The opinion
T.C. Memo. 2010-49
UNITED STATES TAX COURT
DEANNA LANGILLE f.k.a. DEANNA BIRDSONG, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17227-08. Filed March 18, 2010.
Deanna Langille, pro se.
Miriam C. Dillard, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: Petitioner Deanna Langille practiced law
in the years in issue (1993, 1994, and 1995), and she also owned
and leased real estate. The Internal Revenue Service (IRS)
issued a statutory notice of deficiency to Ms. Langille on April
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14, 2008, pursuant to section 6212,1 determining the following
income tax deficiencies and fraud penalties:
Fraud penalty
Year Deficiency Sec. 6663(a)
1993 $44,324 $33,243
1994 70,683 53,012
1995 41,927 31,445
After a concession,2 the issues for decision are:
(1) Whether Ms. Langille received from Birdsong & Smith,
P.A., unreported passthrough income of $8,689 in 1993 and an
unreported passthrough loss of $15,851 in 1994. We find that she
did.
(2) Whether, in connection with Ms. Langille’s law practice,
she received unreported receipts and paid unreported law practice
expenses as follows:
Additional Additional
Year receipts expenses
1993 $112,150 $4,643
1994 193,817 5,485
1995 255,314 135,809
We find that she did.
1
Unless otherwise indicated, all citations of sections refer
to the Internal Revenue Code of 1986 (the Code, 26 U.S.C.), as
amended, all citations of Rules refer to the Tax Court Rules of
Practice and Procedure, and amounts are rounded to the nearest
dollar.
2
Respondent concedes that Ms. Langille did not receive
$2,587 in capital gain income in 1995.
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(3) Whether Ms. Langille received interest income on seller-
financed mortgages as follows:
Mortgage interest
Year income
1993 $11,511
1994 9,601
1995 5,977
We find that she did.
(4) Whether Ms. Langille realized from her rental
activities: $1,935 less income than she reported in 1993, $4,444
more income than she reported in 1994, and $2,019 more income
than she reported in 1995. We find that she did.
(5) Whether Ms. Langille is liable for the fraud penalty
under section 6663(a) for the years in issue. We hold that she
is liable for the fraud penalty for each year but in amounts less
than the IRS determined in the notice of deficiency.
FINDINGS OF FACT
This case was tried in Jacksonville, Florida, on May 6,
2009. We incorporate by this reference the parties’ stipulation
of facts.
Law Practice
Ms. Langille earned her law degree in 1974 and was a lawyer
in private practice during the years in issue. Ms. Langille and
Elinor Smith incorporated Birdsong & Smith, P.A. (the firm), as
an S corporation under section 1361(a) in 1990. They each owned
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half its stock, and they practiced law under the name of the firm
until they dissolved it (for reasons the record does not show) on
October 31, 1994. Thereafter, Ms. Smith practiced law in the
same building as Ms. Langille until July 1995, and Ms. Langille
operated her own solo practice in that building until she stopped
practicing law in November 1996.
Each lawyer had her own client trust account, and each knew
of the other’s client trust account. Neither lawyer wrote checks
against the other’s trust account, and neither reviewed nor
balanced the other’s trust account. Both lawyers disbursed funds
from their individual client trust accounts either directly to
themselves or to pay personal expenses, as follows:
Personal expenditures
Year Ms. Langille Ms. Smith
1993 $47,670 $1,080
1994 -0- 2,731
Ms. Langille did not report the $47,670 as income in 1993.
During the years in issue Ms. Langille had exclusive control
over the account named Birdsong & Smith P.A. General Account
(operating account). Only she had access to the operating
account monthly statements, and only she wrote checks against
that account. She deposited just enough receipts from clients
into the operating account to cover law practice expenses (and
she claimed those expenses as deductions for the firm). She also
wrote checks for distributions to the shareholders from that
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account. Under their agreement Ms. Langille was to provide
monthly distribution checks to Ms. Smith representing the net
income Ms. Smith earned, i.e., Ms. Smith’s income after deducting
common expenses. She distributed $21,631 to Ms. Smith in 1993
and $26,000 in 1994. She did not issue any distribution checks
to herself in 1993, but she distributed $5,000 from the operating
account to herself in 1994.
Ms. Langille wrote monthly checks from the operating account
to her wholly owned subchapter S corporation Birdsong Management
Company (BMC) for the rental of the office building where she
practiced law. She claimed rental expense deductions for the
firm for these payments, and she included the receipts in income,
as is discussed below.
Ms. Langille diverted legal fees for her own use, bypassing
the firm’s bank accounts and depositing additional law practice
receipts into other accounts, from which she also paid some law
practice expenses, as follows:
Deanna McBride
Birdsong Attorney DMB Development Co.
Item at Law account accounts
1993 fees $111,425 -0-
1993 expenses (4,643) -0-
1994 fees 192,651 -0-
1994 expenses (5,485) -0-
1995 fees 12,897 $169,403
1995 expenses (631) (31,728)
She did not report these receipts or expenses on her returns.
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Ms. Langille kept the books for the firm. She prepared and
filed the firm’s tax returns for 1993 and 1994, reporting the
following:
Item 1993 1994
Gross receipts $241,926 $223,228
Deductions (185,451) (158,254)
1
Net income 56,475 65,034
Each 50-percent shareholder’s share 28,238 32,517
of income
1
The 1994 tax return Ms. Langille filed for the firm
contains a subtraction error: The difference between the firm’s
receipts and deductions (i.e., the firm’s net income) is $64,974,
not $65,034; and, thus, each shareholder’s share of that income
is $32,487.
As is noted above, Ms. Langille did not report on the firm’s
return the law practice income she deposited into the Deanna
McBride Birdsong Attorney at Law account in 1993 or 1994, and she
did not claim the expenses she paid from that account. She also
did not report as income any of the money that she and Ms. Smith
expended from their client trust accounts for personal purposes.
Ms. Langille worked long hours in her law practice
throughout the years at issue. Her real estate activities
consumed somewhat less of her time.
Real Estate Activities
Between 1990 and 1992 Ms. Langille sold certain residential
real property with seller financing, i.e., she extended mortgages
to the purchasers. During the years in issue, she received
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payments of principal and interest on two of these mortgages; and
on the third, she received payments until she repurchased the
property in August 1994. She did not report any interest or
other income from the receipt of these payments during the years
in issue, even though she received mortgage interest payments of
the following amounts:
Mortgage interest
Year payments received
1993 $11,511
1994 9,601
1995 5,977
Total 27,089
Ms. Langille rented her office building and certain
residential rental properties through BMC. Ms. Langille’s law
practice paid rent of $1,500 each month throughout 1993 and 1994
(i.e., $18,000 per year) and $1,600 each month in 1995 (i.e.,
$19,200 for the year).3 These amounts were paid to Ms. Langille
through BMC. For the first two of those three years she reported
the following income and expenses on BMC’s Forms 1120S, U.S.
Income Tax Return for an S Corporation:
3
Until it dissolved on October 31, 1994, the firm paid rent
on the office building. After the dissolution of the firm,
Ms. Langille paid rent from her unincorporated law practice. She
reported $18,000 rent paid on the firm’s tax returns for each of
1993 and 1994. Ms. Langille wrote rent checks for the first
seven months of 1995, and the IRS imputed rent for the remaining
five months.
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Amounts reported
Item 1993 1994
Gross receipts $18,000 $1,212
Repairs and maintenance (2,465) -0-
Taxes and licenses (150) -0-
Interest (10,440) -0-
Total deductions (13,055) -0-
Net income 4,945 1,212
That is, for 1993 Ms. Langille entered $18,000 in gross
receipts and amounts for certain expenses for BMC on its
Form 1120S and used those expenses to calculate total deductions
and net income from renting the office building; but for 1994 she
entered not $18,000 but only $1,212 as gross receipts or sales,
drew an arrow to carry that figure down the page to the total
income line, and drew another arrow to carry that figure to the
ordinary income line; she included no other income or expense
information on that return.
