UNITED STATES TAX COURT
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CAL.
STAT.
.
. JUDGE
FILES
T.C. Memo. 2008-264
UNITED STATES TAX COURT
THOMAS J. BARROW, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
BARROW, ALDRIDGE & CO. , Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
14551-02,
14716-02.
Filed November 25,
2008.
Clarence B. Tucker, Sr., for petitioners.
Alexandra E. Nicholaides and Kimberly Webb, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge:
Thomas J. Barrow was a pioneer for African-
Americans in the accounting profession, creating what was for a
time the nation's largest minority-owned accounting firm.
Despite his impressive leadership, Barrow ran into trouble with
SERVED NOV 25 2008
- 2 the IRS when audits revealed that he was not reporting all of the
business income that he received.
The IRS also disallowed
various deductions he took during the years at issue.
Barrow was
convicted at a criminal trial of filing false tax returns, bank
fraud, and income tax evasion.
We must decide whether Barrow and
his firm are liable for tax deficiencies and associated penalties
for the years 1984-89.
FINDINGS OF FACT
I.
The Early Years
Barrow grew up in Detroit, graduated from high school there,
and then attended Wayne State University.
He majored in
accounting while working as an intern for Arthur Andersen when
that firm was still one of the Big Eight national accounting
firms.
He earned his bachelor's degree in accounting in 1971 and
became a certified public accountant in 1973.
Upon graduation from college, Barrow was promoted by
Andersen and he began working on financial audits.
He rose
through the ranks, and eventually became an experienced senior
auditor.
His job was to plan audit e gagements, execute them,
write the audit procedures, review the audit work papers, and
then draft the client's financial statements to make sure they
complied with Generally Accepted Accounting Principle's (GAAP).
He worked only on financial audits, and was never involved with
- 3 -
Andersen's tax department.
He also found time to continue his
education by earning an MBA in finance, again from Wayne State.
II.
Formation of Barrow, Aldridge, & Co.
In March 1975, Barrow and two of his colleagues from
Andersen, William Aldridge and Ron Coleman, founded their own
accounting firm, named Barrow, Coleman, Aldridge & Co.
They
organized it as a corporation in which each owned a one-third
interest.
The firm aimed to build a client list of small
businesses, individuals, and nonprofits, and it soon had a number
of clients in the health-care industry.
And it didn't just do
the financial audits Barrow specialized in--it also offered
bookkeeping, recordkeeping, and tax-return preparation.
The firm quickly took off and, as its revenues grew, it took
on more employees.
Most were CPAs, but the firm needed staff,
too, and one of its first was Cynthia Nobles.
1976, as secretary to all three partners.
She began work in
Over the course of her
employment at the firm, her responsibilities grew until she
became both the firm's office manager and its bookkeeper.
Barrow
taught Nobles some basic accounting skills, such as recording
journal entries, working with a general ledger, and reconciling
the bank account.
At first, he closely supervised her and was
able to correct any mistakes she made.
Barrow soon emerged as the firm's star.
At first this just
meant he had to work harder, because the company generally
followed the eat-what-you-kill model, with each of the senior
partners working mostly for those clients that he brought to the
firm.
Barrow proved to be the superior rainmaker, though, and
was soon bringing in far more clients than he could handle
himself, shifting some of the work to the other partners.
The
principals began to specialize--Aldr-idge in tax, and Barrow on
audit and financial services but with an increasing focus on
client development.
When equal partners generate unequal revenues, trouble
usually ensues.
And in the early '80s, Barrow became
dissatisfied with what he thought was the less-than-equal effort
of both of his partners, but especially of Coleman.
Barrow
didn't feel that he had the power to fire Coleman, so he decided
to leave the firm.
The only problem was that the firm wanted to
leave with him--the clients were predominantly Barrow's, and the
employees said they would follow Barrow out the door.
So Coleman
decided to leave instead, and Aldridge agreed to make some
adjustments so that he and Barrow could continue to work
together, thus forming Barrow, Aldridge & Co.
(BACO) in 1981.
After the shakeup, Barrow became the majority owner with 54-
percent control and was in charge of the firm's finances.
BACO,
like its predecessor, had always managed its finances
using the "modified cash basis of accounting."
At trial, Barrow
first defined the plain-vanilla "cash method of accounting" as
- 5 -
one where a company records revenues when it receives cash or a
cash equivalent.
Likewise, a company using this method records
expenses only when money goes out the door.
Barrow described the
limitations of this method, saying that a company cannot account
for depreciation under it.
But as Barrow explained, BACO used
the modified cash method of accounting, which allowed the company
to record certain expenses when all the events that.surround that
expense had occurred.1
When BACO paid its employees, for
example, it would accrue and deduct the related FICA payments at
that time instead of waiting to deduct those taxes when it
actually paid them over to the government.
Barrow increasingly came to think of BACO as "his" firm and
took it upon himself to lend it money when blips in its cashflow
made meeting payroll a problem.
He did not formally approve
these loans in writing on behalf of BACO, but both Aldridge and
Nobles knew of them and credibly testified that they occurred.
Nobles also credibly testified that she would make journal
entries in the ordinary course of business, adjusting the amount
of the loans outstanding both when BACO received money and when
,
1 BACO's tax returns had a box that required a choice of
accountin'g method: .cash, accrual or "other (specify)." The
Commissioner points out that BACO checked that it used the cash
method of accounting while Barrow now claims BACO used the
modified cash method.
Checking the box for cash method seems
reasonable, however, given that "[r]elatively minor deviations in
the form of accruals will not change the taxpayer from the basic
cash method."
1 Alkire Tax Accounting, sec. 3.01[3] (LexisNexis
2007).
it paid Barrow back.
We specifically find these journal entries
a generally reliable record of Barrow's loans to BACO and their
repayment.
BACO required all employees and owners to abide by a
noncompete agreement.
"that if it
Barrow testified that it was BACO's policy
[was] a service that [BA¼O] offer[ed]," then a BACO
employee couldn't "perform that service outside of the firm's
purview."
Donna West, initially a BACO audit manager and later a
I
principal, credibly testified that she knew that this was BACO's
policy even though she never saw it in writing.
She explained
that she "would not have been able to work for a competitor"
because "as a CPA [she] would not wo 041k
for one of the other *
accounting firms."
She also explained that she could work in-
house for a client, but that under the policy she would still be
a BACO employee receiving her compensation from BACO.
III. Complete Information Systems
The second business whose finanòes are at issue in this case
is Complete Information Systems (CIS .
Started in 1979 by BACO's
principals, CIS leased mainframe time which it resold to its
clients.2
That time would then be available for BACO clients to
automate their bookkeeping.
Barrow completed all the paperwork
2 In those bygone days before personal computers became a
commodity, companies could actually ake money by buying time on
a mainframe computer wholesale and reselling it to clients.
For
the various uses (or the misuses) of the term "time sharing", see
Odeneal, Computer Time Sharing for Managers 17 (1975).
- 7 -
to set up CIS, and at first all the partners of Barrow, Coleman,
Aldridge & Co. owned it, but with the understanding that
distributions from revenues would be unequal and dependent on who
brought the client in.
All the clients of CIS were also clients
of BACO, and the partners would routinely try to cross-sell the
services of both firms.
Over time, CIS also began to lease cars to BACO's owners.
Barrow signed the lease agreements for CIS, and Aldridge and
Nobles signed for BACO.
After the shakeup from which BACO
emerged, Barrow became the sole proprietor of CIS, though Nobles
continued to do its bookkeeping.
For tax years 1984, 1985, 1987,
and 1988, Barrow called this business CIS or CIS Leasing; on his
1986 tax return, Barrow called it "BARCO leasing."
For all of
these tax years, Barrow reported its business income and expenses
on his own Schedule C, using the cash method of accounting, under
which he recorded CIS's income and expenses in the calendar year
in which they occurred.
IV.
BACO's Success and Barrow's Community Involvement
BACO continued to grow, and in 1981 it opened a satellite
office in Illinois.
The firm also negotiated a deal with Coopers
& Lybrand that was essentially a right of first refusal.
If BACO
wanted to partner with a large accounting firm, it had to ask
Coopers first, and likewise if Coopers wanted to partner with a
minority-owned firm.
This agreement gave BACO access to large
- 8 clients that it would not have otherwise been able to work with.
Barrow negotiated this joint venture, and it was the first of its
kind among accounting firms in Detroit.
Barrow successfully
increased the client base of the BACO satellite offices by
marketing his experience and learning to manage client
relationships remotely.
In an effort to bring in new clients and to raise his
stature in both the business and financial communities, Barrow
became active in many professional associations.
He was the
Detroit chapter president for the National Association of Black
Accountants
(NABA), which became the largest chapter in the
country under his leadership.
He later became the national NABA
president, and in that role he visited many U.S. cities to
organize additional chapters.
He served on an advisory board to
the Commissioner of Internal Revenue, and the governor of
Michigan appointed him to the State Board of Accountancy, which
he eventually chaired.
He was also a member of the Accounting
Aid Society of Metropolitan Detroit, and was on the advisory
board to the Small Business Association and the Advisory Council
of the Wayne State University Department of Accounting.
But the community involvement that plays the biggest role in
this case began with Barrow's appointment to the board of
trustees for New Center Hospital3 (NCH) in 1981.
NCH was a
troubled institution, as Barrow quickly discovered after he
arrived.
This prompted him to start asking tough questions of
Alan Weiner, the hospital's executive consultant.
Weiner reacted
by trying to find ways to decrease the strength of the hospital
board, but Barrow led a countercoup in 1984 in which the board
ousted Weiner, and elected Barrow as chairman of NCH.
Barrow's prominence and reputation in Detroit was growing.
But 1985 proved to be its apogee.
That year, Barrow decided to
heed the urging of his friends and run for mayor of the city
against the formidable incumbent Coleman Young.
He believed--and
we specifically find his claim of naivete credible--that this
would simply mean putting his name on the ballot and campaigning
for awhile.
