T.C. Memo. 2016-126
UNITED STATES TAX COURT
CHRIS NGUYEN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20491-13. Filed June 29, 2016.
Chris Nguyen, pro se.
Bryant W. Smith and Trent D. Usitalo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined deficiencies and penalties with
respect to petitioner’s 2008 and 2009 Federal income tax as follows:
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[*2] Penalty
Year Deficiency sec. 6662(a)
2008 $53,063 $10,612.60
2009 105,080 21,016.00
After concessions,1 the issues for decision as to the years at issue are: (1) whether
petitioner’s income reported on Schedule C, Profit or Loss From Business, was
understated and (2) whether petitioner is liable for accuracy-related penalties
under section 6662(a).2
1
Respondent in the notice of deficiency disallowed several of petitioner’s
claimed Schedule C expense deductions. However, respondent determined in the
notice of deficiency that for 2008 petitioner was entitled to deductions of $430 for
advertising, $699 for bank charges, $24,893 for rent expenses, and $1,321 for
insurance. Additionally, respondent determined that for 2009 petitioner was
entitled to deductions of $8,500 for taxes and licenses, $1,310 for utilities, $1,224
for telephone expenses, and $460 for water expenses. Moreover, on the basis of
the evidence at trial, respondent now concedes that for 2008 petitioner is entitled
to cost of goods sold (COGS) of $39,221.18 and a deduction of $11,539.90 for
freight expenses. Additionally, respondent concedes that for 2009 petitioner is
entitled to COGS of $92,947.70 and deductions of $11,388.84 for freight
expenses, $41,450 for rent expenses, $850 for advertising, and $615 for janitorial
expenses. We accept respondent’s determinations and concessions. Accordingly,
the said deductions are to be included in the Rule 155 computations. Finally, the
notice of deficiency included several other adjustments, such as an SE AGI
adjustment, that involve computational matters to be resolved in the parties’ Rule
155 computations consistent with the Court’s opinion.
2
Unless otherwise indicated, all section references are to 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.
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[*3] 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. Petitioner
resided in California at the time he filed his petition.
I. General Background
Petitioner was born in Vietnam in 1980. In 1981 petitioner’s father
immigrated to the United States. Petitioner stayed in Vietnam with his mother. In
2001 petitioner immigrated to the United States. Petitioner speaks limited
English.
II. Petitioner’s Pottery Business
During the years at issue petitioner operated a pottery business in
California. Petitioner maintained several checking and credit card accounts at
various banks.3 Additionally, petitioner did not maintain complete and accurate
books and records for his business. In fact, he relied upon an untrained 18-year-
old woman for his bookkeeping. Moreover, petitioner received several loans from
3
For the years at issue, the Internal Revenue Service (IRS) conducted a
bank deposits analysis of petitioner’s bank accounts and determined that petitioner
had unreported income from his business activities.
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[*4] family and friends--including his mother,4 his mother-in-law, and Liem
Nguyen5--and deposited some of the loan proceeds into his bank accounts.
Petitioner also received gifts from his mother during the years at issue.
III. Income Tax Returns
Petitioner filed Forms 1040, U.S. Individual Income Tax Return, for the
years at issue. Petitioner attached to each of those returns two Schedules C6
reporting gross receipts, COGS, gross income, and net profit for his pottery
business as follows:
Year Gross receipts COGS Gross income Net profit
2008 $79,216 $11,419 $67,797 $2,229
2009 129,118 37,991 91,127 20,079
The IRS conducted an examination of petitioner’s returns for the years at
issue in or about November 2010. Petitioner hired Certified Public Accountant
Son Nguyen to help represent him during the examination. On November 21,
4
Petitioner’s mother operated a successful business in Vietnam that
manufactured rice paddle equipment during the years at issue. In addition,
petitioner’s mother received a large inheritance from her father sometime before
the years at issue.
5
Liem is a close friend of petitioner.
