T.C. Memo. 1999-142

UNITED STATES TAX COURT

GREGORY H. AND ELIZABETH A. PRICE, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 18727-96. Filed April 29, 1999. 

 

Henry W. Tom and Rick Kilfoy, for petitioners.

Richard A. Rappazzo, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge: Respondent determined deficiencies, additions

to tax, and penalties with regard to petitioners' 1989, 1990, and

1991 Federal income tax liabilities as follows:
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Accuracy-Related Fraud

Addition to Tax Penalty Penalty 

Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) Sec. 6663

1989 $46,994 $6,689 -- $35,246

1990 32,846 1,494 -- 24,635

1991 34,974 8,834 $6,995 --

 

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure. All references to petitioner in the singular are to

Gregory H. Price.

After concession of some issues, the primary issues for

decision are the amount of income that should be charged to

petitioner with respect to bank deposits, whether funds received

from landlords for improvements to leased property constitute

taxable income, and whether petitioner is liable for fraud

penalties, additions to tax for late filing of income tax

returns, and accuracy-related penalty.

For convenience, with respect to each of respondent’s

contested adjustments to petitioners’ income and expenses, we

combine our findings of fact and opinion. 

FINDINGS OF FACT AND OPINION

Some of the facts have been stipulated and are so found. 

When the petition was filed, petitioners resided in

Glendale, Arizona. 
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Income with Respect to Bank Deposits

During 1985 through 1991, in Phoenix, Arizona, petitioner,

either in equal partnership with Michael Talerico (the

partnership) or alone, owned and operated seven movie video

rental stores (hereinafter sometimes referred to as the Store or

the Stores). The partnership and petitioner also sold some of

the Stores. The schedule below indicates for each Store the

owner of the Store, the month or year the Store was purchased or

opened, and the month the Store was sold:

Month/Year 

Purchased Month

 Name of Store Owner or Opened Sold 

 Store 1 Petitioner Mid-1980's Mar. 1987

 Store 2 Petitioner July 1988 Feb. 1989

 Store 3 Partnership Nov. 1988 Feb. 1989

 Store 4 Partnership Feb. 1989 --

 Store 5 Partnership June 1989 May 1991

 Store 6 Petitioner Feb. 1990 --

 Store 7 Partnership 1991 --

Petitioner was responsible for finances and managed funds of

the partnership and of the Stores. Payments for rental of the

movie videos (videos) were made by customers with cash, checks,

and credit cards.

Inadequate books and records were maintained with regard to

income and expenses of the partnership and of the Stores. Some

entries were made in what petitioner refers to as general ledgers

reflecting funds received from rental of videos. These so-called
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general ledgers, however, were retained by the partnership and by

petitioner for only a short period of time and were not available

at the trial. 

Petitioner maintained what he refers to as monthly summary

records with respect to funds received from rental of videos. 

The summary records also were not available at the trial. 

There was maintained for each Store a separate bank account

at Valley National Bank. Funds received from rental of videos

were deposited every few days into the bank accounts maintained

for the Stores. 

Most of the funds deposited in the bank accounts represented

cash received by the Stores from the rental of videos. Funds

deposited into the bank accounts also represented checks received

by the Stores from the rental of videos and funds received by the

Stores from credit card companies for video rentals which had

been paid by customers with credit cards. 

Stores 1, 2, and 3 were sold either in 1987 or in the

beginning of 1989, and there is no issue between the parties as

to the income relating to Stores 1, 2, and 3. 

For 1989 and 1990, the partnership timely filed partnership

Federal income tax returns and reported gross receipts and, after

expenses, ordinary losses relating to Stores 4 and 5 as follows:
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 Partnership Year 

 1989 1990 

 Gross receipts $138,756 $282,168 

 Ordinary losses (104,347) (169,491)

Petitioners untimely filed their 1989, 1990, and 1991 joint

Federal income tax returns, to which returns petitioners attached

Schedule E, Supplemental Income and Loss, relating to petitioner's

interest in the partnership that owned and operated Stores 4, 5,

and 7, and reflecting petitioner's one-half interest in the

partnership ordinary losses as claimed on the partnership returns. 

