On July 13, 2021, the Tax Court issued a Memorandum Opinion in the case of Blossom Day Care Centers Inc. v. Commissioner (T.C. Memo. 2021-87). The primary issues presented in Blossom Day Care Centers Inc. v. Commissioner were whether the petitioner was failed to report capital gain and gross receipts, whether the petitioner is entitled to certain deductions, whether the petitioner is entitled to Indian tax credits, and most importantly, whether the petitioner is liable for the civil fraud penalty under IRC § 6663.

Background to Blossom Day Care Centers Inc. v. Commissioner

July 13, 2021, had not started out as what you would call a “good” Tuesday for the Hackers or their Oklahoma daycare conglomerate, as evidenced by their total loss in the employment tax case discussed in a previous post. For more detailed background, you can refer to Briefly Taxing’s summary of Blossom Day Care Centers, Inc. v. Commissioner, T.C. Memo. 2021-86. It only got worse from there.

In short, the petitioner operated six day care centers in or around Tulsa, Oklahoma, and the Hackers (Barry and Celeste) operated the petitioner. The Hackers have three children, who were not employees of the petitioner. In 2002 Mr. Hacker incorporated the Hacker Corp. as an Oklahoma S corporation. During 2004 through 2008, the petitioner made payments in the form of management fees to Hacker Corp., which in turn paid wages to the Hackers and their children for services they rendered to the petitioner. It should surprise no one that no written contract or fee agreement was prepared in connection with the petitioner’s agreement with Hacker Corp.

The Hacker Largesse

Ashley, the middle hacker son, was a paid employee of Hacker Corp. from 2005 through 2008. Steven, the eldest, was a paid employee of Hacker Corp. during 2004 and 2005. From January 2006 to August 2008 Steven operated a car stereo modification business and was not employed by Hacker Corp.

For whatever reason (whether she had scruples or was the black sheep of the family is not clear), young miss Whitney Hacker was not a paid employee of Hacker Corp. during the years at issue. Eschewing her scruples, Whitney did, however, have a credit card in the name of the petitioner…as did the other two Hacker boys.

In addition to routine personal purchases, such as restaurant meals, auto expenses, and personal medical expenses, the Hackers either used the corporate credit card to pay or had the petitioner pay their personal credit cards for such expenses as college tuition, vacations, jewelry, and other luxury items. The Hacker brood continued to make personal purchases with the credit cards even during periods when they were not “employees” of the petitioner or Hacker Corp.

Mr. Hacker drove a 2003 Hummer as his personal vehicle, while Mrs. Hacker primarily used a 2000 Lexus as her personal vehicle. Both vehicles were titled in the Hackers’ names, but the petitioner paid the notes on the vehicles and claimed depreciation deductions for them on its tax returns. Steven drove a 2004 BMW, which was titled in Steven’s name. He was the borrower on the car loan and used the BMW for commuting and other personal purposes. Ashley drove a 2004 Cadillac Escalade, titled in Ashley’s name, and Ashley was the borrower on the car loan.

Once again, Whitney was left out in the cold like a young David Copperfield toiling away in the cellars of Murdstone and Grinby’s before the salvific intercession of dear-aunt Betsey Trotwood. The petitioner paid the notes on both Steven and Ashley’s vehicles and claimed depreciation for those vehicles on its tax returns. Neither the Hackers nor their children maintained any mileage logs or other records of the extent, if any, to which they used the vehicles for the petitioner’s business purposes.

The Bookkeeping Endeavors

From 2004 through 2006, the Hackers used a CPA to keep their books and records. Bless the man, he did what he could with what he was given. The Hackers gave him bank statements from the petitioner’s operating, payroll, and loan accounts but failed to provide any records relating to undeposited cash or other payments. The Hackers also provided credit card statements but, conveniently, did not provide the CPA with any guidance as to which expenditures were business expenses and which were personal. Despite the lack of guidance from the Hackers, the CPA determined that many of the expenses on the credit card statements were personal, and he used a general ledger account entitled “A/R – Officer” as a catch-all for credit card charges that he determined were the Hackers’ personal expenses. From 2004 to 2006 the petitioner’s “A/R – Officer” general ledger account increased from $208,776 to $1,379,408 based primarily on account of credit card charges.

