Court Opinion

ID: 9913792
Source: CourtListenerOpinion
Date Created: 2023-12-28 20:01:31.829419+00
Date Added: 2024-06-11T12:58:30.323814
License: Public Domain

United States Tax Court

                               T.C. Memo. 2023-155

                   DAVID VILLA AND JUANA M. VILLA,
                              Petitioners

                                            v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                      __________

Docket No. 8177-20.                                       Filed December 28, 2023.

                                      __________

Juan F. Vasquez, Jr., and Tania P. Albuja, for petitioners.

Steven D. Garza, Carol Bingham McClure, and Kevin A. Baker, for
respondent.

         MEMORANDUM FINDINGS OF FACT AND OPINION

       COPELAND, Judge: Petitioner David Villa builds fences,
sometimes as a contractor and other times as a subcontractor. The
Commissioner of Internal Revenue (Commissioner) audited the 2016
and 2017 joint federal income tax returns of Mr. Villa and his wife,
Juana M. Villa. On the basis of a bank deposits analysis, the
Commissioner determined unreported gross receipts from Mr. Villa’s
contracting work in both 2016 and 2017 (years in issue). The
Commissioner accordingly issued a notice of deficiency in which he also
disallowed deductions for certain expenses and determined accuracy-
related penalties under section 6662(a). 1 After concessions from both
parties (as explained below), we must decide whether the Villas are

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

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

                                  Served 12/28/23
                                       2

[*2] entitled to costs of goods sold offsets to gross income (or, in the
alternative, additional expenses) and whether they are liable for the
accuracy-related penalties.

                            FINDINGS OF FACT

      Some of the facts have been stipulated by the parties. The
Stipulation of Facts, Supplemental Stipulation of Facts, and attached
Exhibits are incorporated by this reference. The Villas were residents
of Texas when they timely filed their Petition.

I.     Fencing Business

      Mr. Villa was born in Mexico and moved to the United States in
1998 with his father. He completed elementary school in Mexico and
attended (but did not complete) high school in the Unites States. Mr.
Villa went into the fence-building business with his father after they
immigrated. Mr. Villa now runs the business as a sole proprietorship.

      During the years in issue Mr. Villa worked as a subcontractor for
10 Point, Inc., d.b.a. All-Texas Fence (All-Texas), and as a direct
contractor for various customers. All-Texas supplied Mr. Villa with the
wood for his subcontractor projects, but he was responsible for all other
costs (including tools, labor, and transportation). For his direct
contracting work, Mr. Villa had to pay out of pocket for both the
materials and his other costs.

       All-Texas paid Mr. Villa nonemployee compensation of $26,022 in
2016 and $28,314 in 2017, and it reported those amounts to Mr. Villa
and the Internal Revenue Service (IRS) on Forms 1099–MISC,
Miscellaneous Income. For his direct contracting work, Mr. Villa
received payments totaling about $20,817 in 2016 and $40,630 in 2017. 2
When Mr. Villa received a check as payment for his work, he often would
deposit the check but immediately withdraw a portion in cash. He would
use that cash to pay both (1) his business costs and expenses and
(2) personal expenses. These immediate withdrawals, marked “less
cash” on the bank deposit slips, totaled $8,996 in 2016 and $16,480 in
2017. During the years in issue Mr. Villa used both cash and debit cards
to pay his business costs and expenses; he kept some but not all receipts
related to those items.

        2 These amounts are drawn from the Commissioner’s bank deposits analysis,

discussed below.
                                     3

[*3] II.   Tax Returns

       Mr. Villa asked his cousin to prepare his and Mrs. Villa’s joint
income tax returns for each year in issue. Mr. Villa’s cousin was then
teaching physical education classes and had taken some accounting
classes but was not a licensed accountant. Mr. Villa was aware of these
facts but relied on his cousin, in part because the cousin previously had
helped Mr. Villa’s father and brothers prepare their tax returns.
Mr. Villa supplied his cousin with various relevant documents, and his
cousin prepared the returns for free as a favor to Mr. Villa.

