Court Opinion

ID: 9375449
Source: CourtListenerOpinion
Date Created: 2023-02-27 20:01:28.80256+00
Date Added: 2024-06-11T17:16:58.918564
License: Public Domain

United States Tax Court

                          T.C. Memo. 2023-23

                 KEVIN B. CHEAM AND JULIE LIM,
                            Petitioners

                                   v.

            COMMISSIONER OF INTERNAL REVENUE,
                        Respondent

                              —————

Docket Nos. 18650-17, 24734-18,                Filed February 27, 2023.
            11349-20.

                              —————

Kevin B. Cheam and Julie Lim, pro sese.

Erik W. Nelson, Kimberly L. Clark, Catherine J. Caballero, Janice B.
Geier, and Kelley A. Blaine, for respondent.

       MEMORANDUM FINDINGS OF FACT AND OPINION

       BUCH, Judge: Kevin B. Cheam and Julie Lim operated a grocery
business during the years at issue, 2013 through 2016. After
examination, the Commissioner determined unreported gross receipts
and disallowed expense deductions claimed on Schedule C, Profit or Loss
From Business, for each year at issue; he also disallowed all costs of
goods sold for 2014 through 2016. Mr. Cheam and Ms. Lim failed to
establish nontaxable sources of income or substantiate expenses beyond
any concession the Commissioner made. But they established that they
had costs of goods sold and supplied sufficient evidence for the Court to
estimate costs of goods sold for 2014 through 2016.

                           Served 02/27/23
                                           2

[*2]                          FINDINGS OF FACT

I.      Introduction

       Married petitioners Mr. Cheam and Ms. Lim operate Lion
Supermarket in Stockton, California. Lion Supermarket is a Schedule C
grocery business that also provides MoneyGram and check cashing
services. Mr. Cheam and Ms. Lim earned income from Lion
Supermarket during 2013 through 2016.

II.     Tax Returns

      Mr. Cheam and Ms. Lim jointly filed Form 1040, U.S. Individual
Income Tax Return, for each year at issue. The 2013 through 2015
returns were all prepared by the same certified public accountant. The
2016 return was prepared by a different person, Taz Theum, a social
worker and part-time return preparer. Each return included a
Schedule C for Lion Supermarket. On the Schedules C, Mr. Cheam and
Ms. Lim reported the following gross receipts, costs of goods sold, and
business expenses: 1

             Tax Year    Gross Receipts   Cost of Goods Sold    Expenses

               2013         $5,019,722            $3,724,945    $1,031,242

               2014           3,898,595            2,980,328       839,905

               2015           3,623,711            2,750,161       796,902

               2016           4,171,267            3,208,097       908,753

They reported total tax due of $23,201, $27,169, $28,522, and $12,128
for 2013 through 2016, respectively.

III.    Examination

     The Commissioner examined the 2013 through 2016 returns.
During the examination, Mr. Cheam and Ms. Lim failed to provide books
and records sufficient to substantiate their reported income and

        1 Unless otherwise indicated, all statutory references are to the Internal

Revenue Code, Title 26 U.S.C., in effect at all relevant times, all regulation references
are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant
times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
All monetary amounts are rounded to the nearest dollar.
                                   3

[*3] expenses. Because of that failure, the Commissioner computed
their taxable income through a bank deposits analysis. The analysis
included two Wells Fargo accounts that they controlled during the years
at issue.

       The Commissioner determined unreported gross receipts on the
basis of deposits and disallowed costs of goods sold and expenses on the
basis of lack of substantiation. The Commissioner also determined a
section 6662 accuracy-related penalty for each year at issue. The
examiner who made the initial determination to assert penalties
obtained written approval from his group manager for each penalty
before that penalty was first communicated to Mr. Cheam and Ms. Lim
in an examination report or a notice of deficiency.

