UNITED STATES TAX COURT
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T.C. Memo.
2011-65
UNITED STATES TAX COURT
KNUTSEN-ROWELL, INC. ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
27626-07,
27629-07.
Cruz Saavedra,
27628-07,
Filed March 16,
2011.
for petitioners.
Carolyn A. Schenck and Scott B. Burkholder,
for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge:
These three cases are consolidated for
purposes of trial, briefing, and opinion.
One case involves the
Federal income tax of John D. and Kathleen K. Rowell
ICases of the following petitioners are consolidated
herewith:
John D. Rowell, Professional Law Corporation, docket
No. 27628-07; and John D. & Kathleen K. Rowell, docket No. 2762907.
SERVED MAR 1 6 2011
- 2 (respectively, Mr. Rowell and Mrs. Rowell; collectively, the
Rowells)
for 2000 through 2002.
Another case involves the
Federal income tax of Mr. Rowell's wholly owned C corporation,
John D. Rowell, Professional Law Corp.
2002.
(PLC), for 1999 through
The third case involves the Federal income tax of Mrs.
Rowell's wholly owned C corporation, Knutsen-Rowell, Inc.
(Knutsen),
for 2001 and 2002.
Respondent determined the following deficiencies, additions
to tax, and penalties:2
Knutsen, docket No. 27626-07
Year
Deficiency
Addition to Tax
Sec. 6651(a) (1)
2001
2002
$67,973
14,957
$6,797
-0-
Accuracy-Related Penalty
Sec. 66621
$13,595
2,991
Respondent asserts in the answer that Knutsen is liable
for the fraud penalty under sec. 6663 for 2001 and 2002 and
if not, for the accuracy-related penalty under sec. 6662.
PLC, docket No.
27628-07
Year
Deficiency
Addition to Tax
Sec. 6651(a) (1)
Fraud Penalty
Sec. 66631
1999
2000
2001
2002
$5,748
83,784
32,403
76,414
$1,437
8,382
3,240
-0-
$4,311
62,838
24,302
57,311
.
2Unless otherwise indicated, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
Dollar amounts are rounded. The term "years in issue" refers
collectively to 1999 through 2002.
The term "subject
corporations" refers collectively to PLC and Knutsen.
- 3 Respondent determined alternatively that PLC is liable
for the penalty for negligence under sec. 6662 to the extent
it is not liable for the fraud penalty.
The Rowells, docket No.
27629-07
Year
Deficiency
Addition to Tax
Sec. 6651(a) (1)
Fraud Penalty
Sec. 66631
2000
2001
2002
$85,780
110,585
15,079
$4,289
16,588
-0-
$64,335
82,939
11,309
Respondent determined that the fraud penalty applied only
to Mr. Rowell. Respondent determined alternatively that the
Rowells are liable for the addition to tax for negligence
under sec. 6662 to the extent Mr. Rowell is not liable for
the fraud penalty. Respondent in the answer asserts that the
fraud penalty for each year also applies to Mrs. Rowell.
Respondent asserts in an amendment to answer in docket No.
27629-07 that the Rowells are liable for increased deficiencies,
additions to tax, and penalties in the following amounts:3
Addition to Tax
Year
Deficiency
2000
2001
2002
$406,529
340,485
182,000
Sec.
6651(a) (1)
$20,343
51,344
-0-
Fraud Penalty
Sec.
66631
$304,897
255,364
135,500
Respondent asserts alternatively in the amendment to
answer that the Rowells are liable for the penalty
3The Rowells filed amended California income tax returns for
2000, 2001, and 2002 (amended California returns) reporting
income in amounts greater than the amounts report-ed for Federal
income tax purposes. The increased deficiencies (and related
amounts) result mainly from respondent's assertions that the
Rowells' income for 2000, 2001, and 2002 includes the additional
amounts of income reported on the amended California returns.
The increased deficiency (and related amount) for 2002 also
results from respondent's assertion that the Rowells failed to
include in their income (as a constructive dividend) a $100,000
transfer that PLC made on Mr. Rowell's behalf.
- 4 for negligence under sec. 6662 to the extent they are not
liable for the fraud penalty.
Petitioners concede they are liable for the accuracy-related
penalties under section 6662
(because, they state, they were
negligent), to the extent they are not liable for the fraud
penalties under section 6663, and for the failure to file
additions to tax under section 6651(a) (1).
We are left to decide
the following issues:
1.
2002.
Whether Knutsen overreported its income for 2001 and
We hold it did not;
2.
whether PLC underreported its income for 1999, 2000,
2001, and 2002.
3.
whether the Rowells underreported their income for 2000,
2001, and 2002.
4.
We hold it did to the extent stated herein;
We hold they did to the extent stated herein;
whether Knutsen is entitled to deductions of certain
expenses and to costs of goods sold reported on its 2001 and 2002
Federal income tax returns.
We hold it is to the extent stated
herein; and
5.
whether any of petitioners is liable for a fraud penalty
under section 6663.
We hold that none of petitioners is liable
for a fraud penalty.
FINDINGS OF FACT
I.
Preface
The parties submitted to the Court stipulated facts and
related exhibits.
We find those stipulated facts accordingly and
- 5 incorporate those facts and exhibits herein.
The Rowells,
husband and wife, filed joint Federal income tax returns for 2000
through 2002.
filed.
They resided in California when their petition was
Knutsen's mailing address and PLC's principal place of
business were in California when their petitions were filed.
II.
The Rowells
Mr. Rowell is a trial attorney who has practiced law in
California for over 30 years.
His practice areas are personal
injury and products liability.
He has received various awards
and certificates of appreciation from several professional
organizations.
He practiced law during the years in issue
through PLC, his wholly owned corporation.
Mrs. Rowell is a television and screen writer.
During the
years in issue she worked as a screenwriter and as a buyer and
seller of vintage dolls and similar collectible items
(collectively, vintage dolls).
She worked through Knutsen, her
wholly owned corporation.
Each of the Rowells is well educated and devotes long hours
to his or her profession.
Neither of the Rowells is proficient
on the subject of tax law or on the requirements thereof.
- 6 III..
Mr. Rowell's Law Practice
A.
PLC
Mr. Rowell graduated from law school in 1977, and he began
practicing law at a law firm specializing in products liability.
He formed PLC on September 20,
1982.
In 1999 PLC joined the law firm of Cheong, Denove, Rowell,
Antablin & Bennett (Cheong firm).
included products liability.
The Cheong firm's practice
During the years in issue, PLC was
a partner in the Cheong firm, and Mr. Rowell was PLC's sole
shareholder.
While Mr. Rowell (through PLC) worked for the
Cheong firm, he also (through PLC) worked on some cases for PLC
alone.
For 1999 the Cheong firm issued PLC a Schedule K-1,
Partner's Share of Income, Credits, Deductions, etc., reporting
that PLC realized $92,120 of taxable income for 1999 with respect
to its partnership interest in the Cheong firm.
PLC reported on
its 1999 Federal income tax return that it realized $7,574 of
taxable income as to that interest.
B.
Advanced Client Costs
When Mr. Rowell, (through the firm for which he worked)
retained a client, the retainer agreement stated that the firm
would pay certain litigation costs (e.g., costs of depositions,
transcripts, and filing fees)
for the client and that the firm
would recover its payment of those costs (advanced client costs)
- 7 from any proceeds received at the end of the client's case.
Mr.
Rowell (through his firm) represented plaintiffs in lawsuits that
involved significant amounts of advanced client costs.
PLC did
not always recover the full amount of advanced client costs paid
on behalf of a client.
PLC recorded its payment of a client's
advanced client costs as a loan to that client.
IV.
Knutsen
A.
Background
Mrs. Rowell organized Knutsen on September 2, 1982.
Rowell was Knutsen's only employee.
Mrs.
Initially, Knutsen's sole
business was the leasing of Mrs. Rowell's writing services.
B.
Knutsen's Doll Business
In 2001 Mrs. Rowell's earning capacity as a writer began to
decline, and Mrs. Rowell decided to expand Knutsen's business to
include the purchase and sale of vintage dolls.
During 2001 and
2002 Knutsen bought and sold vintage dolls through an eBay store.
Knutsen initially bought and sold collectible Barbie dolls but
later expanded into other collectible items.
During 2001 and
2002 Knutsen generally maintained a daily inventory of 900 to
1,000 vintage dolls.
