On January 8, 2020, the Tax Court issued a Memorandum Opinion in the case of Hommel v. Commissioner (T.C. Memo. 2020-4). The issue presented in Hommel v. Commissioner was whether a petitioner, who presented no evidence to the contrary, could challenge a bank deposits analysis for abuse of discretion. The real issue, however, was how close Judge Holmes could get to calling the petitioner a #^&%$ idiot without actually doing so.
Personal Note in Hommel v. Commissioner – When I Grow Up, I Want to be Like Judge Holmes
Rarely are we given an opinion where the sarcasm isn’t veiled, where the puns aren’t scrapped for platitudes, where the passive aggression is not tamed if not wholly eliminated, and where the Judge doesn’t even attempt to hide his utter scorn for a litigant whose sheer incompetence landed him in the quagmire that he now finds himself mired in.
Judge Holmes’ opinion in Hommel is a Loch Ness monster of a Tax Court opinion. Rumors of it exist, but when you see it, you can’t believe it. Hommel is an example of a jurist throwing caution to the wind, just waiting for one of his more reserved colleagues to do a spit-take and say, “Christ, Mark, you can’t say that.
If this opinion were a fine wine, it would have notes of “I cannot believe that I am having to write this” with subtle, but crisp tones of “but I am, so I might as well have fun with it.” Bless you, Judge Holmes. Your opinion in Hommel was absolute gold. Please consider this post a doffing of my cap to a most worthy jurist.
The Facts – Striking it Rich, Forging Ahead, and Turning Gold into Lead
The opinion begins, where every good opinion begins, with the petitioner running a bullion business from his garage. Notwithstanding the inauspicious beginnings, the petitioner “was good at the business, and the business was good.”*
That’s right. We don’t even get past the second sentence before, wham, chiasmus. I thought to myself, well damn, kudos Judge Holmes. How did you know that chiasmus (ABBA word order) was one of my favorite rhetorical devices? You scamp, you. How was I to know that this wordsmithery was but a harbinger for even more flourishes to come. You will note that I use direct quotations from the case far more often than usual. Credit is given where credit is due.
The petitioner soon outgrew his garage, and he bought a coin shop in 2009. “But fortune varies,” Judge Holmes observes, “and by the end of 2010, [the petitioner] had been charged with false imprisonment by his workers and had lost both businesses.” Wait. What? I must know more. I mean, how can you not help but read on? The IRS sent the petitioner a notice of deficiency stating that he owed more than $1m in 2009 alone.
Petitioner argues (literally, this is his argument) that he should not owe such sums for 2009, “because, in retrospect, he was already far along the path to the ruin he suffered in 2010.” I’m not sure which regulation this is found in, but I’m even willing to suspend disbelief for the moment – if for no other reason than to see what Judge Holmes has in store for us, dear reader.
The petitioner began an online “presence” in the silver trading world, and he cashed out in 2009 and entered into the business of silver-bullion trading. Having found success with silverstockreport.com, the petitioner founded seekbullion.com. The overhead was low, owing both to the fact that the ceiling in the petitioner’s garage was, in fact, low, and because the business actually operated from said garage. Because even a blind squirrel finds a nut every once in a while, the petitioner, against all odds (you’ll see what I mean in a moment), struck a vein of success. By the fall of 2009, the petitioner opened a couple of coin shops and an honest-to-goodness coin mint. But troubles “were about to strike.”*
For the uninitiated, you “strike” coins on a mint. Is it a coincidence that Judge Holmes uses the verb to strike no less than four times in short course in the opinion? Possibly, but for my new personal tax hero, Judge Holmes, not likely.
The petitioner brought in two men to be “comanagers” of the shop. “MV was a ‘banker’ and had reached out to [the petitioner] in response to his newspaper advertisement for the job.” Because, when one contemplates entrusting hundreds of thousands of dollars in easily concealable precious metals to someone, one thinks, Craigslist is just reckless, but the classified section, now we’re talking. “JR was a family acquaintance, whom [the petitioner] really didn’t know much about.” (A footnote explains why the two men are referred to only by their initials: “[the petitioner’s] allegations of their misconduct could seriously harm their reputations if believed, and the truth of his allegations turns out not to be important” in the end. Translation: truth may be a defense to slander, but the petitioner was less believable than a three-dollar bill, and nuttier than your Aunt Ethel’s Christmas fruitcake.