       On the returns for the years in issue the only gross income that
the Villas reported was the payments from All-Texas. They did not
report any of the payments for Mr. Villa’s direct contracting work, and
none of the direct contracting customers had reported their payments to
him on an information return such as a Form 1099–MISC. On the
attached Schedules C, Profit or Loss From Business, Mr. Villa deducted
contract labor expenses of $8,750 for 2016 and $10,501 for 2017 and
“other” expenses of $11,690 for 2016 and $12,096 for 2017.

III.   Examination and Notice of Deficiency

       After selecting the Villas’ returns for examination, the
Commissioner conducted a bank deposits analysis and, in a notice of
deficiency dated March 18, 2020, determined that the Villas’ gross
income for both years in issue should be increased by the payments Mr.
Villa received for his direct contracting work. Also, on the basis of the
receipts and other documents Mr. Villa produced to substantiate the
expenses reported on the Schedules C, the Commissioner determined
adjustments to those expenses. For 2016 he decreased contract labor
expenses from $8,750 (per the return) to $4,814, and he decreased
“other” expenses from $11,690 to $2,860. For 2017 he increased contract
labor expenses from $10,501 to $11,881 and decreased “other” expenses
from $12,096 to zero.

       The notice of deficiency also determined an accuracy-related
penalty under section 6662(a) for each year in issue. The Commissioner
determined that the Villas’ underpayment of tax for each year is
attributable to negligence or disregard of rules or regulations, see I.R.C.
§ 6662(b)(1), and/or a substantial understatement of income tax, see
I.R.C. § 6662(b)(2). Attached to the notice of deficiency is a Civil Penalty
Approval Form that lists negligence as the primary civil penalty position
and substantial understatement as an alternative position. The form
                                           4

[*4] was signed on March 9, 2020, by the supervisor of the IRS official
who initially determined the penalties.

IV.      The Parties’ Concessions and Positions

       Before trial the Villas conceded the increases in their gross
income for both years as determined in the notice of deficiency. The
Commissioner conceded certain expenses after review of additional
receipts produced by Mr. Villa and some of the Villas’ bank statements
(which also reflect debit card transactions and withdrawals).
Specifically, for 2016 the Commissioner agreed to increase contract
labor expenses back to $8,750 (as reported on the return) and to increase
“other” expenses to $4,108. For 2017 the Commissioner agreed to
increase “other” expenses from zero to $10,837.

       The Villas ask us to determine that Mr. Villa’s Schedule C net
profit should be further reduced by costs of goods sold of $8,996 for 2016
and $16,480 for 2017, on the basis of Mr. Villa’s “less cash” withdrawals,
as supported by an estimate of his average profit margin (described
below).

         The amounts at issue are summarized in the following tables:

                                      Determined in       Agreed by
                     Reported on                                           Claimed by
  2016 Amounts                         the Notice of        Parties
                     Schedule C                                            the Villas
                                        Deficiency       Before Trial 3

 Gross Receipts        $26,022            $46,839           $46,839         $46,839

 Cost of Goods
                          —                  —                 —             (8,996)
 Sold

 Contract Labor         (8,750)           (4,814)           (8,750)          (8,750)

 Other Expenses        (11,690)           (2,860)           (4,108)          (4,108)

      Net Profit        $5,582            $39,165           $33,981         $24,985

        3 Before trial the Villas agreed only that Mr. Villa’s contract labor and “other”

expenses for 2016 and 2017 were at least the amounts shown below. They contend that
to the extent their claimed cost of goods sold amounts are not allowed, the “less cash”
withdrawal amounts alternatively should increase the contract labor and “other”
expense deductions.
                                        5

[*5]                                Determined in      Agreed by
                      Reported on                                     Claimed by
     2017 Amounts                    the Notice of   Parties Before
                      Schedule C                                       the Villas
                                      Deficiency        Trial 4

 Gross Receipts         $28,314        $68,944          $68,944        $68,944

 Cost of Goods
                           —             —                —            (16,480)
 Sold

