Opinion ID: 213362
Heading Depth: 2
Heading Rank: 1

Heading: The Coles' omission of income

Text: There are two layers to the standard governing our review of the Tax Court's finding that the Coles omitted income from their 2001 joint tax return. First, we have long held that the Commissioner's tax deficiency assessments are entitled to the `presumption of correctness.' This presumption imposes upon the taxpayer the burden of proving that the assessment is erroneous. Pittman v. Comm'r, 100 F.3d 1308, 1313 (7th Cir.1996) (quoting Gold Emporium, Inc. v. Comm'r, 910 F.2d 1374, 1378 (7th Cir.1990)). To rebut the presumption of correctness and shift the burden to the Commissioner, the Coles must demonstrate that the Commissioner's deficiency assessment lacks a rational foundation or is arbitrary and excessive. Pittman, 100 F.3d at 1313 (citing Ruth v. United States, 823 F.2d 1091, 1094 (7th Cir.1987)). The Coles could do this by demonstrating that the Commissioner failed to make an evidentiary showing or failed to present evidence linking them to the alleged unreported income. Pittman, 100 F.3d at 1313. Second, we limit our review of factual conclusions to whether the tax court was `clearly erroneous.' Coleman v. Comm'r, 16 F.3d 821, 825-26 (7th Cir.1994) (quoting Nickerson v. Comm'r, 700 F.2d 402, 405 (7th Cir. 1983)). A factual finding can be reversed as clearly erroneous only when `the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed.' Coleman, 16 F.3d at 826 (quoting Anderson v. Bessemer, 470 U.S. 564, 573, 105 S.Ct. 1504, 84 L.Ed.2d 518, (1985)). Of course, we review questions of law de novo. Pittman, 100 F.3d at 1312. But because the Coles do not, for the most part, raise errors of law, and focus instead on the factual finding of whether they omitted income from their 2001 joint tax return, our review of that finding is governed by the clearly erroneous standard. Basic principles of tax law underlie this case. I.R.C. § 61(a)(1)-(2) states: Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; [and] (2) Gross income derived from business;.... Another thirteen examples follow § 61(a)(1)-(2), further refining the Internal Revenue Code's broad definition of gross income. In Comm'r v. Glenshaw Glass Co., 348 U.S. 426, 75 S.Ct. 473, 99 L.Ed. 483 (1955), the Supreme Court held that Congress used such language to define gross income (with somewhat different wording and under a different section) to exert in this field `the full measure of its taxing power.' Id. at 429, 75 S.Ct. 473 (citations omitted). Thus, the Court has given a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains except those specifically exempted. Id. at 430, 75 S.Ct. 473 (citations omitted). Starting at I.R.C. § 101, the Code lists dozens of items specifically excluded from the definition of gross income, including Certain death benefits, Gifts and inheritances, Interest on State and local bonds, and Compensation for injuries or sickness. See I.R.C. §§ 101, 102, 103, and 104. The Coles do not raise an exception or argue that the money they earned in 2001 is not gross income. Their dispute with the IRS (and the Tax Court decision) is about whether they or some other entity actually earned the income in question. The Coles' 2001 joint tax return reported adjusted gross income of $100,276, taxable income of $18,265, and a tax liability of $505. Yet, the Coles have produced no records supporting these figures. The evidence presented to the Tax Court showed that the Coles actually made a tremendous amount of money in 2001 that they did not report on their 2001 joint return. Scott, via his representation of the Sandefur Trust and others, helped the Bentley Group earn $1,430,802 in taxable deposits in 2001 as determined by the IRS and found by the Tax Court. Scott also made a decent amount of money independent of the Bentley Group as documented by the $79,652 in taxable deposits in JAC's bank account, all from Scott's legal services. Yet Scott only reported self-employment tax on $1,162 of income for a self-employment tax liability of $164. The Coles do not directly challenge the presumption of correctness granted the Commissioner's deficiency assessment or our clearly erroneous standard for reviewing the Tax Court's factual findings. Internal Revenue Code section 6001 requires taxpayers to keep such records, render such statements, make such returns, and comply with such rules and regulations as