On petitioners' 1990 and 1991 joint Federal income tax

returns, petitioners attached Schedule C, Profit or Loss From

Business, relating to Store 6 that petitioner owned individually

and reporting gross income relating to Store 6 of $47,029 for 1990

and $281,740 for 1991.

On audit, using the bank deposits method of proof,

respondent treated the funds that were deposited into the bank

accounts of the Stores -- the source of which respondent regarded

as unexplained -- as taxable income to the partnership or to

petitioners. Respondent also treated certain funds received for

leasehold improvements (discussed below) as specific items of

taxable income, and respondent treated certain other funds that

were deposited into the bank accounts maintained for the Stores

as nontaxable deposits. 
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1 For 1991, total deposits made into the partnership Store 4

and Store 5 bank accounts were consistent with the total funds

from video rentals reported on the partnership’s 1991 information

Federal income tax return. Accordingly, in his bank deposits

analysis for the partnership for 1991, respondent made no

adjustments for unexplained bank deposits.

For 1989 and 1990,1 total unexplained deposits, as

determined by respondent, made into the bank accounts the

partnership maintained for Stores 4 and 5 consist of the

following amounts: 

 Respondent's Determination of 

Partnership Unexplained Bank Deposits

 1989 1990 1991

 $146,609 $266,352 0

For 1990, unexplained deposits, as determined by respondent,

made into the bank account petitioner maintained for Store 6

consist of $117,514.

Where a taxpayer fails to maintain adequate books and

records relating to taxable income, respondent may reconstruct a

taxpayer's income by any reasonable method. See sec. 446(b);

Edwards v. Commissioner, 680 F.2d 1268, 1270-1271 (9th Cir.

1982), affg. per curiam an Order of this Court; Parks v.

Commissioner, 94 T.C. 654, 658 (1990); United Dressed Beef Co. v.

Commissioner, 23 T.C. 879, 885 (1955).

The bank deposits method for computing income is approved by

the courts. See United States v. Soulard, 730 F.2d 1292, 1296
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(9th Cir. 1984); DiLeo v. Commissioner, 96 T.C. 858, 867 (1991),

affd. 959 F.2d 16 (2d Cir. 1992). Further, for the years in

issue, where respondent uses the bank deposits method to

reconstruct a taxpayer's income, respondent's determination has a

presumption of correctness, and the taxpayer has the burden of

proving that the deposits are not attributable to taxable income. 

See Rule 142(a); Ruark v. Commissioner, 449 F.2d 311, 312

(9th Cir. 1971), affg. per curiam T.C. Memo. 1969-48; Mills v.

Commissioner, 399 F.2d 744, 749 (4th Cir. 1968), affg. T.C. Memo.

1967-67; Doll v. Glenn, 231 F.2d 186, 188 (6th Cir. 1956);

Tokarski v. Commissioner, 87 T.C. 74, 76-77 (1986).

Petitioners contend that the funds deposited into the

partnership’s and into petitioners' bank accounts that respondent

treats as unexplained bank deposits and therefore as additional

taxable income (for the partnership -- $146,609 and $266,352 for

1989 and 1990, respectively; for petitioners -- $117,514 for

1990) are largely attributable to sales of videos that petitioner

owned personally, in which videos petitioner had a cost or tax

basis in excess of the amount for which the videos were sold, and

petitioners therefore contend that the bank deposits in question

do not constitute taxable income.

Respondent argues that petitioner has not established the

nontaxable source of the bank deposits in question.
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Inadequate books and records were maintained relating to

funds received by the Stores for the rental of videos and

relating to the partnership’s and to petitioners’ income from the

Stores. Most of the records that allegedly were maintained were

retained only for a short period of time and were not introduced

into evidence. No records appear to have been maintained

relating to checks and credit card payments received for rental

of the videos. 