Although her practice paid $1,600 per month to rent the
office building in 1995, Ms. Langille did not file a return for
BMC for 1995.
Ms. Langille earned a profit for each year in issue renting
the commercial building to her law practice as follows:
Item 1993 1994 1995
Office rental net income $3,010 $5,656 $4,574
In addition to her own home and the office building she
rented to her law practice, Ms. Langille owned five houses and
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nine condominiums, and she rented those residential properties to
third parties.4 She owned outright one of those houses and five
of those condominiums, and she had mortgages on the remaining
four houses and four condominiums.
Ms. Langille’s residential rental activities lost money
during each year in issue, and for the years in issue she did not
report income or expenses from renting the residential
properties. Because of the losses from the residential rentals,
her rental activities overall lost money during each year in
issue. Adjusting for depreciation, the cash flow from her rental
activity was negative for two of three years in issue, as
follows:
4
Ms. Langille held the residential rental properties and her
personal residence in the name of the David Justin Birdsong
Family Trust (the trust). However, in a year not disclosed by
the record, a U.S. bankruptcy court held that all of the real
estate Ms. Langille ostensibly held in the name of the trust was
actually owned by Ms. Langille individually. The record does not
reflect any bank accounts in the name of the trust or that the
trust had any existence aside from being the putative owner of
Ms. Langille’s real estate. Ms. Langille did not file any tax
returns for the trust during the years in issue, and she does not
challenge the IRS’s decision to disregard the trust or its
conclusion that any income from her rental activities is taxable
to her individually.
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Item 1993 1994 1995
Rental income $36,488 $58,747 $61,017
Total expenses (60,460) (65,489) (76,100)
Net rental income (loss) (23,972) (6,742) (15,083)
Depreciation expense (9,280) (11,970) (14,288)
Cash expenses (51,180) (53,519) (61,812)
Cash flow from rental activities (14,692) 5,228 (795)
Individual Income Tax Returns
Ms. Langille prepared and timely filed income tax returns
for herself, the firm, and BMC. On her Form 1040, U.S.
Individual Income Tax Return, for each year in issue, she claimed
head of household filing status and one dependent, her son, and
she reported the following:
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Item 1993 1994 1995
Schedule K-1 real estate $4,945 -0- -0-
Schedule K-1 lawfirm 28,238 -0- -0-
Schedule E
1 2
Rents received --- $33,729 $19,200
Total expenses --- -0- 16,645
Net income 33,729 2,555
Schedule C
Law office gross receipts --- --- 130,054
Law office total expenses --- --- (87,454)
Net law office profit --- --- 42,600
Total income 33,183 33,729 45,155
1
Ms. Langille appears to have added her share of the income
from the firm, $32,517, to the net income she reported for BMC,
$1,212, and entered that sum, $33,729, as “Rents received” on her
1994 Schedule E, Supplemental Income and Loss (From rental real
estate, royalties, partnerships, S corporations, estates, trusts,
REMICs, etc.).
2
The practice paid BMC rent of $1,600 per month in 1995, but
Ms. Langille reported her commercial rental income and expenses
on Schedule E, and she did not file a Form 1120S for BMC for
1995.
Ms. Smith and Ms. Langille dissolved the firm on October 31,
1994, and Ms. Langille continued practicing law throughout 1994;
but she did not file a Schedule C, Profit or Loss From Business,
for 1994 to report her law practice income and expenses for
November and December 1994. As indicated, she did not report the
law practice income she deposited into the Deanna McBride
Birdsong Attorney at Law account on the firm’s return for 1993 or
1994. She also did not report that income on her individual
return for 1993 or 1994.
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As is shown above, Ms. Langille reported $130,054 in 1995
law practice receipts on Schedule C. However, she earned
$385,368 from her law practice in 1995, and she deposited those
law practice receipts in various accounts, as follows:
Amount
Account deposited
Operating account $183,723
DMB Development Co. operating account 153,616
DMB Development Co. investment account 15,788
Deanna McBride Birdsong Attorney at Law account 12,897
BMC account 19,344
Total law practice deposits 385,368
Ethics Controversies and Resignation
The Florida Bar reviewed the firm’s client trust accounts
for 1993 and determined that Ms. Langille had misappropriated
funds from her client trust account. On January 27, 1994, the
Florida Supreme Court publicly reprimanded Ms. Langille for
professional misconduct. Fla. Bar v. Birdsong, 634 So. 2d 628
(Fla. 1994). On October 26, 1995, the Florida Supreme Court
suspended Ms. Langille from practicing law for 30 days, imposed 1
year of probation, and required her to complete professional
education courses, because the court found that she had continued
to assist a client with a lawsuit after a Florida court had
issued an order disqualifying her from further representing that
client in that matter. Fla. Bar v. Birdsong, 661 So. 2d 1199
(Fla. 1995).
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Ms. Langille stopped practicing law in November 1996. In
1997 she resigned in lieu of disciplinary proceedings. Fla. Bar
v. Birdsong, 690 So. 2d 1301 (Fla. 1997).
Efforts To Sell The Law Practice
In July 1996 Ms. Langille put her law practice up for sale.
She advertised that its gross receipts were $350,000 per year.
Ms. Langille met with a prospective buyer on August 26, 1996, and
again on September 5, 1996. This buyer chose not to purchase the
law practice. Instead he reported to the IRS that Ms. Langille
had indicated that she was keeping two sets of book for the law
practice--one set with reduced income for preparing tax returns
and another set with greater income to show potential buyers.
IRS Criminal Investigation
An undercover agent from the IRS’s Criminal Investigation
Division (CID) posed as a representative of a different
prospective buyer of the law practice and met with Ms. Langille
on November 5, 1996. On the basis of the undercover agent’s
observations and the report from the earlier prospective buyer,
the IRS requested and obtained a search warrant.
The IRS searched Ms. Langille’s law office on November 15,
1996. An IRS special agent interviewed Ms. Langille during the
search. She admitted that she prepared her individual tax
returns and the firm’s corporate tax returns. She acknowledged
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that some of her income might have been unreported, and she
asserted that “everyone has unreported income”.
When asked to identify entities and bank accounts in which
she had an interest, Ms. Langille told the IRS about the firm,
the trust, and BMC; and she told the IRS about the firm’s
operating account, her client trust account, and the BMC account.
She did not inform the IRS of any interest in DMB Development
Company, nor did she identify the two DMB Development Company
accounts (which were at a different bank from the accounts she
did identify). She also did not disclose her Deanna McBride
Birdsong Attorney at Law account.
The undercover agent had reported that certain financial
records were in plastic trash bags and that Ms. Langille had
offered those records for inspection and stated that those
records would not be sold with the practice but would be
destroyed. Following the search of Ms. Langille’s office, the
IRS departed with 10 or more boxes of records and five 39-gallon
plastic bags seized from Ms. Langille’s office. The bags
contained both garbage and financial records, including income
ledgers that closely reconciled to the bank accounts petitioner
disclosed.
When the IRS agents sorted through the documents in the
plastic bags after the search, they found records for the two DMB
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Development Company accounts, including bank statements, canceled
checks, and the envelopes the bank used to mail the statements.
The special agent interviewed Ms. Langille on November 19,
1996, when he returned certain records.5 He asked her about the
DMB Development Company accounts. She stated that she thought
she had disclosed those accounts to him and that she deposited
only rental receipts into those accounts. The agent then
specifically asked her about a $47,000 deposit into the DMB
Development Company investment account, as that seemed too large
an amount for a residential rental receipt. Ms. Langille
identified the deposit as a settlement check related to one of
the clients of her law practice, and she then admitted to
depositing law practice receipts into the DMB Development Company
accounts. Total deposits during 1995 into the DMB Development
Company accounts were $175,081.6
In addition to the special agent who supervised the search
of Ms. Langille’s office and interviewed her, the CID team
included a revenue agent who analyzed the documents seized and
5
The special agent returned records relating to the then-
current year, 1996, which is not one of the years in issue.
