TAX COURT OPINION

Case: Robert E. Thompson & Rose M. Beatty-Thompson
Docket Number: 30130-09
Judge: Holmes
Opinion Type: bench
Filed: 08/10/2012
Pages: 12

UNITED STATES TAX COURT WASHINGTON, DC 20217 ROBERT E. THOMPSON & ROSE M. BEATTY-THOMPSON, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Re spondent . ) ) ) ) ) ) ) ) O R D E R Docket No. 30130-09. Pursuant to Tax Court Rule 152(b), it is ORDERED that the Clerk of the Court shall transmit herewith the to Petitioners and to respondent a copy of transcript of Holmes at San Francisco, California, on June 27, 2012, containing his oral of the trial in the above case before Judge Mark V. the pages of the trial. findings of fact and opinion rendered at the conclusion In accordance with the oral findings of fact and opinion, a decision under Rule 155 will be entered. (Signed) Mark V. Holmes Judge Dated: Washington, D.C. August 10, 2012 seavED AUG 1 7 2012 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Bench Opinion by Judge Mark V. Holmes June 27, 2012 Robert E. Thompson & Rose M. Beatty-Thompson v. Commissioner Docket No. 30130-09 3 THE COURT: In the case of Thompson v. Commissioner, Docket No. 30130-09, the Court has decided to render oral findings of fact and opinion, and the following represents the Court's oral findings of fact and opinion. This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court's Rules of Practice & Procedure. During 2003, 2004, and 2005, Robert E. Thompson was an attorney who operated as a solo practitioner with a concentration in securities and commodities law. He maintained his own books for the law practice and operated Out of two bank accounts. One was a client trust account and the other was a general operating account. He used a check register to keep track of the income and expenses of his business. In fact, he seems not to have had a personal checking account, and so his check register shows a confusing mix of personal and business expenses. For each year at issue, Mr. Thompson filed a Schedule C, although the manner in which he reported his gross income differed in 2003 from that in 2004 and 2005. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 4 In 2003 his gross receipts and gross income were reported identically as $105,923, with no reduction for cost of goods sold. Then in 2004 he reported gross receipts of $467,834, but subtracted cost of goods sold of $354,932, leaving him with a gross income of $112,902. Likewise, in 2005, he showed gross receipts of $115,746 from which he subtracted cost of goods sold of $20,767, leaving gross income of $94,979. This seems highly improbable. Cost of goods sold is generally defined as the difference in inventories between year-end of -- at the beginning, or the beginning of the year minus the end of the year plus inventory. Lawyers don't generally have inventory in the sense in which cost of goods are calculated, and something happened to Mr. Thompson that it caused him to change his method of accounting in 2004 He seems to have included receipts from client funds as gross receipts and then deducted funds that he owed to them as cost of goods sold. Matters became more confusing when the Commissioner's revenue agent adopted this unusual form of accounting to calculate gross income and prepare a bank deposits analysis for the years in issue. In any event, the first issue in this case is whether Mr. Thompson underreported his gross receipts for the years in question. The Commissioner performed a bank deposits analysis for each of the years, involving the Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 client trust account and Mr. Thompson's operating account, as well as an account at a federal credit union which both Thompsons jointly owned. The credit union account, however, was used primarily to withdraw money on the home equity line of credit. This bank deposits analysis found that in tax year 2003 Mr. Thompson had unreported income of $201,834.32; in 2004, that he had unreported income of $39,046.41; and in 2005 unreported income of $5566.57. The bank deposit method for computing unreported income has long been approved by the courts, including the Ninth Circuit. See Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000), When using the bank deposit method to reconstruct a taxpayer's income, all nontaxable sources of deposits must be taken into account. Under this method, one, bank deposits are totalled; two, non-income deposits, re- deposits, or transfers between accounts are eliminated; three, an excess of deposits as adjusted over reported income is considered to be unreported income; four, cash expenditures that did not come from deposited funds or non- taxable sources are added to the amount of underreported income; and, five, deductible expenses not accounted for in the taxpayer's return are allowed. When, like Mr. Thompson, a taxpayer has failed to Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 maintain adequate records as to the amount and source of his income, and the Commissioner has