition, petitioners resided in Eustis,
Florida. During 2000 and 2001, petitioners operated Kingdom
Kreations, an embroidery business specializing in embroidery for
school uniforms. All of petitioners’ business income and
expenses relevant to the instant case relate to their operation
of Kingdom Kreations.
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On March 19, 2002, petitioners filed a joint 2000 Form 1040,
U.S. Individual Income Tax Return (the 2000 tax return). On
Schedule C of the 2000 tax return, petitioners reported gross
receipts of $77,894 and the following business expenses:
Advertising $850
Car and truck expenses 6,890
Office expenses 3,875
Rent or lease
Vehicles, machinery, & equipment 15,400
Supplies 22,450
Taxes and licenses 100
Travel, meals, and entertainment 1,175
Wages 14,250
Other expenses 1,225
Total 66,215
Accordingly, petitioners reported net profit of $11,679,
representing the total income reported by petitioners on the 2000
tax return.
On April 15, 2002, petitioners filed a joint 2001 tax return
(the 2001 tax return). On Schedule C of the 2001 tax return,
petitioners reported gross receipts of $114,589 and the following
business expenses:
Advertising $450
Car and truck expenses 5,710
Office expenses 3,650
Rent or lease
Vehicles, machinery, and equipment 26,400
Supplies 31,642
Travel, meals, and entertainment 1,572
Wages 30,650
Other expenses 950
Total 101,024
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Accordingly, petitioners reported net profit of $13,565,
representing the total income reported by petitioners on the 2001
tax return.
During the years in issue, petitioners maintained ownership
of and access to the following two bank accounts with Bank of
America: (1) Account No. xxxx xxxx 6240 under the name Richard
D. Irving d.b.a. Kingdom Kreations (Account A) and (2) Account
No. xxxx xxxx 7849 under the names Richard D. Irving and Cynthia
A. Irving (Account B). Accounts A and B are hereinafter referred
to collectively as the bank accounts. Petitioners concede that
they paid personal expenses from Account A during the years in
issue. During 2000 and 2001, Bank of America issued monthly bank
statements identifying petitioners’ transactions with respect to
the bank accounts, which bank statements are hereinafter
collectively referred to as the bank statements.
Petitioners maintained their business records with computer
software and stored the records in both electronic and paper
form. Petitioners, however, lost the electronic records due to
computer malfunction, and they subsequently destroyed the paper
records when they ceased to operate Kingdom Kreations.1
1
The record does not indicate the date on which petitioners’
electronic records were lost, and the record does not indicate
the date on which petitioners ceased to operate Kingdom
Kreations.
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In August of 2003, Revenue Agent Fabian A. Gomez commenced
an examination of petitioners’ 2001 and 2002 tax returns.
Petitioners were unable to produce any business records or
substantiating documents, and, therefore, Agent Gomez used the
bank statements to reconstruct petitioners’ income. Agent Gomez
determined petitioners’ gross receipts for the years in issue by
subtracting the deposits that he was able to identify as
nontaxable, such as loan proceeds and transfers from other bank
accounts maintained by petitioners (transfers), from the
aggregate deposits for each year. Petitioners were given the
opportunity to but did not identify on the bank statements the
business expenses for which they claimed deductions. Agent
Gomez, therefore, relied on his own review of the bank statements
to identify business-related payments, which he allowed as
business expense deductions for the years in issue.
On October 15, 2004, respondent issued petitioners a
statutory notice of deficiency with respect to their 2000 and
2001 tax years. Respondent determined that petitioners
understated their gross receipts for the 2000 tax year by $37,634
and for the 2001 tax year by $47,207.2 For both the 2000 and
2
Respondent determined the $37,634.02 understatement of
gross receipts for petitioners’ 2000 tax year by subtracting
gross receipts as reported by petitioners ($77,894) from gross
receipts as determined by Agent Gomez ($115,528.02). Similarly,
respondent determined the $47,207.73 understatement of gross
receipts for petitioners’ 2001 tax year by subtracting gross
(continued...)
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2001 tax years, respondent allowed portions of petitioners’
claimed business expense deductions for supplies and office
expenses but disallowed all others.3 Furthermore, respondent
determined that petitioners are liable for self-employment taxes
of $12,424 for the 2000 tax year and $13,893.57 for the 2001 tax
year. Remaining adjustments set forth by respondent in the
notice of deficiency depend on a Rule 155 computation and need
not be addressed in this opinion.