6
It appears that DMB Development Company’s only existence
was in the name Ms. Langille used on the DMB Development Company
Investment Account and the DMB Development Company operating
account. Ms. Langille provided no evidence that DMB Development
Company was a legitimate business, and the record contains no
indication that she filed a tax return for any such entity during
any year in issue.
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performed bank deposits analyses and check spreads to identify
income and expenses. In the bags and boxes seized from
Ms. Langille’s office, the revenue agent discovered a single
check drawn on the Deanna McBride Birdsong Attorney at Law
account--an account Ms. Langille had not disclosed but into which
she had deposited law practice receipts. The IRS had been
unaware of this account before the revenue agent found this
check. The IRS summoned the bank records for this account and
found total deposits of the following amounts:
Amount
Year deposited
1993 $136,593
1994 210,968
1995 13,359
Total 360,920
IRS Examinations
The IRS summoned the bank records and examined both BMC’s
and the firm’s corporate Federal income tax returns for 1993 and
1994; and it summoned the bank records and examined
Ms. Langille’s individual returns for 1993, 1994, and 1995.
Examination of the S Corporation’s Returns
To determine the income and expenses of the S corporation
law firm, the IRS used both the client trust accounts and the
operating account. Each shareholder knew about the other’s
client trust account, and both knew about the firm’s operating
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account, so the IRS treated deposits to and expenditures from
these accounts as income and expenses of the S corporation.7
However, Ms. Smith had not been aware of the other bank accounts
that Ms. Langille used, so the IRS determined the firm’s income
and expenses without reference to these other accounts, which
instead were attributed to Ms. Langille personally.
As for the trust accounts, the IRS did not include in firm
income the deposits to the client trust accounts, because that
money generally did not belong to the lawyers until they had
earned their fees and paid themselves. However, the IRS did
include in the firm’s income both fees withdrawn from the client
trust accounts that were paid directly to the lawyers and any of
the lawyers’ personal expenses that they paid directly from their
7
Ms. Langille has challenged the IRS’s treating, as firm
income (half of which is taxable to Ms. Langille), amounts that
Ms. Smith took from her client trust account for her own use.
However, while Ms. Smith did not know that Ms. Langille was
diverting law practice income to her other accounts, each lawyer
knew about the operating account and the other’s trust account,
and the IRS consistently characterized trust expenditures for
either lawyer’s personal benefit from either trust account as
income to the firm, with each lawyer taxable for half of the
total. Since Ms. Langille actually took more than half of the
total, she arguably received more income than the IRS
determined--i.e., income in the full amount of what she took.
See James v. United States, 366 U.S. 213, 219-220 (1961)
(“wrongful appropriations [are] within the broad sweep of ‘gross
income’”); Webb v. IRS, 15 F.3d 203, 205 (1st Cir. 1994) (funds
misappropriated from a trust by a trustee are includable in his
gross income). However, this position would result in a greater
deficiency than was determined in the notice of deficiency or
pleaded in the answer, so we do not consider an approach more
aggressive than respondent has proposed.
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trust accounts. For business-related expenses paid from the
client trust accounts, the IRS neither included the payment of
those expenses in corporate income nor allowed deductions
therefor, because such income and expenses would net to zero. We
find this treatment reasonable. As for the operating account,
all expenditures from the account were allowed as law firm
expenses, with the reasonable exception that deductions were not
allowed for distributions paid to Ms. Langille and Ms. Smith.
The books that Ms. Langille had kept for the firm did not
match the income and expenses that the revenue agent found. When
filing the firm’s tax returns, Ms. Langille had understated firm
receipts in 1993 and overstated receipts in 1994, and she
understated deductible firm expenses in both years. The IRS
determined the following for the firm:
Item 1993 1994
Adjustments to gross receipts $33,429 ($21,574)
Adjustments to deductions (16,051) (10,127)
Total adjustments to firm income 17,378 (31,701)
Corporate income as reported 56,475 65,034
Corrected taxable income 73,853 33,333
Adjustment for each shareholder 8,689 (15,851)
Thus, the IRS determined, as to the S Corporation law firm,
adjustments that in one year were favorable to Ms. Langille.
However, as we show below, the adjustments related to
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Ms. Langille’s solo practice outside the firm overwhelmed those
favorable adjustments.
Examination of BMC’s Returns
For 1993 and 1994 the IRS examined the rental activity that
Ms. Langille had undertaken in the name of BMC; and for each year
in issue the IRS analyzed Ms. Langille’s rental receipts, rent
book, and bank account records to determine the rental income and
rental expenses for all of Ms. Langille’s properties. The
revenue agent calculated depreciation schedules for
Ms. Langille’s rental properties and included depreciation
allowances in rental expenses for each year in issue. The IRS
concluded that Ms. Langille did not qualify as a real estate
professional during the years at issue (because she spent most of
her time working in her law practice) and that her passive rental
losses are deductible only against passive income. The IRS
determined that any income generated by Ms. Langille’s renting
the office building to her own law practice was not passive
income and could not be offset by any passive losses from her
other real estate activities. The IRS therefore segregated
Ms. Langille’s office building rental activity from her
residential property rental activity. The IRS determined the
following amounts of rental income and expense:
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Item 1993 1994 1995
Rental income $36,488 $58,747 $61,017
Rental expenses (60,460) (65,489) (76,100)
Net income (loss) (23,972) (6,742) (15,083)
Character of net income (loss)
Non-passive (office rental) 3,010 5,656 4,574
Passive (residential rentals) (26,982) (12,398) (19,657)
Non-passive income 3,010 5,656 4,574
Less rental income reported 4,945 1,212 2,555
1
Adjustment to rental income (1,935) 4,444 2,019
1
In the notice of deficiency for 1995 the IRS determined a
negative adjustment of $4,189 to Ms. Langille’s rental income and
a positive adjustment of $2,587 to her capital gain. At trial
respondent conceded the capital gain adjustment, and on brief he
contends that the correct rental income adjustment is $2,019, as
indicated. However, he also stated that he is not seeking any
greater deficiency than he determined in the notice of deficiency
(which determined a $4,189 reduction rather than a $2,019
increase in rental income). The record does not clearly reflect
how the IRS determined the $4,189 reduction in rental income in
the notice of deficiency, but given that the reduction is in
Ms. Langille’s favor and considering respondent’s concession that
he is not seeking any greater deficiency, we need not address
this issue further.
Because Ms. Langille did not have any passive income during
the years in issue--the capital gain in 1995 from the sale of
real property having been conceded--the IRS contends (and we
hold, for the reasons explained below) that no deduction should
be allowed for any residential rental real estate losses incurred
in the years in issue.
Examination of Ms. Langille’s Returns
Ms. Langille not only failed to report the rental income
discussed above but also failed to report the $27,089 of interest
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income that (as we have found) she received from seller-financed
mortgages that she had taken back from purchasers of property.
The IRS identified the amounts she received during the years in
issue as payments for her prior real estate sales, examined the
sales documents and the terms of the mortgages, and calculated
the amount of interest paid each month.8 Ms. Langille did not
report any of the interest payments she received on her
individual return, on BMC’s corporate return, or on any other
return for any of the years in issue.
The IRS also performed a bank deposits and check spread
analysis of the DMB Development Company accounts and of the
Deanna McBride Birdsong Attorney at Law account, confirming that
Ms. Langille had deposited legal fees into those bank accounts
and that those receipts were not reflected on the books she kept
for her law practice activities, nor were they reported on her
individual returns (including the Schedule C for her
unincorporated law practice) or on the Forms 1120S for the firm.