Instead, it began a long downward slide in his
personal and financial fortunes.
The first sign was neither subtle nor long in coming--BACO's
largest client in 1985 was the City of Detroit, and the City
swiftly decided to cut off its business with the firm, leaving
BACO with a huge revenue shortfall.
effects.
But there were also subtler
As Barrow grew more occupied with politics and
community work, he did not have the time he needed to supervise
3 At the time, New Center Hospital was named Detroit Center
Hospital. The board decided to change the name in 1984 because
Detroit Center Hospital had a poor image in the community.
- 10 Nobles adequately.
Mistakes she made in recording entries in the
books of both BACO and CIS remained uncorrected and leached into
Barrow's and BACO's tax returns.
Many of the problems that led to this case, though, began
with Barrow's work on the NCH board.
His duties started out as
routine trustee chores--attending meetings and cursorily
reviewing Weiner's proposals.
But after Weiner's ouster, Barrow
and the hospital board decided in 1985 to seek outside advice,
which led them to put the hospital and some affiliates under a
holding company.
This new company, called Central Cities Health
Services (CCHS), with Barrow as chairman of its board of
directors, planned to acquire clinics throughout Detroit.
These
clinics could refer patients needing specialized or acute care to
the hospital, giving its patient population a much-needed boost.
He also increased his efforts at the hospital while running for
mayor that year--in fact, the then-chairman of CCHS stepped down
and let Barrow take his place because he knew it would be
valuable for Barrow's mayoral campaign.
Barrow stayed on the hospital's board, too, and was the only
director common to both NCH and CCHS.
The two boards began
paying their members a fee of $100 for each monthly board meeting
attended, and $50 for each subcommittee meeting.
They also paid
Barrow a separate annual chairman's fee of $4000.
CCHS's plan
began to work, and it became the parent company of New Center
- 11 -
Clinic-East, New Center Clinic-West, and New Center ClinicCentral.
The NCH board of trustees hired a chief operating officer.
The new man was to run the hospital's billing, personnel, and
patient care departments, but after a couple years it became
obvious that he didn't know how to run the financial side of the
hospital.
The result was a cashflow problem serious enough to
prompt the board to remove him.
By then, NCH was collecting substantially less than what it
was billing.
Some insurance companies and Medicaid were refusing
to pay bills because of avoidable paperwork problems, but instead
of correcting and resubmitting the bill, the billing department
did nothing.
The result was a perpetual cash crisis.
The board
also discovered that the hospital had a mortgage with HUD on
which it was not current, which then triggered violations of
NCH's corresponding regulatory agreement connected to that
mortgage.
And, to add to the hospital's woes, it also had a
payroll-tax problem because it hadn't been paying over withheld
taxes to the IRS.
Sometime between 1985 and 1988, CIS began providing computer
services to NCH.
These services included aiding the hospital
with its billing system.
It's unclear whether and to what extent
Barrow disclosed his ownership of CIS--a potential conflict of
interest--to the other board members.
But Barrow credibly
- 12 -
testified on this tangential point that every board member did
business with the hospital and its affiliates.
Barrow understood the hospital's financial problems and, so
he began to get more involved in the hospital's day-to-day
operations.
In September 1987, while still a partner at BACO,
Barrow began functioning as a full-time manager to try to bring
order to the chaos in the hospital's financial departments.
The
board agreed in exchange to pay Barrow the same $52,000 (as a
chairman's.fee) that the previous chief operating officer had
received as salary.
Between February 1986 and late 1987, NCH signed two deals
with BACO.
The first was a professional compilation-accounting
services agreement, a service that BACO routinely performed for
its clients.
After receiving bids for contracts from other
accounting firms that the hospital couldn't afford, BACO
essentially "lent" some of its employees at reduced rates to NCH
to help with the billing and finances.
These employees acted
like NCH employees--they worked at NCH every day, and they were
actively involved in reconciling the bank accounts, building and
maintaining relationship with the hospital's vendors, and
creating the quarterly requests for reimbursement from Medicare,
Medicaid, and Blue Cross Blue Shield.
NCH paid BACO directly,
and BACO deposited this money into BACO checking accounts.
Donna
- 13 -
West was the lead on this engagement, and Barrow's work on this
project did not extend beyond supervising her.
In September 1987, at about the time that Barrow took on his
greatly expanded role in managing the hospital, BACO started the
second engagement, which was to reconstruct cost reports,
business records, and other accounting records back to the 1970s.
This project was much more complex:
The money at risk amounted
to several million dollars and the hospital's survival was at
stake.
Barrow got personally involved, but since the hospital
paid him a chairman's fee, he did not have BACO bill NCH for his
time.
Barrow's involvement on this engagement came within the
penumbra of the noncompete agreement, and he admits that the fee
paid to him as NCH's chairman should have belonged to BACO under
that agreement.4
All during these years that he was spending so much time at
CCHS and NCH, Barrow continued to have several outstanding loans
with BACO.
He would often deposit checks from BACO's clients
that were payable to BACO into his own personal account.
On this
important point we specifically find, based on the testimony and
exhibits in evidence, that Barrow had Nobles record in the BACO
general ledger upon receipt of each check a journal entry that
decreased the loan payable to him (a debit) and increased BACO'S
4 There was also a draft agreement between CCHS and BACO for
similar consulting services, but the parties never signed the
agreement or acted upon it.
- 14 -
revenues from the engagement (a credit).
The only check not
properly recorded in the BACO ledger was one for $8,352 from
Ernst & Whinney.
During this.time, Barrow was still receiving a board stipend
from NCH in addition to his chairman's fee.
Barrow credibly
testified that there was a substantial difference between his
role as NCH chairman and his role as NCH board member.
He
received the NCH board stipend for attending and conducting
meetings, and considered it (like the other board stipends and
the CCHS chairman's fee) to be his own income.
The hospital
consistently paid BACO and Barrow, although not all the other
vendors, and for a time Barrow himself managed the hospital's
cashflow by approving all payments before they were sent to the
vendors.
This gave him a very detailed knowledge of the state of
NCH's cash position, and he would sometimes refrain from cashing
his board stipend or chairman's fee checks because he knew the
hospital didn't have the cash on hand to pay him.
While occupied at the hospital and CCHS, Barrow also had to
deal with another outbreak of change at BACO--Aldridge's decision
to leave the firm in December of 1987.
Even though Barrow had
been president of BACO from its start, Aldridge's departure left
him with near total responsibility over administrative and
financial decisionmaking.
It also left him--with the exception
of some partners who owned about 3 percent of the firm's
- 15 outstanding shares--as the firm's owner.
Even more than before,
BACO's fate depended on Barrow.
V.
Personal and Professional Trouble
Despite all his responsibilities, Barrow chose to run for
mayor again in 1989.
This second campaign was especially brutal
because Barrow was by then a legitimate threat to the incumbent
mayor.
Calling his mayoral run "life-altering," Barrow experi-
enced things he only thought happened in fiction, credibly testifying that someone broke into his home and stole only his brief-
case.
And that he found someone pulling documents from his
trash.
And that police began to sit outside his home to observe
who was coming and going.
The 1989 campaign began to founder after the Detroit Free
Press ran a series of articles about Barrow, BACO, CIS, and their
connections with NCH.
Because NCH consistently paid BACO and
Barrow but not its other vendors, the paper questioned whether
Barrow had a conflict of interest.
On one occasion, a reporter
at the paper called Barrow and asked whether he had ever received
payment from NCH for his services.
had not.
Barrow lied and said that he
And even though he thought no one would ever find out,
he stamped the back of his chairman's-fee checks, which he had
already deposited into his personal account, with the BACO
endorsement stamp.
Barrow also kept quiet about the ownership of
CIS--Joseph Valenti, a friend of Barrow's and fellow hospital
- 16 -
board member, testified credibly that even he didn't know CIS and
Barrow were connected until a reporter did an investigative piece
on Barrow during the campaign.
Barrow lost his run for the mayoralty and then lost a race
for Congress in 1990.
He resigned f¶om the NCH board in July
1990, and pulled the BACO staff out òf the engagement with the
hospital at that time as well.
VI.
The Collapse:
Audit and Criminal Trial
In September 1989, IRS Agent Stephen Bulik began
investigating BACO's tax return for the year ending March 31,
1988.
One of the first things he did in his audit was to
reconcile the general ledger to the tax return.
general ledger accounts did not agree.
Many of the
The audit soon expanded
to BACO's tax year ending.March 31, 1989, and to Barrow's
personal taxes for 1984 through 19881
Because Bulik was not able to reconcile the return to the
general ledger, he began a specific-items analysis' for both BACO
and Barrow personally for all years at issue.
Bulik performed a
bank-deposits analysis to determine the CIS portion of Barrow's
understatement.
' A specific-items analysis is d direct method of proof used
when an IRS agent can find a taxpaye 040's
sources of income.
(When
the IRS can't find a taxpayer's souröes of income, it uses an
indirect method of proof such as an analysis of bank deposits.)
See generally Garbis et al., Tax Procedure and Tax Fraud 618 (3d
ed.
1992).
- 17 -
After years of investigation and a referral from the civil
to the criminal side of the IRS, a grand jury indicted Barrow in
October 1993 on one count of bank fraud, one count of making
false statements on a loan application, five counts of tax
evasion under section 7201 for tax years 1984 through 1988, and
five counts under section 7206(1) of willfully submitting.false
tax returns for tax years 1984 through 1988.'
Barrow was also
indicted on three counts of willfully submitting false corporate
tax returns on behalf of BACO for tax years 1987 through 1989.
During the criminal trial, the government pursued a theory
that Barrow had cheated on his taxes by not reporting on his
individual returns the fees that NCH and CCHS paid to him as the
chairman of the board and a trustee.'
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court's Rules of Practice and
Procedure.
7 Neither party chose to introduce the transcript of the
criminal trial into evidence.