Petitioner timely petitioned this Court for a
redetermination of the proposed deficiencies.
OPINION
Section 61(a) defines gross income as “all income from
whatever source derived,” including gross income derived from
2
(...continued)
receipts as reported by petitioners ($114,589) from gross
receipts as determined by Agent Gomez ($161,796.73).
3
Specifically, respondent determined that petitioners
overstated Schedule C business expense deductions as follows:
Amount of claimed deduction
disallowed by respondent
Claimed expenses 2000 2001
Advertising $850 $450
Car and truck expenses 6,890 5,710
Office expenses 3,228 2,983
Rent or lease 15,400 26,400
Supplies 18,678 17,031
Taxes and licenses 100
Meals and entertainment 1,175 1,573
Wages 14,250 30,650
Other expenses 1,225 950
Total 61,796 85,747
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business. Taxpayers are required to maintain books and records
that are sufficient to enable the Commissioner to determine their
correct tax liability. Sec. 1.6001-1(a), Income Tax Regs.
The Commissioner may use the bank deposits method to compute
taxpayers’ income in the absence of substantiating business
records. Estate of Mason v. Commissioner, 64 T.C. 651, 656
(1975), affd. 566 F.2d 2 (6th Cir. 1977). Bank deposits are
prima facie evidence of income. Id. The bank deposits method of
reconstruction assumes that all of the money deposited into a
taxpayer’s account is taxable income unless the taxpayer can show
that the deposits are not taxable. DiLeo v. Commissioner, 96
T.C. 858, 868 (1991), affd. 959 F.2d 16 (2d Cir. 1992). The
Commissioner, however, must take into account any nontaxable
items or deductible expenses of which the Commissioner has
knowledge. Id.
In the instant case, section 7491(a) does not shift the
burden of proof to respondent because petitioners failed to
maintain records or comply with substantiation requirements as
required under section 7491(a)(2)(A) and (B). Consequently,
petitioners bear the burden of proving that respondent’s
determination of income based on the bank deposits method is
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).
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Petitioners do not dispute respondent’s use of the bank
deposits method of reconstruction and do not allege any specific
error in respondent’s computations. Rather, we understand
petitioners to contend that they maintained business records
during the years in issue that were subsequently lost or
destroyed, that the 2000 and 2001 tax returns accurately reported
petitioners’ income and expenses for the years in issue in
accordance with their lost or destroyed business records, and
that respondent’s determinations are therefore erroneous.
The record demonstrates that petitioners failed to produce
books and records from which respondent could determine their tax
liability for the years in issue. Consequently, we conclude that
respondent’s use of the bank deposits method was proper. See
Estate of Mason v. Commissioner, supra. The record further
demonstrates that respondent properly computed the gross receipts
and business expenses for petitioners’ 2000 and 2001 tax years
under the bank deposits method, as discussed below.
With respect to petitioners’ gross receipts, the parties
stipulated that deposits into the bank accounts during 2000
totaled $222,467.13, including $90,804.03 of nontaxable items and
$16,135.08 of transfers.4 Additionally, the parties stipulated
that deposits into the bank accounts during 2001 totaled
4
We note that such “transfers” are nontaxable and could have
been grouped together with the other nontaxable items.
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$187,331.24, including $14,969.51 of nontaxable items and $10,565
of transfers. Based upon the amounts stipulated, respondent
determined that petitioners had gross receipts of $115,528.02 in
2000 and that petitioners had gross receipts of $161,796.73 in
2001.5 As noted above, petitioners reported gross receipts of
$77,894 in 2000 and $114,589 in 2001. In light of the parties’
stipulations, we conclude that petitioners have failed to meet
their burden of proving that respondent erred in determining that
petitioners understated their 2000 gross receipts by $37,634.02
and their 2001 gross receipts by $47,207.73.
With respect to petitioners’ business expenses, respondent
allowed deductions of $4,419 for the 2000 tax year and $15,278
for the 2001 tax year, based upon the amounts that Agent Gomez
identified from the bank statements as business-related payments.