Knutsen attempted to sell each of its
vintage dolls above cost but was not always able to do so.
C.
2001 and 2002 Expenses
During 2001 and 2002 Knutsen paid its business expenses
(including inventory purchases) primarily by check or credit
- 8 -
card.
During those respective years Knutsen paid $157,258 and
$29,661 for vintage dolls it purchased for resale.
Knutsen also
paid the following expenses:
2001
2002
Listing fees
Outside services
$4,678
5,984
$3,172
2,885
Rent
Research
Shared residuals
Dues
Postage
Supplies
Telephone
2,234
13,812
293
-0102
301
375
4,533
13,390
1,443
3,608
, 123
100
203
Bank service fees
57
20
Utilities
73
136
-0720
276
-0-
1,600
30,229
-029,889
Computer maintenance
Accounting
Taxes
Total
I
The listing fees expense related to Knutsen's doll business, and
the research, dues, and shared residuals expenses related to
Knutsen's screenwriting business.
All of the remaining expenses
e related to both businesses.
D.
2001 and 2002 Income
During 2001 and 2002 Knutsen deposited into its operating
accounts the following amounts related to its doll and
screenwriting businesses:
6
Year
Doll Business
Screenwriting Business
Total
2001
2002
$18,055
23,602
$174,622
18,339
$192,677
41,941
- 9 -
V.
Petitioners' Financial Records
The Rowells maintained petitioners' financial records using
Quicken, a computerized accounting system.
Each of the Rowells
(sometimes with the help of others) entered petitioners'
financial information into Quicken's database.
This information
related to checks, expenses, transfers, deposits, and payees.
Petitioners' expenses would be input into various categories of
the -database that reflected the character of the expenditures.
Petitioners used a "split" function in Quicken to apportion the
amount of an expenditure into various categories of expenses and
to account for that expenditure by the various categories.
Petitioners generally did not maintain supporting documents for
entries input into the database.
VI.
Petitioners' Financial Accounts
A.
The Rowells
The Rowells maintained various personal checking accounts .
The Rowells also maintained a personal equity line of credit
account and various personal brokerage accounts.
B.
PLC
PLC maintained.various bank accounts for its operation
(collectively, PLC operating accounts).
various client trust accounts .
PLC also maintained
During the years in issue each of
the Rowells authorized disbursements out of the PLC operating
accounts.
- 10 -
C.
Knutsen
Knutsen maintained various bankraccounts for its operation
(collectively, Knutsen operating=accounts).
maintained a brokerage account.
Knutsen also
During the years in issue each
of the Rowells authorized disbursements out of the Knutsen
operating accounts.
-
D.
Credit Card Accounts
The Rowells had many credit card accounts.
Neither PLC nor
Knutsen had any credit card account in its name.
VII.
The Rowells' Intermingling Personal and Corporate Funds
A.
The Rowells' Personal Use of PLC Funds
During 2000, 2001, and 2002 the Rowells took funds from
PLC's operating accounts for their personal use.
The Rowells
took those funds through checks, withdrawals, and transfers, and
they used those funds to pay their living expenses (including the
expenses of their children) or otherwise spent them at their
discretion.
With one exception, none of the transactions
underlying the taking or the use of those funds related to PLC's
business, and the Rowells did not report any of those funds as a
distribution (or other type of income).4
funds were -$427,870 in 2000,
'l
The amounts of those
$272,862 in.2001, and $92,631 in
2002.
4The single exception is that the Rowells reported $109,000
of those funds as wages that PLC paid Mr. Rowell in 2000.
- 11 Mr. Rowell transferred $28, 000 to PLC during 2000, and he
caused another $20,000 to be deposited during that year into the
PLC operating accountsr.
Mr. Rowell transferred $48,500 to .PLC
during 2001.
B.
The Rowells' Personal Use of Knutsen Funds
During 2001 and 2002 the Rowells took funds from Knutsen' s
operating accounts for their personal use.
The Rowells took
those funds through checks, withdrawals, and -transfers, and they
used those funds to pay their living expenses (including the
expenses of their children) or otherwise spent them at their
discretion.
None- of .the transactions, underlying the taking or
the use of those funds related to sKnutsen's business, and the
Rowells did not report any of those funds as a distribution (or
other type of income) . -
The amounts of those funds were $222, 871
in 2001 and $97, 675 rin 2002.
The Rowells transferred $69,.030 and $58,675 to Knutsen
during 2001 and 2002, respectively.
C.
The Rowells' Payment of Corporate Expenses With Credit
Cards
The Rowells routinely used their personal credit cards'to
pay the business expenses of the subject corporations.
12 =
VIII.
Petitioners' Tax Returns
A.
Overview
Edward Cutter (Mr. Cutter) prepared all of the Federal
income tax returns at issue.
Mr. Cutter is a certified public
accountant who was the Rowells'
longtime tax return preparer.
He
prepared the subject returns following his regular practice
whereby Mr. Rowell brought in petitioners' data, Mr. Cutter input
the data into his tax preparation system, Mr . Cutter and Mr .
Rowell discussed the data superficially, and Mr. Cutter printed
the returns (and possibly in some cases reprinted a return after
correcting a mistake that Mr. Rowell identified on the return) .
With respect to each of the Rowells' Federal income tax
returns at issue, Mr. Cutter spent a total of approximately 1
hour preparing that return and the related State income tax
return for the year.
With respect to each of the subject
corporations' Federal income tax returns at issue, Mr. Cutter
spent a total of approximately 1 hour preparing that return.
Mr.
Cutter prepares a lot of tax returns each tax season, and he
tries not to get involved with a client's financial situation or
to offer a client advice on the particulars of tax law.
Mr.
Cutter did not help (nor did he want to help) the Rowells
ascertain petitioners' data for their tax returns, or explain to
them the requirements for any particular deduction.
When he
prepared each of the tax returns for the subject corporations,
- 13 Mr. Cutter checked the return to make sure it was consistent with
the prior year's return, and he checked to make sure the balance
sheet balanced.
PLC's 1999 through 2002 returns reported that at the end of
those respective years PLC owed Mr. Rowell $428,234,
$561,674, and $574,862 in loans."
$513,801,
Knutsen's 2001 and 2002
returns reported at the end of those respective years that
Knutsen owed Mrs. Rowell $44,000 and $31,162 in loans.
There
were no written agreements or promissory notes evidencing any of
the amounts reported as loans to or by PLC or Knutsen, and
neither Mr. Rowell nor Mrs. Rowell charged interest on any amount
that was lent to his or her separate corporation.
None of the
amounts reported as loans were collateralized, and none of those
amounts were repayable pursuant to a schedule or any other
specific term.
The Rowells and the subject corporations did not
record the amount of any loan between them or otherwise keep
track of it accurately.
B.
PLC's Returns
PLC's 1999 through 2002 Federal income tax returns reported
total income and claimed total deductions in the following
amounts:
sPLC's 1999 return reported $280,234 of loans from Mr.
Rowell at the beginning of the year.
- 14 Year
Total Income Reported
Total Deductions Claimed
1999
2000
2001
2002
$355,560
487,235
107,941
287,735
$355,896
481,954
108,105
287,735
Mr. Rowell did not anticipate before these returns were prepared
that PLC would owe any tax for 1999 through 2002.
Such was so
because PLC had limited cases and had just closed a case where it
was unable to recover approximately $200,000 in advanced client
costs.
C.
Knutsen's Returns
Knutsen's 2001 and 2002 Federal income tax returns reported
total income and claimed total deductions in the following
amounts:
Year
Total Income Reported
Total Deductions Claimed
2001
2002
$53,679
69,084
$53,800
68,514
-
The..Rowells did not anticipate before these returns were prepared
that Knutsen would owe any tax for 2001 or 2002.
Such was so
because Knutsen had purchased what the Rowells considered to be a
significant amount of inventory in 2001.
IX.
Audit of the Subject Tax Returns
A.
Overview
Respondent audited petitioners' Federal income tax returns
that are the subject of the notices of deficiency (subject tax
returns).
Respondent also included the Rowells' 1999 tax return
- 15 -
in the audit .
Respo dent started auditing PLC on February 6,
2003, and expanded the audit on October 23,
2003
to include the
ded the audit on June 29, 2004,
Rowells .
Respondent further expan
to include Knutsen.