6
Although petitioner stated on his tax returns that he operated two
businesses--Art Craft Trading and Phelan Co.--the record indicates that the two
businesses are in fact one pottery business.
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[*5] 2011, petitioner submitted Forms 1040X, Amended U.S. Individual Income
Tax Return, for the years at issue, which were not processed by the IRS.
On May 30, 2013, the IRS mailed petitioner a notice of deficiency for the
years at issue that made adjustments to his original returns. In the notice of
deficiency the IRS determined deficiencies and penalties as stated supra.
Petitioner filed a timely petition with this Court for redetermination.
OPINION
We must determine whether petitioner understated his Schedule C income
for the years at issue. In order to decide this, we must first determine whether
petitioner understated his Schedule C gross income for the years at issue.
I. Schedule C Gross Income
Generally, the Commissioner’s determinations of deficiencies in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of showing that
the Commissioner’s determinations are in error. See Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). In the Court of Appeals for the Ninth
Circuit, to which an appeal of this case presumably would lie absent a stipulation
to the contrary, see sec. 7482(b)(1)(A), (2), the presumption of correctness does
not attach in cases involving unreported income unless the Commissioner first
establishes an evidentiary foundation linking the taxpayer to the alleged income-
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[*6] producing activity, see Weimerskirch v. Commissioner, 596 F.2d 358, 361-
362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). The requisite evidentiary
foundation is minimal and need not include direct evidence. See Banister v.
Commissioner, T.C. Memo. 2008-201, aff’d, 418 F. App’x 637 (9th Cir. 2011).
Once the Commissioner produces evidence linking the taxpayer to an
income-producing activity, the burden shifts to the taxpayer “to rebut the
presumption of correctness of * * * [the Commissioner’s] deficiency
determination by establishing by a preponderance of the evidence that the
deficiency determination is arbitrary or erroneous.” Petzoldt v. Commissioner, 92
T.C. 661, 689 (1989); see also Hardy v. Commissioner, 181 F.3d 1002, 1004 (9th
Cir. 1999), aff’g T.C. Memo. 1997-97.
The Commissioner has broad powers under section 446 to compute the
taxable income of a taxpayer. Sec. 446; Petzoldt v. Commissioner, 92 T.C. at 693.
Generally, such computation is made using the taxpayer’s regularly employed
method of accounting. Sec. 446(a). If the taxpayer’s method of accounting does
not clearly reflect income, then the method used shall be the method which, in the
Commissioner’s opinion, clearly reflects income. Sec. 446(b); see Palmer v. IRS,
116 F.3d 1309, 1312 (9th Cir. 1997).
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[*7] For the years at issue, respondent reconstructed petitioner’s gross income
using the bank deposits method. “The use of the bank deposit method for
computing income has long been sanctioned by the courts.” Estate of Mason v.
Commissioner, 64 T.C. 651, 656 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977). “A
bank deposit is prima facie evidence of income and * * * [the Commissioner] need
not prove a likely source of that income.” Tokarski v. Commissioner, 87 T.C. 74,
77 (1986) (citing Estate of Mason v. Commissioner, 64 T.C. at 656-657).
Respondent has established the requisite minimal evidentiary foundation
linking petitioner with an income-producing activity by introducing evidence that
he was engaged in a trade or business and received unreported gross income from
his business during the years at issue. Therefore, petitioner bears the burden of
proving that respondent’s deficiency determinations are arbitrary or erroneous.
On the basis of the credible testimony presented7 and the documentary
evidence introduced at trial, petitioner has established by a preponderance of the
evidence that a portion of the disputed determinations is erroneous. Petitioner
testified that he received various loans from his mother, his mother-in-law, and
Liem during the years at issue and that he deposited some of the loan proceeds
7
Having had the opportunity to observe petitioner and Liem at trial, we
find them to be honest, forthright, and credible.