required by the Commissioner. When a taxpayer fails to regularly use an accounting method, or if the method used does not clearly reflect income, I.R.C. § 446(b) allows the Commissioner to determine taxable income via a method that in its discretion does clearly reflect income. See Webb v. Comm'r, 394 F.2d 366, 371-72 (5th Cir.1968) (holding that because a taxpayer's records did not clearly reflect his income, the Commissioner was authorized to use such methods as in his opinion clearly reflected that income (citing 26 U.S.C. § 446(b)); Factor v. Comm'r, 281 F.2d 100, 117 (9th Cir.1960) (holding that an undisputed rule is that, because of the failure of the taxpayer to keep books clearly reflecting his income, the Commissioner had the right to compute the income using a method the Commissioner believes accurately reflects income (citations omitted)). Courts have long approved of the bank deposits and the specific items methods. See United States v. Merrick, 464 F.2d 1087, 1092 (10th Cir.1972) (affirming a tax evasion convictionchallenged on sufficiency of the evidencethat was established by the specific items method); United States v. Stein, 437 F.2d 775, 779-81 (7th Cir.1971) (holding that a tax evasion conviction could be proved on a bank deposits analysis (citations omitted)). The reconstruction of a taxpayer's income need only be reasonable in consideration of the case's circumstances and facts. See Bradford v. Comm'r, 796 F.2d 303, 306 (9th Cir.1986). The Commissioner's reconstruction of the Coles' income shows that they omitted $1,215,183 of income and $1,329,268 of self-employment income from their 2001 return. The Coles failed at the Tax Court to rebut the assessment's presumption of accuracy and fail on appeal to show clear error in the court's finding that because the Coles did not produce credible documentary or other evidence showing otherwise, the Commissioner's reconstruction was reasonable and substantially accurate. Instead, the Coles argue that Scott did not actually earn the money; rather, the Bentley Group earned the money. Against nearly all the evidence, Scott argues that he suddenly stopped owning part of the Bentley Group on January 1, 2001. Scott alleges, without any contemporary documentary evidence, that he divested his Bentley ownership by assigning it to SCC in spite of the evidence that Scott directed more than $1 million of the Bentley Group's funds to other entities and persons in 2001. The Coles also cite Jennifer's purported 50% passive ownership of JAC along with her family trust's purported 49% ownership. According to the Coles, they only owed tax on the 1% of JAC that Scott owned. These arguments fail on several levels. The Coles fail to show that the Tax Court clearly erred in finding (1) that there is insufficient evidence showing SCC's ownership in the Bentley Group and (2) that Scott and Darren were the only Bentley Group partners in 2001. The only documentary evidence of SCC's alleged Bentley Group partnership status was the group's 2001 return. This return was filed in November 2004long after the Cole brothers became aware that the IRS audit had begun. This return also indicates that during 2001 there was no distribution of property or a transfer ... of a partnership interest. Not only are the timing and internal inconsistencies of the Bentley Group's 2001 return suspect given the dramatic increase in the Bentley Group's reported income in 2001 (from $46,121 in 1999, $69,698 in 2000, to $1,583,900 in 2001), SCC failed to file a return for 2001 (thus, paying no income tax) and became a defunct entity in 2001. We find no clear error in the Tax Court's finding that [t]here is no written evidence for 2001 to suggest that SCC was involved with the Bentley Group. Nor was the Tax Court clearly in error to find that the Cole brothers' testimony offered to support their after-the-fact explanation of SCC's ownership of Bentley lacked credence. The Coles argue that because Darren signed the Bentley Group's 2001 tax return and the questions on the return were presented to the Bentley Group, the omission of a property distribution or transfer does not show that a transfer of ownership interest... did not occur. The Coles also argue that SCC's administrative dissolution was simply [d]ue to an oversight. These excuses fail to show that the Tax Court clearly erred in finding that the Coles did not rebut the presumption of correctness as to the