Initially, Mr. Cutter was petitioners' representative in the
audit, - and Mr . Rowell gave
Mr
•
Cutter documents to give to
)
Mr
Rowell eventually met
respondent' s revenue agent (agent .
•
d he personally produced many
repeatedly with the agent, an
documents to the agent and answered many questions .
The agent
also interviewed Mrs. Rowell•
B.
P_.LG
PLC' s records for 1999 throug
h 2002 were incomplete and
1 to its tax returns . Respondent
conflicting and did not reconci e
for 1999 through 2002 using a
ascertained PLC' s gross receipts
that included a review of deposits,
bank deposits analysis
canceled checks, and transfers into and out of PLC's operating
.
accounts.
for 1999 through 2002 as reported
PLC's gross receipts
by PLC and as..ascertained by respondent through the bank deposits
analysis are as follows:
ts determined through
'In addition to unreported, grndent determined that PLC failed
the bank deposits analysis, respof' m of $84,546 ($92,120 to report income from the Cheong irort interest income of $197
$7 57$41 =19$84 546200 anfailed tore ectively. Petitioners concede
these other adjustments .
16 Year
Per Examination
1999
2000
2001
2002
Per Return
Difference
$649,033
115 111
39,058
26 640
$184,047
51,652
60,032
4'949
$833,080
1166,763
299,090
31,389
IIncludes $8,220 of legal fees realized bycoun s.ut
deposited into the Rowells' persona
t determined was
2Includes $27,073 that responden
a chess tournament
taxable income that Mr. Rowell wono ted into the Rowells'
on behalf of PLC but which was ep
personal bank accounts.
Respondent allowed PLC certain deductions for each year.
Two deductions were for advanced client costs and bad debts with
respect to advanced client costs.
Respondent allowed PLC to
.
t to the extent that its clients'
deduct advanced client cos s
cases were settled and the clients reimbursements of the
luded in PLC's reconstructed gross
advanced client costs were inc
receipts.
Respondent allowed PLC to deduct a bad debt with
respect to advanced client costs to the extent that PLC could not
recover advanced client costs because its clients' cases were
concluded without available funds to reimburse the advanced
The amounts of these allowed deductions are as
client costs.
follows:
Bad Debt
22Ahl
$338,639
$75,286
72,999
$413,925
90,995
17,996
5,063
37
49,199
21,381
54,262
21,418
Year
Advanced_Client Costs.
1999
2000
2001
2002
- 17 -
Respondent determined that PLC owed Mr, Rowell $45,192 in
loans at the end of 1999.
Respondent determined that PLC had no
loans payable to Mr. Rowell at the end of 2000, 2001, or 2002.
C.
Knutsen
Knutsen's records for 2001 and 2002 were incomplete and
conflicting and did not reconcile to its tax returns.
Respondent
determined Knutsen's gross receipts for 2001 and 2002 using a
bank deposits analysis that included a review of deposits,
canceled checks, and transfers in and out of Knutsen's operating
accounts.
Knutsen's gross receipts for 2001 and 2002 as reported
by Knutsen and as initially determined by respondent through the
bank deposits analysis are as follows:
Year
Per Examinationi
Per Return
Difference
2001
2002
$181,466
20,472
$219,859
83,184
$38,393
62,712
Respondent concluded that Knutsen's receipts from
doll sales were Mrs. Rowell's personal proceeds and
omitted those proceeds from these amounts.
Respondent later determined that some of Knutsen's gross receipts
were not deposited into the Knutsen operating accounts and
superseded his initial computation of Knutsen's gross receipts as
follows:
7This superseding computation also includes Knutsen's
receipts from doll sales.
- 18 -
Year
Per Examination
Per Return
Difference
2001
2002
$219,859
83,184
$219,859
83,184
-0-0-
Respondent disallowed all of Knutsen's reported deductions
and costs of goods sold for 2001 and 2002 except for $2,681 and
$4,063 of deductions that Knutsen claimed for the respective
years as "other deductions".
The amounts of these disallowed
items are as follows:
.I
Expense Item
Cost of goods sold
Repairs and maintenance
Rents
Taxes and licenses
Advertising
Other deductions
2001
2002
$166,241
13,272
5,400
1,488
375
30,584
$14,100
-04,533
80
1,833
58,005
Respondent determined that Knutsen had no loans payable to
Mrs. Rowell at the end of 2001 or 2002.
D.
The Rowells
1.
Overview
The Rowells' records for 2000 through 2002 were incomplete
and conflicting and did not reconcile to their tax returns.
Respondent determined the Rowells'
income for 2000 through 2002
primarily on the basis of the bank deposits analyses of the
subject corporations.
Respondent also reviewed deposits,
canceled checks, and transfers into and out of the Rowells'
personal bank accounts.
- 19 2.
D is tr ibut ion_s__Froogt_PMC_
As stated M pp. 10-11, the Rowells took PLC funds for
their personal use, and the amounts of these funds were $427,870
in 2000, $272,862 in 2001, and $92,631 in 2002.
amounts, respondent determined t
Of these
hat the Rowells had received
225 678 for 2000, .$224,362 for
constructive distributions of $
,
2001, and $92,487 for 2002. Respondent determined the amounts of
these constructive distributions after taking into account the
$45,192 in loans that PLC owed Mr. Rowe 11 as of January 1, 2000,
that the Rowells reported Mr . Rowell
the $109, 000 of .wages
received from PLC in 2000, the $96,500 that Mr. Rowell
transf erred to PLC, and a $144 credit .
With respect to
the constructive distributions that he
PLC during 2000 through 2002,
determined Mr. Rowell received from
t that PLC' s current and accumulated
respondent determined, firs ,
(E & P)
får 2000,
2001, and 2002 were such
earnings and profits
that $225, 678,
$124 , 967 ,
and $
92 487 of the distributions in the
,
respective years were dividends .
Second, because the
ded PLC' s current and accumulated E &
distribution for 2001 excee
nt)
respondent determined that
P (as determined by responde
,
$1, 000 of that distribution was a nontaxable return of capital
and the remainder, $
98 395
,
respondent characterized Mr.
from PLC as follows:
a taxable capital gain.
In sum,
Rowells' constructive distributions
- 20 -
† Year
Distributions
Dividends
Return of
Capital
$225,678
224, 362
92,487
$225,678
124, 967
92,487
-0$1, 000
-0-
2000
2001
2002
3.
Capital Gain
-0$98, 395
-0-
Distributions From Knutsen
As stated supra p. 11, the Rowells took Knutsen funds for
heir personal use, and the amounts of these funds were $222, 871
n 2001 and $97, 675 in 2002.
Of those amounts, respondent
etermined that the Rowells had received constructive
istributions of $163,425 for 2001 and $35,752 for 2002.8
espondent determined the amounts of these constructive
distributions after taking into account the $127,705 that the
owells transferred to Knutsen and the $41, 657 of doll sales
income (which respondent determined was realized by Mrs. Rowell)
deposited into the Knutsen operating accounts.
Respondent characterized the constructive distributions that
he determined Mrs. Rowell received from Knutsen during 2001 and
2002.
First, respondent determined that Knutsen's current and
"Respondent determined that during 2001 and 2002 the Rowells
respectively took $250,511 and $118,029 of Knutsen funds for
their personal use and that the respective constructive
distributions were $163,425 and $35,752. ~ We find that $27,640
and $20,354 of the respective amounts for 2001 and 2002 were
spent in Knutsen' s doll business and do not include those amounts
in the amounts that the Rowells took for their personal use.
Consequently, t-he constructive distributions are reduced to
$135,785 for 2001 and $15,398 for 2002.
9A $1 discrepancy is attributable to rounding.
- 21 -
accumulated E & P for those years were such that $163,425 and
$31,258 of the distributions in the respective years were
characterized as dividends.
Second, in that the distribution for
2002 exceeded Knutsen's current and accumulated E & P for that
year (as determined by respondent), respondent determined that
$1,000 of that distribution was a nontaxable return of capital
and the remainder, $3,494, a taxable capital gain.
In sum,
respondent characterized Mrs. Rowells' constructive distributions
from Knutsen as follows:
Year
Distributions
Dividends
Return of
Capital
2001
2002
$163,425
35,752
$163,425
31,258
-0$1,000
4.