Cf. Oliver v. Commissioner, T.C.
Memo. 1993-508 (where we allowed admission of a transcript from
the criminal trial and held that we had discretion in deciding
the weight to afford testimony of the taxpayer and other
witnesses at the criminal trial); but see Costa v. Commissioner,
T.C. Memo. 1990-572 (where we disallowed admission of an
affidavit from the criminal trial since it wasn't made under Fed.
R. Evid. 801(d) (1)). We therefore rely where relevant on the
indictment (which was introduced), credible testimony in this
case of what happened in the criminal case, and the concessions
of each party. Barrow did include massive excerpts from the
criminal trial transcript in his posttrial brief.
Rule 143(b),
however, says that statements in briefs are not evidence. And we
have previously held that parties cannot attempt to supplement
(continued...)
- 18 In 1994, a jury convicted Barrow on eight of the twelve
counts against him:
042 Making false statements in|connection with
a bank loan application under 18 U.S.C. 1014;
042 Bank fraud under 18 U.S.C. 1344;
042 Income tax evasion for tax years 1985, 1987,
and 1988 under section 7201; and
042 Willfully filing false income tax returns
for years 1985, 1987, and 1988 under section
7206(1).
Barrow was also convicted under section 7206(1) for willfully
filing a false corporate income tax return for BACO in tax years
ending March 31, 1988 and 1989.
VII. Barrow and BACO Tax Returns
Barrow would collect all of the yearend adjusting ·entries
and the calculated ending balances for each of the general ledger
accounts.
Then Aldridge (at first) òr Barrow (after Aldridge
left) would prepare BACO's tax returns.
Both Barrow and BACO
routinely filed their returns late during the years 1984-1989.
Just as often, the returns were later amended after Barrow
discovered reporting mistakes made by Nobles or remembered income
or expenses that he had previously been too busy to write down.
7(...continued)
the record with new material provided in the post-trial briefs.
See Snyder v. Commissioner, 93 T.C. 529, 533 (1989); Hartford v.
Commissioner, T.C. Memo. 1995-351. We therefore do not use that
information in reaching our decision.
- 19 -
Barroy's Persond Inc.ome TãX9ReÜùrns
Tax Year
Form
Date Filed
1984
1040
7/13/87
1985
1040
1/11/88
1986
1040
1040X
1040X
1/14/88
2/04/88
4/10/90
1987
1040
1040X
12/29/89
1/10/90
1988
1040
1/10/90
BACO' s Inco3ne Tax Retprns
Fiscal Year Ending 3/31
Form
Date Filed
1988
1120
1120
1120X
1120X
7/18/88
9/20/89
1/10/90
4/10/90
1989
1120
1120X
10/04/89
4/10/90
VIII.
The Civil Trial
The IRS began a civil examination of Barrow and BACO in
1998.
After several years of investigation, the Commissioner
sent notices of deficiency to Barrow for tax years 1984 through
1988, and to BACO for tax years ending March 31,
1988 and 1989.
The Commissioner determined deficiencies arising from the
following unreported income:
- 20 -
ré
Year
NCH
CCHS
NCC-W
NCC-E
Ernst &
Whinney
1988
$63,955.66
$64,811.55
1989
63,513.66
54563
$4,500
$9,000
$8,352
Barrow! e Unrepopt ed Income
Year
Bank-Deposit
Method
Portion Due to BACO
Distributions
Portion Due to
Wages
1984
$107,337.34
$7,694.07
$76,015.84
1985
4,410
14,600
---
1986
92,457.05
?0,232.58
---
1987
27,176.08
121,965.16
---
1988
137,237.15
167,271.27
---
Instead of attributing the NCH and CCHS fees to Barrow
personally, the Commissioner now argues that they belonged to
BACO, and that Barrow diverted them by depositing them into his
own personal checking account.
The Commissioner treats this
income and diversion for tax purposes as income to BACO, followed
by a constructive dividend to Barrow.
Even though the government
now believes this is the proper way to treat the fees, it used a
completely different theory at Barrow's criminal trial--an
important change, as it will turn out.
The Commissioner also disallowed several deductions .
of these were expenses connected with Barrow's plane.
Some
Because he
- 21 -
traveled so often to meet with clients spread throughout Michigan
and Illinois, and to visit various other cities for his work with
NABA, Barrow--an instrument-rated pilot--had begun flying himself
to save time.
The FAA requires pilots to keep a logbook of all
their flights and to record the purpose of each.
But during the
initial audit, Barrow gave the logbook to the IRS without making
a copy.
The IRS lost it, and Barrow was unable to reproduce its
content.
Both Barrow and BACO petitioned this Court for relief.
The
main issues for decision are:
042 Did Barrow or BACO engage in fraud, thereby
tolling the 3-year statute of limitations?
042 Does collateral or judicial estoppel bar
any claims or issues in this case?
042 Did Barrow or BACO understate income?
042 May Barrow or BACO take the income tax
deductions disallowed by the Commissioner?
042 Is Barrow or BACO liable for the fraud penalty
under former section 6653(b) (1)?
Barrow resided in Detroit throughout the events of this case,
including the day he filed his petition.
BACO is now a defunct
corporation originally headquartered in Det'roit.8
8 Michigan law provides that a dissolved corporation "may
sue and be sued in its corporate name and process may issue by
and against the corporation in the same manner as if dissolution
had not occurred." Mich Comp. Laws Serv. sec. 450.1834 (e)
(Lexis-Nexis 1973); see also id. sec. 450.1833; Freeman v. Hi
Temp Prods.,
580 N.W.2d 918,
921
(Mich. Ct. App.
1998).
- 22 OPINION
I.
Fraud
This case hinges on whether Barrow committed fraud.
On this
question hangs the Commissioner's ability to redetermine Barrow's
and BACO's deficiencies for 1984-89, because the Commissioner
generally has only three years after a taxpayer files a return to
assess a deficiency or issue a notice of deficiency.
6501(a).
Sec.
Barrow filed all original personal and business returns
for the years in question by the end of 1990,' but the
Commissioner waited until 2002 to send notices of deficiency.
Barrow urges us to apply the three-year statute of limitations,
but the Commissioner points us to section 6501(c) (1), which says
that
[i]n 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.
8(...continued)
(Lexis-Nexis 1973); see also id. sec. 450.1833; Freeman v. Hi
Temp Prods., 580 N.W.2d 918, 921 (Mich. Ct. App. 1998).
9 We lOOk to the date that Barrow filed the original
returns, not any amended returns, in applying section 6501(c) (1).
Badaracco v. Commissioner, 464 U.S. 386,
394
(1984), ("[0]nce a
fraudulent return has been filed, the case remains one 'of a
false or fraudulent return,' regardless of the taxpayer's later
revised conduct, for purposes of * * * civil fraud liability
under section 6653(b).
It likewise should remain such a case for
purposes of the unlimited assessment period specified by section
6501(c) (1).").
- 23 Whether we get to decide the merits of each year depends on the
success of his assertion.
Fraud is an intentional wrongdoing, and the Commissioner
must prove by clear and convincing evidence that Barrow
specifically intended to evade a tax that he believed he or BACO
owed "by conduct intended to conceal, mislead, or otherwise
prevent the collection of taxes."
See Niedringhaus v.
Commissioner,
99 T.C.
202, 210
(1992); accord, Wright v.
Commissioner,
84 T.C.
636,
(1985).
639
We look to Barrow's
actions to determine whether any BACO underpayment resulted from
fraud because "corporate fraud necessarily depends on the
fraudulent intent of the corporate officers."
Commissioner,
1992).
96 T.C.
858,
875
(1991), affd.
DiLeo v.
959 F.2d 16
(2d Cir.
We do not impute or presume fraud--the Commissioner
must prove that:
042 there is an underpayment of tax for each
year at stake; and
042 some part of that underpayment is due to
fraud.
Sec.
7454 (a); Rule 142(b); Wright,
A.
84 T.C. at 639.
Underpayment
To prove an underpayment, the Commissioner can use methods
different from those the taxpayer used to calculate income when
the taxpayer's method of accounting doesn't clearly reflect
income.
Sec. 446(b); Parks v. Commissioner,
94 T.C.
654,
658
-
(1990).
24·-
Barrow has the burden to prove that the Commissioner's
determination of unreported income is unfair or inaccurate.
DiLeo,
96 T.C. at 871; Parks,
94 T.C. at 658.
The Commissioner argues that Barrow underpaid his personal
tax liability for tax years 1984-88, and that Barrow caused BACO
to underpay its tax due in 1988 and 1989.
We need not delve into
the details in this part of our opinion, because Barrow concedes
at least some underpayment for 1984
W-2),
and 1985
(due to using the wrong Form
(due to a missing Form 1099 for. CCHS income).
We
have also held that a taxpayer admits an underpayment by filing
an amended return that increases his tax liability.
Badaracco,
464 U.S. at 399; Delvecchio v. Commissioner, T.C. Memo. 2001-130,
affd. 37 Fed. Appx, 979 (11th Cir. 2002).
That's just what
Barrow did for 1986 when he filed a
Form 1040X for 1986 that
showed an increase in tax liability.
We therefore find with
little difficulty that Barrow had at least some underpayment in
1984,
1985,
and 1986.
Whether an underpayment existed for 1987 and 1988, and for
BACO in 1988 and 1989, 1s a more difficult question.
Barrow did
file an amended return for 1987--but it decreased his tax
liability by $28,750.
BACO's 1988 and 1989 amended returns show
no increase in tax liability because of the availability of net-
operating-loss carryforwards.
returns as admissions.
So we can't use these amended
- 25 -
But we can use the fact that he filed all four of these
returns late.
