On April 23, 2020, the Tax Court issued a Memorandum Opinion in the case of Collins v. Commissioner (T.C. Memo. 2020-50). The issues before the court in Collins v. Commissioner were (1) whether petitioners were entitled to numerous categories of deductions and whether they provided substantiation to prove entitlement; (2) whether the petitioners are liable for additions to tax for failing to timely file their returns; and whether petitioner-husband is liable for the civil fraud penalty of IRC § 6663(a).
Intro Note to Collins v. Commissioner
There is a lot packed into Judge Ashford’s 57-page opinion. Ultimately, the court found for the IRS on every issue, including the civil fraud penalty, but it was not without substantial work that Judge Ashford reached his conclusions. The arguments on the part of the petitioners are thoroughly impressive considering that they represented themselves.
They were not frivolous, and they certainly made the IRS work for their victory. I am not saying that they didn’t try to game the system when they filed their 2009-2012 returns – that much becomes very clear – but I am more very cynical at the end of an opinion involving a pro se litigant. This one left me feeling only moderately like we live in a Lord of the Flies world, and I’m Piggy without my glasses. So that’s good.
The record tells us that the petitioners were not stupid. The petitioner-wife (PW) was an IT engineer for UMass Medical School, and the petitioner-husband (PH) had an MBA in finance and M.S. in applied mathematics and computer science. This just goes to show that smart people can still be idiots when greed gets ahold of them. Oh, and PH’s primary line of business was tax return preparation operated through an S corporation of which he was the sole shareholder.
Twenty-odd pages are spent going through the deductions and transactions flagged and adjusted by the IRS. It is long and pedantic, though I suppose necessary for this type of case where every number (even a total of $15 spent on tolls by PW) were at issue. I will not bore you with the specifics of the petitioners’ finances, but they were well within the upper middle class and intended to stay there by not paying their fair share of taxes.
The petitioners 2009-2012 returns were audited, and the petitioners were generally apathetic towards the matter and wholly unresponsive to requests for information and documents. Ultimately, the RA assigned to their case performed a bank deposits analysis to end all bank deposit analyses. Petitioners had 22 different accounts at 5 different banks, and so these took the RA a bit of time to perform.
With the evidence against them having been painstakingly compiled (and perhaps because it was such a pain in the ass to so compile) the RA proposed the civil fraud penalty of IRC § 6663(a), though only against PH. Tacked on were failure to file, pay, and pay estimated tax payments. The RA (after having received prior written supervisory approval for the penalties) issued a statutory notice of deficiency (SNOD) to the petitioners and issued a separate SNOD to PH.
With regard to the joint SNOD petitioners timely filed a petition for redetermination of the deficiencies, additions to tax, and penalties. With regard to the personal SNOD (regarding the civil fraud penalty) PH alone filed the petition for redetermination. The IRS answered both, and in response to PH’s petition, the IRS affirmatively alleged facts in support of the fraud determination. Though PH was required to file a reply to the answer regarding the allegations in the answer, PH failed to file a reply.
The IRS moved for an order deeming the undenied allegations admitted pursuant to Tax Court Rule 37(c), and the Tax Court ordered that PH respond. Once again, he did not do so, and the Tax Court granted the IRS’s motion. The IRS filed a motion for summary judgment, which was also granted after PH failed to timely respond to it. The Tax Court is silent about the history of the joint petition, but one has to assume that PW took matters a bit more seriously.
Burden of Proof Regarding Unreported Income – Bank Deposits Analysis
The bank deposits method of income reconstruction assumes that all of the money deposited into a taxpayer’s account is taxable income unless the taxpayer can show otherwise that the deposits are not taxable. Enayat v. Commissioner, T.C. Memo. 2009-257, *36; DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
Because this case was appealable to the First Circuit, the Tax Court applied the law of that court to its analysis of the IRS’s bank deposits analysis. See IRC § 7482(b)(1)(A). In the First Circuit, the IRS bears the initial burden of production (not proof) that the taxpayer earned income, that the taxpayer made regular deposits into the accounts, and that an adequate and full investigation of those accounts was conducted in order to distinguish between income and non-income deposits.” United States v. Morse, 491 F.2d 149, 152 (1st Cir. 1974). If the IRS presents sufficiently probative evidence, the burden shifts to the taxpayer to prove that the IRS’s determination of unreported income by a bank deposits analysis is incorrect. See Parks v. Commissioner, 94 T.C. 654, 658 (1990).