 Contract Labor         (10,501)       (11,881)        (11,881)        (11,881)

 Other
                        (12,096)         —             (10,837)        (10,837)
 Expenses

      Net Profit        $5,717         $57,063         $46,226         $29,746

                                    OPINION

I.       Burden of Proof

       Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of
proving that those determinations are erroneous. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Further, a taxpayer is
required to maintain sufficient permanent records to substantiate all
components of reported net income, including deductible business
expenses and cost of goods sold. See I.R.C. § 6001; Treas. Reg.
§ 1.6001-1(a). The burden of showing entitlement to a claimed deduction
(from gross income) or reduction (from gross receipts) is on the taxpayer.
See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992). The Villas do not contend, and the evidence does not establish,
that the burden of proof shifts to the Commissioner under section
7491(a) as to any issue of fact.

       If a taxpayer clearly shows that he incurred a deductible expense
but is unable to substantiate the exact amount, the “Cohan rule” permits
the Court to estimate the amount of the expense, provided there is a
reasonable basis for making such an estimate.            See Cohan v.
Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930); Vanicek v.
Commissioner, 85 T.C. 731, 742–43 (1985); Goldsmith v. Commissioner,
31 T.C. 56, 62 (1958). In making an estimate under the Cohan rule, the

         4 See supra note 3.
                                          6

[*6] Court “bear[s] heavily if it chooses upon the taxpayer whose
inexactitude is of his own making.” Cohan v. Commissioner, 39 F.2d
at 544. Further, while the Cohan rule by its terms applies to deductible
expenses, this Court has adapted it to estimate cost of goods sold as well.
See, e.g., Olive v. Commissioner, 139 T.C. 19, 34 (2012), aff’d, 792 F.3d
1146 (9th Cir. 2015); Alterman v. Commissioner, T.C. Memo. 2018-83,
at *30–31; Huzella v. Commissioner, T.C. Memo. 2017-210, at *7–9.
However, the Court may not use the Cohan rule to estimate expenses
covered by the strict substantiation requirements of section 274(d)
(which during the years in issue applied to most expenses for
transportation, lodging, meals and entertainment, among other things).
See Sanford v. Commissioner, 50 T.C. 823, 827–29 (1968), aff’d per
curiam, 412 F.2d 201 (2d Cir. 1969).

II.   Cost of Goods Sold

       Deductions from gross income—such as for “ordinary and
necessary” business expenses, see I.R.C. § 162(a)—are a matter of
legislative grace and are allowed only to the extent provided by statute,
see INDOPCO, Inc. v. Commissioner, 503 U.S. at 84; New Colonial Ice
Co. v. Helvering, 292 U.S. 435, 440 (1934). By contrast, the reduction of
gross receipts by cost of goods sold is mandatory (i.e., not a matter of
legislative grace), as only income is taxable under the Sixteenth
Amendment. See Doyle v. Mitchell Bros., 247 U.S. 179, 184–85 (1918);
BRC Operating Co. v. Commissioner, T.C. Memo. 2021-59, at *8; Treas.
Reg. § 1.61-3(a) (providing that gross receipts are reduced by cost of
goods sold to arrive at gross income).

       Mr. Villa testified that he used his “less cash” withdrawals to pay
for both business needs (including fencing materials and contract labor)
and personal expenses. He did not specify what proportion of the
withdrawals went towards business needs versus personal expenses.
He provided a small amount of evidence indicating that he made modest
cash payments to a fencing supply distribution company and large cash
payments toward business-related accounts he held at Lowe’s and Home
Depot. Mr. Villa also testified about the details of recent work he
performed on one of his direct contracting jobs: He built an 81-foot fence
using $1,584 of materials and $166 of contract labor, and the customer
paid $2,400. The Villas ask the Court to use this sample job as a basis
for estimating total cost of goods sold. They suggest that the job’s 73% 5
ratio between cost of goods sold and gross receipts can be used to fairly