Capital Gain
-0$3,494
Summary of Distributions
Respondent determined that the characterization of
constructive distributions received by the Rowells was as
follows:
Year
Distributions
Dividends
Return of
Capital
Capital Gain
2000
2001
2002
$225,678
387,788
128,239
$225,678
288,393
123,745
-0.$1,000
1,000
-0$98,395
3,494
5.
NOL Deduction for 2002
The Rowells reported on their 2000 Federal income tax return
that they were entitled to deduct a net operating loss (NOL)
carryover of $31,996.
The 2000 return provides no explanation of
- 22 -
the computation or genesis of the claimed NOL carryover.
Respondent disallowed this deduction.
X.
$100,000 Wire Transfer
In 2001 Mr. Rowell and a fellow businessman, Phil Weber (Mr.
Weber), began discussing a possible joint investment in a charter
school to be formed by Mr. Weber and another individual.
Mr.
Weber worked hard on the project during 2002, and he aspired to
form the school.
On December 31, 2002, as part of the joint investment, Mr.
Rowell caused $100,000 to be transferred from a PLC operating
account to the bank account of Sandra Raposa (Ms. Raposa).
Ms.
Raposa was the domestic partner of Mr. Weber, and she (at the
request of Mr. Weber) accepted the $100,000 transfer on his
behalf.
Mr. Weber used Ms. Raposa's account because he did not
I
have a bank account at the time.
Mr. Rowell caused the $100,000
to be transferred so late in 2000 because Mr. Rowell anticipated
claiming for that year a tax deduction (or a tax credit) as to
the payment.
As of that time, Messrs. Rowell and Weber did not
have a set investment plan.
On January 2, 2003, Ms. Raposa transferred $88,500 of the
$100,000 to a personal account of the Rowells.
She did so
because Messrs. Rowell and Weber did not yet have a set
investment plan and Mr. Weber did not want to keep the funds in
Ms. Raposa's account without such a plan.
Mr. Rowell.used the
- 23 $88,500 to pay down a loan he had received in his individual
capacity.
Mr. Weber retained the remaining $11,500 asr a payment
due him for -previous business dealings with Mr. Rowell.
Respondent asserts in the amendment to answer in docket No.
27629-07 that the $100,000 is a constructive dividend that the
Rowells failed to include in their income for 2002.
The charter school project fell through in April or May of
2003 when the individual whom Mr. Weber had been dealing with
opted out of the project.
XI.
The Rowells' Additional Income Reported on Amended
California Returns
On December 21, 2005, Mr. Rowell retained an enrolled agent,
Donald Cormier, Sr.
(Mr. Cormier), to replace Mr. Cutter as
petitioners' representative in the audit because Mr. Rowell was
no longer comfortable with Mr. Cutter's representation of
petitioners' interests.
Mr. Cormier met with the agent, and he
gave the agent information the agent requested.
On October 2,
2006, the agent gave Mr. Cormier respondent's proposed reports
for the Rowells' 2000; 2001, and 2002 taxable years, and the
agent discussed those proposed reports with Mr. Cormier.
Mr.
Cormier then discussed the proposed reports with Mr. Rowell.
Mr. Rowell anticipated that respondent's audit would cause
the State of California to audit petitioners'
2000 through 2002
State income tax returns, and he thought that the Rowells would
not have to pay the State of California any penalty for those
- 24 years if he voluntarily informed the State that the Rowells had
realized more income than they had previously reported to the
State.
On December 29, 2006, the Rowells filed amended
California income tax -returns to report additional income of
$789,287,
$572,181, and $349,915 for 2000,
respectively.
2001, and 2002,
The amended California returns reflected the
following information:
Year
AGI
Originally
Reported
State Tax
Originally
Reported
20 0 0
2001
2002
$77, 950
26,110
12,243
$291
-0-0-
AGI on Amended
California Returns
State Tax
on Amended
California Returns
$867, 237
598,291
362,249
$75, 204
50,067
25,327
Mr. Cormier's accounting firm prepared the amended
California returns on the basis of the amounts of additional
income that Mr. Rowell told Mr. Cormier to report.
Mr. Rowell
set the amounts of that income to generate a State tax liability
that represented a portion of the Federal income tax adjustment
proposed by respondent .
The amended California returns stated
that the Rowells had become aware of additional income not
reported on their State returns but did not disclose that
petitioners'. Federal income tax returns for the related years
were under audit by the Internal, ,Revenue Service .
The ,Rowells
paid the State income ,tax liabil;it-ies reported on the amended
California returns.
The Rowells did not tell the agent that they
filed the amended California returns.
- 25 The Rowells did not amend any of their Federal income tax
returns for 2000 through¡2002-.
XII.
Notices of Deficiendy
On August 31, 2007, respondent mailed petitioners the
notices of deficiency in issue.
I
OPINION
I.
Burden of Proof
A.
Deficiencies Listed in'the Notices of Deficiency
The 'Commissioner's determinations of deficiencies in tax (as
listed in a notice of deficiency) generally are presumed correct,
and the taxpayer bears the burden of proving those determinations
wrong.
See Rule 142(a) (1); Welch v. Helvering,
(1933); Durando v. United States*,
1995).
70 F.3d 548,
290 U.S. 111,
550
115
(9th Cir.
The Court of Appeals for the Ninth Circuit, to which an
appeal of these 'cases would lie, has held that the presumption of
correctness attaches to a notice of deficiency in unreported
income cases only when the Commissionen establishes a minimal
evidentiary foundation demonstrating that the taxpayer received
unreported income.
1313
(9th Cir.
See Palmer v. U.S.
1997); Edwards v.
1270 (9th Cir. 1982).
IRS,
116 F.3d 1309,
Commissioner,
1312-
680 F.2d-1268,
Once,such a foundation is established, as
it is here, the burden shifts to the taxpayer to prove the
portion of the unreported incože that is not taxable.
v. Commissioner, 181 F.3d 1002, 1004
See Hardy
(9th Cir. 1999), affg. T.C.
lvlemo. 1997-97; .Palmer v. U.S.
IRS,
supra at 1312-1313.
Accordingly, petitioners bear the burden of proof as to gthe
deficiencies listed in the notices of deficiency.
This is true
as to both the unreported income and the disallowed deductions
underlying those def iciencies .1°
B.
Increased Deficiencies
3-
Respondent in an amendment to answer in docket No. 27629-07
asserts that the Rowells are liable for deficiencies in amounts
greater than the amounts listed in, the corresponding notices of
deficienay.
Respondent bears the burden of proof as to these
increased deficiencies.
C.
See Rule 142(a) (1) .
Fraud
Respondent determined (or asserts in his answer or an ;
amendment -thereto) that petitioners ares liable for fraud
penalties under section 6663 .
Respondent must prove fraud by
clear and convincing evidence .
See sec . 7454 (a) ; Rule 142 (b) ; :
Rowlee v. Commissioner,
80 T.C. .1111,
11.23
(1983) .
While sec. 7491(a) (1) provides that the burden of proof
shifts to the Commissioner in certain cases, we conclude that
this is not one of those cases . Petitioners have neither alleged
in their petitions nor asserted in their opening brief that sec.
7491(a) applies here. Nor have petitioners established that they
have met thd requirements of sec. 7491(a) (2) (A) and (B) to
substantiate items, to maintain required records, and to
cooperate fully with respondent's reasonable requests.¯ Sée
Weaver v. Commissioner,
121 T.C.
273,
275
(2003) .
- 27 II.
Bank Deposits Analysis
A.
Overview
Gross income includes all income from whatever source
derived, see sec. 61(a), and taxpayers are required to keep books
and records sufficient to establish their Federal income tax
liabilities, see sec. 6001; see also sec. 1.6001-1(a),
Income Tax Regs.
(b),
(e),
Where taxpayers fail to maintain adequate
records to establish that liability, the Commissioner may
reconstruct their income by any method that the Commissioner
believes reflects income clearly.
Palmer v. U.S. IRS,
654,
658
(1989).
See sec. 446(b); see also
supra at 1312; Parks v. Commissioner, 94 T.C.
(1990); Petzoldt v.
Commissioner,
92 T.C.
661,
686-687
The Commissioner's- method need not be exact; however, it
must be reasonable in light of the surrounding facts and
circumstances.
See Holland v. United States, 348 U.S. 121
(1954); Petzoldt v. Commissioner, supra at -687; see also
Cracchiola v.