In 2007, the Hackers hired an in-house bookkeeper, as the poor CPA had probably fired the Hackers as clients by this time. She posted the majority of the credit card expenditures to petitioner’s general ledger Supplies account and the remainder to Food and Activities. Like the CPA, Ms. King posted in the “A/R – Officer” account those expenses that appeared to be personal.

The returns that the poor CPA’s firm prepared for the Hackers claimed deductions for the expenses as posted in the petitioner’s general ledger and reported among its Current Assets on Schedule L, a receivable entitled “Note Rec Officer,” which constituted the amounts believed to be personal expenditures. The Hackers, to no one’s surprise or bemusement, never made any repayment of the amount designated as a loan nor did the petitioner pay the Hackers any wages or salary, and the reported receivable amount increased from $236,189 at the beginning of 2004 to $1,332,066 at the end of 2007.

The Exam and Determinations

The IRS examined petitioner’s tax returns for 2004-2007 in an examination that also covered the Hackers’ personal tax returns for 2004-2008, as well as the petitioner’s worker classification of the Hackers for 2005-2007 (the subject of the prior opinion). After a lengthy examination, the IRS determined deficiencies of $70,239, $109,813, $109,557, and $130,967 for 2004, 2005, 2006, and 2007, respectively. Not quite done, however, the IRS also determined civil fraud penalties under section 6663 of $52,679, $82,360, $82,168, and $98,225 for the years at issue, as well as a failure to file penalty pursuant to IRC § 6651(a)(1) for 2007 of $32,742.

If you’re keeping score at home, that’s a total liability of $768,750 give or take a few pennies.

The Bank Deposits Analysis

The petitioner did not argue that the IRS’s use of the bank deposits analysis was erroneous or that any specific deposit included in respondent’s determination was from a nontaxable source…nor did the petitioner dispute that it received undeposited cash payments. Instead, Mr. Hacker testified that he did not “believe that the total deposit summaries were reliable,” citing the possibility of duplicate entries or mislabeling cash as checks or vice versa.

Unfortunately for Mr. Hacker, loyalty did not run deep in the Blossom Day Care Centers, and not wishing to perjure themselves as Mr. Hacker may have, no less than three of petitioner’s daycare center directors testified, however, about the procedures and safeguards the company followed to ensure the accuracy of the daily deposit summaries and that the entries matched the amounts actually received. Et vos,[1] directors? Consequently, the Tax Court found that the petitioner failed to satisfy its burden of proof, as bank deposits are prima facie evidence of income, a presumption of correctness that must be overcome by the petitioner. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Bolles v. Commissioner, T.C. Memo. 2019-42, at *14.

Depreciation Recapture

The IRS determined an increase in the petitioner’s capital gain income for 2004 of $58,980. Of that amount, $39,676 relates to recapture of prior-year excess depreciation on two vehicles. IRC § 167(a) allows as a depreciation deduction a reasonable allowance for the exhaustion, wear, and tear of property used in a trade or business or held for the production of income. Further, IRC § 168(a) specifies that the amount allowed as a depreciation deduction under IRC § 167(a) is determined by using the applicable depreciation method, the applicable recovery period, and the applicable convention. In turn, IRC § 280F limits the allowable depreciation deduction where listed property, including any passenger automobile or any other property used as a means of transportation, is not predominantly used in a qualified business use. See IRC § 280F(b)(1); IRC § 280F(d)(4)(A)(i), (ii).

As a general rule, where any listed property is not predominantly used in a qualified business use for the taxable year, the general depreciation method of IRC § 168(b)(1) (i.e., double declining, switching to straight line depreciation) is not used. See IRC § 280F(b)(1). Rather, the alternative depreciation system of IRC § 168(g) (the straight-line method) is used to compute the allowable depreciation deduction. See IRC § 280F(b)(1); IRC § 168(g)(1), (2).

Where the qualified business use of any listed property falls to 50% or less, the taxpayer is required to include excess depreciation in gross income (recapture) for the taxable year in which the property is first not predominantly used in a qualified business use. IRC § 280F(b)(2)(A). The term “excess depreciation” means the excess, if any, of (1) the amount of depreciation deductions allowed when the property was predominantly used in a qualified business use, over (2) the amount of depreciation deductions that would have been allowed if the property had not been predominantly used in a qualified business use for the taxable year in which it was placed in service. IRC § 280F(b)(2)(B). Property is treated as predominantly used in a qualified business use if the business use for the year exceeds 50%. IRC § 280F(b)(3). The term “qualified business use” generally means any use in the taxpayer’s trade or business. IRC § 280F(d)(6)(B).