Petitioners presented no receipts, invoices, photographs, or 

other credible evidence to establish and verify petitioner’s

ownership and sale of, and tax basis in, personal videos that

would explain the nature and source of the bank deposits in

question. 

Petitioners have failed to establish the nontaxable nature

of the bank deposits treated by respondent as unexplained and as

taxable income. We sustain respondent’s adjustments to the

partnership's and to petitioner's income based on the unexplained

bank deposits.

Reimbursements for Leasehold Improvements

On March 20, 1989, the partnership leased from MC-Peoria

Limited Partnership (Peoria) a portion of a building for Store 5. 

Under terms of the lease, the partnership was obligated to make

certain capital improvements to the building, and Peoria was
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obligated to transfer to the partnership up to $100,000 to

reimburse the partnership for costs of the improvements. During

1989, the partnership received from Peoria $99,946 to make the

improvements to Store 5. 

In November of 1989, petitioner leased for a period of

10 years from the College Park Partnership (College Park) a

portion of a building for Store 6. Under terms of the lease,

petitioner was obligated to make certain capital improvements to

the building, and College Park was obligated to transfer to

petitioner up to $70,000 to reimburse petitioner for costs of the

improvements. During 1989, petitioner received $56,921 from

College Park to make the improvements to Store 6.

In 1989, Store 5 and in early 1990 Store 6 were opened and

conducted business, and it appears from the evidence that the

required improvements to the buildings were made and that the

above funds were received from Peoria and from College Park by

the partnership and by petitioner as reimbursement for costs of

the improvements.

During 1990, petitioner received $8,465 from College Park to

make improvements to Store 6.

On the partnership's and on petitioners' 1989 income tax

returns, the $99,946 the partnership received from Peoria in 1989

to make improvements to Store 5 was not reflected as income of

the partnership. Also, on petitioners’ joint Federal income tax
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2 Respondent treated $17,133 of the funds received by

petitioner from College Park in 1989 as a nontaxable

reimbursement for leasehold improvements. 

return for 1989, the $56,921 that petitioner received from

College Park in 1989 to make improvements to Store 6 was not

reflected as taxable income. Similarly, on petitioners’ joint

Federal income tax return for 1990, the $8,465 that petitioner

received from College Park in 1990 to make improvements to Store

6 was not reflected as taxable income. 

On audit, respondent treated the $99,946 received by the

partnership from Peoria in 1989, $39,788 of the $56,9212 received

by petitioner from College Park in 1989, and the $8,465 received

by petitioner from College Park in 1990 as specific items of

unreported taxable income.

Under section 61, gross income includes all income from

whatever source derived. See Commissioner v. Glenshaw Glass Co.,

348 U.S. 426, 431 (1955). Respondent relies on this general

proposition in treating as taxable income the funds the

partnership and petitioner received in 1989 and 1990 from Peoria

and College Park. 

Generally, however, gross income does not include funds

received by a taxpayer in reimbursement for expenses paid on

behalf of another. See Gray v. Commissioner, 10 T.C. 590, 596-
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3 Generally, under sec. 110, for leases entered into after

Aug. 5, 1997, funds received by tenants in reimbursement from

landlords for improvements to certain buildings leased under

short-term leases are treated as nontaxable income to the

tenants.

597 (1948); Rev. Rul. 67-407, 1967-2 C.B. 59; 1 Mertens, Law of

Federal Income Taxation, sec. 5.06, at 16 (1999 rev.).