The version of section 6653(c) (1) effective for
Barrow's 1987 and 1988, and BACO's 1988 and 1989, returns states
that
For purposes of this section, the term "underpayment"
means * * * a deficiency as defined in [section 6211]
(except that, for this purpose, the tax shown on a
return referred to in section 6211(a) (1) (A) shall be
taken into account only if such return was filed on or
before the last day prescribed for the filing of such
return * * *
And for purposes of section 6653(c) (1),
"'a taxpayer will
automatically create an "underpayment" in the amount of the
correct tax simply because he * * * files an untimely return.'"
Campbell v. Commissioner, T.C. Memo. 1997-415 (quoting Emmons v.
Commissioner,
92 T.C.
342,
349
(1989), affd.
898 F.2d 50
(5th
Cir. 1990)).
This means that, to answer the question of whether
the Commissioner has proven that there were underpayments for the
1987, 1988, and 1989 tax years, we can simply look to see if
Barrow reported any nonzero tax due for those years.
301.6653-1(c) (1) (ii),
Proced.
& Admin. Regs.
See sec.
Even if Barrow
contests the Commissioner's deficiency, a late-filed return is an
admission that one owes at least the amount of tax shown due on
it, making it an admission of underpayment.
And even if we
assumed the accuracy of the tax reduction shown on the amended
1987 return, Barrow would still be deemed to have admitted that
he owed some tax for 1987.
We therefore conclude that there was
- 26 -
at least some underpayment as defined in section 6653(c) (1) for
Barrow in 1987 and 1988.
The Commissioner can find no comfort in this reasoning for
the BACO returns in this case.
BACO's original returns for 1988
and 1989 show zero tax liability because of a net-operating-loss
carryforward that eliminates any tax that would've otherwise been
due.
The notice of deficiency for these years recalculated and
reduced the net operating loss available for 1988 and 1989, and
included Barrow's hospital board fees and chairman's fees in
BACO's income during those years.
This created a tax deficiency,
and as we said above, an underpayment for purposes of section
6653(c) (1) includes a deficiency as defined in section 6211.
Rather than make findings on the merits that an underpayment
exists, we move along to the second part of the fraud test for
these two years as well.
B.
Collateral Estoppel, Judicial Estoppel, and
BACO's Noncompete Policy
Before deciding whether Barrow had the required fraudulent
intent, we must first consider whether we need to decide the
question at all.
Each party vigorously argued that the other is
estopped on the issue.
We'll start with the Commissioner.
He contends that Barrow
is collaterally estopped from contesting that he had the required
fraudulent intent when he filed his 1985, 1987, and 1988 returns,
because he was convicted for criminal tax evasion under section
- 27 -
7201 for those years.
The Commissioner is right that a
conviction under section 7201 for tax evasion necessarily carries
with it the factual determination that some part of the resulting
deficiency was due to fraud, and as a general rule we
collaterally estop a taxpayer from arguing any defenses to the
civil fraud penalty for the .same year.
Niedringhaus, 99 T.C. at
214; see also Gray v. Commissioner, 708 F.2d 243, 246 (6th Cir.
1983), affg. T.C. Memo. 1981-1.
It's possible, however, that the
Commissioner's procedural missteps bar him from succeeding on
this argument.
The possible misstep here is that we require a party
asserting an affirmative defense--here, collateral estoppel--to
raise the issue in his pleading.
didn't do that.
Rule 39.
The Commissioner
He argues, however, that there was implied
consent because Barrow didn't object to his collateral-estoppel
defense at trial, and Rule 41(b) (1) says that when an issue is
tried by express or implied consent, we are to treat the issue as
if it was raised in the pleadings.
T.C. Memo. 2003-188
In Pierce v. Commissioner,
[citations omitted], our Court held that this
rule.applies to collateral estoppel.
[I]n deciding whether to apply the principle of implied
consent, [we have] considered whether the consent
results in unfair surprise or prejudice toward the
consenting party and prevents that party from
presenting evidence that might have been introduced if
the issue had been timely raised.
- 28 -
In Estate of Huntsman v. Commissioner, 66 T.C. 861, 871-72
(1976), we held that there was no implied consent where the
taxpayer had no notice of the Commissioner's tardy argument, the
Commissioner didn't raise the issue at trial, and we found that
the taxpayer had no opportunity to defend against the
Commissioner's claim.
Barrow's case is different.
The Commissioner raised the
issue in his pre-trial memo, putting Barrow on notice of his
collateral-estoppel defense.
Barrow|does argue that the
Commissioner never filed a posttrial motion to conform the
pleadings to the proof presented, and therefore we should bar the
Commissioner from relying on collateral estoppel now.
41(b) (1)
But Rule
says that
The Court, upon motion of any party at any time, may
allow such amendment of the pleadings as may be
necessary to cause them to conform to the evidence and
to raise these issues, but failure to amend does not
affect the result of the trial of these issues.
(Emphasis added).
We therefore will address the collateral-
estoppel issue on its merits.1°
We use collateral estoppel to prevent parties from
litigating issues that were necessarily decided in a prior suit.
1° Barrow also argues that he notified our Court at trial of
the Commissioner's failure to raise collateral estoppel as an
affirmative defense.
He cites the trial record in one of his
post-trial briefs, but·his citation is incorrect.
- 29 Peck v. Commissioner,
90 T.C.
525
There are five conditions:
(9th Cir.
1990).
162,
166-67
(1988),
affd.
904 F.2d
042 The issue in the second suit must be identical
in all respects with the one decided in the
first suit.
042 There must be a final judgment rendered by a
court of competent jurisdiction.
042 Collateral estoppel may be applied against
parties and their privies to the prior
judgment.
042 The parties must actually have litigated the
issues and the resolution of these issues must
have been essential to the prior decision.
042 The controlling facts and applicable legal
rules must remain unchanged from those in the
prior litigation.
Both parties agree that this case meets the second and third
conditions:
the District Court in the criminal case rendered a
final judgment and the parties to each case are the same."
Because they contest the remaining criteria we analyze them, in
turn,
for 1985,
1.
1987, and 1988.
Are the Issues Identical in All Respects?
The Commissioner simply asserts that the issues in each case
are the same.
Niedringhaus, 99 T.C. at 217 ("'willfully' as used
" The Commissioner limits his estoppel argument to the
three years in which Barrow was individually convicted of tax
evasion under section 7201.
We've previously held that a
corporation--even if it's closely held--that was not a part of
the criminal case cannot be collaterally estopped from denying
fraud based on a majority shareholder's conviction for tax
evasion.
C.B.C. Super Mkts., Inc. v. Commissioner, 54 T.C. 882,
894
(1970).
- 30 -
in section 7201 encompasses all the elements of fraud which are
envisioned in section 6653(b)").
But Barrow says the issues are
different because the Commissioner uses a new theory of corporate
diversion, a position that he says contradicts the theory of
personal income-tax evasion the government used in winning the
criminal case.
Barrow argues that the new theory was not before
the jury in the criminal case and that, if it had been, the
government would have had to prove at that trial both that
(1)
the income belonged to BACO and (2) Barrow deliberately diverted
the income to himself.
Because these issues weren't considered
at the criminal trial and Barrow never had a chance to challenge
them there, Barrow says that collateral estoppel cannot apply.
The government admits that its theory is different in this
case from what it argued in the criminal case:
In the criminal case, the United States presented to an
unsophisticated jury that the unreported income was the
direct income of Thomas J. Barrow * * *. By doing so,
the United States cast the clearest presentation of the
facts to the jury so as to avoid any confusion the
jurors may have had with the concept of double
taxation.
In the instant case, [the Commissioner]
introduced sufficient evidence to show that the income
was also the corporate earnings of [BACO,) therefore
adding the double tax component that was omitted in the
criminal case. In both instances, the income is
attributable to [Barrow].
Reply Brief for Respondent, at 5.
In other words, the government
successfully persuaded the District Court jury in the criminal
case to find that all of the unreported income was directly
- 31 -
received by Barrow."
The Commissioner argues that this direct-
income theory is consistent with his corporate-diversion theory
because in both cases, the income is taxable to Barrow.
The
Commissioner says he is simply adding another layer by
determining that the income is also taxable to BACO."
Even though we agree with Barrow that the government's
position has changed between the criminal case and this one (as
we explain later in discussing judicial estoppel), there
are relatively minor items of unreported income or incorrect
expenses whose consequences for Barrow's tax liability are
unaffected by the switch in government theories between the
cases.
At the criminal trial, the government had the burden to
establish willful tax evasion beyond a reasonable doubt.
Because
the jury didn't have to return a verdict detailing which items of
income Barrow hadn't reported or which items of expense he hadn't
Recall that the government had to prove an underpayment
in the criminal case. But the government wasn't required to
prove the specific amount of the underpayment, just that an
underpayment of tax existed.
See Moore v. United States, 360
F.2d 353, 356-57
Memo. 1997-133.
(4th Cir.
1965); Wapnick v. Commissioner, T.C.
Corporations are subject to double taxation because the
Code taxes income f.irst when the company receives it and then
again when the company distributes it to its shareholders.
See
Prescott v.
Commissioner,
66 T.C.
128,
138
(1976), affd.
561 F.2d
1287 (8th Cir 1977).
For a historical account of the development
of double taxation, see Bank, "Is Double Taxation a Scapegoat for
Declining Dividends? Evidence From History", 56 Tax L. Rev. 463,
479-516
(2003).
- 32 -
substantiated, we have no way of figuring out any precise
deficiency from the judgment in the criminal case.
We do know
that the Commissioner's burden to prove fraud here by clear and
convincing evidence is a lower standard than the U.S. attorney's
burden of proving Barrow's willful evasion beyond a reasonable
doubt.
And we know from the jury's verdict that at least some
part of Barrow's underpayment for 1985, 1987, and 1988 is
attributable to fraud.
We have also previously stated:
it is now well settled that the criminal judgment of
conviction requires application of the doctrine of
collateral estoppel and that * * * at least part of any
underpayment for the prosecution years must be deemed
already to have been judicially determined to be "due
to fraud" within the meaning of section 6653(b).