determined that the deposits are income, the taxpayer has the burden of showing that the determination is incorrect. If a taxpayer in this situation feels that the government's method of computation is unfair or inaccurate, the burden is on him to show the unfairness or inaccuracy. I found that Revenue Agent Lo was generally credible, though he, too, was unable to explain why cost of goods sold exists in a law practice and particularly in such amounts in Mr. Thompson's law practice. Nevertheless, Mr. Lo appeared to have shown considerable skill in dealing with the numerous transfers into and out of the Thompsons' accounts. More importantly, Mr. Thompson showed no flaws in Revenue Agent Lo's analysis. And this issue is one that, given the inadequacy of the records that the Commissioner had, the burden of proof should not be on him, but on the Thompsons. My conclusion is that I will sustain the bank deposit analysis and the consequent increase in gross, unreported gross, receipts that it found, and include in the calculation of gross income the reduction in cost of goods sold for 2004 of $10,530. Of course, Mr. Thompson wasn't challenging the increase in the cost of goods sold for the 2003 tax year. but so be it. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 7 The second issue in this case, claimed expenses. Mr. Thompson claimed various expenses on his Schedule C for 2003, 2004, and 2005. He did not provide any worksheets to show how he claimed these expenses or how he calculated their totals, but he apparently told Revenue Agent Lo that he used the check register to estimate the expenses that he claimed on his returns. Mr. Lo reviewed the payments, including copies of cancelled checks and debit card statements to determine the following allowable deductions. In 2003, the Commissioner allowed expenses of $68,743.83, as against claimed expenses of $80,799, leaving a reduction in the deduction for claimed expenses of $12,055.17. In 2004, the Commissioner allowed expenses of $74,160.87, as against claimed expenses of $78,749, leaving an adjustment of $4588.13; and in 2005, allowed $52,946.15 on claimed.expenses of $67,761, leaving a reduction in claimed expenses of $14,814.85. The contested expenses that I looked at were, first of all, travel expenses. The numerous travel expenses that Mr. Thompson claimed are all subject to section 274, and in particular, the regulations under that section, 26 CFR 1.274-5T(a), which states, 'No deduction or credit shall be allowed to travelling away from home, including meals and lodging and any activity which is of a type generally considered to constitute entertainment, amusement, or Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 8 recreation, or with respect to a facility used in connection with such an activity,' The regulation goes on to provide that the required elements of substantiation for travel away from home are, one, amount; amount of each separate expenditure for travelling away from home such as cost of transportation or lodging, except for the daily cost of the traveller's own breakfast, lunch, and dinner, and of expenditures incidental to such travel may be aggregated if set forth in reasonable categories such as for meals, for gasoline and oil, and for taxi fares. Two, time; dates of departure and return for each trip away from home and number of days away from home spent on business. Three, place; destinations or locality of travel described by name of city or town or other similar designation. And, four, business purpose; the business reason for travel or nature of the business benefit derived or expected to be derived as a result of travel. 26 CFR section 1.274-5T(c) provides for the rules of substantiation of travel expenses, and in particular, (c) (2) (i) states, 'To meet the adequate records requirements of section 274(d), a taxpayer shall maintain an account book, diary, log, statement of expenses, trip sheets, or Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 9 similar record, as provided in paragraph (c) (2) (ii) of this section, and documentary evidence sufficient to establish each element of an expenditure or use specified in paragraph (b) of this section. It is not necessary to record information in an account book, diary, log, statement of expense, trip sheet, or similar record which duplicates information reflected on a receipt so long as the account book and receipt complement each other in an orderly manner.' Following that is 26 CFR section 1.274-5T(c) (2) (ii) (B), 'In order to constitute an adequate record of business purpose within the meaning of section 274 (d) and this paragraph (c) (2), a written statement of business purpose generally is required.' Well, for tax year 2003, Mr. Thompson reported $6266.62 in travel expenses; in 2004, $13,411.75 in travel expenses; and in 2005, $1267.43 in travel expenses. Though there are some exceptions in the regulations, none of those are relevant here. That means that Mr. Thompson's failure to produce evidence that he met these