1981)
Commissioner
643 F.2d 1383,
1384-1385
(9th Cir.
(stating that the Commissioner's method of reconstructing
income is reasonable if it is "rationally based")., affg. T.C.
Memo. 1979-3.
Respondent reconstructed petitioners' income by using the
bank deposits method.
The bank deposits method is an acceptable
method for reconstructing income.
54 T.C.
1121
See Harper v. Commissioner,
(1970); see also United States v. Stone,
770 F.2d
- 28 -
842, 844 (9th Cir. 1985)
(holding that the Commissioner may use
the bank deposits method to establish a deficiency to support a
conviction for attempted income tax evasion) .
Funds deposited in
a taxpayer's bank accounts are presumed to be from a taxable
source unless the taxpayer establishes they are from a nontaxable
source (e.g., from gifts, loans, or transfers between bank
accounts) .
See Clayton v. Commissioner,
102 T.C.
(1994) ; see also Calhoun v. United States,
(9th Cir.
Cir.
1978) ; Price v. United States,
632,
645-646 -
591 F.2d 1243,
335 F.2d 671,
1245
677
(5th
1964) .
B.
Knutsen' s Disputed Income
Respondent's initial bank deposits analysis of Knutsen's
bank accounts showed that Knutsen' s deposits for 2001 and 2002
were $38, 393 and $62, 712, respectively, less than the gross
receipts reported on Knutsen' s 2001 and 2002 Federal income tax
returns .
Petitioners argue that Knutsen may adjust its reported
gross receipts to match the reduced amounts reflected in
respondent's initial bank deposits analysis.
We disagree.
Petitioners cite no authority (nor are we aware of any authority)
which allows a corporate taxpayer such as Knutsen to reduce its
reported gross receipts to the amount of its deposits as
ascertained through a bank deposits analysis without further
proof that the lower amount is correct .
Such is especially so
where, as here, the record does not establish that Knutsen' s
- 29 -
reported gross receipts reflected only the amounts that Knutsen
deposited into its bank accounts-and respondent's superseding
bank deposits analysis reflected gross receipt s that were not
deposited into Knutsen's bank accounts.
Soulard,
730 F.2d 1292,
1296 n.1
See United States v.
(9th Cir.
1984)
(explaining that
a bank deposits analysis requires that amounts deposited into
bank accounts be increased by income not deposited into the bank
accounts
(citing United States v. Hall,
(9th Cir. 1981))).
650 F.2d 994,
996 n:4
We also note that respondent's initial
analysis omitted $18, 055 and $23', 602 of gross receipts
attributable to Knutsen's doll business on the belief that the
doll business was Mrs. Rowell's business.
We hold for respondent
on this issue.
C.
PLC' s Disputed Income
Respondent's bank deposits analysis of PLC's accounts
determined that PLC failed to report gross receipts of $184,047
for 1999, $51,652 for 2000, $60,032 for 2001, and $4,749 for
2002.
Petitioners concede that respondent correctly determined
PLC's deposits for each year but argue that respondent failed to
characterize PLC's advanced client costs reimbursements as
nontaxable income.
Petitioners argue that those reimbursements
are nontaxable pursuant to Herrick v. Commissioner, 63 T.C. 562
(1975) , because they are akin to the repayment of a loan.
- 30 -
We disagree with petitioners' assertion that PLC is entitled
to an adjustment with respect to respondent' s treatment of its
advanced client costs.
While respondent included the
reimbursements in PLC' s reconstructed gross receipts, respondent
also allowed the related costs to be deducted.
Thus, if we were
to accept petitioners' invitation now to exclude the
reimbursements from income because they- are akin to the repayment
of loans, we would be compelled to deny the accompanying
deductions because they are akin to the making of loans . . Whi~Le
petitioners are correct that advanced client costs are generally
considered to be loans rather than expenses, and hence that the
reimbursements of these costs are generally considered nontaxable
income as are amounts received in repayment of loans, petitioners
have offered no reason why respondent's treatment of these costs
does not accomplish the same result in these cases.
Nor have
petitioners persuaded us that any advanced client cost that was
reflected in the reconstructed gross receipts was not deducted
from their gross income.
Petitioners also identify nine deposits in respondent's bank
deposits analysis that petitioners claim represent nontaxable
income.
These deposits are in the amounts of $10,000, $5,000,
$3, 500,
$5, 000,
$5, 000,
$10, 000 ,
$3, 000,
$15, 000, and $30, 000 .
Petitioners state that these deposits "appear to be either
shareholder loan repayments, interbank transfers or partnership
I
- 31 -
distributions" because PLC had "no likely source of income that
would generate 'round' number deposits".
Petitioners ask the
Court to characterize these deposits as nontaxable income.
We decline to do so.
As stated above, PLC's bank deposits
are prima facie evidence of income, and all money deposited into
PLC bank accounts is presumed to reflect taxable income unless
petitioners establish otherwise.
Petitioners have not submitted
sufficient evidence to rebut this presumption.
Petitioners' mere
belief that the amounts "appear" to be from a nontaxable source
and that PLC did not have a "likely source of income" that would
be in "round" numbers is not sufficient to disprove respondent's
determination under the bank deposits analysis."
III.
The Rowells' Disputed Income
A.
Overview
Respondent adjusted the Rowells' income to reflect his
determination that they received constructive distributions from
the subject corporations.
Respondent also adjusted the Rowells'
income to reflect the disallowed NOL deduction.
Respondent also
adjusted the Rowells' income to reflect the amended California
returns and the $100,000 transfer to Ms. Raposa's account.
We
address each adjustment in turn.
"Nor have petitioners established that a $7,773 deposit in
2000 represents nontaxable income.
They have established,
however, that a $23,980 deposit in 2001 is not taxable income in
that it was a repayment of a loan to a client.
32 -
B.
Constructive Distributions
1.
Overview
Respondent determined that the Rowells received constructive
distributions from the subject corporations and that some of the
distributions were taxable to the Rowells as constructive
dividends while others were taxable to the Rowells as capital
gains.
We agree with this determination for the most part.
2.
Rules Applicable to Distributions
Under section 301,
funds (or other property) distributed by
a corporation to a shareholder with respect to its stock are
taxable under section 301(c).
Under sections 301(c) and 316, a
distribution is taxed to the distributee shareholder as a
dividend to the extent of the distributor corporation's E & P
i
Any excess is considered to be a nontaxable return of capital to
the extent of the shareholder's basis in the corporation, and any
remaining amount is then taxable to the shareholder as a gain
from the sale or exchange of property.
See sec. 301(c) (2) and
(3); Truesdell v. Commissioner,
1280,
89 "T.C.
1295-1298
(1987).
Section 301 characterizes a distribution as a dividend regardless
of whether the distribution is formally declared to be a
dividend.
See Boulware v. United States, 552 U.S. 421, 429
(2008); Truesdell v. Commissioner, supra at 1295; see also Noble
v.
Commissioner,
Memo.
1965-84.
368 F.2d 439,
442
(9th Cir.
1966),
affg. T.C.
- 33 -
Corporate funds that a controlling shareholder diverts to
personal use are generally characterized as constructivé
distributions to the shareholder for tax purposes. - See Erickson
v. Commissioner,
598 F.2d 525,
531
(9th Cir.
1979) ,
affg.
in part
and revg. in part T.C. Memo. 1976-147; Strong v. Commissioner,
T.C. Memo. 2005-125.
Such a diversion may occur,
for example,
where a corporation makes a distribution to a controlling
shareholder that serves no legitimate corporate purpose and the
distribution results in an economic benefit to the shareholder.
See Strong v. Commissioner, supra; see also Meridian Wood Prods.
Co. v. United States,
725 F.2d 1183,
1191
(9th Cir.
1984) .
Such
a diversion also may occur where a controlling shareholder causes
a corporation to pay his or her personal expense and the payment
primárily benefits the shareholder and is made without a
expectation of repayment or without a bona fide intent- that it be
in repayment of a shareholder loan.
115 T.C.
172,
179-180
See Hood v. Commissioner,
(2000); see also Noble v.
supra at 443; Clark v. Commissioner,
Commissioner,
266 F.2d 698,
710-711
(9th
Cir. 1959), affg. in part, revg. in part and remanding T.C. Memo.
1957-129.