IRS's determination that the money deposited into the Bentley Group's account was income allocated to Scott and Darren, not SCC. The Coles' excuses and justifications aside, the Commissioner presented sufficient evidence showing Scott's ownership in the Bentley Group. The Bentley Group did business as Cole Law Offices, without mentioning the existence of a corporate partner. Indiana Rule of Professional Conduct 7.5(b) at the time prohibited (it has since been modified) lawyers from practicing under a name that is misleading as to the identity, responsibility, or status of those practicing thereunder. The Bentley Group's tax returns for 1999 and 2000filed before the audit began list Darren and Scott as the owners. Bentley Group clients wrote checks to Cole Law Offices in 2001. A $300,000 check, made out by the trustees of the Sandefur Trust to Scott Cole and Associates on June 18, 2001, was deposited into the Bentley Group's bank account. Even at trial, the Cole brothers could not keep their answers about the Bentley Group's ownership consistent. [Attorney for the Commissioner] Did you practice law in partnership with your brother under the name Bentley Group, DBA Cole Law Offices during the year 2001? [Darren] Yes. Scott later cross-examined Darren on the issue. [Scott] Okay, now you had mentioned that in the year 2001 you did not practice law or you were not a partner with anyone but Scott Cole. Did you mean Scott Cole or Scott Cole professional corporation? [Darren] I guess it would be the corporation. When, you know, you're thinking as far as Disciplinary Commission wise or whatever, I thought of you personally as my partner, on paper Scott Cole PC was the partner. [Scott] So in the year 2000, who were the partners with Cole Law Offices? [Darren] Myself and Scott Cole PC. [Scott] Okay, in the year 2000? [Darren] Oh, myself and you. [Scott] Okay, and then in 2001, who were the partners? [Darren] Myself and Scott Cole PC. The Coles do not show how the Tax Court clearly erred in finding that Scott did not divest his Bentley Group interest in 2001 or that Scott earned the vast majority of the Bentley Group's 2001 income (which thus should be allocated to him) as evidenced by the fact that he directed the withdrawal of $1,173,263 from the group's account. The Coles argue that the Tax Court erred by finding that Scott misreported his interest in the Bentley Group in his 2002 bankruptcy filing. They argue, despite the lack of evidence, that his filing was consistent with the Bentley Group's 2001 return and the purported divestment of his Bentley Group ownership, and that he did not disclose SCC because it was dissolved on September 5, 2001. This spurious argument only accents the game of thimblerig [2] suggested by Scott's legal and financial maneuvering. It goes something like this. Scott did not earn any of the Bentley Group-related income in 2001. Look to the Bentley Group, it earned the income from Scott's legal work. Isn't Scott a Bentley Group partner? No, Scott disclaimed the entirety of his Bentley Group partnership in 2001, and now his personal corporation SCC is the primary owner of all but 1% of the Bentley Group. But wait, don't look to Scott to claim any interest in SCC because SCC disappeared on September 5, 2001, along with, poof!, apparently any obligation Scott believed he had to pay taxes on his 2001 financial windfall. As Darren testified at trial, SCC was at best a Bentley Group partner on paper (the paper consisting only of a tax return created after the audit began), but in reality Scott never ended his Bentley Group partnership. Because the Coles do not show how the Tax Court's findings of fact as to the Bentley Group ownership were clearly erroneous, they are dispositive of the arguments that the Bentley Group income was not attributable to the Coles. Ignoring the clearly erroneous standard of review for factual findings such as the ownership of the Bentley Group, the Coles argue that the Tax Court lacked jurisdiction over the Bentley Group. The Coles' theory is the Bentley Group is not a relevant party because the group's 2001 tax return did not list either Scott or Jennifer as Bentley Group partners. Only Darren Cole and SCC were listed as partners. Because Scott and Jennifer were not listed as partners, they contend that they were somehow surprised when the IRS attributed partnership income to them. This lack of notice, the argument goes, prevented