At this point, the petitioner was seeing the world through rose (gold) colored glasses and decided to turn the shop’s operation over to MV and JR so that he could “open up a mint and write a book.” The petitioner, however, “seems to have wanted a paper trail that would lead any nosy people away from him.” Thus, when he executed an agreement to manage the shop with MV, it was structured “on paper” as a sale of the business to MV. Although “on paper” the petitioner had sold the shop to MV, and “on paper” the sale contained no actual agreement about payment of anything to the petitioner, and “on paper” the petitioner retained zero rights, the petitioner argued “paper-shmaper” and assured the Tax Court that he and MV had a binding oral agreement to the contrary.
Judge Holmes breaks the fourth wall a bit here, when he notes: “Lawyers might also be concerned that such an oral agreement would leave [the petitioner] vulnerable to assertions of the parol evidence rule and statute of frauds, because [the “oral” contract] was not at all what was put on paper.” He also notes that “Lawyers might at this point be concerned that the transaction might look like a sham,” but it was “justified” in “[the petitioner’s] own mind.” Phew. Dodged a bullet there.
The bill of sale transferring the shop did not include the inventory. The petitioner, however, left the entire inventory of silver bullion in the safe, which safe he had, technically, “sold” to MV. By failing to mention the silver in the bill of sale, “[the petitioner] thought MV wouldn’t “exactly own the inventory,” which at the time of the “sale” had a value of approximately $1m. Notwithstanding the written contract, “[the petitioner] sincerely believed that he “retained full ownership of everything at all times, because MV never gave [the petitioner] any consideration to buy the store.”
The petitioner then opened up a mint. “To forge this dream,” the petitioner leased a warehouse and then “called around to determine how to build a mint.” Sure, “forge” could have been a coincidence, but for the footnote, which describes the process of forging and minting coins. The best laid plans of mice and men… “It will come as no surprise to those with a darker view of human nature that shortly after this transaction” things began to go downhill for the petitioner. Apparently, Judge Holmes and I share this “darker view,” and I have no apologies.
Although Judge Holmes never, actually, states that he will assume all facts in favor of the petitioner (this was not a summary judgment proceeding; therefore, doing so would have been, technically, improper), the sage jurist observes that, in regard to the petitioner’s shit-for-brains business transactions, he unequivocally “believe[s] [the petitioner] when he says that he did not consult with a lawyer, broker, or anyone else.” This is typified by the fact that the petitioner ran all of the trades and transactions through his personal bank account, but did not otherwise keep a record of the business purpose of the transactions, which transactions, when later viewed through the critical lens of a bank deposits analysis, did not look so good for the petitioner.
The facts pour on like this for a number of pages, but Judge Holmes’ wit is not tempered by the outcome, which, as you may have foreseen, was not positive for the petitioner. The “employees” of the shop (read: owners) began to “steal” from the petitioner (read: keep what belonged to them). The final die was cast when the petitioner performed a “spot check” on the shop, only to discover (oh, the humanity!) that substantial inventory was “missing.” Petitioner, “then decided to take matters into his own hands” by removing (read: illegally absconding with) the remaining inventory from the safe. Not to be outdone by himself, the very next day, having become “quite upset,” the petitioner “decided to make what he called a ‘citizen’s arrest.’”
In deference to the petitioner, he did “first [go] to the local police station, where he dropped off a document, which he called an ‘indictment.’” He then went to the shop “carrying a gun, a chain, and a padlock and subsequently locked JR inside the store.” Having followed the correct “procedure” for a proper “citizen’s arrest,” the petitioner believed all was as it should be. Wrongs were righted, vengeance was had, and above all, the petitioner had protected what, in his addled brain, was his. For the moment, JR was in “custody” and all was right in petitioner’s world.