      5 ($1,584 + $166) ÷ $2,400 = 73%.
                                        7

[*7] estimate Mr. Villa’s total cost of goods sold for both years in issue.
However, because Mr. Villa did not pay for the materials used in his
subcontracting work for All-Texas, the Villas agree that we should apply
the 73% ratio only to the gross receipts from Mr. Villa’s direct
contracting work. The parties agreed that those gross receipts were
$20,817 for 2016 and $40,630 for 2017, yielding (as the Villas see it) an
estimated cost of goods sold of $15,196 for 2016 and $29,660 for 2017. 6

       While the Court found Mr. Villa’s testimony about this sample job
credible and likely representative of the direct contracting work that Mr.
Villa completed during the years in issue, it does not apply to the
indeterminate portion of the “less cash” withdrawals that Mr. Villas
admitted he used for personal expenses. In addition, it is unclear from
the record whether some portion of the above-estimated cost of goods
sold for Mr. Villa’s direct contracting work might already have been
included in the stipulated contract labor or “other” expenses—and such
inexactitude will be held against the Villas under the Cohan rule. In
particular, neither the Villas nor the Commissioner explained to the
Court the composition of the Schedule C “other” expenses the parties
agreed to before trial: $4,108 for 2016 and $10,837 for 2017. It is unclear
to what extent these amounts include materials Mr. Villa used in his
direct contracting work. It is clear, however, that a substantial portion
of the “less cash” withdrawals represent material and labor costs.
Accordingly, we will allow 50% of the “less cash” withdrawals as cost of
goods sold. As a result, costs of goods sold of $4,498 for 2016 and $8,240
for 2017 are allowed. 7

III.   Redetermined Net Profit

      We therefore redetermine the following amounts of Schedule C
net profit (and thus of total income) for the years in issue:

       6 Mr. Villa’s trial testimony was ambiguous about whether All-Texas supplied

him only with wood or with all materials needed for the fences he built as a
subcontractor. Even if we were to assume that Mr. Villa paid for the nonwood
materials for his subcontracting work, we would have no reasonable basis for
estimating those costs under the Cohan rule.
        7 Calculated from the “less cash” amounts as follows: $8,996 × 50% = $4,498

for 2016 and $16,480 × 50% = $8,240 for 2017.
                                         8

[*8]                               2016 Amounts                2017 Amounts

 Gross Receipts                       $46,839                     $68,944

 Cost of Goods Sold                    (4,498)                     (8,240)

 Contract Labor                        (8,750)                    (11,881)

 Other Expenses 8                      (4,108)                    (10,837)

      Net Profit                      $29,483                     $37,986

IV.      Accuracy-Related Penalties

       Section 6662(a) imposes a 20% penalty on any portion of an
underpayment of tax attributable to (among other things) negligence or
disregard of rules or regulations or a substantial understatement of
income tax. I.R.C. § 6662(b)(1) and (2). “Negligence” includes any
failure to make a reasonable attempt to comply with the internal
revenue laws or to exercise reasonable care in the preparation of a tax
return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). “Disregard”
includes any careless, reckless, or intentional disregard of the Code,
regulations, or certain IRS administrative guidance. I.R.C. § 6662(c);
Treas. Reg. § 1.6662-3(b)(2). An understatement of income tax is
substantial if it exceeds the greater of 10% of the tax required to be
shown on the return for the year in question or $5,000. I.R.C.
§ 6662(d)(1)(A).

      Under section 7491(c), the Commissioner bears the burden of
production regarding penalties for individual taxpayers and must come
forward with sufficient evidence indicating that it is appropriate to
impose a penalty. Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001).
One part of this burden is to show compliance with section 6751(b)(1),
which provides that “[n]o penalty . . . shall be assessed unless the initial
determination of such assessment is personally approved (in writing) by
the immediate supervisor of the individual making such determination.”
See Graev v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and

        8 Because we have determined the portion of “less cash” withdrawals allocable

to cost of goods sold, we do not reach the Villas’ alternative argument that such
amounts could also be considered contract labor or “other” expenses beyond the
stipulated amounts. We have no basis in the record for further increasing the latter
two categories.
                                     9

[*9] overruling in part 147 T.C. 460 (2016). The Villas do not dispute
that the Civil Penalty Approval Form attached to the notice of deficiency
establishes that the Commissioner complied with section 6751(b)(1).