C.B.C. Super Mkts.,
Commissioner,
54 T.C. at 893; see also Rodney v.
53 T.C.
287,
305
(1969).
Because a portion of the
deficiencies that were at issue in the criminal case remains at
issue in this case, we cannot say that the fraud issue as it
related to the individual deficiencies is different.
2.
Did the Parties Actuallly Litigate the Issues and
Was There a Resolution Essential to the Prior
Decision?
The issue of whether or not Barrow evaded tax was litigated
in the criminal case.
The jury agreed with the Government that
Barrow evaded tax in 1985, 1987, and 1988.
Because we have held
that a conviction for evading tax decided the issue of whether
some part of Barrow's underpayment was due to fraud, we agree
I
- 33 -
with the Commissioner that the parties actually litigated the
issue and there was a resolution in the Government's favor.
3.
Have the Controlling Facts and Applicable Legal
Rules Remained Unchanged From Those in the
Criminal Case?
The applicable legal rules remain unchanged--both criminal
tax evasion and civil tax fraud require proof of an underpayment.
Sec.
7201; United States v. Heath,
525 F.3d 451,
2008); Niedringhaus, 99 T.C. at 210.
456
(6th Cir.
The controlling facts
relevant to Barrow's criminal tax evasion are also the same as
those the Commissioner argues apply in this case--at least with
regard to part of Barrow's individual income-tax deficiency not
attributable to the new theory of corporate diversion.
And there
are no new facts that weren't available to the parties in the
criminal case.
States,
Barrow urges us to consider Boulware v. United
552 U.S. __,
128 S. Ct.
1168
(2008), as a change in the
applicable legal rules sufficient to defeat the application of
collateral estoppel."
Boulware held that a shareholder in a
criminal tax evasion case can claim that distributions from his
company were a return of capital, without producing evidence that
he or the company intended this type of distribution.
Id.
But
On April 15, 2008, Barrow filed a motion asking us to
take judicial notice of Boulware, a motion which in effect
allowed him to cite supplemental authority for his case. We
asked for a response from the Commissioner, in which he correctly
argued that the proper venue for deciding the impact of the
Boulware decision is District Court.
- 34 -
the Commissioner is correct in asserting that the theory pursued
by the government in Barrow's criminal case didn't involve this
issue.
We therefore collaterally estop Barrow from denying fraud
for tax years 1985, 1987, and 1988.
This means we can redeter-
mine Barrow's tax liability for those years.
The Commissioner,
however, must still prove fraud for Barrow's individual income
tax in years 1984 and 1986, an issue that we analyze below in
redetermining the deficiency for all five years."
The Commissioner is not alone in urging estoppel.
too, raises the issue.
estoppel.
Barrow,
But the theory he argues for is judicial
Judicial estoppel is a doctrine that prevents a party
from winning judicial acceptance of a theory in one case, only to
pursue a contradictory theory later.
U.S. 742,
(1995)
(2001); Fazi v. Commissioner,
105 T.C.
436,
(citing Huddleston v. Commissioner,
100 T.C.
17,
(1993)).
749
New Hampshire v. Maine, 532
445
28-29
The rule's purpose is to "protect the integrity of the
judicial process ... by prohibiting parties from deliberately
changing positions according to the exigencies of the moment."
New Hampshire v. Maine, 532 U.S. at 749-50
quotation marks omitted).
(citations and
"Judicial estoppel does not bar a
party from contradicting itself, but from contradicting a court's
Because we have found no underpayment for BACO, see infra
p. 50, we need not consider whether its 1988 and 1989 returns
were fraudulent.
- 35 -
determination that was based on that party's position."
Teledyne
Indus.,
1990).
Inc. v. NLRB,
911 F.2d 1214,
1217 n.3
(6th Cir.
This doctrine generally requires us to accept the earlier of
the two inconsistent positions.
Huddleston, 100 T.C. at 26.
Factors that may lead us to judicially estop the Commissioner
from adopting a new position in this case include, but are not
limited to, the following:
042 Is the government's later position "clearly
inconsistent" with its earlier one?
042 Did the government succeed in persuading the
criminal court to accept its earlier
position?
042 Would the Commissioner derive an unfair
advantage or impose an unfair detriment if
not estopped?
Maine v. New Hampshire, 532 U.S. at 750-51; Bussell v.
Commissioner, T.C. Memo. 2005-77, affd. 262 Fed. Appx.
Cir. 2007).
770
(9th
It's Barrow's burden to show that the government
took a contrary position in a prior proceeding and that this
position was accepted by the court.
1218.
Teledyne Indus., 911 F.2d at
Barrow has easily borne this burden by pointing to the
Commissioner's rather startling admission that the government
changed theories because it didn't think the jury was smart
enough to understand what he now says really happened--the
diversion by Barrow of money owed to BACO.
The Commissioner says he's merely adding the double tax
component to the previous determination.
We disagree.
The
- 36 -
government's positions in the two cases are inconsistent because
the corporate-diversion theory doesn't simply increase Barrow's
deficiencies, it changes both the nature of the income and the
computation of the tax owed by both BACÓ and Barrow.
We find this case similar to Warda v. Commissioner, 15 F.3d
533
(6th Cir.
1994), affg. T.C. Memo.
1992-43,
in which a
taxpayer argued in a will contest case that she was the owner of
certain real estate and in a later tax case argued that her son
was the owner, in order to claim that the transfer of real estate
to her son was a tax-free gift.
The appeals court determined
that the outcome of the earlier case turned on the question of
the property's ownership--the taxpayer benefiting from being the
owner in the first case--so that her change in theory represented
a "knowing assault on the integrity of the judicial system."
at 539 (citation and quotation marks omitted).
Id.
Although we won't
accuse the IRS of trying to "assault *** the integrity of the
judicial system," it remains true that IRS witnesses helped
convict Barrow with the simple story that he was receiving income
directly from NCH and CCHS that he didn't report on his income
tax returns and are now trying to help the IRS win by testifying
that Barrow was really taking money from his firm that wasn't
owed to him personally--a theory that would allow the
Commissioner to tax BACO on that income and then tax Barrow again
on what the government now calls dividends.
We should probably
- 37 -
be flattered that the Commissioner thinks us more intelligent
than the jury, but we hold that such flattery only gets him
estopped here.
We also hold, in the alternative, that money Barrow earned
from his hospital chairman's fees was not actually a "corporate
diversion."
The Commissioner argues that all compensation Barrow
earned from his relationship with the hospital should be taxed as
corporate income because BACO's noncompete policy allowed BACO to
claim as corporate income any compensation earned by BACO
employees performing competing services.
The Commissioner offers
little explanation for why money that never reached BACO, and to
which BACO never had unfettered access, should nonetheless have
been claimed on BACO's corporate tax return rather than Barrow's
individual return.
The problem with this argument is that BACO's noncompete
policy appears to be, in the words of Captain Barbossa, "more
what you'd call guidelines than actual rules."
Pirates of the
Caribbean: The Curse of the Black Pearl (Walt Disney Pictures
2003).
The trial exhibits show no sign of a written policy.
And
though trial testimony was more useful in fleshing out the
boundaries of the policy, it still gave us no clear sense of when
BACO's interest in the money might have attached, potentially
leaving us adrift in the ocean of contract law.
Further
complicating this issue is the fact that at least one court has
- 38 -
found that a corporate interest in the form of a constructive
trust attaches immediately upon a fiduciary's misappropriation of
corporate funds.
883,
885
See, e.g., Murphree v. United States, 867 F.2d
(5th Cir. 1989).
If Michigan follows similar law, the
Commissioner would have a colorable argument that Barrow's
hospital income was actually attributable to BACO, if the
government can prove that this was a misappropriation of a
corporate opportunity.
The Commissioner argued none of this, however, and so we
find that the policy simply affirmed BACO's adherence to the
common-law doctrine of the fiduciary duty of loyalty, as codified
in Mich. Comp. Laws Ann. secs.- 450.1541 (West 1973), commonly
known as the Michigan Business Corporation Act (MBCA).
Because
BACO was incorporated in Michigan, we look to Michigan common law
and the MBCA to determine whether a breach of duty occurred and
if so, when BACO's interest in the money attached.
We look to
the laws in place at the time of the behavior in question; in
this instance, the version of the law in effect from 1977 through
the end of 1989 would control.
Under Michigan common law, an officer or director
misappropriates a corporate opportunity and thereby breaches his
fiduciary duties when
there is presented to a corporate officer or director a
business opportunity which the corporation is
financially able to undertake which is, from its
nature, in the line of the corporation's business and
- 39 -
is of practical advantage to it, and which is one in
which the corporation has an interest or a reasonable
expectancy, and if, by embracing the opportunity, the
self interest of the officer or director will be
brought into conflict with that of this corporation
***
Prod. Finishing Corp. v. Shields,405 N.W.2d 171,
App. 1987)
174
(citations and quotation marks omitted).
such a breach,
(Mich. Ct.
In cases of
"all profits made and advantage gained by the
agent in the execution of the agency belong to the principal."
Mechem, 1 Mechem on Agency (2d Ed.), sec. 1224
Finishing,
(cited in Prod.
158 Mich. App. at 486).
For all periods before September 1987, when Barrow became a
full-time manager, it is not clear that Barrow's hospital income
was "in the line of the corporation's business" or that BACO had
"an interest or a reasonable expectancy" in the income.
During
that time Barrow served only as director and chairman of the
hospital.
We think it illogical to assume that an accounting
firm would want or benefit from a position as director or
chairman of a troubled hospital; we therefore find these
activities to be mere civic activities for Barrow.
Our reasoning is different for the period from September 17,
1987 through March 31, 1989, a time during which Barrow provided
accounting services and BACO staff to help the hospital's billing
and accounting departments.
Barrow admits that during this time
income he earned from the hospital should have been turned over
to BACO.
Therefore, the only time in which BACO may have had an
- 40 -
interest in Barrow's income would be September 17, 1987, through
March 31, 1989.