The IRS also identified legal fees Ms. Langille deposited (along
with rental receipts) into the BMC account.9 The revenue agent’s
check spread analysis also determined that Ms. Langille had paid
8
Ms. Langille sold each of the properties before the years
in issue, so any gain or loss on the sales themselves is not at
issue.
9
Legal fees deposits into the BMC account were $725 in 1993,
$1,167 in 1994, and $19,344 in 1995, totaling $21,236.
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additional law practice expenses from those accounts and had not
deducted them on any return.
The IRS treated the legal fees that Ms. Langille diverted
from the firm and into her other accounts as Schedule C income
from her running an unincorporated solo law practice on the side
and allowed as deductions from that Schedule C income the
previously unreported expenses.10 The shareholders dissolved the
firm on October 31, 1994, and Ms. Langille included her 1995 law
practice income on Schedule C. The IRS adjusted the income and
expenses on that Schedule C to include all amounts related to the
law practice that Ms. Langille deposited to or paid from any of
her accounts.
The IRS’s analysis produced the following adjustments to
Ms. Langille’s individual income tax reporting:
10
If the diverted proceeds were attributed to the
S corporation, then each shareholder’s share of the net income
would be increased, and Ms. Smith would be taxable on income that
Ms. Langille had diverted for her own use. Ms. Langille has not
challenged the IRS’s characterization of diverted legal fees as
Schedule C income to her rather than as income to the firm.
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Item 1993 1994 1995
1
Capital gain or (loss) --- --- $2,587
Interest income $11,511 $9,601 5,977
Schedule C
Gross receipts 112,150 193,817 255,314
Expenses (4,643) (5,485) (135,809)
Sch. K-1 income from the firm 8,689 (15,851) n/a
Net law practice income 116,196 172,481 119,505
2
Sch. E rental income/expense (1,935) 4,444 (4,189)
Self employment AGI adjust. (5,011) (6,279) (2,956)
Personal exemptions 752 2,940 800
Itemized deductions (10,354) -0- (8,950)
Standard deduction 5,450 -0- 5,750
Total adjustments 116,609 183,187 118,525
Self employment tax 10,022 12,588 11,930
1
Respondent conceded the capital gain adjustment at trial,
as is discussed above on page 20.
2
At trial respondent asserted that the correct Schedule E
income adjustment for 1995 is a $2,019 increase, but he also
stated that he is not seeking any greater deficiency than
determined in the notice of deficiency, which determined a $4,189
decrease in rental income, as is discussed above on page 20.
The phaseout of personal exemptions, the self-employment
taxes, and the self-employment tax adjustments are computational
in nature and flow from the resolution of the other issues. The
IRS determined that the sum of the real estate taxes and the
mortgage interest Ms. Langille paid on her personal residence in
1993 and 1995 exceeded the standard deduction she claimed on her
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returns. Thus, the IRS allowed the larger itemized deduction
for those years. The IRS determined that the standard deduction
was more beneficial for Ms. Langille in 1994. She has not
challenged these adjustments.
Fraud Determination
The IRS determined that Ms. Langille, a lawyer, was aware of
the requirement that she report her law practice receipts, rental
receipts, and mortgage interest receipts as income, and that she
deliberately omitted this income for the purpose of evading
Federal income tax. The IRS compared the sum of the deposits
into Ms. Langille’s accounts and the amounts withdrawn from the
client trust accounts for personal expenses to the amount of
income Ms. Langille reported for each year for the firm, BMC, and
herself, as follows:
1993 1994 1995
Total deposits & client trust
account income $449,596 $451,355 $442,193
Total income reported 259,926 224,500 149,254
Total unreported income 189,670 226,855 292,939
The IRS determined therefrom that Ms. Langille had significantly
understated her income for the years in issue. The IRS concluded
that Ms. Langille intentionally concealed and omitted income with
the intent to evade tax she knew she owed.
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Criminal Prosecution
The U.S. Attorney’s Office for the Middle District of
Florida obtained an indictment11 against Ms. Langille, and she
pleaded guilty to one count of the indictment: violating section
7206(1) by willfully filing a false tax return for 1994. The
Government had the remaining count of the indictment (a charge as
to 1995) dismissed pursuant to the plea agreement. In that plea
agreement Ms. Langille admitted that she did not report all of
her income for 1994 and 1995. The court sentenced her to time
served and 12 months of supervised release and ordered her to pay
$144,360 in restitution to the IRS and a $50 special assessment.
United States v. Birdsong, No. 8:01CR126T17 (M.D. Fla. Sept. 10,
2004).
Notice of Deficiency and Petition
The IRS issued the notice of deficiency on April 14, 2008.
The IRS derived the adjustments in the notice of deficiency from
the criminal investigation conducted by the special agent and the
analysis performed by the revenue agent. The IRS determined that
Ms. Langille is liable for the civil fraud penalty under section
6663 for each year in issue.12
11
The record before us includes the plea agreement but does
not include the indictment.
12
The IRS did not determine an accuracy-related penalty
under section 6662 as an alternative to the fraud penalty.
Accordingly, we are not asked to decide whether the 20-percent
(continued...)
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Ms. Langille filed a timely petition in this Court for
redetermination of the deficiency, asserting that she provided a
list of business deductions to the IRS but that the IRS did not
allow her those deductions. Her petition includes a summary of
income and expenses and a summary of further adjustments that she
asserts result in her having no aggregate deficiency for the
years in issue. When she filed her petition, Ms. Langille
resided in Florida.
Trial
Ms. Langille testified at trial, and she did not call any
other witnesses. Respondent called the lawyer who answered the
advertisement to purchase Ms. Langille’s practice.13 He also
called the IRS special agent who searched the office and
interviewed Ms. Langille; the revenue agent who analyzed the
records and summoned documents, performed the bank deposits
12
(...continued)
penalty for negligence or disregard of rules or regulations
should apply, pursuant to section 6662(a) and (b)(1), to any
portion of the underpayment not attributable to fraud.
13
This lawyer applied for a monetary award pursuant to
section 7623(b) when he reported his concerns to the IRS, and his
reporting triggered the investigation into Ms. Langille’s tax
returns and led to the criminal prosecution and the notice of
deficiency. As indicated, Ms. Langille pleaded guilty to
willfully filing an inaccurate tax return. The record developed
by the IRS following this lawyer’s tip is sufficient for us to
decide this case without reciting or relying upon details of his
testimony.
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analyses, and calculated the deficiencies determined by the IRS;
and a lawyer who was a former employee of the firm.
Summary of Findings
We find that the IRS’s bank deposits analyses of the firm’s
accounts, the BMC account, and the accounts Ms. Langille held in
various names were reasonable, as was its reconstruction of her
real estate income and expenses; and we find that Ms. Langille
had unreported income and expenses as determined in the notice of
deficiency (except as conceded; see supra note 2).
We find further that Ms. Langille was aware of her
obligations to maintain books and records of her business
activities, that she did not keep records that accurately
reflected her income, that she maintained bank accounts under
different names, that she diverted law practice receipts away
from the firm and into her own accounts, that she failed to
disclose all her bank accounts to the IRS, that she did not
report any income from her residential rental activities (but
that she also did not have any profit on those activities during
the years in issue), that she failed to report interest income on
mortgage payments she received, and that she intentionally failed
to report law practice income. We find that she knew of her
obligations to accurately report her income on her tax returns,
that her actions were willful, and that she had the fraudulent
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intent to evade tax on her unreported law practice income for
each year in issue.
However, we do not find that she had the fraudulent intent
to evade tax with respect to her unreported mortgage interest
income or her commercial rental income.
OPINION
I. Statute of Limitations
As a threshold matter, we must determine whether the IRS
timely issued the notice of deficiency from which Ms. Langille
timely filed a petition for redetermination. The IRS issued the
notice of deficiency more than 12 years after Ms. Langille filed
her tax return for the last year in issue.