Once again, the petitioner offered ZERO evidence to demonstrate what percentage of the use of the vehicles was for a qualified business use, rather than personal use. Even if they had, the percentage would likely have either been very low, or very perjurious.

Depreciation Expenses

IRC § 167(a) allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used in a trade or business or held for the production of income. To substantiate entitlement to a depreciation deduction, a taxpayer not only must show that the property was used in a business but also must establish the property’s depreciable basis by showing the cost of the property, its useful life or recovery period, and its previously allowable depreciation. See, e.g., Cluck v. Commissioner, 105 T.C. 324, 337 (1995); WSK & Sons, Inc. v. Commissioner, T.C. Memo. 2015-204, slip op. at *11-*12.

A taxpayer may alternatively elect to treat the cost of certain property used in an active trade or business as a current expense in the year that the property is placed in service. IRC § 179(a), (d). If the property is used for both business and other purposes, then the portion of the cost that is attributable to the business use is eligible for expensing under IRC § 179 only if more than 50% of the use is for business purposes. See Treas. Reg. § 1.179-1(d).

With respect to certain items, including passenger automobiles and any other property used as a means of transportation, IRC § 274(d) establishes heightened substantiation requirements that must be met to establish business use. See also IRC § 280F(d)(4). In the case of such property the taxpayer must substantiate by adequate records or sufficient evidence corroborating the taxpayer’s own statement the amount, time, place, and business purpose of the expense. IRC § 274(d). No deduction is allowed for personal, living, or family expenses. IRC § 262(a).

The petitioner threw in the towel as to certain of the depreciation deductions. With respect to all of the others, the Tax Court notes that the petitioner “offer[ed] little in the way of argument to establish its entitlement” to depreciation at trial.

Disallowed Business Expense Deductions

As discussed above, IRC § 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An ordinary and necessary expense is one which is appropriate and helpful to the taxpayer’s business and results from an activity that is a common and accepted practice in the business. Amdahl Corp. v. Commissioner, 108 T.C. 507, 523 (1997); Krist v. Commissioner, T.C. Memo. 2001-140, slip op. at *6.

Whether a payment qualifies for a deduction under IRC § 162(a) is a factual issue which must be decided on the basis of all relevant facts and circumstances. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). The petitioner bears the burden of proving its entitlement to the disallowed expense deductions. See Rule 142(a); Welch v. Helvering, 290 U.S. at 115. IRC § 274(d) disallows any deduction for any traveling expense or for listed property, including automobile expenses, unless the taxpayer substantiates by adequate records or sufficient evidence corroborating the taxpayer’s own statement the amount, time, place, and business purpose of the expense. No deduction is allowed for personal, living, or family expenses. IRC § 262(a).

The Wrong Argument about Substantiation

“Nuh uh,” is not sufficient to substantiate expenses. Neither is arguing that the IRS was wrong, when the petitioner doesn’t have the books and records to back up its idle contention of fallaciousness. At present, however, this is precisely what the petitioner did, arguing only that the IRS “arbitrarily disallowed deductions for all expenditures made by credit card” (other than payments to wholesale food distributors).

The Tax Court notes that the petitioner “explains at great length on brief” why the general ledger and spreadsheets relied upon by its return preparers were incorrect, miscategorized purchases, did not match perfectly with petitioner’s credit card statements, or were otherwise wrong. In sum, the petitioner argued that “the only explanation provided by the IRS” is that expenditures “have not been verified as business expense” and spends “considerable portions of its brief” listing the charges on its credit cards during the years at issue.

Unfortunately, “the petitioner misunderstands the burden of proof in this case.”

Determinations set forth in the notice of deficiency are presumed correct. A taxpayer is required to maintain books and records adequate to establish entitlement to deductions claimed. IRC § 6001; Treas. Reg. § 1.6001-1(a). It is the petitioner’s burden to demonstrate its entitlement to the deductions claimed on the returns, including that each expense was paid and that it was an ordinary and necessary business expense. “In large part, the petitioner has failed to do so.” Evidence was provided that the Hackers and their children incurred the charges on the credit card statements, or that petitioner paid those charges and claimed deductions for the purchases on its returns. “What the petitioner fails to provide, however, is substantiation of what the charges represented or their business purpose.”