IV.   Notices of Deficiency

      The Commissioner mailed a notice of deficiency for 2013 on
June 2, 2017. Among other adjustments that are not relevant to our
Opinion, the Commissioner determined additional gross receipts of
$2,160,114 and disallowed various Schedule C expense deductions. The
Commissioner also determined a section 6662 penalty based on an
underpayment due to a substantial understatement of income tax.

       The Commissioner mailed a notice of deficiency for 2014 and 2015
on September 11, 2018. Among other adjustments that are not relevant
to our Opinion, the Commissioner determined additional gross receipts
of $2,463,932 and $2,701,483 for 2014 and 2015, respectively, and
disallowed all costs of goods sold and expense deductions. The
Commissioner also determined a section 6662 penalty for each year
based on an underpayment due to a substantial understatement of
income tax or, alternatively, negligence.

       The Commissioner mailed a notice of deficiency for 2016 on
January 2, 2020. Among other adjustments not relevant to this Opinion,
the Commissioner determined additional gross receipts of $1,995,336.
The Commissioner disallowed the entire cost of goods sold and almost
all expense deductions. The Commissioner also determined a section
6662 penalty based on an underpayment due to a substantial
understatement of income tax or, alternatively, negligence.

V.    Petitions for Redetermination

       While residing in California, Mr. Cheam and Ms. Lim filed
Petitions for redetermination. In those Petitions, they challenge the
                                         4

[*4] notices of deficiency in their entirety. The following amounts are in
dispute:

                        Tax Year   Deficiency   I.R.C. § 6662
                          2013     $1,329,192     $265,838
                          2014      2,668,243      533,649
                          2015      2,641,682      528,336
                          2016      2,568,602      513,720

       With respect to Lion Supermarket, they assert in their Petitions
that the Commissioner erroneously determined additional gross
receipts, disallowed costs of goods sold and expense deductions, and
imposed section 6662 penalties. In their Petition for 2013, they allege
that the Commissioner did not give them “enough time to provide
supporting documentation” during the examination. In their Petitions
for 2014 through 2016, they allege that they “have adequate records to
substantiate” nontaxable deposits, costs of goods sold, and expenses.
They also dispute various other adjustments that are not relevant to this
opinion.

VI.   Tax Court Proceeding

       Although more than five years lapsed between the filing of Mr.
Cheam and Ms. Lim’s first Petition and the trial of these cases, they
provided little in the way of documentary support for their positions.
They responded to only one of four of the Commissioner’s requests for
admissions. 2 The parties did not file a stipulation, and only the
Commissioner complied with the Court’s deadline for filing proposed
trial exhibits.

      We tried these cases on October 24, 2022, during the Court’s San
Francisco, California, trial session. Ms. Lim appeared without Mr.
Cheam, and she called one witness, Mr. Theum. The only issue
addressed at trial was Schedule C income.

      Both parties made concessions at trial. On the basis of the
documentation provided, the Commissioner conceded gross receipts in
amounts equal to withdrawals to MoneyGram and Schedule C expenses.
The Commissioner conceded gross receipts of $863,855, $904,564,
$920,121, and $626,145 for 2013 through 2016, respectively. The

      2   The other three are deemed admitted. See Rule 90.
                                    5

[*5] Commissioner also conceded all amounts deducted for utilities for
2013, and all amounts deducted for utilities, wages, and mortgage
interest for 2014 through 2016. Mr. Cheam and Ms. Lim conceded office
expenses for 2013.

       Although the parties did not file a stipulation, Ms. Lim offered
various Exhibits at trial. Mr. Cheam and Ms. Lim’s Exhibits included
Excel spreadsheets prepared by Mr. Theum. Mr. Theum prepared a
spreadsheet purporting to substantiate cost of goods sold for each year
at issue. For 2013 through 2015, he attempted to reconstruct costs of
goods sold. However, those spreadsheets do not correspond to amounts
reported on the 2013 through 2015 returns, which Mr. Theum was not
involved in preparing. They also contain obvious errors such as
duplicate entries. In other words, they are unreliable.