Ms. Langille timely filed her individual income tax returns
for the years in issue. A return is considered filed on the last
day prescribed for filing if it is filed before that day. Sec.
6501(b). Thus the latest-filed return at issue (for 1995) was
deemed filed April 15, 1996. Generally, the IRS must assess a
deficiency within 3 years of the date of filing of the tax
return. Three years from the filing date for the latest year in
issue would be April 15, 1999. The IRS issued the notice of
deficiency with respect to all three years on April 14, 2008.
Clearly more than 3 years elapsed (in fact almost 12 years
elapsed) between the deemed filing date for Ms. Langille’s latest
tax return in issue and the date the IRS issued the notice of
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deficiency, which is the first step in the process of assessing a
deficiency. If the general rule of section 6501(a) applied, then
the IRS would have failed to assess the deficiency within the
period of limitations and would be barred from assessing and
collecting any of the deficiencies or penalties for the 3 years
in issue.
However, section 6501(c) provides exceptions to the general
rule, including:
(1) False return.--In the case of a false or
fraudulent return with the intent to evade tax, the tax
may be assessed, or a proceeding in court for
collection of such tax may be begun without assessment,
at any time.
The period for assessing Ms. Langille’s liability for a
deficiency determined in this case remains open if she filed “a
false or fraudulent return with the intent to evade tax” for the
year of the deficiency; if she did, then the exception provided
in section 6501(c)(1) permits the IRS to assess the tax for that
year “at any time.”
As is discussed below in parts IV and V.B, Ms. Langille
fraudulently failed to report income in each year in issue, and
her intent was to evade tax. Accordingly, the statute of
limitations does not bar assessment; rather, the exception
provided in section 6501(c)(1) applies, and the IRS may assess at
any time.
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II. Burden of Proof
A. Generally
The Commissioner’s determinations set forth in a notice of
deficiency are presumed correct, and generally speaking the
taxpayer bears the burden of showing the determinations are in
error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). (The different burden of proof for fraud is discussed
below in part II.B.) Deductions and credits are a matter of
legislative grace, and the taxpayer bears the burden of proving
that she is entitled to any deduction or credit claimed. Rule
142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934). This includes the burden of substantiation. Hradesky v.
Commissioner, 65 T.C. 87 (1975), affd. per curiam 540 F.2d 821
(5th Cir. 1976).
The unreported income that the IRS determined Ms. Langille
earned during the years in issue is predicated on bank deposits--
prima facie evidence sufficient to relieve the IRS of any
threshold burden of proving the source of that income. See
Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
Under certain circumstances, the burden of proof as to
factual matters may shift pursuant to section 7491(a) from the
taxpayer to the Commissioner, but only if the taxpayer introduces
credible evidence regarding a factual matter affecting her
liability and only if she has complied with substantiation
-31-
requirements, has maintained all required records, and has
cooperated with the IRS’s reasonable requests. Sec. 7491(a)(1)
and (2). Ms. Langille has not introduced credible evidence
raising factual questions about her liabilities (rather, she has
made conclusory arguments based on her own summaries of income
and expenses, without supporting those summaries with references
to exhibits in the record); she has not complied with
substantiation or record-keeping requirements; and she did not
cooperate with the IRS, specifically with the special agent’s
request for banking information (rather, the special agent
discovered the DMB Development Company accounts and the revenue
agent discovered the Deanna McBride Birdsong Attorney at Law
account without deliberate help from Ms. Langille). Accordingly,
section 7491(a) does not shift the burden to respondent, and
Ms. Langille therefore retains the burden of proof with respect
to the deficiencies. See Rule 142(a)(1).
B. Fraud
Conversely, the Commissioner has the burden of proof with
respect to the issue of fraud with intent to evade tax, and that
burden of proof must be carried by clear and convincing evidence.
Sec. 7454(a); Rule 142(b); see Rowlee v. Commissioner, 80 T.C.
1111, 1123 (1983). He must establish each element of fraud by
clear and convincing evidence for each of the years at issue.
See sec. 7454(a); Rule 142(b); Smith v. Commissioner, 926 F.2d
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1470, 1475 (6th Cir. 1991), affg. T.C. Memo. 1989-171. Section
6663(b) provides that a determination that any portion of an
underpayment is attributable to fraud results in the entire
underpayment’s being treated as attributable to fraud, except any
portion the taxpayer proves is not so attributable. Thus
respondent must show not only that Ms. Langille has underpaid her
taxes for each year but also that some part of her underpayment
for each year is due to fraud. See DiLeo v. Commissioner, 96
T.C. 858, 873 (1991), affd. 959 F.2d 16 (2d Cir. 1992).
Section 6664(a) defines an underpayment as
the amount by which any tax imposed by this title
exceeds the excess of--
(1) the sum of--
(A) the amount shown as the tax by the
taxpayer on his return, plus
(B) amounts not so shown previously
assessed (or collected without assessment),
over
(2) the amount of rebates made.
Section 6211(a) defines a “deficiency” as the “amount by
which the tax imposed * * * exceeds * * * the amount shown as tax
by the taxpayer upon his return”. The record does not indicate
any previous assessments or collections without assessments nor
any rebates made to Ms. Langille for the years in issue. Thus,
in this case the underpayment asserted and the deficiency
determined by the IRS are the same.
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Therefore, if respondent proves that any of Ms. Langille’s
deficiency for a particular year is due to fraud, then
Ms. Langille will owe the fraud penalty on the entire deficiency,
except to the extent that Ms. Langille shows that a given
component was not due to fraud.14
Thus the burden is initially on respondent to show fraud as
to some of the underpayment for each year; and if he satisfies
that burden as to even part of the underpayment, then the burden
will shift to Ms. Langille to demonstrate that any part of the
underpayment is not due to fraud.
III. Passive Activity Limitations
A. General Rules
Congress designed section 469 to prevent taxpayers from
reducing taxable income by losses attributable to passive
activities. Section 469 operates by generally prohibiting the
deduction of passive activity losses from unrelated income, thus
permitting passive losses to offset only passive income.
Schwalbach v. Commissioner, 111 T.C. 215 (1998). Disallowed
passive activity losses are not lost; rather, they are deferred
or suspended and are available as a deduction against income from
that activity in the next year. Sec. 469(b). Suspended passive
14
In addition, as is stated in part I above, if respondent
proves that Ms. Langille filed a fraudulent return with the
intent to evade tax for a year in issue, then pursuant to
section 6501(c) the IRS may assess the entire deficiency for that
year at any time.
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activity losses may be carried forward indefinitely. Ziegler v.
Commissioner, T.C. Memo. 2007-166, affd. 282 Fed. Appx. 869
(2d Cir. 2008). Finally, upon the taxable disposition of a
passive activity, a taxpayer may generally use any remaining
suspended passive activity loss from that activity first against
passive income from that activity, then against net passive
income from other passive activities, and then as a non-passive
loss against other income. Sec. 469(g)(1).
A passive activity is one in which the taxpayer does not
materially participate. Sec. 469(c)(1). Material participation
is defined as involvement in the operations of the activity that
is regular, continuous, and substantial. Sec. 469(h)(1).
Rental activity is treated as a per se passive activity
regardless of whether the taxpayer materially participates.