But we find it unnecessary to reach the question
of whether Barrow actually breached a fiduciary duty during that
time, because even if Barrow breached his fiduciary duty by
misappropriating the hospital income, under Michigan law BACO
should have filed suit against Barrow to recover the alleged
interest in the misappropriation "within 3 years after the cause
of action has accrued, or within 2 years after the time when the
cause of action [was] discovered."
450.1541(2) (West 1989).
Mich. Comp. Laws Ann. sec.
Therefore, even if Barrow did breach his
fiduciary duty and violate the noncompete policy, BACO never
actually filed suit, either within the following 3 years or
within 2 years after his criminal conviction in which his alleged
misappropriation was revealed.
Such a suit was never brought,
and the money remained with Barrow under an undisputed claim of
right.
Therefore, we find that Barrow correctly put this money
on his 1040 rather than on the BACO corporate return.
C.
Fraudulent Intent
The Commissioner must prove fraud separately for Barrow's
1984 and 1986 tax years, and for BACO's 1988 and 1989 tax years.
See Temple v. Commissioner, T.C. Memo. 2000-337, affd. 62 Fed.
Appx. 605
(6th Cir. 2003).
The Commissioner may use
circumstantial evidence to meet his burden--this includes using
Barrow's entire course of conduct during the tax years at issue.
- 41 -
Parks, 94 T.C. at 664.
But we won't find fraud where the
circumstances merely lead to a suspicion of fraud.
Id.
To show
fraud by circumstantial evidence, the Commissioner may point to
what we have identified as "badges of fraud"--factors which tend
to show the required intent to evade tax.
These include these
badges which the Commissioner argues apply to this case:
042 Pattern of consistent underreporting of
income, Miller v. Commissioner, T.C. Memo.
1989-461;
042 Failure to keep adequate books and records,
Richardson v. Commissioner, 509 F.3d 736, 743
(6th Cir. 2007), affg. T.C. Memo. 2006-69;
Bradford v. Commissioner, 796 F.2d 303, 308
(9th Cir.
1986), affg. T.C. Memo.
1984-601;
042 Diverting corporate assets for personal use,
Solomon v. Commissioner, 732 F.2d 1459, 1462
(6th Cir. 1984), affg. T.C. Memo. 1982-603;
042 Education and business knowledge of the
taxpayer, Solomon, 732 F.2d at id. 1461;
042 Prior tax-related convictions, Wright, 84 T.C.
at 643-44; and
042 Dishonest dealings with others, Solomon, 732
F.2d at 1462.
As we noted in discussing the effects of Barrow's conviction, the
Commissioner doesn't have to prove the exact amount of the
underpayment resulting from the fraud, only that fraud
contributed to a portion of the underpayment.
Commissioner, T.C. Memo. 1989-461.
See Miller v.
No single factor is
necessarily sufficient to establish fraud by itself, but a
combination of factors may be persuasive.
Ferguson v.
- 42 -
Commissioner, T.C. Memo. 2004-90.
We address each of the
Commissioner's arguments in favor óf finding fraud.
1.
Consistent Pattern of Understating Income
The Commissioner claims that Barrow--and consequently BACO-engaged in a consistent pattern of understating income, and that
this habit is an indicator of fraud.
There are two categories of
BACO income that the Commissioner believes the company excluded
which relate to adjustments made to Barrow's individual income.
The first category includes all checks payable to BACO but
deposited into Barrow's personal account.
Barrow's response is
that they represent repayment of loans he made to BACO.
The
Commissioner says that, despite the riepayment theory, it remains
income to BACO because the payor's intent was to pay BACO.
no one disagrees:
But
The Commissioner admits that, after a thorough
examination of the available records, BACO reported all but one
of the checks in this category as income on its books.
$8,352 check from Ernst & Whinney was not included.
Only the
The
Commissioner does claim that the money Barrow deposited in his
personal checking account as loan repayments should be income to
Barrow because there were no written loan agreements in place
between Barrow and his company.
Althpugh no written loan
agreement existed between Barrow and BACO, Cynthia Nobles,
William Aldridge, and even IRS agent Stephen Wernert all
testified that they knew Barrow made loans to BACO.
Because
- 43 -
there were never any written loan documents and Barrow maintained
authority over BACO's general ledger, the Commissioner argues
that it's possible that Barrow was simply lending BACO its own
funds and that Ms. Nobles couldn't have known the actual source
of funds for the loans."
But this is sheer speculation.
Based
on credible testimony at trial, we find that Barrow made loans to
his own business from his own funds during hard times.
But, even
so, the Commissioner says, Barrow should have posted loan
repayments to BACO's general register and issued a check as
repayment of the debt.
This may have been better business
practice, but its absence is not a plausible marker of fraudulent
intent in this case.
Given Barrow's hectic schedule during those
years and the fact that BACO was closely owned, there is no way
we can find he had fraudulent intent when he deposited funds
directly into his own account after recording the funds as income
on the BACO ledger.
The second categ.ory of purported BACO income consists of the
checks paid to Barrow from NCH and its affiliates for board of
directors' and chairman's fees.
The Commissioner points to
BACO's policy that all income earned by its officers and
employees from clients for services the.firm also offered was
income to BACO.
But we've already found the Commissioner's
" We must note that the Commissioner includes imputed
interest income resulting from these contested loans in the
notice of deficiency.
- 44 -
position on corporate diversion is judicially estopped, and in
the alternative, that he cannot now e!nforce BACO's noncompete
policy to recategorize the income without showing that BACO
itself successfully sought to recover it.
The Commissioner also claims two additional types of
underreporting by Barrow individually
One involves unreported
wages from BACO, and another comes from CIS.
The Commissioner
used the bank-deposits method--a method long approved by our
Court, see Estate of Mason v. Commissioner, 64 T.C. 651, 656
(1975), affd. 566 F.2d 2
(6th Cir. 1977)--to reconstruct what he
believes to be CIS's true income.
"The bank deposits method
assumes that all money deposited in a taxpayer's bank account
during a given period constitutes taxable income."
Commissioner, 96 T.C. at 868.
DiLeo v.
Barrow argues that the
Commissioner uses a different method of accounting than he did to
construct his CIS income making it is impossible for him to
determine where his own errors may lie.
But Barrow is confusing
method of accounting with method of proof.
The Code requires the
Commissioner to use a taxpayer's method of accounting (i.e. cash
or accrual) as long as it clearly reflects income.
Sec. 446(a).
But the Commissioner can use a variety of methods, including the
bank-deposits method, to prove that Barrow underreported his
income.
Holland v. United States, 348 U.S. 121,
Goichman v. Commissioner, T.C. Memo. 1987-489.
130-132
(1954);
- 45 -
Barrow agrees that he understated his income for several
years, but he also claims that the understatements were much
smaller than the Commissioner alleges and due to unintentional
errors.
Because of the importance of this issue, we will analyze
each year that is not subject to collateral estoppel individually
to determine what portion of the understatements Barrow can
credibly defend.
But we are aware he need not prove errors in
the deficiency determinations themselves.
As we have previously
explained, we will not "bootstrap a finding of fraud upon a
taxpayer's failure to prove [the Commissioner's] deficiency
determinations erroneous."
Parks, 94 T.C. at 661.
Barrow only
needs to prove by a preponderance of the evidence that he lacked
fraudulent intent to remove this as a badge of fraud.
a.
1984
The following chart summarizes changes the Commissioner made
to Barrow's individual adjusted gross income (AGI) during the
audit for 1984, and reflects the changes that Barrow concedes:
- 46 -
C
n§ei
041gjBarj@ffs
1
yIRS
r
BACO dividends
$7,694.07
---
NCH board fees
---
$785
CCHS board fees
---
3,536
CIS schedule C receipts
23,627.43
23,627.43
BACO salary
76,015.84
76,015.84
Total understatement
107,337.34
103,964.27
Although he admits an understated amount similar to the one
calculated by the Commissioner, Barrow contends he didn't commit
fraud with regard to any portion of it in 1984.
He claims the
amounts the Commissioner calculates as BACO dividends were
actually loan repayments.
As for the missing NCH board fees, he argues that the
original NCH Form 1099 reported fees of only $3,373.07.
After
reviewing payment records, Barrow now concedes he should've
reported $785 more but says his was an honest mistake caused by
his using the number reflected on the original Form 1099.
He
also now concedes that his CCHS fees began in December 1984, but
he says he didn't receive a Form 1099 from CCHS for.that first
payment, and as a result he unintentionally failed to include
those fees on his 1984 return.
He also admits that he
underreported the CIS receipts but says that it is a result of
errors made by Nobles when she prepared the CIS books.
errors included deposits omitted from the CIS ledger.
These
- 47 -
Finally, Barrow agrees that he underreported his BACO
salary, but he says this was because he mistakenly used his 1985
W-2 instead of the 1984 W-2.
He explains that he kept a separate
folder for each tax year and that somehow the 1985 W-2 got into
the 1984 folder.
This led Nobles to use the 1985 figure when
preparing the ledger Barrow later used to prepare his taxes.
Barrow's assertion that he received an incorrect Form 1099
from CCHS in 1984 is credible.
We've recounted the chronic
disorganization at the hospital already--a problem that later led
BACO to step in and start helping in 1987.
It's reasonable that
Barrow unintentionally made mistakes reporting his CCHS board
fees because of the hospital's disorganization and Barrow's own
preoccupation with the mayoral race during those years.
We are also convinced that Nobles made significant mistakes
and that Barrow unintentionally missed many of them.
Nobles
testified that Barrow was her supervisor and generally the person
reviewing her work.
Donna West, a principal who started at BACO
in 1988, testified that she had the opportunity to review some of
Nobles's work and thought Nobles sometimes didn't pay enough
attention to detail.
The Commissioner argues that Barrow "turned
a blind eye" to Nobles's mistakes.