“Moreover, the IRS’s respondent’s determinations were not arbitrary.” Rather, “the record shows, and the petitioner has acknowledged,” that the Hackers and their children routinely charged personal expenses to their credit cards, which were then paid by the petitioner, and either posted on the petitioner’s general ledgers or claimed as deductions on its returns, including personal vehicles, meals, college tuition, jewelry, vacations, holiday decorations for the Hackers’ personal residence, and even their one of their son’s wedding (but not poor Whitney’s). Petitioner deducted credit card charges made by the Hacker children even during periods when they were not paid employees. Such expenses are inherently personal and nondeductible. See IRC § 262(a).

But wait, Judge Paris is not quite finished with the Hackers just yet.

“Further, the Hackers did not adequately substantiate any of petitioner’s reported expenses.” They failed to notate the credit card statements to indicate which charges were business expenses and which were personal or provide receipts or any additional information regarding the purchases. In the case of the reported automobile and travel expenses, they did not provide any of the required information to meet the heightened substantiation requirements of IRC § 274(d). In the absence of such evidence the Tax Court “cannot assess whether and to what extent the purchases were ordinary and necessary business expenses.” (Stated differently, the Tax Court cannot determine quite to what level the Hacker’s were full of shit, therefore it accepted the IRS’s determination that the Hackers’ crock was, in fact, completely full-up of shit.)

The Failure to File Penalty

IRC § 6651(a)(1) imposes an addition to tax for failure to timely file a Federal income tax return unless it is shown that the failure is due to reasonable cause and not due to willful neglect. The addition to tax is equal to 5% of the amount required to be shown as tax on the delinquent return for each month or fraction thereof during which the return remains delinquent, up to a maximum addition of 25% for returns more than four months delinquent. IRC § 6651(a)(1). A taxpayer is not liable for the addition to tax for failure to timely file if the untimeliness was due to reasonable cause and not due to willful neglect. IRC § 6651(a)(1); Higbee v. Commissioner, 116 T.C. 438, 447 (2001). The burden of proving reasonable cause and lack of willful neglect falls on the taxpayer. See Rule 142(a); United States v. Boyle, 469 U.S. 241, 249 (1985).

Petitioner’s 2007 income tax return was due March 15, 2008. See IRC § 6072(b). Petitioner filed that return on October 27, 2008. Petitioner does not allege, and the evidence does not show, that its untimely filing was due to reasonable cause. Accordingly, petitioner is liable for the addition to tax under IRC § 6651(a)(1) for 2007.

The Fraud Penalty

Stupid is as stupid does. This much is true. Still, being stupid does not mean that a taxpayer had fraudulent intent…just beetles for brains.

The IRS determined that the petitioner is liable for IRC § 6663 fraud penalties for the years at issue. A penalty equal to 75% will be imposed on any part of the taxpayer’s underpayment of Federal income tax that is due to fraud. IRC § 6663(a). Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax believed to be owing. Edelson v. Commissioner, 829 F.2d 828, 833 (9th Cir. 1987), aff’g T.C. Memo. 1986-223; DiLeo v. Commissioner, 96 T.C. at 874; Minchem Int’l, Inc. v. Commissioner, T.C. Memo. 2015-56, slip op. at *43, aff’d sub nom. Sun v. Commissioner, 880 F.3d 173 (5th Cir. 2018).

If any portion of the underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud. IRC § 6663(b); see also, Minchem T.C. Memo. 2015-56, slip op. at *43-*44. The IRS has the burden of proving fraud by clear and convincing evidence. See IRC § 7454(a); Rule 142(b). To carry that burden of proof, the IRS must show, for each year, that (1) an underpayment of tax exists and (2) at least some portion (however large or small) is attributable to fraud. See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983); Benavides & Co., P.C. v. Commissioner, T.C. Memo. 2019-115, slip op. at *31. Fraud is a question of fact to be resolved upon consideration of the entire record. DiLeo, 96 T.C. at 874. Fraud is never presumed and must be established by independent evidence. Minchem, T.C. Memo. 2015-56, slip op. at *45.

In the present case, it is true that the petitioner failed to report numerous items of income and claimed numerous deductions to which it was not entitled for all years at issue. Consequently, there was indeed an underpayment of tax in each year. The first element of the fraud penalty has thus been established.