Sec. 469(c)(2), (4). However, professional real estate lessors
argued that non-passive classification would be more beneficial
to them, and they convinced Congress to amended section 469 in
1993. Fransen v. United States, 191 F.3d 599, 601 (5th Cir.
1999). Congress carved out an exception for rental activities of
real estate professionals by adding paragraph (7) to subsection
(c). Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66,
sec. 13143, 107 Stat. 440, effective for tax years beginning
-35-
after December 31, 1993;15 see Estate of Quick v. Commissioner,
110 T.C. 172, 184 (1998). Under section 469(c)(7)(B), the rental
activities of a taxpayer in the real property business (a real
estate professional) are not per se passive activities under
section 469(c)(2) but rather are treated as trade or business
activities and are subject to the material participation
requirements of section 469(c)(1). See Sec. 1.469-9(e)(1),
Income Tax Regs. (26 C.F.R.), effective for tax years beginning
after January 1, 1995. Under section 469(c)(7)(B), a taxpayer
qualifies as a real estate professional and is not engaged in a
passive activity under section 469(c)(2) if:
(i) more than one-half of the personal services
performed in trades or businesses by the taxpayer
during such taxable year are performed in real property
trades or businesses in which the taxpayer materially
participates, and
(ii) such taxpayer performs more than 750 hours of
services during the taxable year in real property
trades or businesses in which the taxpayer materially
participates.
B. Residential Rental Activities
Ms. Langille did not provide any estimate of the number of
hours she worked on her rental activities, and she did not allege
that she spent more time on her rental activities than she
15
Because of the effective date--tax years beginning after
December 31, 1993--this exception would not provide any
opportunity for non-passive treatment of rental activities for
Ms. Langille’s 1993 tax year, even if she could show that she
satisfied the requirements of section 469(c)(7).
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devoted to her law practice. The record reflects that
Ms. Langille worked long hours in her law office, and there is no
evidence that she worked most of those hours on real estate
rental activities and not on legal matters. Ms. Langille has not
demonstrated either that she met the 50-percent requirement of
section 469(c)(7)(B)(i) or that she satisfied the 750-hour
requirement of section 469(c)(7)(B)(ii). We conclude that she
was not a real estate professional for purposes of section
469(c)(7) for 1994 or 1995. Accordingly, her residential rental
real estate activities are per se passive activities for each
year in issue. See supra note 15.
C. Office Rental Activity
Section 1.469-2(f)(6), Income Tax Regs., is effective for
taxable years ending after May 10, 1992, sec. 1.469-11(a)(1),
Income Tax Regs., and provides in relevant part:
§ 1.469-2. Passive activity loss.--* * *
* * * * * * *
(f)(6) Property rented to a nonpassive activity.
An amount of the taxpayer’s gross rental activity
income for the taxable year from an item of property
equal to the net rental activity income for the year
from that item of property is treated as not from a
passive activity if the property--
(i) Is rented for use in a trade or business
activity * * * in which the taxpayer materially
participates * * * for the taxable year * * *.
“In essence, the regulation provides that when a taxpayer
rents property to his own business, the income is not passive
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activity income.” Fransen v. United States, supra at 600. The
IRS identified self-rental of property as presenting an
opportunity to shelter income (e.g., by having the passive rental
activity charge exorbitant rent to the trade or business, and
then using passive activity losses to offset trade or business
income) and promulgated this regulation to foreclose that
practice. The regulation has been upheld as a valid
interpretation of section 469. Id. at 601.
Ms. Langille owned the building where her law practice
operated, and she rented the office to her law practice (i.e., to
the firm until it dissolved, and to her unincorporated law
practice thereafter). As is discussed above in part III.B, she
also rented residential real property during the years in issue.
The IRS determined that the office rental was self-rental,
concluded that any income from that rental activity was not
passive income, and thus denied any offset of losses from
Ms. Langille’s residential real estate rental activities (per se
passive activities) against any income from the office building
rental (not a passive activity).
It is undisputed that Ms. Langille rented the office
building to her law practice for use in its trade or business,
and it is clear that Ms. Langille’s involvement in the law
practice’s activities was regular, continuous, and substantial.
See sec. 469(h)(1). Accordingly, Ms. Langille materially
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participated in the law practice to which she rented the office
building, and we sustain the determination that Ms. Langille’s
income from renting the office to her law practice is nonpassive
under section 1.469-2(f)(6), Income Tax Regs. Thus Ms. Langille
may not offset office rental income with losses from her passive
residential rental activities; rather, those losses are suspended
until she either has passive income from those activities or
disposes of her interest in those activities. See sec. 469(b)
and (g).
IV. Unreported Income
A. Income Reconstruction Generally
Taxpayers bear the responsibility to maintain books and
records that are sufficient to establish their income. See sec.
6001; DiLeo v. Commissioner, 96 T.C. at 867; sec. 1.446-1(a)(4),
Income Tax Regs. Ms. Langille failed to fulfill that
responsibility as to both her law practice and her real estate
activities.
The Commissioner may use any of several methods to
reconstruct a taxpayer’s taxable income; and when a taxpayer
fails to keep adequate books and records, the Commissioner is
authorized by section 446 to determine the existence and amount
of the taxpayer’s income by any method that clearly reflects
income. See Holland v. United States, 348 U.S. 121, 130-132
(1954) (“To protect the revenue from those who do not render true
-39-
accounts, the Government must be free to use all legal evidence
available to it in determining whether the story told by the
taxpayer’s books accurately reflects his financial history”
(internal quotation marks omitted)); Mallette Bros. Constr. Co.
v. United States, 695 F.2d 145, 148 (5th Cir. 1983). The
Commissioner has latitude in selecting a method for
reconstructing a taxpayer’s income, and the method need only be
reasonable in light of all surrounding facts and circumstances.
Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).
A bank deposit is prima facie evidence of income, and bank
deposits analysis is a method of income reconstruction that this
Court has long accepted. Tokarski v. Commissioner, 87 T.C. at
77. When a taxpayer keeps inadequate or incomplete books or
records and has large bank deposits, the IRS is not acting
arbitrarily or capriciously by resorting to the bank deposits
method. See DiLeo v. Commissioner, supra at 867-868. The bank
deposits method of reconstruction assumes that all of the money
deposited into a taxpayer’s account is taxable income unless the
taxpayer can show that the deposits are not taxable. See id. at
868; see also Price v. United States, 335 F.2d 671, 677 (5th Cir.
1964). The IRS need not show a likely source of the income when
using the bank deposits method, but the IRS must take into
account any nontaxable items or deductible expenses of which the
IRS has knowledge. See Price v. United States, supra at 677.
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B. Reconstruction of Income and Expenses From
Ms. Langille’s Activities
In the instant case, the IRS chose to apply the bank
deposits method. The special agent identified the DMB
Development Company bank accounts, and the revenue agent
discovered the Deanna McBride Birdsong Attorney at Law account.
Because Ms. Langille’s records appeared incomplete, the IRS
summoned the bank records for the firm’s operating account, the
client trust accounts, the BMC account, and the other accounts
discovered during the investigation. The revenue agent performed
a detailed check spread analysis to identify legal expenses paid
from all these accounts (which expenses the IRS allowed as
deductions), rental expenses paid from these accounts (which
expenses the IRS allocated to Ms. Langille’s rental activities),
and personal expenses paid from these accounts (which expenses
the IRS did not allow as deductions). The agent performed a bank
deposits analysis to compute gross income; and the record shows
that she did not include in income deposits to the client trust
accounts, but she did identify personal expenses paid from those
accounts and included those payments in income.
The bank deposits analysis was thoroughly documented in the
exhibits submitted at trial, which included the revenue agent’s
work papers and copies of canceled checks, bank statements, rent
receipts, law firm fee receipts, and other substantiating
documents. The revenue agent thoroughly supported her analysis,
-41-
and we accept her reconstruction of Ms. Langille’s income and
expenses as reasonable and accurate.
C. Mortgage Interest Analysis
The revenue agent obtained the loan documents for the
mortgages Ms. Langille took back from selling properties, and she
calculated the (non-taxable) principal and (taxable) interest
portions of the mortgage payments that Ms. Langille received each
year. The revenue agent also obtained the loan documents for the
mortgages (on Ms. Langille’s rental properties) on which
Ms. Langille made payments during the years in issue, in order to
differentiate deductible mortgage interest payments from non-
deductible principal payments and to ensure that the IRS’s
determination properly accounted for the mortgage interest
expenses. The revenue agent prepared depreciation schedules for
Ms. Langille’s properties and calculated the amounts of suspended
passive losses that Ms. Langille incurred during each year in
issue. We find the IRS’s reconstruction of Ms. Langille’s
mortgage income and expenses to be reasonable.