Shift of Burden of Proof to Government for Factual Issue
If the taxpayer produces credible evidence with respect to any factual issue relevant to ascertaining his Federal income tax liability and meets certain other requirements, the burden of proof shifts from the taxpayer to the IRS as to that factual issue. IRC § 7491(a)(1) and (2). However, the Tax Court notes, statements in a party’s brief are not part of the evidentiary record. See Tax Court Rule 143(c); see also Ashkouri v. Commissioner, T.C. Memo. 2019-95, at *36 (opportunity to testify was at trial, not through testimony on brief).
Level of Proof Required for Penalties
The IRS bears the burden of production with respect to penalties and additions to tax. See § 7491(c). The taxpayer bears the burden of proving that the IRS’s determinations with respect to the additions to tax are incorrect. See Wheeler v. Commissioner, 127 T.C. 200, 207-208 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008). With respect to the civil fraud penalties under IRC § 6663(a), the IRS bears the burden of proving fraud by clear and convincing evidence. See IRC § 7454(a); Tax Court Rule 142(b).
Ordinary and Necessary Business Deductions
A taxpayer may deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. IRC § 162(a); Treas. Reg. § 1.162-1(a). A taxpayer may not, however, deduct a personal, living, or family expense unless the Code expressly provides otherwise. IRC § 262(a). An expense is ordinary if it is “normal, usual, or customary” in the taxpayer’s trade or business or arises from a transaction that frequently occurs in that type of business. Deputy v. du Pont, 308 U.S. 488, 495 (1940).
An expense is necessary if it is “appropriate and helpful” to the taxpayer’s business; it does not have to be “essential,” however. Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Welch v. Helvering, 290 U.S. 111, 113 (1933). The determination of whether an expense satisfies the requirements of IRC § 162 is a question of fact. Cloud v. Commissioner, 97 T.C. 613, 618 (1991); Commissioner v. Heininger, 320 U.S. 467, 473-75 (1943).
If a taxpayer is eligible for reimbursement from his employer but fails to claim the reimbursement, the expense will not be considered necessary and, thus, is not deductible under IRC § 162. Orvis v. Commissioner, 788 F.2d 1406, 1408 (9th Cir. 1986), aff’g T.C. Memo. 1984-533; Podems v. Commissioner, 24 T.C. 21, 22-23 (1955).
Cohan Rule and Inapplicability in Certain Cases
Under the Cohan rule, if the taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount, the Tax Court may estimate the amount of the deductible expense. Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir. 1930); see also Vanicek v. Commissioner, 85 T.C. 731, 742-43 (1985). In order for the Tax Court to estimate the amount of a deductible expense, there must be some basis upon which an estimate may be made, and if the “inexactitude” of the numbers is due to the taxpayer’s “own making,” the taxpayer faces tough sledding ahead. Norgaard v. Commissioner, 939 F.2d 874, 879 (9th Cir. 1991), aff’g in part, rev’g in part T.C. Memo. 1989-390; Vanicek, 85 T.C. at 742-43. Otherwise an allowance would be an unearned boon for the taxpayer. Norgaard, 939 F.2d at 879; Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).
The Tax Court will not apply the Cohan rule to permit court-generated-taxpayer-guided estimates for expenses specified in IRC § 274, such as traveling expenses (including meals and lodging while away from home), entertainment expenses, and expenses regarding certain items of “listed property.” IRC §§ 274(d), 280F(d)(4)(A); Treas. Reg. § 1.274-5T(a); see also Boyd v. Commissioner, 122 T.C. 305, 320 (2004). This is so because IRC § 274 expenses are subject to strict substantiation rules. See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969); Treas. Reg. § 1.274-5T(a).
The Tax Court requires that the taxpayer corroborate his statement through adequate records or sufficient other evidence. Treas. Reg. § 1.274-5T(c)(3)(i). Records are adequate and documents are sufficient if they set out each of the following elements. First, the evidence must show the precise amount of the expense, not just an estimate. Second, the evidence must set fort the time and place the expense was incurred. Third, the evidence must demonstrate the actual business purpose of the expense. Fourth (if it is an entertainment or gift expense), the evidence must show the business relationship to the taxpayer of each expense. See Treas. Reg. § 1.274-5T(b)(6)(i); Balyan v. Commissioner, T.C. Memo. 2017-140, *7
Substantiation by adequate records requires the taxpayer to maintain (1) an account book, diary, log, statement of expense, trip sheet, or similar record prepared contemporaneously with the expenditure and (2) documentary evidence, such as receipts or paid bills, which together provide each element of an expenditure. Balyan, T.C. Memo. 2017-140 at *8; Treas. Reg. § 1.274-5(c)(2)(iii); Treas. Reg. § 1.274-5T(c)(2).