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[*8] into his bank accounts.8 Additionally, petitioner produced loan documents at
trial to corroborate the existence of some of the loans. Moreover, in addition to
his own testimony, petitioner offered testimony from his close friend, Liem, to
support his contention that some of his bank deposits were loan proceeds. Liem in
fact testified that he made various loans to petitioner during the years at issue. On
the basis of the evidence presented at trial, we find that petitioner deposited loan
proceeds into his bank accounts as follows: $62,500 for 2008 and $15,000 for
2009. Because loan proceeds do not constitute gross income to a taxpayer, see
Commissioner v. Tufts, 461 U.S. 300, 307 (1983), we hold that the above-stated
amounts are not gross income to petitioner.
Furthermore, the record establishes that petitioner received a gift of $7,000
from his mother for each of the years at issue. Because gifts do not constitute
gross income to a taxpayer, see sec. 102(a), we hold that the above-stated amounts
are not gross income to petitioner.
Thus, although petitioner failed to report some gross income for the years at
issue, $69,500 and $22,000 of the deposits for 2008 and 2009, respectively, found
in petitioner’s accounts were not gross income but rather were the proceeds of
loans and gifts from third parties.
8
The purpose of these loans was to help petitioner run his business.
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[*9] Accordingly, in view of the record and our findings herein, petitioner’s
gross receipts, COGS, and gross income for the years at issue are as follows:
Year Gross receipts COGS Gross income
1
2008 $153,382.05 $39,221.18 $114,160.87
2
2009 350,661.22 92,947.70 257,713.52
1
This figure is calculated by subtracting the loans and gifts of $69,500 for
2008 from the stipulated gross receipts of $222,882.05 for 2008. Given
petitioner’s lack of sophistication in legal and accounting matters, we believe that
when he agreed to the stipulated gross receipts of $222,882.05 for 2008, he was
unaware that the loans and gifts amounts were excludable from gross receipts. See
Rule 91(e) (explaining that the Court may treat a stipulation as other than a
conclusive admission).
2
This figure is calculated by subtracting the loans and gifts of $22,000 for
2009 from the gross receipts of $372,661.22 for 2009.
Next we must determine whether--in addition to the above-mentioned
concessions--petitioner is entitled to additional Schedule C deductions for the
years at issue.
II. Schedule C Deductions
Deductions are a matter of “legislative grace”, and “a taxpayer seeking a
deduction must be able to point to an applicable statute and show that he comes
within its terms.” New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934);
see also Rule 142(a). As a general rule, section 162(a) authorizes a deduction
for“all the ordinary and necessary expenses paid or incurred during the taxable
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[*10] year in carrying on any trade or business”. An expense is ordinary for
purposes of this section if it is normal or customary within a particular trade,
business, or industry. Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense
is necessary if it is appropriate and helpful for the development of the business.
Commissioner v. Heininger, 320 U.S. 467, 471 (1943). Section 262, in contrast,
generally precludes deduction of “personal, living, or family expenses.”
The breadth of section 162(a) is limited by the requirement that any amount
reported as a business expense must be substantiated, and taxpayers are required to
maintain records sufficient therefor. Sec. 6001; Hradesky v. Commissioner, 65
T.C. 87, 89-90 (1975), aff’d, 540 F.2d 821 (5th Cir. 1976); sec. 1.6001-1(a),
Income Tax Regs. When a taxpayer adequately establishes that he or she paid or
incurred a deductible expense but does not establish the precise amount, we may
in some circumstances estimate the allowable deduction, bearing heavily against
the taxpayer whose inexactitude is of his or her own making. Cohan v.
Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). There must, however, be
sufficient evidence in the record to permit us to conclude that a deductible expense
was paid or incurred. Williams v. United States, 245 F.2d 559, 560 (5th Cir.
1957).