“But this attempt at a citizen’s arrest and reclaiming any missing inventory was not received well by local law-enforcement officials.” The police arrested the petitioner for false imprisonment, for which he was indicted and convicted two years later.
Unsurprisingly, the petitioner’s returns were, thereafter, selected for exam. The petitioner refused to provide any records of his dealings during the audit. Whether or not he actually had any records is questionable. He claimed that it was legally impossible to access any of “his” businesses’ records for the year in question, because of the nasty “restraining order” that barred him from coming within 500 feet of the shop and its “owners.”
Because the petitioner had not kept adequate records, the IRS conducted a bank-deposits analysis to reconstruct his income. The IRS analyzed five accounts that the petitioner owned, and he concluded that there was just under $9.2 million in Schedule C gross receipts, meaning that he had allegedly failed to report nearly $8.1 million in income. However, the IRS also concluded that the petitioner had undervalued his costs of goods sold by nearly $4.4m, meaning that the petitioner was entitled to COGS of over $6m.
As a consequence, the IRS issued a statutory notice of deficiency (SNOD) in the amount of $1.2m. It also “pressed on” (for Judge Holmes’ final mint-related pun), a late-filing penalty and an IRC § 6662(a) accuracy-related penalty. Ironically, the IRS failed to introduce any evidence that it had complied with the prior written supervisory approval requirement for the IRC § 6662(a) penalty pursuant to IRC § 6751(b)(1).
I blame this on a Grade 3 clerk (Felicia) who failed to deliver the Civil Penalty Approval Form to the RA’s supervisor, but it’s just as likely that it was an example of simple, but gross incompetence on the part of Exam.
Substantiation of Records and Bank Deposits Analysis
When a taxpayer does not keep adequate records of his income, the IRS may reconstruct it and may use a taxpayer’s bank deposits to do so. See IRC § 6001; IRC § 446(b); Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir. 1997) (holding that the IRS may rationally reconstruct income where taxpayers fail to offer accurate records); Parks v. Commissioner, 94 T.C. 654, 658 (1990). A bank deposits analysis assumes that all money deposited in a taxpayer’s bank accounts during a given period is taxable income; unexplained deposits are considered prima facie evidence of income. See United States v. Helina, 549 F.2d 713, 715 n.2 (9th Cir. 1977); Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). The taxpayer then has the burden to show that such deposits were nontaxable, such as inheritances, loan proceeds, transfers from another personal account, etc. See Palmer, 116 F.3d at 1312.
The IRS is required to subtract reported transactions and income from nontaxable sources that it knows or has good reason to know is not taxable income. Helina, 549 F.2d at 715 n.2. If a taxpayer believes the IRS’s computation is unfair or inaccurate, the taxpayer has the burden to show the Tax Court the error of the IRS’s ways. Palmer, 116 F.3d at 1312. In the present cases, although the petitioner decried the impropriety not only of the bank deposits analysis, but also the sheer gumption of the IRS to penalize (read: tax) a man so down on his luck due to the unmitigated malfeasance of others, the petitioner failed to offer any evidence to support his arguments.
Costs of Goods Sold (COGS)
The Tax Court recognizes, in very short order, that gross receipts are not an accurate representation of the taxpayer’s taxable income. The petitioner had inventory costs and other expenses in his coin and minting business. COGS is the cost of acquiring inventory, through either purchase or production. See, e.g., Reading v. Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980). COGS is computed under IRC § 471. No matter the line of business (even income that is “illegal” by Federal standards, as we’ll see in the Richmond Patients Group case), taxpayers may use COGS to offset their gross receipts when they calculate gross income. See, e.g., Olive v. Commissioner, 139 T.C. 19, 20 n.2 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015).
Ultimately, the petitioner was hoisted by his own petard, and the fact that the IRS increased his COGS amount and utterly dropped the ball on the IRC § 6571(b)(1) requirement regarding the accuracy related penalty show that somewhere a functionally incompetent guardian angel, ever so slightly, saved face. Bad things happen to good people, and in Hommel the opposite proved true.