Rental Real Estate Deduction
Deductions for personal, living, or family expenses are generally prohibited under IRC § 262(a). Furthermore, a taxpayer ordinarily may not deduct expenses (other than expenses, such as interest and taxes, that are allowable without regard to their connection with a trade or business or an income-producing activity) with respect to a dwelling unit that he or she uses as a personal residence. See § 280A(a); See § 280A(b).
The taxpayer uses a dwelling unit as a residence if he or she uses the dwelling unit for personal purposes for greater of 14 days or 10% of the number of days during the year for which the unit is rented at a fair rental value. IRC § 280A(d)(1); see also Rose v. Commissioner, T.C. Memo. 2019-73, *23; Savello v. Commissioner, T.C. Memo. 2015-24, *14; Langley v. Commissioner, T.C. Memo. 2013-22, *5. Further, a taxpayer is deemed to have used a dwelling unit for personal purposes when, for any part of a day, the taxpayer or the taxpayer’s qualifying relatives uses the unit for personal purposes or any individual uses the unit unless, under the facts and circumstances, a fair rent is charged for the use. See IRC § 280A(d)(2)(A) and (C); see also Rose, T.C. Memo. 2019-73 at *24; Savello, T.C. Memo. 2015-24 at *14-*15; Langley, T.C. Memo. 2013-22 at *5-*6. A taxpayer’s spouse is considered to be a qualifying relative. IRC § 267(c)(4).
The general rule of IRC § 280A(a), therefore, applies unless petitioners can show they meet an enumerated exception to the general rule under IRC § 280A(c). As relevant in Collins, IRC § 280A(c)(3) provides that IRC § 280A(a) applies to any item attributable to the rental of the dwelling unit or portion thereof determined after the application of IRC § 280A(e).
Under IRC § 280A(e), a taxpayer who uses the dwelling unit for personal purposes during the taxable year, as a residence or otherwise, is required to limit his or her deduction to the amount determined after applying the percentage obtained by comparing the number of days the unit is rented at fair rental value to the total number of days the unit is used. Yet another limitation to the deduction in the case of rental use of a residence is set forth in IRC § 280A(c)(5). The deduction is limited to the excess of the gross rental income over the portion of the expenses otherwise allowable (such as mortgage interest and taxes) that are attributable to the rental use. “In other words, any net rental loss cannot be offset against unrelated income.” Savello, T.C. Memo. 2015-15 at *15-*16; Feldman v. Commissioner, 84 T.C. 1 (1985), aff’d, 791 F.2d 781 (9th Cir. 1986).
IRC § 6651(a)(1) – Failure to File Penalty and Reasonable Cause
The Code imposes an addition to tax for a taxpayer’s failure to file a required Federal income tax return on or before the specified filing date, including extensions. IRC § 6651(a)(1). The IRS satisfies its burden of production with respect to additions to tax (contained in IRC § 7491(c)) by providing sufficient evidence to show that the taxpayer filed his Federal income tax return late. Wheeler, 127 T.C. at 207-208; Higbee, 116 T.C. 438, 447 (2001).
Application of IRC § 6651(a)(1) may be avoided if the taxpayer shows that the failure to timely file was due to reasonable cause and not due to willful neglect. The burden of showing reasonable cause under IRC § 6651(a)(1) remains with petitioners. See Higbee, 116 T.C. at 447-448. A taxpayer’s selective inability to perform his tax obligations while performing his regular business and personal activities does not excuse his failure to file. See Godwin v. Commissioner, T.C. Memo. 2003-289, *22-*23.
The Treasury Regulations circumscribe reasonable cause for failure to file penalties. The taxpayer must show that despite reasonable cause, he was unable to file the return(s) on time. Treas. Reg. § 301.6651-1(c)(1). The taxpayer can show that he did not act with “willful neglect” if he can “prove that the late filing did not result from a ‘conscious, intentional failure or reckless indifference.’” Niedringhaus v. Commissioner, 99 T.C. 202, 221 (1992); United States v. Boyle, 469 U.S. 241, 245-246 (1985).