The subject corporations' payments of the Rowells' personal
expenses primarily benefited the Rowells, and the payments had no
- 34 connection with the subject corporations'-businesses.
Petitioners claim that the distributions were either repayments
of shareholder loans or the making of shareholder loans and
therefore that the distributions were erroneously characterized
as distributions.
We carefully scrutinize this claim and give
greater weight to the- objective indicia of debt than to
petitioners' self-serving statements of intent.
See Turner v.
Commissioner,
affg. T.C.
812 F.2d 650,
654
(11th Cir.
1987),
Memo. 1985-159; Berry- Petroleum Co. & Subs. v. Commissioner, 104
T.C.
584,
642
(1995),
442
(9th Cir. 1998).
affd. without published opinion 142 F.3d
The critical question is whether the
Rowells and the subject corporations intended at the time of the
distributions to create a bona fide debtor/creditor relationship.
See Estate of Chism v. Commissioner,
322 F.2d 956,
960
(9th Cir.
1963), affg. Chism Ice Cream Co. v. Commissioner, T.C. Memo.
1962-6.
-
Factors to consider in answering this question include:
(1) Whether the promise to repay is evidenced by a note or other
instrument;
(2) whether interest was charged;
schedule for repayment was established;
was given to secure payment;
(3) whether a fixed
(4) whether collateral
(5) whether repayments were made;
(6) whether the borrower had a reasonable prospect of repaying
the loan and whether the lender had sufficient funds to advance
"Payees included, for example, the Rowells' housekeeper,
gardener, grocers, tailor, hair stylist, insurer, pool cleaner,
utility providers, and medical care providers.
- 35 the loan; and ('/) whether :the parties conducted themselves as if
the transaction was a loan.
1228, 1230
-See Welch v. Commissioner, 204 F.3d
(9th Cir.« 2000), affg. T.C..Memo. 1998-121; see also
Commissioner v. Valley Morris÷ Plan, 305 F.2d 610, 618 (9th Cir.
1962)
(defining a."loan" for Federal tax purposes as "'an
agreement, either expressed or implied, ewhereby one person
advances money to the other and the other agrees :to repay it upon
such terms -as'to time and rate of interest, or without interest,
as'the parties may agree'"
Fidelity &'Cas. Co.,
(quoting Natl. Bank of Paulding v.
131 F. Supp. 121,
123-124
(S.D. Ohio 1954)),
revg. 33 T.C. 572
(1959) and Morris Plan Co. v. Commissioner, 33
T.C. 720 (1960)
We are mindful that formalities are not always
followed where, as here, the- setting involves shareholders and
their closely held corporations.
See, e.g., Teymourian v.
Commissioner, T.C. Memo.s2005-232.
We reject-petitioners' claim assunsupported by the record.
The record does not establish that the subject corporations and
the Rowells intended at the time of any distribution that the
dist'ribution be an actual repayment of a loan to a shareholder or
the actual making of a loan tó a shareholder.'
'Nor does the
record establish'that the Rowells and the subject corporations
conducted themselvés as if the distributed amounts were loans or
repayments of loans." ihe purported sharehölder loans were not
evidenced by notes 'or other writings, they were not secured by
l
- 36 -
collateral, they did not require the payment of interest, and
they were not subject to repayment schedules or to any specific
terms of repayment .
The Rowells and the subject corporations did
not record the amount of any loan between them or otherwise keep
track of it accurately.
The distributed amounts were not
contemporaneously designated as the proceeds of a loan or the
repayment of a loan.
Petitioners also have not persuaded us that
there was any outstanding loan at the time of any distribution
(other than those loans that were reflected in the payments for
which respondent gave the Rowells credit in arriving at the
amounts of the distributions) , " or that the Rowells reimbursed
the subject corporations any of the funds reflected in the
distributions . - Nor have they persuaded us that either the
Rowells or the subject corporations had sufficient funds either
to make loans of that magnitude or to repay loans of that
magnitude.
In fact, it appears from the record that the subject
corporations' repayment to the Rowells of any loan of that
While PLC reported significant amounts of outstanding
shareholder loans at the end of 2000, 2001, and 2002 and Knutsen
reported significant amounts of outstanding loans at the end of
2001 and 2002, respondent determined that neither subject
corporation had any outstanding shareholder loan as of those
dates .
Petitioners have failed. to prove that determination
wrong. We note in this regard that petitioners have effectively
conceded that the subject corporations substantially overstated
the amounts of the shareholder loans reported on the returns in
issue and, have introduced no credible evidence that allows the
Court to find amounts that are different from those respondentdetermined.
- 37 -
magnitude would not be assured with any reasonable likelihood but
would be subject to the risk of the success of the subject
corporations' businesses.
464 F.2d 394,
402
(5th Cir.
Cf. Estate of Mixon v. United States,
1972)
(factor to consider in deciding
whether a payment reflects debt or equity).
In sum, petitioners
have failed to establish that the requisite bona fide
debtor/creditor relationship existed between the Rowells and the
subject corporations at the time of any of these distributions,
and such is so notwithstanding our recognition that shareholders
and their closely held corporations may sometimes be lax in
formalizing their dealings with each other."
We sustain
respondent's determinations set forth in.the-notices of
deficiency as to the total amounts of the constructive
distributions (subject to our adjustment discussed supra note 8).
3.
E & P
As discussed supra, the constructive distributions to the
Rowells are deemed to be dividends to them to the extent of each
distributor's E & P.
Respondent determined each corporation's
"We have no doubt that a shareholder and his or her closely
held corporation can enter into regular loans with each other or
can enter into an agreement whereby the corporation pays for all
of the shareholder's'personal expenses and the amounts of those
payments are considered to be loans between the two. We believe,
however, that such an agreement musd be accompanied by reliable
outward manifestations of debt, given the close relationship
between the shareholder and the corporation and the risk of
abuse, and we do not find that the distributions at hand have
sufficient manifestations or specificity of debt other than as
established through the bald assertions of Mr. Rowell.
- 38 E & P, and that determination is presumed to be correct.
DiLeo v. Commissioner,
96 T.C.
858,
884
(2d Cir. 1992); see also Rule 142(a) (1).
(1991),
affd.
See
959 F.2d.16
Petitioners set forth
no specific argument in response to respondent's determinations
of each corporation's E & P, and petitioners have failed to
disprove those determinations.
We sustain them, subject to any
adjustment to E & P that results from this opinion."
4.
Characterization of Constructive Distributions
Respondent's application of the rules of section 301(c)
to
the constructive distributions received by the Rowells is set
forth in our findings of fact.
We have reviewed those
computations, and we sustain them subject to any adjustment that
must be made in accordance with this opinion.
C.
NOL Deduction
The Rowells claimed on their Federal income tax return for
2000 that they were entitled to deduct an NOL of $31,996.
Respondent determined that the Rowells were not entitled to this
deduction.
We agree.
Section 172 allows a taxpayer to deduct an NOL for a taxable
year.
The amount of the NOL deduction equals'the sum of the NOL
carryovers plus NOL carrybacks to that year.
See sec. 172(a).
Absent an election to the contrary, an NOL for a taxable year
"Petitioners also do not dispute respondent's determination
that each of the Rowells had a $1,000 basis in the stock of his
or her corporation.
We sustain that determination as well.
- 39 -
must first be carried -back 2 years and then may be carried
forward up to 20 years.
See sec. 172(b) (1) (A),
(2),
(3).
Petitioners bear the burden of establishing both the existence of
the NOL and the amount of any NOL that may be carried over to
2000.
See Rule 142(a) (1); United States v. Olympic Radio &
Television,
Inc.,
Commissioner,
349 U.S.
115 T.C.
605,
232,
235
(1955); Keith v.
621
(2000) .
Such a deduction is a
matter of legislative grace; it is not a matter of right.
United States v. Olympic Radio.& Television
Deputy v. du Pont,
308 U.S.
488,
493
See
Inc., supra at 235;
(1940).
The Rowells admit that they lack any documentation to
support their NOL deduction claimed-for 2002 and have failed to
establish that they otherwise are entitled to any of that claimed
NOL deduction.
We sustain respondent's determination that the
Rowells are not entitled to the claimed NOL deduction.
D..
Amended California Returns and Transfers
Through an amendment to answer, respondent asserts that
petitioners failed to report "other earned-income" of $789,287,
$572,181, and $349,915 for 2000,
2001,
and 2002,
respectively,
and additional dividend income of $100,000 for 2002.