Although petitioners claimed business expense deductions of
$66,215 for the 2000 tax year and $101,024 for the 2001 tax year,
petitioners did not identify such expenses from the bank
statements when Agent Gomez provided them with the opportunity to
do so. At trial, petitioners were unable to provide any credible
5
Respondent’s determination that petitioners had gross
receipts of $115,528.02 in 2000 represents the total deposits
into accounts A and B during 2000 ($222,467.13), less nontaxable
items ($90,804.03) and transfers ($16,135.08). Similarly,
respondent’s determination that petitioners had gross receipts of
$161,796.73 in 2001 represents the total deposits into accounts A
and B during 2001 ($187,331.24), less nontaxable items
($14,969.51) and transfers ($10,565).
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evidence to substantiate the claimed business expense deductions
disallowed by respondent. Although petitioners contend that they
incurred significant labor expenses during the years in issue,
they were able to provide no more than the names of four
employees and an estimate of weekly payments made to such
employees.6 The Court may estimate the proper amount of
deductible expense when a taxpayer establishes that he paid or
incurred the expense but does not establish the amount of the
deduction. Boyd v. Commissioner, 122 T.C. 305, 320 (2004).
For such an estimate to be proper, however, the record must
evidence that the taxpayer paid or incurred a deductible expense
at least of the amount allowed. Id. The record in the instant
case provides no such evidence. Consequently, we conclude that
petitioners have failed to meet their burden of proving that
respondent erred in disallowing claimed business expense
deductions of $61,796 for petitioners’ 2000 tax year and $85,746
for petitioners’ 2001 tax year.
Section 1401 imposes a percentage tax on the self-employment
income of every individual. Self-employment income is defined as
“the net earnings from self-employment derived by an individual *
* * during any taxable year”. Sec. 1402(b). The term “net
earnings from self-employment” is defined as “the gross income
6
Petitioner estimated the amounts paid to each of the four
employees per week but provided no evidence as to the number of
weeks worked by such employees.
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derived by an individual from any trade or business carried on by
such individual, less the deductions * * * which are attributable
to such trade or business”. Sec. 1402(a). Petitioners have made
no contention and offered no evidence as to whether they are
liable for self-employment taxes during the years in issue. The
record, however, demonstrates that petitioners’ gross receipts
during 2000 and 2001 were attributable to their business, Kingdom
Kreations. Consequently, we conclude that respondent correctly
determined that petitioners had self-employment income of
$111,109 for the 2000 tax year and $146,518 for the 2001 tax
year, representing petitioners’ gross receipts less business
expense deductions for each respective tax year. Accordingly, we
hold that petitioners are liable for the corresponding self-
employment taxes as determined by respondent with respect to the
years in issue.
We now turn to the issues of whether petitioners are liable
for the addition to tax for failure to timely file pursuant to
section 6651(a)(1) with respect to petitioners’ 2000 tax year and
whether petitioners are liable for section 6662 accuracy-related
penalties for the years in issue. Section 7491(c) provides that
respondent bears the burden of production with respect to the
liability of any individual for any addition to tax or penalty.
Consequently, respondent must produce sufficient evidence to
demonstrate that the addition to tax for failure to file timely
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and the accuracy-related penalties are appropriate. See Higbee
v. Commissioner, 116 T.C. 438, 446 (2001). Once respondent meets
his burden of production, petitioner must produce sufficient
evidence to persuade the Court that respondent’s determination is
incorrect. Id. at 447.
Section 6651(a)(1) provides for an addition to tax of 5
percent of the tax required to be shown on the return for each
month or fraction thereof for which there is a failure to file,
not to exceed 25 percent. The addition to tax for failure to
file a return timely will be imposed if the return is not filed
timely unless the taxpayer shows that the delay was due to
reasonable cause and not willful neglect. Sec. 6651(a)(1). In
the instant case, the parties stipulated that petitioners filed
the 2000 tax return on March 19, 2002. Consequently, we must
determine whether petitioners have shown that the delay was due
to reasonable cause and not willful neglect.7
A delay is due to reasonable cause if the taxpayer exercised
ordinary business care and prudence and was nevertheless unable
to file the return within the prescribed time. Sec. 301.6651-
1(c)(1), Proced. & Admin. Regs. “[W]illful neglect” is defined
7
We note that the parties have made no contentions and
offered no evidence as to whether petitioners filed a written
statement with respondent pursuant to sec. 301.6651-1(c)(1),
Proced. & Admin. Regs.
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as a “conscious, intentional failure or reckless indifference.”