enhanced substantiation requirements for any of his travel expenses results in their disallowance. Random collections of supposed business and personal receipts regarding travel are simply not enough. The second category of expenses that Mr. Thompson Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 10 claimed for these years that were at issue are his meals and entertainment expenses. In 2003, these were, to the extent disallowed by the Commissioner, $327.11; for 2004, $859.89; and for 2005, $356.04. Once again, Mr. Thompson did not have the section 274 enhanced substantiation requirements necessary to get these expenses And, owever, in any event, Revenue Agent Lo allowed them. Mr. Thompson did not seek any enhanced or greater deductions on this score, so I will allow these as having been conceded by the Commissioner. On the issue of other Schedule C expenses, in 2003, these amounted to $12,055; in 2004, $4588; and in 2005, $14,815. These disallowed expenses were actually disallowances of only a small fraction of the total expenses that Mr. Thompson claimed in these categories. Mr. Thompson, however, did not try to identify which receipts or which credit card statements or which entries on debit card statements he was representing as having been disallowed by the Commissioner, and so it was impossible to figure out what the Commissioner had already allowed and compare it to what Mr. Thompson had been claiming on his return. On this point, I conclude that Mr. Thompson failed in his burden of proof, and so I will not allow him any increase in the already considerable other Schedule C expenses that the Commissioner has already allowed. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 11 Issue no. 3, the negligence penalty, or accuracy- related penalty, under section 6662. Section 1662 of the Code provides for an addition to tax equal to 20 percent of the underpayment to be imposed when any portion of the underpayment is due to negligence or disregard of rules and regulations, or any substantial understatement of income tax. Here I find that the Commissioner met his burden of production, because Mr. Thompson's failure to keep adequate records is an indication of negligence. See 26 CFR section 1.6662-3 (b) (1). In addition, the Commissioner also met his burden of production showing a substantial understatement of income tax. -T.his.........=sad substantial understatement occurs when the amount of the understatement for a particular tax years exceeds the greater of 10 percent of the tax required to be shown on the return, or $5000. See code section 6662(d) (1). The Thompsons understated more than 10 percent of the tax required to be shown on the return, and more than $5000. That's enough to meet the Commissioner's burden of production. A penalty under section 6662(a), however, may not be imposed if there is a reasonable cause and the taxpayer acted in good faith with respect to the underpayment. Courts look at such factors as taxpayer's knowledge and experience and his effort to assess the proper Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 12 tax liability. Here, the Thompsons have not demonstrated that they had reasonable cause and acted in good faith, as enumerated in 26 CFR section 1.6664-4 (c) (1). In particular, Mr. Thompson, who is, after all, an attorney, would have been aware of his obligations to file an accurate Schedule C, but he failed grossly to maintain adequate books and records to properly determine his income and expenses. My conclusion is that any underpayment that results from the computation of a deficiency is subject to section 6662, and therefore I sustain the Commissioner's determination that that penalty applies in this case. That leaves only one issue, issue no. 4, Mr. Thompson's claim of duress in agreeing to an extension of the statute of limitations for the 2003 and 2004 tax years. However, as Mr. Thompson testified, this duress consisted of putting in a notice of deficiency the disallowance of any unsubstantiated expenses, and including in his income any unexplained deposits into his bank accounts; stating that the appeals officer would do so is simply in keeping with the IRS appeals office's policy that sufficient time needs to remain on the statute of limitations for a given year to consider any further determination at exam. As we have said in Ballard v. Commissioner, Tax Court Memo 1987-471, this 'was nothing Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 13 more than notice that Respondent intended to use lawful means at his disposal to assess the tax.' No duress shown here. Again, this case will require submission of settlement documents under Rule 155, because innocent spouse, at the very least, because innocent spouse relief was granted to Mrs . Thompson. This concludes the Court's oral findings of fact and opinion in this case. (Whereupon, at 5:44 p.m., the bench opinion in the above-entitled matter was concluded.) // // // // // // // // // // // // // // Heritage Reporting Corporation (202) 628-4888