the Coles from presenting evidence regarding their tax liability for the group's income. This argument lacks citation to authority. The Coles do not explain what type of notice was necessary to substantively make a difference. And the Coles had notice that the IRS would find Scott at least partially liable for Bentley Group income because the April 11, 2008, deficiency notice attributed the group's income to the Coles. Most importantly, the Coles do not show how the Tax Court clearly erred in finding that Scott was in fact a Bentley Group partner in 2001. Even if Scott had effectively documented his purported divestment of his Bentley Group interest, the divestment lacked economic substance as demonstrated by his continuous dominion and control over the group's assets for personal purposes. Under the assignment of income doctrine, taxpayers may not shift their tax liability by merely assigning income that the taxpayer earned to someone else. Kenseth v. Comm'r, 259 F.3d 881, 884 (7th Cir.2001) (citing Lucas v. Earl, 281 U.S. 111, 114-15, 50 S.Ct. 241, 74 L.Ed. 731 (1930); United States v. Newell, 239 F.3d 917, 919-20 (7th Cir.2001)). In Lucas, the Supreme Court held that a taxpayer's salary may not escape tax by anticipatory arrangements and contracts however skilfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. 281 U.S. at 114-15, 50 S.Ct. 241. Tax law makes no distinction... according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew. Id. at 115, 50 S.Ct. 241. In Griffiths v. Helvering, the Court refused to allow the refinements of title to determine a taxation issue and focused instead on the actual command over the property taxed. 308 U.S. 355, 357, 60 S.Ct. 277, 84 L.Ed. 319 (1939) (quoting Corliss v. Bowers, 281 U.S. 376, 378, 50 S.Ct. 336, 74 L.Ed. 916 (1930)). The Court held that a lawyer's ingenuity devised a technically elegant arrangement that created an intricate outward appearance ... to the simple sale ... and the passage of money. Griffiths, 308 U.S. at 357, 60 S.Ct. 277. Scott never gave up control of the Bentley Group or its funds as demonstrated by his transferring $1,173,263 in Bentley Group money in 2001. The Coles claim that some of these transfers were investment loans, but they do not explain why Scott gave his mother Bentley Group money and loaned his father $40,000 of Bentley Group funds. The Coles argue that they did not receive any personal benefit from these transactions. But they do not explain how they could not have benefitted when Scott's father gave Scott's church $40,000 and then Scott claimed a $40,000 charitable deduction on the Coles' personal tax return without ever reporting the money as income. As found by the Tax Court, Scott acknowledged that as an attorney he earned income from providing legal services but thought he could avoid reporting that income by depositing that money into the Bentley Group account and assigning his Bentley Group interest to SCC. The Coles fail to show that the court clearly erred in finding that Scott may not avoid tax liability on his income by assigning it to SCC when substantively his Bentley Group ownership never changed as evidenced by Scott's continued dominion and control over the partnership's funds. See Trousdale v. Comm'r, 219 F.2d 563, 567 (9th Cir.1955) (affirming the Tax Court's finding that the transaction was not in substance and effect the sale of a partnership interest). The Coles' argument that they did not benefit from the loans is frivolous because gross income means all income from whatever source derived, including ... [c]ompensation for services. I.R.C. § 61(a)(1). Even if the Coles provided genuine documentation as to the loans (providing information such as the loans' terms or interest rates) and we were inclined to view them as bona fide loans, Scott would still owe taxes on the income because before he loaned the money, he incurred an undeniable accession to this wealth, clearly realized it, and exercised dominion over it. See Glenshaw Glass Co., 348 U.S. at 431, 75 S.Ct. 473. A majority of the Bentley Group's income came from the Sandefur Trust for legal representation undoubtedly performed by Scott. Regardless of whether this was an inadvertent error, the first of the four checks was made out to Scott Cole and Associates, indicating that the trustees intended to pay Scott for his legal services. As previously noted, co-trustee Gestner signed an affidavit