It's true that Barrow
probably should have taken steps, such as hiring a tax
accountant, to ensure proper reporting.
But "turning a blind
eye" indicates negligence, and "[f]raud 'does not include
- 48 -
negligence, carelessness, misunderstanding or unintentional
understatement of income.'"
Zhadanov v. Commissioner, T.C. Memo.
2002-104 (citation and quotation marks omitted).
Also, Nobles
worked closely with Barrow and credibly testified that he never
asked her to do anything improper or that she felt she shouldn't
do.
We will not use the underpayment in 1984 as a badge of
fraud.
b.
1986
The following chart reflects income changes made during the
IRS audit for 1986 that amounts to understated income and
Barrow's response:
Change to Bagogs
G
198
perëIRSyg f1R86fpergBarr,op
BACO dividends
$66,607.58
---
CIS schedule C receipts
24,399.47
24,399.47
BACO capital gains
Total understatement
1,450
92,457.05
---
24,399.47
Barrow says he didn't commit fraud with regard to any
portion of his underreported income in 1986.
He claims the IRS's
dividends and capital gains calculation improperly includes board
fees that he already included on his Form 1040 because they were
not earned in violation of BACO's policy.
It also includes
repayment to Barrow of BACO loans.
He accounts for the additional CIS income by explaining that
the IRS included in CIS's 1986 income two deposits made in
- 49 -
January 1987.
Because they were made in the following year,
Nobles didn't record them as 1986 income.
He concedes that these
payments are income in 1986, but he argues that this was an
honest mistake, not due to fraud.
We've already dismissed the Commissioner's arguments
regarding corporate diversion and determined that Barrow's loan
repayments weren't fraudulent.
For reasons similar to those
discussed earlier, we believe Nobles made mistakes and that
Barrow's explanation of those mistakes for 1986 are credible.
We
thus won't credit the underpayment from 1986 as circumstantial
evidence of Barrow's fraudulent intent.
We do find that there was a pattern of underreporting
because Barrow failed to report some taxable personal income to
the IRS each year from 1984 until 1988.
For the several reasons
provided in this section, however, we do not find this pattern of
underreporting to be a badge of fraud.
c.
BACO's 1988 and 1989 Income
The Commissioner claims that Barrow understated BACO's
income by not including the following items:
BACO's Unreported Income
Year
NCH
CCHS
NCC-W
NCC-E
Ernst &
Whinney
1988
$63,955.66
$64,811.55
---
---
1989
63,513.66
54,563.80
$4,500
9,000
8,352
- 50 -
We've already found that the fees paid to Barrow relating to
NCH and its affiliates do not belong to BACO but Barrow
individually.
This eliminates all of the income the Commissioner
claims BACO failed to report for these two years except the Ernst
& Whinney check.
Barrow concedes that he should've included this
check in BACO's 1989 income, but he says Nobles mistakenly
omitted it from the general ledger.
We believe him; and though
the omission of this check from the general ledger was mistaken,
and might be negligent, we find its òmission was not fraud."
2.
Failure To Keep Adequate Books and Records
The Commissioner contends that the books for BACO were so
poorly maintained that he was unable to reconcile the expenses
reported on BACO's tax return to BACO's general ledger.
He also
repeats his argument that the general ledger omitted large
amounts of gross income, including hospital chairman's fees paid
to Barrow for accounting services.
The Commissioner again points
out that BACO failed to include in gross revenues a check for
$8,352 from Ernst & Whinney in 1989.
Barrow again admits that he
" The elimination of the hospital fees from BACO's income
also means that BACO likely didn't understate its income for
these two years either.
The Commissioner looked back to tax
years 1983-87 to recalculate BACO's net operating loss available
for 1988 and 1989.
While he is able to use this method of
recalculation, see Hill v. Commissioner, 95 T.C. 437, 441 (1990),
he shouldn't have included the hospital fees in BACO's income for
purposes of the recalculation in those years either.
Because he
did so, he also improperly reduced the net operating loss
carryforward available for 1988 and 1989.
- 51 should've reported this check on BACO's return instead of his
own.
But Barrow also says that this was a mistake, one of many
small oversights that the IRS is adding together to portray
intentional misconduct.
And because we aren't considering BACO's
returns at all for this examination of fraud, many of the
Commissioner's arguments fall outside of our analysis.
The Commissioner also takes issue with Barrow's
recordkeeping for items relating to his personal income tax.
To
support this argument he refers us generally to the record, and
says that often Barrow's wages, dividends, and corporate
distributions were not accounted for in his personal checkbook.
But we've already detailed Barrow's credible response--he
mistakenly used the wrong W-2, relied on an incorrect Form 1099,
and received nontaxable loan repayments from BACO.
And we've
dismissed the Commissioner's corporate-diversion theory, so the
hospital fees were properly counted as his personal income.
The Commissioner also argues that Barrow's CIS checkbook
failed to reconcile with his Schedule C gross receipts.
After
completing a bank-deposits analysis, the Commissioner claims he
discovered that gross bank deposits exceeded gross receipts.
Barrow admits problems with his CIS ledger, but mainly attributes
these mistakes to errors made by Nobles.
Again, we believe
Barrow was negligent in his reliance on Nobles, but we found that
he didn't intentionally doctor the CIS books to hide income.
- 52 Although Barrow may have been careless with his bookkeeping,
there is no evidence that he attempted to conceal assets or
withheld information from the IRS during the audit.
In fact, we
find that Barrow cooperated with the IRS audit at all times.
See
Kemp v. Commissioner, T.C. Memo. 2004-153; McGowan v.
Commissioner, T.C. Memo. 2004-146 affd. 187 Fed. Appx. 915 (11th
Cir. 2006).
Barrow credibly testified that when IRS Agent Bulik
went to the BACO offices for information, he "went to the files
and gave him everything that was in the file," even copies of
draft agreements never put into place.
IRS Agent Bulik was asked
at trial about the condition of Barrow's business records, and
his response was that "[t]hey were easy to follow * * *
were in order."
[t]hey
Barrow's cooperation and Bulik's testimony about
his organization cut against any inference of fraud we might
otherwise draw from mistakes in his bookkeeping.
3.
Diverting Corporate Assets for Personal Use
The Commissioner argues that Barrow diverted BACO funds for
his own use, and that this is evidence of fraud.
But we've
already determined that the Commissioner cannot pursue this
theory.
The Commissioner also points out that Barrow tried to
conceal the receipt of NCH checks into his personal account by
stamping BACO's endorsement onto the canceled checks.
While we
.agree that this behavior was deceptive, we find that it was
- 53 intended to deceive Barrow's journalistic i.nquisitors, not the
IRS.
4.
Barrow's Education and Business Knowledge
The Commissioner portrays Barrow as someone sophisticated in
tax matters.
We agree that Barrow was highly educated and
experienced in accounting and finance.
But Barrow maintains that
his specialty was in auditing and financial reporting, and that a
CPA is not necessarily an expert in every area in which he has a
license to practice.
He even suggests that if he had a deeper
knowledge of tax law, he wouldn't have permitted himself to be
convicted on the basis of explainable transactions in the
criminal trial.
Barrow was an entrepreneur and budding
politician, mainly focused on the nontax activities of saving a
struggling hospital and expanding his reputation as a civic
leader in Detroit.
And even in cases that involve attorneys or
accountants with a proven knowledge of tax law, we have not found
fraud where the specific intent to evade tax didn't exist.
See,
e.g., Daios v. Commissioner, T.C. Memo. 1986-330.
5.
Prior Tax-Related Convictions
A criminal court convicted Barrow for tax evasion and
willfully filing false individual tax returns for 1985, 1987, and
1988, and for doing the same with respect to BACO's corporate tax
returns in fiscal years 1988 and 1989.
The Commissioner contends
that, although not dispositive, these convictions are evidence of
- 54 -
fraudulent intent in other years.
Barrow argues that his
convictions were wrongly decided, but since we don't have the
power to overturn them, we must take them at face value.
We
agree that this factor weighs against Barrow.
6.
Dishonest Dealings With Others
The Commissioner claims that Barrow engaged in a pattern of
deceptive conduct that reflects his fraudulent intent.
The
Commissioner argues the following behavior supports his claim:
First, the Commissioner says Barrow made false statements to
procure loans.
Barrow submitted unfiled tax returns to financial
companies showing more income than reported to the IRS in order
to obtain bank loans.
And a jury did convict him for making
false statements in connection with a bank loan application and
for bank fraud.
See 18 U.S.C. secs.
1014,
1344
(2006).
Second, the Commissioner says Barrow made false statements
to business associates.
The Commissioner claims Barrow concealed
his ownership of CIS from his colleagues on the board of NCH.
Barrow credibly testified that although he may not have
specifically disclosed CIS to be his personal Schedule C
business, he informed both NCH and the bankruptcy court that CIS
was affiliated with BACO.
We find that Barrow honestly thought
this somewhat analogous disclosure was enough.
The Commissioner also claims Barrow hid the same information
from the Bankruptcy court while serving as trustee of Salem
- 55 -
Mortgage, causing the court to approve a contract between Salem
Mortgage and CIS."
The application instead says that BACO owned
a minority interest in CIS.
Although this information isn't
accurate, it is consistent with Barrow's explanation that he
considered CIS to be part of the BACO business plan.
We find
that this half-hearted disclosure doesn't indicate that Barrow
had a pattern of dishonest dealings.
The Commissioner next argues that Barrow engaged in selfdealing by approving NCH's bills payable to BACO while requiring
his consent to pay other vendors in hard financial times.
Barrow
claims that while NCH had cashflow problems, he extended the
payment due dates of many of NCH's creditors.
And we already
have discussed how Barrow waited to cash some of the chairman's
fee checks until NCH had cash in the bank to actually pay those
obligations.
In this light, and with knowledge that BACO was
already reducing its normal rates for BACO employees working at
NCH, we find no evil intent or malicious purpose behind Barrow's
dealings with the hospital.