      The 2016 spreadsheet is reliable. Mr. Theum assisted with Lion
Supermarket’s bookkeeping and accounting for 2016 and prepared the
2016 return. Using the 2016 spreadsheet, he kept track of monthly
amounts paid to various vendors, which he determined from invoices
and check registers. The total amount paid to vendors in the 2016
spreadsheet equals the cost of goods sold reported on the 2016 return.

       But the 2016 spreadsheet includes amounts paid to vendors that
clearly are not cost of goods sold, including gas and electric utilities,
employee payroll, pest control, and waste management. After
corrections for items that clearly were not cost of goods sold and items
that did not reasonably appear to be cost of goods sold, the actual cost of
goods sold for 2016 was $1,739,760. When considering the relationship
of cost of goods sold and gross receipts, the cost of goods sold was 31.4%
of adjusted gross receipts for 2016.

                                OPINION

      The main issue in these cases is Schedule C profit from Lion
Supermarket, taking into account gross receipts, costs of goods sold, and
expenses. Mr. Cheam and Ms. Lim generally argue that the
Commissioner’s determinations were erroneous. The Commissioner
argues that his determinations were not in error, subject to the
concessions above.

       Mr. Cheam and Ms. Lim placed various other adjustments at
issue in their Petitions but failed to put on evidence about those
adjustments at trial. Because Mr. Cheam and Ms. Lim bear the burden
of proof, their failure to put on evidence precludes them from prevailing
                                    6

[*6] on these other adjustments. See Nitschke v. Commissioner, T.C.
Memo. 2016-78, at *4–5, *9; Miller v. Commissioner, T.C. Memo. 2014-
105, at *8, *10, *12–14.

I.    Burden of Proof

       Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and taxpayers bear the burden of
proving error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
In the Court of Appeals for the Ninth Circuit, to which these cases would
be appealable, determinations of unreported income must be supported
by a “minimal evidentiary foundation” before the presumption of
correctness applies. Weimerskirch v. Commissioner, 596 F.2d 358, 361
(9th Cir. 1979), rev’g 67 T.C. 672 (1977); see Golsen v. Commissioner, 54
T.C. 742, 756–58 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). “[T]he
Commissioner must offer some substantive evidence showing that the
taxpayer received income from the charged activity.” Weimerskirch v.
Commissioner, 596 F.2d at 360. In Weimerskirch, the Commissioner
relied on a “naked assertion” and did not attempt to substantiate the
unreported income through “other means, such as . . . bank deposits.”
Id. at 362.

       Here, the Commissioner determined unreported gross receipts by
using bank deposits, which are prima facie evidence of income. Tokarski
v. Commissioner, 87 T.C. 74, 77 (1986). The record reveals that the
deposits stem from Lion Supermarket, and Mr. Cheam and Ms. Lim do
not dispute that the deposits arose from their business. The
Commissioner’s determinations are presumptively correct, and the
record does not support shifting the burden back to the Commissioner.
See I.R.C. § 7491(a).

II.   Gross Receipts

          “[G]ross income means all income from whatever source derived
. . . .” I.R.C. § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426,
429–31 (1955). Taxpayers must maintain books and records sufficient to
establish their income and expenses. I.R.C. § 6001; Treas. Reg. § 1.6001-
1(a). If they fail to do so, the Commissioner may reconstruct income
through any reasonable method that clearly reflects income. I.R.C.
§ 446(b); Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989). We have
long accepted the bank deposits method for this purpose. Clayton v.
Commissioner, 102 T.C. 632, 645–46 (1994). The bank deposits method
assumes all deposits are taxable, but the Commissioner must account
                                    7

[*7] for any nontaxable source or deductible expense of which he has
knowledge. Id. Taxpayers bear the burden of proving a nontaxable
source for deposits. Barnes v. Commissioner, T.C. Memo. 2016-212,
at *32–34, aff’d, 773 F. App’x 205 (5th Cir. 2019). Beyond the amounts
of gross receipts that the Commissioner has conceded, Mr. Cheam and
Ms. Lim have failed to demonstrate that additional amounts were
nontaxable.