IRC § 6651(a)(2) – Failure to Pay Penalty
The Code imposes an addition to tax for a taxpayer’s failure to timely pay the amount shown as tax on a Federal income tax return unless the taxpayer shows that such failure was due to reasonable cause and not due to willful neglect. IRC § 6651(a)(2). The IRS’s burden of production under IRC § 7491(c) requires him to come forward with sufficient evidence that the tax was shown on a Federal income tax return and was not paid. See Wheeler, 127 T.C. at 206, 207-208; Cabirac v. Commissioner, 120 T.C. 163, 170 (2003). Where the taxpayer has not filed Federal income tax returns for certain taxable years, substitutes for returns prepared by the IRS that meet the requirements of IRC § 6020(b) for those years are treated as the returns filed by the taxpayer for purposes of IRC § 6651(a)(2). See IRC § 6651(g); Wheeler, 127 T.C. at 208-209.
IRC § 6654(a) – Failure to Pay Estimated Tax Payment
The Code imposes an addition to tax in the case of any underpayment of estimated tax by an individual. IRC § 6654(a). The addition to tax is calculated with reference to four required installment payments of the individual’s estimated tax liability. See IRC § 6654(c); IRC § 6654(d). The IRS’s burden of production under IRC § 7491(c) requires the IRS to produce evidence that the taxpayer (a) had a “required annual payment” and (b) had tax shown on the taxpayer’s return for the previous year or that the taxpayer filed no such return. Wheeler, 127 T.C. at 212; Schlussel v. Commissioner, T.C. Memo. 2013-185. There is no reasonable cause exception for IRC § 6654. See Rader v. Commissioner, 143 T.C. 376, 390 (2014), aff’d in part, dismissed in part, 616 F. App’x 391 (10th Cir. 2015).
Existence of Fraud – Burden of Proof
Next, the Tax Court must determine whether the IRS has proven by clear and convincing evidence that any portions of the underpayments are attributable to fraud. Fraud for this purpose is defined as intentional wrongdoing by the taxpayer motivated by a specific purpose of avoiding tax believed to be owing. Maciel v. Commissioner, 489 F.3d 1018, 1026 (9th Cir. 2007), aff’g in part, rev’g in part T.C. Memo. 2004-28; Neely v. Commissioner, 116 T.C. 79, 86 (2001).
Fraud “does not include negligence, carelessness, misunderstanding or unintentional understatement of income,” but it does include any conduct designed to conceal, mislead, or otherwise prevent the collection of taxes. United States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956); see Holland v. United States, 348 U.S. 121, 139 (1954); United States v. Murdock, 290 U.S. 389, 396 (1933). The existence of fraud is a question of fact to be resolved upon consideration of the entire record. See DiLeo, 96 T.C. at 874.
Fraud will never be presumed; it must be established by independent evidence of fraudulent intent. Recklitis v. Commissioner, 91 T.C. 874, 909-10 (1988). However, because direct proof of a taxpayer’s fraudulent intent is rarely available, fraud may be established by circumstantial evidence and inferences drawn from the facts. Niedringhaus, 99 T.C. at 210. The taxpayer’s entire course of conduct during each relevant year and leading up to the preparation of the year’s return may establish the requisite intent. DiLeo, 96 T.C. at 874; Stone v. Commissioner, 56 T.C. 213, 224 (1971).
Badges of Fraud
Fraudulent intent may be inferred from various kinds of circumstantial evidence or “badges of fraud.” Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601. To this end, courts have routinely considered whether the following badges of fraud are present: (1) a pattern of understating income, (2) failing to maintain adequate records, (3) offering implausible or inconsistent explanations of behavior, (4) concealing income or assets, (5) dealing in cash, (6) providing incomplete or misleading information to his or her tax return preparer, (7) filing false documents, including filing false Federal income tax returns, (8) failing to file Federal income tax returns, (9) failing to cooperate with tax authorities, and (10) engaging in and attempting to conceal illegal activity. Id.; Niedringhaus, 99 T.C. at 211. The existence of any one factor is not dispositive, but the existence of several factors is persuasive circumstantial evidence of fraud. See Niedringhaus, 99 T.C. at 211; Petzoldt, 92 T.C. at 700 (1989).
(T.C. Memo. 2020-50) Collins v. CommissionerAdd to favorites