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Rivera v. Commissioner (T.C. Memo. 2020-7)

On January 13, 2020, the Tax Court issued a Memorandum Opinion in the case of Rivera v. Commissioner (T.C. Memo. 2020-7). The issues presented in Rivera were whether (1) the petitioners’ partnership received and failed to report gross receipts on Forms 1065, (2) the partnership is entitled to certain deductions claimed on the partnership returns, and (3) the petitioners are liable for IRC § 6662(a) accuracy-related penalties.

Background: Hiring a Guy Named Roosevelt L. Drummer as a Tax Expert was a Poor Decision

The petitioners were born and raised in the Philippines and immigrated to the United States in 1983. They do not have any training in taxation or accounting. The petitioners also showed a supreme lapse in judgment when they selected an individual named Roosevelt L. Drummer to prepare their tax returns and accepted the utterly asinine tax advice that Mr. Drummer “provided” to them, in part, because he held himself out to be a former IRS agent and an expert in business and taxation.

What is, perhaps, worse is that Mr. Drummer came highly recommended by a coworker of the petitioner-husband. This fact alone does not, perhaps, indicate the petitioners’ liability for the deficiencies determined against them, but it certainly begs the question whether the Tax Court should be censured for failing to warn the petitioners not to sell their cow for a handful of magic beans if the opportunity ever presented itself (which, given their track record, is a distinct possibility).

Reconstruction in Absence of Maintenance of Books and Records

Every individual liable for tax is required to maintain books and records sufficient to establish the amount of his or her taxable income. IRC § 6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). Where a taxpayer fails to maintain or produce adequate books and records, the IRS may compute the taxpayer’s taxable income by any method that, in the IRS’s opinion, clearly and accurately reflects income. IRC § 446(b); Holland v. United States, 348 U.S. 121 (1954); Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), aff’g T.C. Memo. 1966-81.

The computation of income through reconstruction need only be reasonable in the light of all surrounding facts and circumstances. See Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). The IRS is given fairly wide latitude in determining which method of reconstruction to apply when a taxpayer fails to maintain records. Petzoldt v. Commissioner, 92 T.C. T.C. 661, 693 (1989).

The acceptability of the bank deposits method of proof to reconstruct petitioners’ taxable income is well established. DiLeo, 96 T.C. at 867; Estate of Mason v. Commissioner, 64 T.C. 651, 656 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977). Bank deposits are prima facie evidence of income. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Estate of Mason, 64 T.C. at 656-657. When using the bank deposits method, the IRS is not required to show that each deposit or part thereof constitutes income or prove a likely source. See Gemma v. Commissioner, 46 T.C. 821, 833 (1966) (no requirement to show deposits were income); Clayton v. Commissioner, 102 T.C. 632, 645 (1994) (no requirement to show source of deposits). Unless the nontaxable nature of deposits is established, gross income includes all deposits into bank accounts over which the taxpayer has dominion and control of the funds. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955); Davis v. United States, 226 F.2d 331, 334-335 (6th Cir. 1955); Manzoli v. Commissioner, T.C. Memo. 1988-299, aff’d, 904 F.2d 101 (1st Cir. 1990).

Errors in Reconstruction Unavoidable

It is well established that some errors are unavoidable when an indirect method is used to reconstruct income, especially where (as here) the taxpayer failed to maintain adequate records. See United States v. Stonehill, 702 F.2d 1288, 1295-1296 (9th Cir. 1983); Canatella v. Commissioner, T.C. Memo. 2017-124, at *12-*13. When, however, a taxpayer fails to maintain adequate records or identify the source of deposits, the IRS’s reconstruction of income will generally be found to be reasonable in the light of the surrounding facts and circumstances. See Giddio, 54 T.C. at 1533.

Substantiation and the “Cohan” Rule

Taxpayers generally bear the burden of proving that they are entitled to any deductions claimed. Tax Court Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Deductions for ordinary and necessary business expenses are generally allowed under IRC § 162(a). However, such expenses must be directly connected with or pertain to the taxpayer’s trade or business. Treas. Reg. § 1.162-1(a).

Generally, no deduction is allowed for personal, living, or family expenses, nor is deduction proper for expenditures that should have been categorized as capital expenditures. See IRC § 262; IRC § 263. The determination of whether an expenditure satisfies the requirements of IRC § 162 is a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943).

If the taxpayer is able to establish that he paid or incurred a deductible expense but is unable to substantiate the precise amount, the Tax Court may approximate the deductible amount, but only if the taxpayer presents sufficient evidence to establish a rational basis for making the estimate (the so-called “Cohan” rule). See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Even then, the taxpayer might catch the Tax Court on a bad hair day and find it unwilling to apply the Cohan rule.