The first
three amounts, respondent asserts., result from the Rowells'
filing of the amended California returns reporting income in
amounts greater than the amounts reported for Federal income tax
- 40 -
purposes.
The $100,000 dividend, respondent asserts, results
from the $100,000 transfer to Ms. Raposa.
Respondent argues that the Rowells' filing of the amended
California returns means that they underreported their Federal
income by like amounts.
Respondent relies primarily upon the
case of Badaracco v. Commissioner, 464 U.S. 386
support his result.
misplaced.
(1984), to
Respondent's reliance upon that case is
There, the Court noted that the filing with the
Commissioner of an amended Federal tax return reporting income
not reported on the initial Federal return may be an admission of
unreported income for Federal income tax purposes.
399.
See id. at
Here, Mr. Rowell testified credibly at trial that he filed
the amended California returns on the basis of a hypothetical
amount of income that would present a "worst case" scenario on
any liability that the Rowells could owe the State of California,
with an eye towards escaping the imposition of any penalties at
the State level.
As respondent sees it, the Rowells voluntarily
reported to the State of California significantly more taxable
income than respondent determined through his extremely long,
arduous, and detailed audit of petitioners' Federal income tax
returns.
We reject respondent's claim that the Rowells had
additional income on account of the amended California returns.
On the record before us we do not deem the protective State
returns determinative of the Federal income tax liabilities.
- 41 As to the additional income from the $100,000 transfer, we
generally agree with respondent on this point.
Gross income
includes all accessions to wealth over which a taxpayer has
complete dominion, see James v. United States, 366 U.S. 213, 219
(1961); Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 431
(1955), and a taxpayer has dominion and control over cash when he
has the freedom to use it at will, see Rutkin v. United States,
343 U.S.
130,
137
(1952).
Mr. Rowell exercised his dominion and
control over the $100,000 when he caused PLC to transfer that
money to Ms. Raposa in connection with an investment contemplated
by Mr. Rowell.
While petitioners invite the Court to treat this
distribution as occurring in 2003, i.e., the year in which
$88,500 of that amount was transferred to their personal account,
we decline to do so.
The $100,000 was transferred from PLC's
account in 2002 for the personal benefit of Mr. Rowell.
the year in which it is taxable.
98 T.C.
IV.
165
That is
See Ianniello v. Commissioner,
(1992)."
Knutsen's Disputed Deductions and Expenses
Respondent disallowed all of Knutsen's reported deductions
for 2001 and 2002, except for $2,681 and $4,063 of deductions
that Knutsen claimed for the respective years as "other
"Of course, the treatment of the $100,000 must take account
of sec. 301(c). We leave it to the parties to compute the
portion of the $100,000 that is taxable as a dividend and the
portion that is taxable as a capital gain.
- 42 -
deductions".
Petitioners argue that they may deduct some or all
of the disallowed amounts because Knutsen engaged in the doll
business for profit, and petitioners substantiated Knutsen's
entitlement to the disallowed amounts through documentation and
the testimony of Mrs. Rowell.
We agree in part.
The parties spend undue time disputing the applicability of
section 183 to Knutsen's doll business and, more specifically,
I
whether Knutsen had the profit motive described in that section
so as not to preclude Knutsen from deducting certain amounts
attributable to its doll business.
section 183 is misplaced.
The parties' reliance upon
Section 183 does not apply where, as
here, the taxpayer (Knutsen) is a C corporation.
See sec. 183(a)
(stating that deductions may be limited by section 183 when "an
activity engaged in by an individual or an S corporation * * * is
not engaged in for profit"); sec. 1.183-1(a), Income Tax Regs.
(stating that no inference may be drawn from section 183 and its
regulations as to whether a C corporation is engaged in an
activity for profit); see also Misko v. Commissioner, T.C. Memo.
2005-166
(stating that section 183 does not apply to C
corporations)."
Respondent also argues that the Rowells, rather than
Knutsen, conducted the doll business. The facts at hand
establish to the contrary, e.g., that Knutsen (as opposed to the
Rowells) realized revenue from the doll business and paid the
expenses of that business.
- 43 As otherwise framed by the parties, our resolution of this
issue turns on whether Knutsen substantiated the amounts that it
claimed as deductions.
Mrs. Rowell explained at trial the manner
in which Knutsen paid its business -expenses, and the record
includes documentary evidence supporting Knutsen's claim that it
purchased dolls and paid operating expenses during 2001 and 2002.
We list in our findings of fact the expenses and costs of goods
sold that Knutsen claimed for 2001 and 2002.
We conclude that
Knutsen is entitled to those items with two exceptions.
First,
petitioners concede that one-half of the amount of the research
expenses was paid for the personal expenses of the Rowells.
Knutsen may not deduct those personal expenses of $6,906 for 2001
and $6,695 for 2002.
Second, petitioners concede that Knutsen's
cost of goods sold deductions for 2001 and 2002 are limited to
the amounts of its doll sales in those respective years.
Thus,
pursuant to petitioners' concession, Knutsen's costs of goods
sold for 2001 and 2002 are capped at $18,055 and $23,602,
respectively.
V.
Petitioners' Liability for Fraud
A.
Overview
We decide whether any of petitioners is liable for a fraud
penalty under section 6663."
Respondent determined (or asserts
* In relevant part, sec. 6663 provides:
(continued...)
in his answer or an amendment thereto) that each petitioner is
liable for fraud penalties under section 6663.
Section 6663(a)
imposes a penalty of 75 percent of the portion of an underpayment
that is attributable to fraud.
In order to establish fraud,
respondent must prove by clear and convincing evidence that:
(1)
Petitioners underpaid their Federal income taxes, and (2) some
part of each underpayment was due to fraud.
Granquist, 252 F.2d 56
94 T.C.
332
654,
(1990).
660-661
See Powell v.
(9th Cir. 1958); Parks v. Commissioner,
(1990); Miller v. Commissioner,
94 T.C.
316,
If respondent meets this burden, we consider all of
the underpayments to be attributable to fraud unless petitioners
establish.otherwise by a preponderance of the evidence.
See sec.
6663 (b).
i-
"(...continued)
SEC.
6663.
IMPOSITION OF FRAUD PENALTY.
(a) Imposition of Penalty.--If any part of any
underpayment of tax required to be shown on a return is
due to fraud, there shall be added to the tax an amount
equal to 75 percent of the portion of the underpayment
which is attributable to fraud.
(b) Determination of Portion Attributable to
Fraud.--If the Secretary establishes that any portion
of an underpayment is attributable to fraud, the entire
underpayment shall be treated as attributable to fraud,
except with respect to any portion of the underpayment
which the taxpayer establishes (by a preponderance of
the evidence) is not attributable to fraud.
- 45 -
B.
Underpayment of Tax
Petitioners concede that they underpaid their taxes for each
year to which the notices of deficiency apply.
We conclude as to
each of those years that respondent has met the first part of his
burden of proof; i.e., establishing underpayments of tax.
C.
Presence of Fraud
The second part of respondent's burdenerequires that he
establish the presence of fraud.
Fraud requires an intentional
wrongdoing on the part of a taxpayer with the specific purpose of
evading a tax believed to be owing.
See Powell v. Granquist,
supra at 60; Miller v. Commissioner,' supra at 332.
Such a
fraudulent intent is present where a taxpayer files a return
intending to conceal, mislead, or otherwise prevent the
collection of tax.
(1943); Akland v.
See Spies v. United States, 317 U.S. 492, 499
Commissioner,
1985),
affg. T.C. Memo.
85,
(1970).
93
767 F.2d 618,
621
(9th Cir.
1983-249; Beaver v. Commissioner,
55 T.C.
A finding of a fraudulent intent is a factual
determination that turns on the facts and circumstances of the
case.
See Gaiewski v. Commissioner,
67 T.C.
affd. without published opinion 578 F.2d 1383
181,
199
(1976),
(8th Cir. 1978).
Where fraud is determined for multiple years, as here, the
Commissioner must establish a fraudulent intent -for each year in
order to prevail for all years.
53 T.C.
96,
105
(1969).
See Otsuki v. Commissioner,
- 46 -
Fraud is never presumed or imputed; it must be established
by independent evidence that establishes a fraudulent intent on
the taxpayer's part.