D. Ms. Langille’s Contentions
Ms. Langille has not identified any specific errors or
omissions in the bank deposits analysis; rather, she has argued
generally and summarily that the total of her income and expenses
shows that her net unreported income for the three years is less
than the IRS determined. Although the Court invited Ms. Langille
-42-
to provide a detailed post-trial brief, clearly delineating
errors in the IRS’s analysis and supporting any such assertions
with specific references to the record evidence, she failed to do
so.
Ms. Langille argues on brief that the IRS failed to allow
deductions for certain “necessary business expenses such as
mortgage interest expense, property taxes, HOA fees, [insurance
and] utilities”. Ms. Langille has not demonstrated that the
revenue agent failed to account for any particular rental
business expenses; and her argument for a greater amount of
expenses for her rental activity is based in part on her
including the total monthly payment amounts for her mortgages on
each of her rental properties--ignoring the facts that only the
interest portion of mortgage payments is currently deductible and
that the revenue agent computed the mortgage interest payments
she made and included those amounts in the IRS’s analysis.
Furthermore, to the extent that she complains of the IRS’s
determination that the passive activity loss limitations prohibit
her from deducting residential rental activity losses from office
rental income, interest income, or law practice income, her
argument does not survive the section 469 analysis, set out above
in part III.
Ms. Langille does allege on brief that the calculations the
revenue agent performed at trial to quickly calculate
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Ms. Langille’s total deposits for the years in issue include
“$13,000 which was a transfer from Sun Bank to Barnett [Bank] to
open a new account and $16,000 for an account that belonged to a
good friend of Petitioner who had a small business for a very
short while.” Ms. Langille argues that these amounts are not
income and were erroneously included by the revenue agent. She
provides no documentary support for this assertion, and her
unsupported allegations are not proof. See ASAT, Inc. v.
Commissioner, 108 T.C. 147, 177 (1997).
Ms. Langille acknowledged the Court’s admonition that she be
specific on brief, and she apologized for her lack of
specificity. She explained: “The point of analyzing these
expenses however is not to arrive at an exact amount but rather
to show how far off and totally unreasonable the Commissioner’s
assessment of a tax deficiency is”. Ms. Langille clearly missed
the point, which was that she had an opportunity on brief to
argue her case (and carry her burden) by citing specific exhibits
in evidence and providing precise rebuttals to the IRS’s income
and expense analysis. Instead, she complained vaguely but failed
to prove at trial and to support on brief her assertions that she
repaid amounts she took from her client trust account (by not
taking future fees and expense reimbursements from the trust
account), that Ms. Smith’s personal expenditures from her client
trust account are not income to her (ignoring the implications of
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their decision to practice law as equal shareholders in an S
corporation),16 that the IRS did not allow rental expenses, that
the IRS limited certain personal deductions due to income
limitations, that various deductible business expenses were not
credited, and that certain deposits are not income.
She included no record references and no particularized
answer to the IRS’s very detailed income and expense analysis of
her activities. Rather, she argues that her generalized
adjustments show that the summary exhibit she introduced “in
which she totaled all deposits in all business and personal bank
accounts and all withdrawals is fairly accurate.” She argues
that the amount of her unreported taxable income is much smaller
than the amount determined by the IRS, but without showing, with
specific reference to evidence admitted in the record, precisely
how she reaches that conclusion.17
16
Ms. Langille also ignores the fact that her trust account
misappropriations dwarfed Ms. Smith’s ($47,670 vs. $3,811), yet
the IRS held Ms. Langille liable for only 50 percent of that
income.
17
In her summary exhibit Ms. Langille asserted that the sum
of her net taxable income for the 3 years in issue was $147,799,
while on brief she asserted the correct figure was $188,934. She
then subtracted the $112,066 total income reported on Forms 1040,
arriving at unreported income of $35,733 (summary exhibit) or
$76,868 (brief). She argues that both figures are “a long, long
way from the amount, $418,320, alleged by the Commissioner.” The
IRS’s analysis is well supported while Ms. Langille’s sums are
unreconciled, and Ms. Langille has identified neither errors in
nor any necessary adjustments to the IRS’s determinations.
-45-
E. Unreported Income Conclusion
Ms. Langille has not identified any specific errors in the
IRS’s analysis, and her challenges on brief to respondent’s
proposed findings of fact are unsupported by evidentiary
references. Ms. Langille has not demonstrated that her
unreported income for the years in issue differs from the IRS’s
determinations. As noted, a taxpayer bears the burden of showing
that the IRS’s determination is in error, and Ms. Langille has
failed to carry that burden.
The IRS’s deficiency determinations are sustained, with the
exception of the portion due to the capital gain item conceded.
See supra note 2.
V. Fraud Penalties
A. Legal Principles
As indicated above in part II.B, respondent has the burden
of proving fraud by clear and convincing evidence, and he must
prove (1) that Ms. Langille underpaid her taxes in each year and
(2) that she intended to evade taxes by conduct intended to
conceal, mislead, or otherwise prevent tax collection. See Parks
v. Commissioner, 94 T.C. 654, 661 (1990). Fraud is an actual
wrongdoing committed with the intent to evade a tax believed to
be owed. Marshall v. Commissioner, 85 T.C. 267, 272 (1985).
Fraud is never presumed, and the Commissioner must produce
independent evidence of fraudulent intent to establish fraud.
-46-
Petzoldt v. Commissioner, 92 T.C. at 699. Whether fraud exists
is a question of fact, and before finding fraud a court must
consider the entire record and the taxpayer’s entire course of
conduct. Id. “Fraud ‘does not include negligence, carelessness,
misunderstanding or unintentional understatement of income.’”
Zhadanov v. Commissioner, T.C. Memo. 2002-104 (quoting United
States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956)). As
indicated above in part II.B, if the Commissioner demonstrates
fraud as to any portion of an underpayment, then the entire
underpayment is deemed due to fraud unless the taxpayer shows by
a preponderance of the evidence that some or all of the
underpayment is not due to fraud.
Courts have developed a nonexclusive list of factors that
demonstrate fraudulent intent. These “badges of fraud” include:
(1) understating income; (2) maintaining inadequate records;
(3) implausible or inconsistent explanations of behavior;
(4) concealing income or assets; (5) failing to cooperate with
tax authorities; (6) engaging in illegal activities; (7) an
intent to mislead, which may be inferred from a pattern of
conduct; (8) lack of credibility of the taxpayer’s testimony;
(9) filing false documents; (10) failing to file tax returns; and
(11) dealing in cash. Spies v. United States, 317 U.S. 492, 499
(1943); Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).
Although no single factor is necessarily sufficient to establish
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fraud, the combination of a number of factors constitutes
persuasive evidence. Solomon v. Commissioner, 732 F.2d 1459,
1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603.
B. Ms. Langille’s Underpayments Due to Fraud
The IRS asserted the presence of the following indicia of
fraud in this case, in that Ms. Langille--
1. Substantially understated her law practice income.
2. Maintained records for her reported income.
However, during the search warrant the bank
records for the unreported law practice income
were in the garbage. Still, the records for the
corporation are incomplete and do not tie to the
amounts reported.
3. Opened bank accounts in a fictitious name, DMB
Development Company [Operating Account] and DMB
Development Company, Investment Account.
4. Opened bank accounts in her name only, which she
used to divert law practice income from her
partner.
5. Failed to disclose the unreported law practice
accounts to the Special Agent [who searched her
office and interviewed her and her staff].
6. When confronted about the accounts stated,
incorrectly, that they contained rental income vs.
law practice income.