that was included among the documents before the Tax Court declaring that the trustees retained Scott Cole as the Attorney to represent the Trust. The fee Scott Cole chargednot the Bentley Group or Cole Law Officesexceeded the usual fee for such legal services, but Gestner was very satisfied with Scott's legal representation, considering his $1.2 million fee to be worthwhile. Another document presented in the Tax Court was a motion before the Shelby County, Indiana, Circuit Court signed by Scott declaring that Scott Cole worked in his legal capacity to quash any attempt to contest the trust, among other matters. Scott exercised control over the fees by having the money deposited into the Bentley Group account and then moving $1,173,263 of Bentley Group money in 2001 to other persons and entities. The Coles' attempt to avoid paying taxes on this income by declaring that they did not benefit from the loans and thus somehow assigned the income is a nonstarter. See United States v. Basye, 410 U.S. 441, 447-48, 93 S.Ct. 1080, 35 L.Ed.2d 412 (1973) (noting that two familiar principles of income taxation are first, that income is taxed to the party who earns it and that liability may not be avoided through an anticipatory assignment of that income, and, second, that partners are taxable on their distributive or proportionate shares of current partnership income irrespective of whether that income is actually distributed to them); Comm'r v. First Sec. Bank of Utah, 405 U.S. 394, 403-04, 92 S.Ct. 1085, 31 L.Ed.2d 318 (1972) (noting that it is well established that income assigned before it is received is nonetheless taxable to the assignor); Comm'r v. Sunnen, 333 U.S. 591, 604, 68 S.Ct. 715, 92 L.Ed. 898 (1948) (As long as the assignor actually earns the income or is otherwise the source of the right to receive and enjoy the income, he remains taxable.). [3] The Coles also do not show how the Tax Court clearly erred in finding that the Coles omitted other income, namely, the funds deposited into accounts held by JAC Investments and Jennifer Cole. The Coles do not explain their failure to report $79,294 in deposits into Jennifer Cole's personal checking account, including $59,264 in legal fees earned by Scott. We do not find clear error in the Tax Court's finding that the Coles failed to report these deposits as income. JAC reported gross receipts of $146,957 in 2001 (with $28,647 in unsubstantiated expenses), yet Scott only reported $1,162 in income for self-employment tax purposes in 2001 and Jennifer reported none at all. The Coles' theory for the tax treatment of this income is that Jennifer owned 50% and her family trust 49% as members. Scott conveniently owned only 1% as a member-manager who ran JAC's day-to-day operations. Yet, as noted above, the assignment of income doctrine prohibits taxpayers from shifting their tax liability by simply assigning income that the taxpayer earned to someone else. Kenseth, 259 F.3d at 884. The deposits into JAC's account were almost exclusively checks written to Scott. And the Coles used the JAC money for personal reasons, such as church tithing and mortgage payments. The Tax Court's finding of fact that the Coles avoided income and self-employment taxes by assigning income from Scott's law practice to JAC and using those funds for personal purposes was not clearly erroneous. The Coles raise another jurisdictional argument that bears little mention but we will address it anyway. The Coles argue that the Tax Court erred in taking jurisdiction over JAC Investments because the Commissioner failed to apply the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) audit and litigation procedures, see I.R.C. §§ 6221-6234, namely by not sending JAC's partners a Notice of Final Partnership Administrative Adjustment. This argument lacks merit. Internal Revenue Code section 6231(g)(2) permits the Commissioner to find that TEFRA does not apply to a partnership based on its tax return. Scott answered no to the question on JAC's 2001 return asking whether JAC was subject to TEFRA. The Coles' attempt to raise TEFRA, when Scott expressly stated that JAC was not subject to TEFRA, is misguided. Because none of the Tax Court's findings as to the Coles' unreported income from 2001 were clearly erroneous, we affirm the court's finding that the Coles omitted $1,215,183 of income and $1,329,268 of self-employment income from their 2001 joint tax return. [4]