The Tax Court next examined whether the petitioner had the requisite fraudulent intent. Because direct evidence of fraudulent intent is seldom available, fraud may be proven by circumstantial evidence and reasonable inferences drawn from the facts. Niedringhaus v. Commissioner, 99 T.C. 202, 210 (1992); Benavides, T.C. Memo. 2019-115, slip op. at *34. The taxpayer’s entire course of conduct may be indicative of fraudulent intent. Benavides, T.C. Memo. 2019-115, slip op. at *34.

A corporation acts only through its officers and cannot escape responsibility for their acts in that capacity. DiLeo, 96 T.C. at 875; Benavides, T.C. Memo. 2019-115, slip op. at *35. Whether the petitioner’s intent was fraudulent therefore depends upon the intent of Mr. and Mrs. Hacker, its only shareholders and officers.

Circumstances that may indicate fraudulent intent, commonly referred to as “badges of fraud,” include but are not limited to (1) understating income; (2) maintaining inadequate records; (3) giving implausible or inconsistent explanations; (4) concealing income or assets; (5) failing to cooperate with authorities; (6) engaging in illegal activities; (7) providing incomplete or misleading information to one’s tax return preparer; (8) lack of credibility of the taxpayer’s testimony; (9) filing false documents, including false income tax returns; (10) failing to file tax returns; and (11) dealing in cash. Minchem, T.C. Memo. 2015-56, slip op. at *46. No single factor is dispositive; however, the existence of several factors “is persuasive circumstantial evidence of fraud.” Vanover v. Commissioner, T.C. Memo. 2012-79, *4.

Ultimately, the Tax Court found that the Hackers were greedy and stupid, but lacked the requisite intent—or at least, the IRS failed to meet its burden to show that the Hackers (and, in turn, the petitioner) had the fraudulent intent necessary for the imposition of penalties under IRC § 6663(a).

Though the IRS emphasized a number of the badges of fraud that, it contended, demonstrate the petitioner’s fraudulent intent, including its failure to report cash receipts, the claiming as business expenses of thousands of dollars in personal expenses, and Mr. Hacker’s vague, misleading, or uncorroborated statements to the revenue agent; and the petitioner’s recordkeeping “certainly left much to be desired.”

Nevertheless, the failures (and they were many) appear to stem more from sloppiness and a lack of sophistication than from an effort to defeat tax. The petitioner’s cooperation during the exam (by consenting to extend the IRS’s time to assess by executing the Forms 872 for 2004 through 2007, thereby allowing time to complete the examination) went a long way with the Tax Court in determining that the petitioner lacked fraudulent intent under IRC § 6663.

Accuracy Related Penalties

Judge Paris leaves the Hackers with this little note in sustaining the IRC § 6662(a) accuracy-related penalties.

The frequency, nature, and pervasiveness of the adjustments giving rise to the deficiency in this case leave little question that petitioner disregarded the rules and regulations and failed to make a reasonable attempt to comply with the Code.

Because the petitioner did not argue, and the record does not show, that petitioner had reasonable cause for its underpayments, accordingly, the accuracy-related penalties were sustained.

Vengeance for Whitney

Somewhere, sitting in her hovel in tattered Christian Louboutins (the red soles practically non-recognizable at this point), Whitney sheds a single tear that her veritable orphanage has been avenged. Though not quite a Cinderella ending, to the rest of the Hacker’s crew, who, it can be gleaned from the opinion, had so long forsaken her, their uppance has come. She dries her solitary tear on the remains of a silk kerchief, a token of a childhood long past, and takes up to darning her cashmere socks once more…

(T.C. Memo. 2021-87) Blossom Day Care Centers, Inc. v. Commissioner

 

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Footnote and Latin Lesson

[1] Vos being the nominative plural of the Latin pronoun tu. It should be noted that Gaius Julius Caesar, whether apocryphally or not, is actually believed to have said (if he was capable of words, having been stabbed nearly two dozen times) “Kai su, teknon?” which is Greek for “You too, child?” “Et tu, Brute,” however, fit Shakespeare’s liking a bit better, and the rest is history. These words were directed at Marcus Junius Brutus, son of Caesar’s favorite mistress Servilia and reputed (though unlikely) to be the illegitimate son of Caesar himself.

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