United States v. Boyle, 469 U.S. 241, 245 (1985).
In the instant case, the record demonstrates that
petitioners maintained business records that ultimately provided
the financial information reported on petitioners’ 2000 and 2001
tax returns. Prior to filing the 2000 tax return, however,
petitioner suffered a debilitating physical ailment, and
petitioner Cynthia A. Burrough Irving suffered a miscarriage. To
access their electronically stored business records and file the
2000 tax return, petitioners sought and received assistance from
their friend, Scott Yusem. Mr. Yusem testified credibly that he
helped petitioners file their tax returns because he “had some
knowledge of accounting from running [his own] business” and
petitioners lacked the resources to hire a professional tax-
preparer. On the basis of the foregoing, we conclude that
petitioners’ delay in filing the 2000 tax return was due to
reasonable cause and not willful neglect. Accordingly, we hold
that petitioners are not liable for the asserted section
6651(a)(1) addition to tax for failure to file timely with
respect to their 2000 tax year.
Section 6662(a) imposes a 20-percent accuracy-related
penalty with respect to the portion of any underpayment of tax
attributable to a substantial understatement of income tax. An
“understatement” is the excess of the amount of tax required to
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be shown on the return over the amount of tax that is actually
shown on the return. Sec. 6662(d)(2)(A). A “substantial
understatement” of income tax exists if the amount of the
understatement for the taxable year exceeds the greater of (1) 10
percent of the tax required to be shown on the return or (2)
$5,000.8 Sec. 6662(d)(1)(A). On the basis of the record in the
instant case, we conclude that each of the underpayments for
petitioners’ 2000 and 2001 tax years is attributable to a
substantial understatement of income tax.
Notwithstanding section 6662(a), section 6664(c)(1) provides
that the accuracy-related penalty shall not apply to any portion
of an underpayment if it is shown that there was reasonable cause
for the taxpayer’s position with respect to that portion and that
the taxpayer acted in good faith with respect to that portion.
The determination of whether a taxpayer acted with reasonable
cause and in good faith within the meaning of section 6664(c)(1)
is made on a case-by-case basis, taking into account all the
pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income
Tax Regs. The most important factor is the extent of the
8
Sec. 6662(d)(2)(B) provides that the amount of an
understatement is reduced by any portion for which (1) there was
substantial authority for the taxpayer’s treatment, or (2) the
relevant facts affecting the item’s tax treatment were adequately
disclosed and there is a reasonable basis for the tax treatment.
In light of our holding below that there was reasonable cause for
petitioners’ position and that petitioners acted in good faith,
we need not decide whether petitioners’ understatement is
properly reduced pursuant to sec. 6662(d)(2)(B).
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taxpayer’s effort to assess his proper tax liability for the
year. Id. “Circumstances that may indicate reasonable cause and
good faith include an honest misunderstanding of fact or law that
is reasonable in light of all of the facts and circumstances,
including the experience, knowledge, and education of the
taxpayer.” Id.
In the instant case, the record demonstrates that
petitioners used computer software to maintain business records
for Kingdom Kreations during the years in issue and that they
delegated responsibility for maintaining the business records to
employee Monica Mann, who was unavailable to testify. As noted
above, petitioners required the assistance of Mr. Yusem to access
their electronically stored business records and file their 2000
and 2001 tax returns. Mr. Yusem testified credibly that the
amounts reported on petitioners’ tax returns were taken directly
from petitioners’ electronic records. Furthermore, Agent Gomez
testified that petitioner was “very cooperative” during the
audit. Based on the foregoing, we are satisfied that petitioners
maintained business records to the best of their ability and that
the information reported on their 2000 and 2001 tax returns
reflects the amounts recorded in such business records. We
conclude that petitioners made a substantial effort to assess
their proper tax liabilities for the years in issue and,
consequently, that petitioners acted with reasonable cause and in
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good faith for purposes of section 6664(c)(1). Accordingly, we
hold that petitioners are not liable for section 6662 accuracy-
related penalties with respect to their 2000 and 2001 tax years.
To summarize, we hold that petitioners are liable for a
deficiency of $32,133 with respect to their 2000 tax year and a
deficiency of $43,431.65 with respect to their 2001 tax year.
However, we hold that petitioners are not liable for the addition
to tax and accuracy-related penalties determined by respondent.
To reflect the foregoing,
Decision will be entered
under Rule 155.