The evidence is sufficiently clear that the funds received

in 1989 and 1990 relating to leasehold improvements to buildings

in which Stores 5 and 6 operated under short-term leases were

received by the partnership and by petitioner in reimbursement

for capital expenditures made to the buildings owned by the

landlords. As such, these funds do not constitute taxable income

to the partnership or to petitioner. See Suwalsky, 47-5th T.M.,

Real Estate Leases and Improvements, A-22 to A-26 (July 6,

1998).3

Depreciation Recapture Income

In June of 1989, the partnership opened Store 5. Throughout

the years in issue, the partnership purchased videos that Store 5

owned and rented to customers. 

On May 1, 1991, for a stated sales price of $200,000, the

partnership sold Store 5 and the videos associated with Store 5. 

 The partnership's total cost basis in the assets of Store 5

equaled $288,239. The sale took the form of an installment sale
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4 Respondent apparently computed the partnership’s $170,267

gain on the 1991 sale of Store 5 as follows: $200,000 sales

price for Store 5 less partnership’s depreciated tax basis in

Store 5 and in the associated videos of $29,733 equals $170,267.

under which the purchaser paid the partnership a cash downpayment

of $12,500 and gave the partnership a $187,500 promissory note.

On its 1989, 1990, and 1991 partnership Federal income tax

returns, the partnership claimed accelerated depreciation with

respect to the partnership’s tax basis in Store 5. 

On its 1991 partnership Federal income tax return, the

partnership did not reflect the sale of Store 5. Rather, the

sale of Store 5 was reflected only on petitioners’ 1991 joint

Federal income tax return as an installment sale with respect to

which a capital gain for 1991 of $298 was reported.

On audit, respondent determined that the partnership’s total

$170,267 gain on the sale of Store 5 and the associated videos4

was attributable to depreciation recapture and was taxable to the

partnership for 1991 as ordinary income under section 453(i).

Under the installment sale provisions of section 453(i), it

is provided that on an installment sale, all income related

thereto that would be treated as ordinary recapture income under

sections 1245 or 1250 if received in the year of the sale, must

be treated as ordinary income as if received in the year of the

sale. See Murry v. Commissioner, T.C. Memo. 1993-471; 2 Mertens,
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Law of Federal Income Taxation, sec. 15.05, at 21, 15.22, at 57

(1997 rev.).

Although petitioners object to this adjustment to the

partnership’s income for 1991, petitioners provide no basis for

their objection. We sustain respondent’s adjustment.

Rental Income

During the years in issue, petitioners owned a number of

rental properties on which they received rental income. 

Petitioners reported on their 1990 joint Federal income tax

return $29,550 in rental income relating to these properties. 

Respondent determined that in 1990 petitioners received

$31,441 of rental income from these rental properties and that

petitioners failed to report $1,891 of such rental income.

Under section 61(a)(5), funds received from rental of

property are included in a taxpayer’s income.

Although petitioners dispute respondent’s adjustment,

petitioners provided no testimony or evidence to disprove the

adjustment. We sustain this adjustment. 

Depreciation of Videos

As indicated, during the years in issue, videos were

purchased by the partnership and by petitioner for rental to

customers. 
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On the partnership’s and on petitioners’ Federal income tax

returns for the years in issue, the costs of some of the videos

purchased for rental to customers were expensed currently. In

the partnership's and on petitioners' income tax returns,

depreciation expense deductions relating to the balance of the

videos rented to customers were claimed using the Modified

Accelerated Cost Recovery System, a 3-year life, and the halfyear convention. 

On audit, respondent disallowed the current expenses claimed

for the cost of videos rented to customers. Respondent also

determined that the proper method for computing depreciation on

the videos was the straight-line method using a 2-year life and a

$5 per-tape-salvage value (straight-line method). For some

years, respondent’s adjustments to depreciation resulted in a

decrease in the depreciation claimed, and in other years,

respondent's adjustments to depreciation resulted in an increase

in the depreciation to be allowed. 