       As for the substantive part of the Commissioner’s burden, he has
established that the Villas failed to report any of Mr. Villa’s gross
receipts from his direct contracting work. This was a clear instance of
reckless (if not intentional) disregard for the rule of section 61 that gross
income includes income “from whatever source derived” absent a clear
exclusion provided by law. See Treas. Reg. § 1.6662-3(b)(2) (defining an
instance of disregard as “reckless” if the taxpayer “makes little or no
effort to determine whether a rule or regulation exists, under
circumstances which demonstrate a substantial deviation from the
standard of conduct that a reasonable person would observe”). The
Commissioner therefore has made a prima facie case for imposing the
penalties under section 6662(a) and (b)(1).               In addition, the
understatements in this case are clearly substantial under section
6662(b)(2) and (d).

       Section 6664(c)(1) generally provides an exception to the section
6662 penalty with respect to any portion of an underpayment “if it is
shown that there was reasonable cause for such portion and that the
taxpayer acted in good faith with respect to such portion.” The
determination as to whether a taxpayer acted with reasonable cause and
in good faith is made on a case-by-case basis, considering all pertinent
facts and circumstances. Treas. Reg. § 1.6664-4(b)(1). Generally the
most important factor in determining the existence of reasonable cause
is the taxpayer’s effort to ascertain his or her correct tax liability. Id.
Circumstances that may signal reasonable cause and good faith “include
an honest misunderstanding of fact or law that is reasonable in light of
all the facts and circumstances, including the experience, knowledge,
and education of the taxpayer.” Id. Reliance on professional advice
“constitutes reasonable cause and good faith if, under all the
circumstances, such reliance was reasonable and the taxpayer acted in
good faith.” Id.; see also Neonatology Assocs., P.A. v. Commissioner, 115
T.C. 43, 98–99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

       The only explanation Mr. Villa offered for failing to report any
gross receipts from his direct contracting work is that those customers
did not send him Forms 1099–MISC or any other information returns,
and he therefore “didn’t know how to” report that income. Even if we
assume that Mr. Villa honestly believed that he owed tax only on
amounts reported to him via information returns, such an honest
                                   10

[*10] misunderstanding would not have been reasonable.            Any
reasonable person in Mr. Villa’s position—with his same education and
experience—would have suspected that an exclusion for the income from
his direct contracting work would be “too good to be true” and would
have inquired into whether such an exclusion really exists (and would
have ascertained that it does not).

       Likewise, Mr. Villa’s reliance on his cousin to prepare the Villas’
tax returns was unreasonable under the circumstances. The record does
not show whether Mr. Villa’s cousin was aware of the gross receipts from
the direct contracting work. In either case, however, Mr. Villa’s reliance
was unreasonable. If the cousin knew of the gross receipts and told Mr.
Villa they were not taxable, then Mr. Villa was unreasonable in relying
on such advice: It would have been incredible on its face and would have
warranted further investigation on Mr. Villa’s part—all the more so
because his cousin was not a professional tax advisor or accountant. See
Treas. Reg. § 1.6664-4(c)(1)(ii) (“The advice must not be based on
unreasonable factual or legal assumptions . . . .”). If the cousin was not
aware of the gross receipts, then Mr. Villa could not have trusted his
cousin to prepare an accurate return. Id. (“[T]he advice must not be
based upon a representation or assumption which the taxpayer knows,
or has reason to know, is unlikely to be true . . . .”).

       We therefore hold the Villas liable for the penalties under section
6662(a) applicable to the deficiencies for both years in issue. We have
considered all the arguments made by the parties and, to the extent they
are not addressed herein, we find them moot, irrelevant, or without
merit.

      To reflect the foregoing,

      Decision will be entered under Rule 155.