III.   Cost of Goods Sold

      In a merchandising business such as a grocery store, a taxpayer
“may subtract cost of goods sold from gross receipts to arrive at gross
income.” Mileham v. Commissioner, T.C. Memo. 2017-168, at *35;
Kroger Co. & Subs. v. Commissioner, T.C. Memo. 1997-2, 73 T.C.M.
(CCH) 1637, 1638–39. “Cost of goods sold is the amount that the
taxpayer expended to purchase or construct the inventory sold during
the year.” Mileham, T.C. Memo. 2017-168, at *35. Taxpayers must
maintain books and records sufficient to establish their cost of goods sold
and must substantiate all amounts claimed on their return. Id.

       If the taxpayer lacks sufficient records but the record clearly
indicates that he or she incurred cost of goods sold, the Court may supply
an estimate. Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930);
Mileham, T.C. Memo. 2017-168, at *36. The taxpayer must provide a
sufficient evidentiary basis for such an estimate. Mileham, T.C. Memo.
2017-168, at *36. In estimating an allowable amount, “the Court bears
heavily against taxpayers whose inexactitude is of their own making.”
Id.

       Mr. Cheam and Ms. Lim lack sufficient records to establish their
precise costs of goods sold for 2014 through 2016. Only the 2016
spreadsheet they provided to substantiate their cost of goods sold is
reliable, but it contains obvious errors. That spreadsheet provides
evidence to support cost of goods sold of $1,739,760 for 2016. Regarding
2014 and 2015, the spreadsheets are unreliable, but given the nature of
their business, it is clear that Mr. Cheam and Ms. Lim incurred costs of
goods sold greater than zero, as determined by the Commissioner.

      Because the evidence for 2016 is reliable, we will supply an
estimate for 2014 and 2015 based on a ratio calculated from 2016 data.
We have used percentages to estimate a taxpayer’s cost of goods sold,
and will do so here. See id. at *38. For 2016, the cost of goods sold was
31.4% of Lion Supermarket’s adjusted gross receipts. Thus, the
                                   8

[*8] allowable amount for costs of goods sold for 2014 and 2015 is 31.4%
of adjusted gross receipts for each respective year.

IV.   Expenses

      Taxpayers bear the burden of proving that they are entitled to
claimed deductions. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992). That burden requires substantiation. Higbee v.
Commissioner, 116 T.C. 438, 440 (2001). Taxpayers must maintain
records sufficient to establish the amount of each deduction. Rogers v.
Commissioner, T.C. Memo. 2014-141, at *17; Treas. Reg. § 1.6001-1(a),
(e).

        Beyond the amounts the Commissioner conceded for Schedule C
utilities, wages, and mortgage interest, Mr. Cheam and Ms. Lim failed
to establish their expenses. They did not specifically address any of the
disallowed expenses at trial, so they failed to meet their burden. See
Miller, T.C. Memo. 2014-105, at *12–13.

V.    Section 6662 Penalties

       The Commissioner determined a section 6662(a) accuracy-related
penalty for each year at issue. Section 6662(a) provides that a taxpayer
may be liable for a penalty of 20% of the portion of an underpayment of
tax required to be shown on a return that is attributable to, among other
things, negligence or disregard of the rules or regulations or a
substantial understatement of income tax. See I.R.C. § 6662(b)(1) and
(2). The Commissioner determined penalties based on substantial
understatements for 2013 through 2016 and alternative penalties based
on negligence for 2014 through 2016. Only one section 6662 accuracy-
related penalty may be imposed with respect to a given portion of an
underpayment. Treas. Reg. § 1.6662-2(c); see Mileham, T.C. Memo.
2017-168, at *46.