The schedule below sets forth respondent’s recomputation of

the partnership’s and of petitioners' allowable depreciation

relating to videos rented to customers:
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 Respondent's Recomputation of Depreciation 

 1989 1990 1991 

 Partnership 

Depreciation claimed on return $55,452 $145,057 $118,404

Videos expensed on return 44,264 -- --

Recomputed depreciation (86,765) (181,015) (159,833)

Total decrease/(increase) 12,951 (35,958) (41,429)

 petitioner's one-half share 6,475 (17,979) (20,715)

 Petitioners 

Depreciation claimed on return 56,074 95,293

Videos expensed on return 73,991

Recomputed depreciation (55,715) (121,075)

Total decrease $ 359 $ 48,209 

A reasonable depreciation deduction is allowed for the

exhaustion and wear and tear of property used in a trade or

business. See sec. 167(a). Under sections 167(c) and 168(f),

movie videos are to be depreciated for Federal income tax

purposes using a straight-line method. See Rev. Rul. 89-62,

1989-1 C.B. 78. 

Petitioner argues that for 1989 and 1991, respectively, of

the above adjustments made by respondent, respondent incorrectly

classified $44,264 for the partnership and $73,991 for

petitioners as costs of videos, as not currently deductible, and

as subject to straight-line depreciation. Petitioners claim that

such funds related to the cost of supplies for the Stores and

were properly expensed by the partnership and by petitioners. 

No evidence supports petitioners’ contention. We sustain

respondent’s adjustments to current expenses and to depreciation

claimed relating to videos rented to customers.
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Repair and Maintenance Expenses

On their 1989, 1990, and 1991 joint Federal income tax

returns, petitioners claimed current business expenses of $1,598,

$4,333, and $2,014, respectively, relating to repair and

maintenance work on petitioners' rental properties. On audit,

respondent disallowed $893, $3,486, and $1,020, for 1989, 1990,

and 1991, respectively, of the claimed repair and maintenance

expenses.

Petitioners presented no evidence to dispute respondent's

adjustments for repair expenses. We sustain respondent's

adjustments for each year. See Rule 142(a).

Summary of Adjustments

Based on the above findings and conclusions relating to

disputed issues, on petitioners’ concession of adjustments, and

certain mechanical adjustments, we set forth below, in schedule

format, the total adjustments that are to be made to petitioners’

reported income, expenses, and taxable income:
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Partnership Adjustments - Contested by

Petitioners (Stores 4, 5, and 7): 1989 1990 1991 

Unexplained bank deposits $146,609 $266,352 

Depreciation recapture on Store 5 $170,267 

Depreciation of videos 12,951 (35,958) (41,429)

Total adjustments to partnership income $159,560 $230,394 $128,838 

Petitioner's one-half interest in total 

 partnership adjustments $ 79,780 $115,197 $ 64,419 

Individual Adjustments: 

 Contested by Petitioners: 

Unexplained bank deposits $117,514 

Rental income 1,891 

Depreciation of videos 359 $ 48,209

Repair and maintenance expenses $ 893 3,486 1,020

 Conceded by Petitioners or 

 Mechanical Adjustments: 

State tax refund 240 443

Rental interest paid 2,453 

Rental depreciation 3,540 3,540 3,540

Capital gains/losses (298)

Self-employment tax deduction (3,924) (1,076)

Itemized deductions (3,964) (4,454) 1,662

Exemption adjustment 387 

Corrected individual adjustments

 before partnership adjustments $ 2,922 $118,652 $ 53,887 

Total combined individual adjustments to 

 taxable income and to petitioner's one-half 

 interest in total partnership income

 adjustments $ 82,702 $233,849 $118,306 

Fraud (1989 and 1990) Penalties, AccuracyRelated Penalty, and Additions to Tax 

For 1989, 1990, and 1991, petitioners untimely filed their

joint Federal income tax returns. 