7. Stated to the Special Agent that “Probably,
everyone has unreported income.”
8. Incorrectly told the special agent that all of her
rental receipts were deposited when an analysis
showed that a significant portion was not
deposited.
9. Credit card payments on personal cards were higher
each year than [the amount of income] the taxpayer
reported on her return.
10. The taxpayer left off an entire source of income--
interest income from seller-financed mortgages.
11. The taxpayer diverted law practice trust monies
for personal use.
Respondent thus contends that the following badges of fraud
are present: (1) understating income; (2) maintaining inadequate
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records; (3) implausible or inconsistent explanations of
behavior; (4) concealing income or assets; (5) engaging in
illegal activities; (6) failing to cooperate with tax
authorities; (7) an intent to mislead; and (8) filing false
documents.18
We find many of those badges of fraud to be present. First,
Ms. Langille understated her law practice income for every year
in issue. Second, she maintained inadequate records: Those she
kept reflected only the income she intended to report and not the
law practice income she intentionally diverted into other
accounts; the special agent found some of her records in garbage
bags--hardly a credible storage or filing system; and she told
prospective purchasers that not all of the records documenting
the law practice income would be permanently available. Third,
her explanations are implausible: She claimed to have diverted
trust account deposits into her personal account for the
convenience of a client, and she claimed that she repaid trust
account amounts used for personal expenses and that she
intentionally refrained from taking fees or reimbursements later
from her client trust account as a means to replace the funds.
18
Respondent’s counsel has implied that Ms. Langille engaged
in illegal activities when she diverted funds from the firm into
her own accounts and when she used client trust account funds for
personal purposes. The record before us is far from clear on the
details of Ms. Langille’s ethical and disciplinary proceedings
and in any event does not show that she has been indicted or
convicted of any crimes related to these activities.
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The convenience argument is not credible, the alleged repayment
is not supported by the bank records analyzed by the IRS, and her
choosing not to take reimbursements or fees in the future did not
change the character of the money she took from the trust account
when she took it. It was income when taken, regardless of
whether she considered it repaid when she allegedly forwent
payments later. Fourth, Ms. Langille concealed income by
diverting payments to the firm into the DMB Development Company
accounts and the Deanna McBride Birdsong Attorney at Law account.
Fifth, she engaged in illegal activities (i.e., willfully filed
tax returns she did not believe to be true and correct as to
every material matter, the crime to which she pleaded guilty).
Sixth, she failed to cooperate with IRS investigators by not
identifying all the entities she was involved with when the
special agent interviewed her (i.e., omitting the apparently
fictitious business called DMB Development Company) and by
failing to identify every bank account she used (i.e., omitting
the DMB Development Company accounts and the Deanna McBride
Birdsong Attorney at Law account). Seventh, her conduct supports
a reasonable inference (and we do infer) that she intended to
mislead: (i) by diverting law practice funds into other
accounts; (ii) by paying personal expenses directly from her
client trust account; (iii) by keeping books reflecting only the
income she intended to report; and (iv) by omitting law practice
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income from her returns and not offering any explanation for her
failure to report that income. Eighth, she filed false tax
returns, as she admitted in her plea agreement for 1994 and 1995,
and as we find she did for 1993. Accordingly, we find
Ms. Langille’s actions were intended to prevent tax collection by
concealing her income and misleading the IRS.19
We find fraudulent Ms. Langille’s failure to report the
following income items:
Item 1993 1994 1995
Schedule C gross receipts $112,150 $193,817 $255,314
Sch. K-1 income from the firm 8,689 --- ---
Ms. Langille has offered no explanation for failing to include
these items of income in her tax returns, and she has not shown
that her omission resulted from mere negligence or carelessness
and not from fraud. On the basis of our finding that she
intentionally omitted this income, we find that respondent has
shown that at least some of Ms. Langille’s underpayment in each
of the years in issue was due to fraud.20 Unless Ms. Langille
19
In her plea agreement, Ms. Langille admitted telling a
prospective purchaser of her law practice “that she did not
report all her income and was able to do so because she was
smarter than the IRS.”
20
A necessary consequence of our finding fraud for at least
some of the underpayment for each year is that the exception in
section 6501(c)(1) applies to (i) trigger the exception to the
statute of limitations provided in section 6501(a) and
(ii) authorize the IRS to assess at any time (and hence to issue
(continued...)
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demonstrates by a preponderance of the evidence that part of the
underpayment is not due to fraud, the entire underpayment for
each year is treated as due to fraud. See sec. 6663(b).
Ms. Langille testified that she became overwhelmed each
year, after preparing the firm’s Form 1120S, when she realized
that she had a net loss from her rental activities. She asserts
that she was uncertain how to report a rental loss and that since
no tax is due on a loss, she felt she was doing nothing wrong in
not reporting all of her real estate income--i.e., omitting her
residential rental income and mortgage interest income.
Although her subjective perceptions ignored some of the
applicable legal principles, those perceptions were plausible.
Combining Ms. Langille’s mortgage interest income with her net
rental income (without separating nonpassive and passive rental
activities) shows:
Item 1993 1994 1995 Total
Mortgage interest income $11,511 $9,601 $5,977 $27,089
Net rental income (loss) (23,972) (6,742) (15,083) (45,797)
Net real estate income (12,461) 2,859 (9,106) (18,708)
Thus, Ms. Langille’s belief was correct for 1993 and 1995--i.e.,
her real estate transactions did result in net losses for those
two years. For 1994 the result is a slight profit, but for the
20
(...continued)
the notice of deficiency at any time), as is discussed above in
pt. I.
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three years combined the record shows that the real estate
activities (netting mortgage interest income against rental
losses) produced an economic loss over the years in issue.
As is discussed above in part III, the self-rental passive
activity rule of section 1.469-2(f)(6), Income Tax Regs.,
prohibits Ms. Langille from offsetting her residential rental
real estate losses against the deemed non-passive self-rental
income earned from renting the office building to her law
practice. However, as is also discussed above, fraud is an
actual wrongdoing committed with the intent to evade a tax
believed to be owed. Marshall v. Commissioner, 85 T.C. at 272.
The Code’s “passive activity” rules are hardly intuitive, and we
cannot say that it was fraudulent for Ms. Langille, suffering net
negative cash flow of $10,259 from her rental activity over the
years in issue, to fail to realize that the passive activity
rules required her to report positive income.21 While
Ms. Langille’s reporting of her rental income and expenses was
negligent (and her entering an arbitrary income amount in 1994
and omitting her actual expenses was willful, see sec. 7206(1)),
we are satisfied that she did not omit her rental activity income
with the requisite intent to evade a tax she believed she owed;
21
Ms. Langille may also have thought she could avoid
reporting her mortgage interest income because it was offset by
mortgage interest she paid on loans encumbering the properties
she rented. This, too, is wrong, but the error was negligent and
not fraudulent.
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and we do not find that she intended to conceal, mislead, or
otherwise prevent tax collection with respect to her rental
activities. She believed she could net all her rental activities
and that the net was negative for each year in issue. Her belief
was based on ignorance and was incorrect, but her action as to
this income was negligent rather than fraudulent.
Ms. Langille seems to argue that she should be able to
deduct the entirety of her mortgage payments (both principal and
interest) because from a cashflow perspective that is the amount
she paid each month. But that contention is clearly wrong; only
the interest portion of such payments is currently deductible.
Ms. Langille has not shown that any of the underpayment
resulting from her unreported law practice income for any year in
issue resulted from anything other than fraud. The only portions
of the underpayment Ms. Langille has demonstrated did not result
from fraud are those arising from her rental income and her
mortgage interest income. Accordingly, we do not sustain the
section 6663(a) fraud penalty as determined in the notice of
deficiency as it applies to these items, but we sustain the fraud
penalty as to her unreported law practice income.
To reflect the foregoing,
Decision will be entered
under Rule 155.