       Under section 7491(c), the Commissioner bears the burden of
production with respect to penalties and must produce evidence that
penalties are appropriate. See Higbee, 116 T.C. at 446. Because section
6751(b) requires managerial approval of section 6662 penalties, under
our precedent, the Commissioner’s burden of production includes
establishing compliance with section 6751(b). Walquist v.
Commissioner, 152 T.C. 61, 68 (2019). Once the Commissioner meets his
burden, Mr. Cheam and Ms. Lim must come forward with persuasive
evidence that the Commissioner’s determination is incorrect or that an
                                          9

[*9] exception applies. See Higbee, 116 T.C. at 446–47; see also I.R.C.
§ 6664(c)(1) (reasonable cause and good faith exception).

       A.      Penalty Approval

      Section 6751(b)(1) provides that no penalty shall be assessed
unless the initial determination to assert penalties is approved (in
writing) by the immediate supervisor of the person who made that
determination. This Court has held that an “initial determination”
occurs the earlier of when the Commissioner issues a notice of deficiency
or when he otherwise formally communicates a decision to determine
penalties. Belair Woods, LLC v. Commissioner, 154 T.C. 1, 14–15 (2020);
Clay v. Commissioner, 152 T.C. 223, 248–49 (2019), aff’d, 990 F.3d 1296
(11th Cir. 2021). However, the Ninth Circuit arguably applies a different
standard as to timing. 3 See Laidlaw’s Harley Davidson Sales, Inc. v.
Commissioner, 29 F.4th 1066 (9th Cir. 2022), rev’g and remanding 154
T.C. 68 (2020). In Laidlaw’s, which involved a penalty that was not
subject to deficiency procedures, the Ninth Circuit held that approval
can occur after formal communication to the taxpayer, so long as it
occurs before assessment. Id. at 1074.

      Under both the Tax Court’s and the Ninth Circuit’s precedent,
approval was timely in these cases. The initial determination to impose
each penalty was approved before it was communicated to Mr. Cheam
and Ms. Lim in a notice of deficiency or an examination report, so the
Commissioner satisfied section 6751(b) both as interpreted by this Court
and under the standard established by the Ninth Circuit.

       B.      Substantial Understatement

       Section 6662(d)(1)(A) defines a substantial understatement of
income tax 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. Mr. Cheam
and Ms. Lim’s understatements of income tax for 2013 through 2016 are
substantial because they exceed $5,000 and are greater than 10% of the
amount required to be shown on their returns.

        3 Laidlaw’s involved an assessable penalty that was not subject to deficiency

procedures. Neither our Court nor the Ninth Circuit has addressed whether the
rationale of Laidlaw’s extends to penalties that are subject to deficiency procedures.
We need not reach that question in these cases.
                                   10

[*10] C.     Negligence

       “‘Negligence’ . . . includes any failure by the taxpayer to keep
adequate books and records or to substantiate items properly.” Treas.
Reg. § 1.6662-3(b)(1). For 2014 through 2016, the record shows that Mr.
Cheam and Ms. Lim were negligent because they failed to keep adequate
books and records to substantiate Lion Supermarket’s gross receipts,
expenses, and costs of goods sold. See Mileham, T.C. Memo. 2017-168,
at *46.

      D.     Conclusion as to Penalty

       The Commissioner met his burden of production as to penalties,
and Mr. Cheam and Ms. Lim failed to put on evidence that the
Commissioner’s determinations were erroneous or that the reasonable
cause and good faith exception of section 6664(c)(1) applies. Thus, they
failed to meet their burden of proof, and are liable for section 6662
accuracy-related penalties.

VI.   Conclusion

      Mr. Cheam and Ms. Lim are entitled to costs of goods sold to offset
Lion Supermarket’s adjusted gross receipts in accordance with our
opinion above, but they failed to establish any expenses beyond those
allowed by the Commissioner. To reflect the foregoing and the parties’
concessions,

      Decisions will be entered under Rule 155.