Petitioners reported on their 1989, 1990, and 1991 joint

Federal income tax returns the following taxable income:

 Year 

 1989 1990 1991 

Reported taxable income -0- -0- $22,967
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For 1989, respondent determined that petitioner is liable for

fraud and that the fraud is attributable to the taxable income

relating to the unexplained bank deposits and the reimbursements

for leasehold improvements. For 1990, respondent determined that

petitioner is liable for fraud and that the fraud is attributable

to the taxable income relating to the unexplained bank deposits,

the reimbursements for leasehold improvements, and the $359 of

claimed depreciation expense.

For the years in issue, under section 6663(a), a penalty of 75

percent applies to the portion of an understatement of tax that is

attributable to fraud. To establish fraud, respondent is required

to prove that the understatement is due to fraudulent intent. See

sec. 7454(a); Rule 142(b); DiLeo v. Commissioner, 959 F.2d 16 (2d

Cir. 1992), affg. 96 T.C. 858, 873 (1991). Respondent has the

burden of proving fraud by clear and convincing evidence. See sec.

7454(a); Rule 142(b); Bagby v. Commissioner, 102 T.C. 596, 607

(1994).

Where allegations of fraud are intertwined with unreported and

indirectly reconstructed income, respondent is required to

establish a likely taxable source for alleged unreported income or

to disprove nontaxable sources alleged by the taxpayer. See DiLeo

v. Commissioner, 96 T.C. at 873; Parks v. Commissioner, 94 T.C.

654, 661 (1990).
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Indicia of fraud include: (1) Understatements of income;

(2) inadequate books and records; (3) lack of cooperation with tax

authorities; and (4) implausible or inconsistent explanations of

behavior. See Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th

Cir. 1986), affg. T.C. Memo. 1984-601; Clayton v. Commissioner, 102

T.C. 632, 647 (1994); Petzoldt v. Commissioner, 92 T.C. 661, 699-

700 (1989); Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).

With regard to the fraud alleged by respondent for 1989 and

1990, the evidence establishes that petitioner failed to maintain

adequate books and records with regard to income and expenses of

the Stores, that petitioner received significant taxable income not

reported on petitioners’ joint Federal income tax returns, and that

significant understatements of tax were made on petitioners’

Federal income tax returns.

We conclude that for 1989 and 1990 respondent has established

by clear and convincing evidence that petitioner fraudulently

intended to evade his correct Federal income tax liabilities. 

For 1989 and 1990, we conclude that the increases to

petitioner's taxable income that we have sustained herein and that

relate to unexplained bank deposits are attributable to fraud. For

purposes of the fraud penalties, none of the other adjustments that

we sustain herein are attributable to fraud.

With regard to the section 6662(a) 20-percent accuracy-related

penalty that respondent determined for 1991, such penalty applies
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where and to the extent that understatements of tax are

attributable to negligence. Respondent asserts that this penalty

applies to the adjustments for depreciation recapture and

depreciation. Taxpayers are required to maintain adequate records

and failure to do so may constitute negligence and a disregard of

rules or regulations. See sec. 6001; see also Nehus v.

Commissioner, T.C. Memo. 1994-631, affd. without published opinion

108 F.3d 338 (9th Cir. 1997); Schroeder v. Commissioner, 40 T.C.

30, 34 (1963); Bard v. Commissioner, T.C. Memo. 1990-431. 

Taxpayers bear the burden of proof with regard to this issue. See

Rule 142(a).

For 1991, the failure of petitioner to maintain adequate

records constitutes negligence. We sustain respondent's

determination of the accuracy-related penalty with respect to the

adjustments for depreciation recapture and depreciation.

For the years in issue, section 6651(a)(1) provides for an

addition to tax for failure to timely file Federal income tax

returns. The addition to tax equals 5 percent of the amount

required to be shown as tax on the return for every month the

return has not been filed, but not exceeding 25 percent. This

addition to tax will not be imposed if it is established that the
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late filing was due to reasonable cause and not due to willful

neglect. We sustain respondent's determination of the additions to

tax for failure to timely file.

To reflect the foregoing,

Decision will be entered

under Rule 155.