202, 210
(1992).
See Niedringhaus v. Commissioner, 99 T.C.
Because direct proof of a taxpayer's intent is
rarely available, fraud may be proven by circumstantial evidence
and reasonable inferences may be drawn from the relevant facts.
I
See id.
We often rely, on certain indicia of fraud to decide
whether fraud is present.
The "badges of fraud" include:
(1) Understatement of income;
records;
(2) maintenance of inadequate
(3) failure to file tax returns;
inconsistent explanations of behavior;
or assets;
(4) implausible or
(5) concealment of income
(6) failure to cooperate with tax authorities;
engaging in illegal activities;
(8) dealing in cash;
(7)
(9) failure
to make estimated tax payments; and (10) filing false documents.
See Estate of Trompeter v.
Cir.
Commissioner,
279 F.3d 767,
200.2), vacating and remanding 111 T.C...57
v. Commissioner, 796 F.2d 303, 307-308
T.C. Memo.
773
(9th
(1998); Bradford
(9th Cir. 1986), affg.
1984-601; Recklitis v. Commissioner,
(1988); see also Spies v. United States,
91 T.C.
874,
910
supra at 499-500.
Respondent argues that the Rowells are financially
sophisticated and tax-savvy individuals who were intimately
involved with and highly knowledgeable of petitioners' finances
and who consciously perpetrated a scheme for petitioners to evade
Federal income taxes by understating income and overstating
- 4'7 deductions.
We are not clearly convinced that such is the .case.
Nor are we persuaded by respondent's view of the indicia of fraud
that support his - f indings of f raud .
First, we disagree with respondent' s view that the Rowells'
understanding of taxes and their :involvement with and knowledge
of petitioners'
finances support the requisite finding of fraud.
The record establishes, and we find as facts, that neither of the
Rowells is proficient on the subject of tax law or on the
requirements thereof and that each . of the Rowells devoted long
hours to his or her profession to the neglect of recordkeeping
responsibilities.
In addition, we are left unpersuaded by the
record that the Rowells knew that petitioners' reported tax.
liabilities failed to reflect petitioners' true tax liabilities.
Although respondent notes that Mr . Rowell was the source of most
of the data reported on petitioners' returns, we do not find that
Mr. Rowell understood the tax sighificance of that data or
sufficiently consulted petitioners' records (or attempted to
compile supporting documentation) before giving that data to Mr.
Cutter.
We do find, however, that Mr. Cutter was of limited
assistance to the Rowells when it came to their receiving
professional advice on the preparation of petitioners' returns
and that he chose to prepare · those returns quickly rather than
accurately.
- 48 -
Second, we disagree with respondent's view that petitioners'
underreporting of income on each of the subject returns leads to
a finding that petitioners intended to evade Federal income tax.
nstead, as similarly discussed above, it appears mor
likely
hat the underpayments in these cases were due to the Rowells'
attempt to file petitioners' tax returns without properly and
sufficiently reviewing petitioners' records and to Mr. Rowell's
belief that PLC's unrecovered advanced client costs and Knutsen's
inventory purchases, each of which was substantial in amount,
would sufficiently offset PLC's and Knutsen's income for those
years.
Third, we disagree -with respondent's view that petitioners
failed to maintain adequate records with an intent to evade
Federai income tax.
Petitioners maintained their records in
Quicken, their computerized accounting system, but they failed to
maintain sufficient documentation to support their entries into
the Quicken database.
The Rowells also did not.maintain
sufficient records to allow them to ascertain the expenses
incurred by them and by each of the corporate entities.
The
Rowells had themselves and two other taxpayers to account for,
and they failed to respect the separate status of each of the
subject áorporations.
Under the.facts at hand, however, we are
not clearly convinced that petitioners' recordkeeping
deficiencies in these cases were attributable to fraud as
- 49 respondent asserts.
It appears more likely, as we find, that
petitioners' -recordkeeping deficiencies are the result of
negligence as petitioners concede.
Fourth, we-disagree with respondent's view that the Rowells
failed to cooperate with respondent during the audit in a further
attempt to evade Federal tax.
By the agent's own admission,
respondent's determination of fraud was spearheaded by the slow
pace at which Mr. Rowell was allowing the agent to complete the
audit.
While Mr. Rowell did in fact reschedule many appointments
with the agent because of conflicts with his work schedule, and
he was slow to get documents to the agent as requested, Mr.
Rowell eventually met with the agent on various occasions and he
repeatedly provided the agent with documents and with answers.
On one occasion, for example, at the beginning of the audit, the
agent demanded of Mr. Cutter that Mr. Rowell appear in person by
the end of the day.
Mr. Rowell complied with that demand, almost
immediately abandoning his work commitments to appear before the
agent shortly thereafter and to allow the agent to interview him
at length.
Mrs. Rowell also met with and allowed herself to be
interviewed by the agent.
Mr. Rowell also tried earnestly on the
basis of the limited information he had to provide a solid
foundation to respondent to support the deductions claimed on
petitioners' returns.
bec. Rowell, on behalf of petitioners, also
agreed with respondent's requests to extend the applicable
- 50 -
periods of limitation for assessment so that a more complete
audit could be performed.
While it appears that Mr. Rowell may
have made some inconsistent statements to the agent during the
audit and provided to the agent some documents which were
facially inconsistent with each other, we do not conclude in the
setting of the record as a whole that he consciously did so to
hinder the audit."
Fifth, we disagree with respondent' s view that fraud is
found in the fact that the Rowells caused the subject
corporations to pay the Rowells' personal expenses .
The Rowells
use of corporate funds to pay their personal expenses and their
use of their personal credit cards to pay the subject
corporations' business expenses appear to us to be the result of
seeking convenience and lack of attention to detail rather than a
conscious and clever scheme to avoid Federal income taxes as
t
asserted by respondent .
The. Rowells repeatedly used corporate
funds to pay their personal expenses, and they apparently thought
(without a supporting foundation) that the pay.ments were loans
from the subject corporations to their shareholders (or
"Respondent also as-serts that the Rowells failed to
cooperate in the audit in that they did not inform the agent they
had filed the amended California returns and did not volunteer
information or documents on their and their corporations'
financial holdings.
We do not believe that the matter in those
assertions is indicia of fraud in the setting of these cases.
- 51 repayments of such loans)."
Mr. Rowell had a loan repayment due
from the corporation in 1999 which was accepted as such by
respondent.
Subsequently, he was cavalier about maintaining
accurate records of the amounts paid by the corporation for his
benefit, but we see his actions as negligent rather than
fraudulent.
While the subject corporations may have deducted
some of these personal payments as business expenses, we are left
unconvinced on the basis of the record at hand that the
corporations did so intending to evade tax.
Respondent also finds fraud in the $100,000 transfer to Ms.
Raposa and the fact that PLC failed to report income that it
received as a partner of the Cheong firm.
We do not do the same.
We consider it unlikely that Mr. Rowell would have entered into a
fraudulent transaction as to the $100,000 given that at the time
petitioners were under examination by the Internal Revenue
Service.
We also consider it unlikely that Mr. Rowell was
consciously attempting to conceal the income he received from the
Cheong firm given that the firm had reported that amount to both
Mr. Rowell and to the Internal Revenue Service.
For the same
reason, we also do not believe that PLC's failure to report its
interest income correctly was a conscious attempt to conceal its
receipt of that income.
Nor do we believe that PLC's isolated
"This explains to our satisfaction why the Rowells did not
report all of the constructive distributions as income.
l
- 52 deposits into the Rowells' personal bank account of the $8,220 in
legal fees and the $27,073 in chess winnings evidences that
intent."
D.
Conclusion
After our detailed review of the facts and circumstances of
these cases, in conjunction with our analysis of the applicable
badges of fraud, we conclude that respondent has not clearly and
convincingly proven a fraudulent intent on the part of any
petitioner.
We hold that none of petitioners is liable for a
fraud penalty under section 6663.
VI.
Epiloque
All of the parties' arguments have been considered.
rejected those not discussed herein as meritless.
We have
Accordingly,
Decisions will be entered
under Rule 155.
"Respondent also finds fraud in the Rowells'
misrepresentation of their income to a proposed mortgagee and to
the State of California. While we do not condone that practice,
we do not view these actions as clear and convincing evidence of
the requisite fraudulent intent.
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