Expenses Subject to IRC § 274

It must be noted that as helpful as the Cohan rule might be, it has zero application to expenses incurred for entertainment, travel, meals, allegedly business-related gifts, etc., because IRC § 274(d) requires strict substantiation for such expenses.  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).  Thus, even where such expenses may otherwise be deductible, if the taxpayer doesn’t have appropriate records or other evidence, the Tax Court will not estimate the value of the steak the taxpayer bought for its new client to seal the deal on that mobile home park the taxpayer’s been itching to build.

No deductions are allowed with respect to travel, entertainment, or listed property (as defined in IRC § 280F(d)(4)), unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statements (1) the amount of expense or item, (2) the time and place of the travel, entertainment, or expense, (3) the business purpose of the entertainment or expense, and (4) the business relationship to the taxpayer of the person or persons entertained. IRC § 274(d).

To substantiate by adequate records, the taxpayer must provide (1) an account book, log, or similar record prepared at or near the time of the expenditure and (2) documentary evidence, which together are sufficient to establish each element of an expenditure. Treas. Reg. § 1.274-5T(c)(2). Documentary evidence includes receipts, paid bills, or similar evidence. Treas. Reg. § 1.274-5(c)(2)(iii).

To substantiate by sufficient evidence corroborating the taxpayer’s own statement, the taxpayer must establish each element by his or her own statement and through the presentation of documentary or other direct evidence. Treas. Reg. § 1.274-5T(c)(3)(i). To establish the business purpose of an expenditure, however, a taxpayer may corroborate his or her own statement with circumstantial evidence. Id.

Reasonable Reliance on Tax Advisor to Avoid Accuracy Related Penalties under IRC § 6662(a)

A taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax due to: (1) negligence or disregard of Code or Treasury Regulations, or (2) a substantial understatement of income tax. See IRC §§ 6662(a), (b)(1), and (b)(2). “Disregard” includes any careless, reckless, or intentional disregard of the Code or Treasury Regulations. IRC § 6662(c). “Negligence” is defined as any failure to make a reasonable attempt to comply with the provisions of the Code, including by failing to keep adequate books and records or substantiate items properly. IRC § 6662(c); Treas. Reg. § 1.6662-3(b)(1).

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 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947 (1985). “Understatement” means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return, reduced by any rebate. IRC § 6662(d)(2)(A). A “substantial” understatement of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. IRC § 6662(d)(1)(A).

The accuracy-related penalty of IRC § 6662(a) does not apply with respect to any portion of the underpayment for which the taxpayer shows that there was reasonable cause and that he acted in good faith. See IRC § 6664(c)(1). Reasonable cause and good faith are determined on a case-by-case basis, considering all of the pertinent facts and circumstances. Treas. Reg. § 1.6664-4(b)(1). Such circumstances include an honest and reasonable misunderstanding of fact or law, where reasonableness is measured against the experience, knowledge, and education of the taxpayer. Id. Reliance on a tax professional demonstrates reasonable cause when a taxpayer (1) selects a competent tax adviser, (2) supplies the adviser with all relevant information, and (3) relies in good faith on the adviser’s professional judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

The IRS bears the burden of production with respect to the taxpayer’s liability for penalties, including the IRC § 6662(a) penalty. Therefore, the IRS and must produce sufficient evidence indicating that it is appropriate to impose the penalty. See IRC § 7491(c); Higbee, 116 T.C. at 446-447. Once the IRS meets its burden of production, the taxpayer must come forward with persuasive evidence that the IRS’s determination is poppycock or that the taxpayer had reasonable cause or substantial authority for the position. See Higbee, 116 T.C. at 446-447.

The petitioner-husband credibly testified that he believed Mr. Drummer was a former IRS agent on the basis of a coworker’s recommendation. The Tax Court found it “more likely than not” that petitioners reasonably believed Mr. Drummer was a competent tax adviser. See Lopez v. Commissioner, T.C. Memo. 2017-171, at *11-*12 (citing Neonatology Assocs., 115 T.C. at 99).

The fact that the petitioners hired Mr. Drummer to prepare their returns does not, by itself, establish that they acted with reasonable cause and good faith. See Neonatology Assocs., 115 T.C. at 99-100. They must also establish that they supplied him with all relevant information and relied in good faith on his professional judgment. Id.

Original opinion here: (T.C. Memo. 2020-7) Rivera v. Commissioner

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