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[*11] Furthermore, certain business expenses described in section 274 are subject
to rules of substantiation that supersede the Cohan rule. Sanford v. Commissioner,
50 T.C. 823, 827-828 (1968), aff’d, 412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a),
Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). Section 274(d)
provides that no deduction shall be allowed for, among other things, traveling
expenses, entertainment expenses, gifts, and expenses with respect to listed
property (as defined in section 280F(d)(4), which includes passenger automobiles)
“unless the taxpayer substantiates by adequate records or by sufficient evidence
corroborating the taxpayer’s own statement”: (1) the amount of the expenditure or
use; (2) the time and place of the expenditure or use or date and description of the
gift; (3) the business purpose of the expenditure or use; and (4) in the case of
entertainment or gifts, the business relationship to the taxpayer of the recipients or
persons entertained. Sec. 274(d).
Petitioner argues that in addition to the above-mentioned concessions, he is
entitled to additional Schedule C deductions for the years at issue. Petitioner,
however, did not maintain sufficient records and did not present sufficient
evidence to substantiate the amounts and business purpose of these expenses.
Accordingly, subject to adjustment to reflect respondent’s concessions,
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[*12] respondent’s determinations regarding petitioner’s deductions for expenses
are sustained.
III. Conclusion
In view of the foregoing, we hold that petitioner’s Schedule C income was
understated for the years at issue. The exact amounts of the understatements and
the resulting deficiencies will be resolved in the parties’ Rule 155 computations.
IV. Section 6662(a) Penalty
Section 7491(c) provides that the Commissioner bears the burden of
production with respect to the liability of any individual for additions to tax and
penalties. “The Commissioner’s burden of production under section 7491(c) is to
produce evidence that it is appropriate to impose the relevant penalty, addition to
tax, or additional amount”. Swain v. Commissioner, 118 T.C. 358, 363 (2002);
see also Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The Commissioner,
however, does not have an obligation to introduce evidence regarding reasonable
cause or substantial authority. Higbee v. Commissioner, 116 T.C. at 446-447.
Section 6662(a) imposes a penalty in an amount equal to 20% of the portion
of the underpayment of tax attributable to one or more of the items set forth in
subsection (b), including negligence or disregard of rules or regulations. The term
“negligence” in section 6662(b)(1) includes any failure to make a reasonable
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[*13] attempt to comply with the Internal Revenue Code and any failure to keep
adequate books and records or to substantiate items properly. Sec. 6662(c); sec.
1.6662-3(b)(1), Income Tax Regs. Negligence has also been defined as the failure
to exercise due care or the failure to do what a reasonable person would do under
the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925
F.2d 348, 353 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947 (1985).
The term “disregard” includes any careless, reckless, or intentional disregard. Sec.
6662(c).
Failure by a taxpayer to keep adequate records may justify imposition of the
penalty for negligence. See Lysek v. Commissioner, 583 F.2d 1088, 1094 (9th
Cir. 1978), aff’g T.C. Memo. 1975-293; Crocker v. Commissioner, 92 T.C. 899,
917 (1989). Failure to maintain adequate records also indicates disregard of rules
or regulations that require a taxpayer to keep permanent records sufficient to
establish, inter alia, the taxpayer’s gross income and deductions. See Crocker v.
Commissioner, 92 T.C. at 917.
The accuracy-related penalty is not imposed with respect to any portion of
the underpayment as to which the taxpayer acted with reasonable cause and in
good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with
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[*14] reasonable cause and in good faith depends upon all the pertinent facts and
circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent satisfied his burden of production with regard to negligence.
Respondent established that petitioner: (1) did not substantiate several items
properly and (2) failed to properly report some gross income. Thus, respondent
met his burden of production for the section 6662(a) penalty for the years at issue.
Furthermore, petitioner offered no evidence that he acted with reasonable cause
and in good faith. Accordingly, we hold that petitioner is liable for a section
6662(a) accuracy-related penalty for each year at issue, which the parties shall
compute in their Rule 155 calculations.
In reaching our holding, we have considered all arguments made, and to the
extent not mentioned, we consider them irrelevant, moot, or without merit.
To reflect the foregoing,
Decision will be entered under
Rule 155.