Finally, the Commissioner points out that Barrow made false
statements while campalgn1ng.
The Commissioner cites, and Barrow
admits to, lying to the media during Barrow's campaign by telling
one reporter that NCH wasn't paying him for his work on the board
is Salem Mortgage was one of BACO's clients. When it
slipped into bankruptcy, Barrow became its court-appointed
trustee.
and with the hospital affiliates.
Barrow admits that he wasn't
always forthright with the media during his campaigns in 1988 and
1989, but again we attribute this more to fear of candor's effect
on his political career than proof of an intent to defraud the
IRS.
Despite Barrow's many mistakes, we find that the
Commissioner offers no clear and convincing proof that Barrow
possessed the specific intent to evade a tax that he believed he
owed for 1984 or 1986, or that BACO owed for 1988 or 1989.
We
therefore find, not just that the Commissioner has failed to show
by clear and convincing evidence that Barrow filed his 1984 and
1986 tax returns, and BACO's 1988 and 1989 tax returns, with
fraudulent intent, but that Barrow had no fraudulent intent with
regard to any portion of his 1984 and 1986 underpayments, or
BACO's 1988 and 1989 underpayments.
We therefore hold that the
statute of limitations imposed by secition 6501(a) precludes the
Commissioner from assessing the deficiencies and additions to tax
that might otherwise be due for those years.
II.
Determination of Barrow's 1985,
1987, and 1988 Tax Liability
Our task for the years in which Barrow is collaterally
estopped from denying fraud is to redetermine the amount of
Barrow's deficiency.
As a general rule, we presume that the
Commissioner's determinations in a notice of deficiences are
correct, and Barrow bears the burden of proving those
- 57 -
determinations wrong.
290 U.S.
111,
115
See Rule 142(a) (1); Welch v. Helvering,
(1933).
We begin by discussing the categories of income in dispute
for all three years.
First, as we have already found, the
Commissioner is judicially estopped from pursuing his corporatediversion theory here.
Therefore, all of the NCH and CCHS fees
are income to Barrow directly.
Barrow claims that he would
sometimes refrain from cashing the hospital's checks when they
were issued because he knew the hospital didn't have the money to
pay him.
Some of the checks the hospital issued near the end of
a calendar year were held over until the next year because of
this.
Barrow reported those checks in the year he cashed them
because he believed the hospital's lack of cash on hand was a
restriction on his ability to get paid.
We agree with Barrow.
We have held that when a payee knows there are insufficient funds
and that knowledge causes him to refrain from cashing a check,
the payment is income to him in the later year rather than the
earlier.
Blumeyer v. Commissioner, T.C. Memo. 1992-647
(discussing knowledge of insufficient funds as an exception to
the relation back doctrine).
To the extent Barrow reported fees
in a year subsequent to the check's issue date because of
insufficient funds, we find him taxable in the later year.
Second, we find that all of the checks made payable to BACO
that Barrow deposited into his account as loan repayments are
- 58 -
neither capital gains nor ordinary income taxable to Barrow.
Theodore v. Commissioner,
38 T.C.
1011,
1040-41
(1962).
See
The
Commissioner admits that all of the checks were recorded in the
BACO ledger and although Barrow should've deposited them into a
BACO account and then issued a check for loan repayment, we find
that this mistake doesn't change the character of this income.
A.
Issues for 1985
After resolution of the corporate-diversion and loan-
repayment issues above, there remain only these challenged items
from his 1985 tax return:
Disputed 1985 Adjust'ments:
Item
Per IRS
Schedule C Depreciation
Schedule C Receipts - CIS
Per Barrow
$11,777.36
$8,877.36
1,000
--
Barrow claimed $2900 Schedule C depreciation for his 1977
Cessna airplane in 1985, which the Commissioner denied.
He and
Barrow now argue over substantiation and whether Barrow used the
plane for business, rather than personal, reasons.
Barrow says
that he provided trip and engine logbooks, as well as time slips
and other substantiation of the plane expenses, to Agent Bulik.
Initially, Bulik testified that Barrow showed him some records
relating to his airplane, but that Barrow wouldn't let him take
them or make copies.
Later on, Bulik recalled that during the
audit he used copies of documents showing the use of the plane,
- 59 -
records of places traveled, and an engine log to deny the
expenses.
Barrow claims the Commissioner lost the material he
handed over for substantiation, and argues that he's entitled to
an inference that if the records were available, they would favor
him.
He also asks us to apply the Cohan rule and estimate the
amount of the expenses.
See Cohan v. Commissioner, 39 F.2d
540(2d Cir. 1930).
It is a rote statement for this Court to declare that the
taxpayer bears the burden of proving a claimed deduction.
INDOPCO,
Inc. v. Commissioner,
503 U.S. 79,
84
(1992).
The
taxpayer must maintain records sufficient to substantiate such
amounts.
Sec. 6001; sec. 1.6001-1(a), Income Tax Regs.
But when
the taxpayer is unable to meet this burden because the IRS loses
his records, we may estimate the allowable amount.
The wrinkle
here is that section 274 (d) expressly overruled Cohan for certain
types of business deductions (including travel) by imposing
strict substantiation requirements.
827
See Sanford v. Commissioner,
50 T.C.
823,
(1968), affd. per curiam 412 F.2d 201
(2d Cir.
1969).
Barrow appears to have provided documentation--the
logbook--that would have complied with section 274 (d), but it was
lost by the IRS and there are no backup copies available.
Section 1.274-5A(c) (5), Income Tax Regs., exempts a taxpayer from
these strict requirements when there is a loss of records beyond
his control.
That's what happened here.
Faced with such
- 60 -
difficulties, we believe Barrow's and Nobles's testimony that the
logbook verifies that deductions taken in conjunction with the
plane were for business use, and characterize as a credible
substantiation their testimony that the logbook would also have
verified their amount.
We therefore sustain the amounts claimed
by Barrow on his returns.
Barrow also contests the Commissioner's upward adjustment of
CIS's income by $1,000.
Barrow says he is unable to determine
which deposit contains an error and account for the difference
because the IRS switched from the "bank deposits method of
accounting" to the "taxable checks" method in order to make this
adjustment, and in any case didn't reconcile their method of
accounting with the cash method that he used for CIS in the same
year.
We've already pointed out that the Commissioner may use a
variety of methods of proof to uncover a taxpayer's unreported
income.
And Barrow's complaint about this isn't enough to meet
his burden to refute the Commissioner's determination, so we find
that he is liable for the $1,000 difference.
There are two additional 1985 computations that Barrow
disputes--the addition of self-employment tax and the AMT.
Barrow admits that he failed to include the self-employment tax
calculation when he filed his 1985 tax return, and that he was
liable for the tax.
Since both items are computational, they
will be recalculated under Rule 155.
But Barrow also seems to
- 61 dispute whether these items can be counted as part of the 1985
deficiency for purposes of the fraud penalty if all of the
information needed to calculate them was available on his
original ret.urn as filed.
We think this issue is directly
related to the computation of the fraud penalty, and we address
it below.
B.
Issues for 1987
Barrow concedes that his 1987 CIS income should increase by
$11,279 because he is now unable to find his ledger for that
year, and agrees with other adjustments made by the Commissioner.
We have found against.the Commissioner on the issue of whether
Barrow was receiving corporate distributions rather than
repayments of loans.
There remain only these challenged items
from his 1987 tax return:
Disputed
Item
Sch C Depreciation
987@diu tments
Per IRS
Per Barrow
$8,803.49
$5,903.49
Sch C Expenses
13,799
10,237.28
Cost of Sales
6,500
---
Imputed Interest Income
3,693.03
---
Passive Partnership /1120S
5,658.75
---
Barrow claimed Schedule C depreciation and expenses for his
car, boat, and plane in 1987.
The Commissioner denied all of the
expenses and Barrow now contests only those related to his
airplane -- $2900 for depreciation, and $3561.72 for other
- 62 -
expenses.
He makes the same argument that he did for his 1985
airplane expenses, we agree with him.again.
Barrow provides a recalculation of his tax liability for
1987 in a simple chart.
As part of this effort, he determines
that there should be no adjustment for cost of sales, imputed
interest income, or passive partnership income.
The notice of
deficiency explains that the cost of goods sold was reduced by
$6500 because Barrow didn't establish that the amount was paid or
incurred during 1987 or that the expense was ordinary and
necessary.
The notice of deficiency also determines that "since
[Barrow] made loans to [BACO] at below market interest rates,
interest income is imputed to [him]
for 1987 and 1988."1'
Finally, the passive partnership adjustment stems from a
determination that the losses from Hambrose Leasing, an entity on
Barrow's return not otherwise involved in this case, are subject
to at-risk limitations and passive-loss limitations for 1987 and
1988.
Barrow fails to explain why he disputes these items.
Therefore, he doesn't meet his burden to show that the notice of
deficiency is wrong, and so we cannot relieve him of liability
for these items.
C.
Issues for 1988
19 Although this adjustment is inconsistent with the
Commissioner's theory in this case, it is consistent with our
findings that Barrow did in fact make loans to BACO.
- 63 -
There remain only these challenged items from his 1988 tax
return:
Item
Per IRS
Per Barrow
Interest Income
$(1,692)
Itemized Deductions
6,097.55
$4,750
2,751
844
Sch C Expenses
Imputed Interest Income
Loss on Sale of Asset
---
2,728.52
---
9,040
---
The Commissioner denied Barrow's Schedule C airplane
expenses of $1,906.45.
He makes the same argument that he did in
1985 and 1987, and we reach the same result.
Barrow also contests the adjustments to his interest income,
itemized deductions, imputed-interest income, and loss on sale of
asset.
The Commissioner claims that Barrow received $1,692 less
in interest than reported, and we are unsure why Barrow disputes
this adjustment.
In any event, we will sustain the Commissioner
on this.
The Commissioner reduces Barrow's itemized deductions by
$6,097.55.
Based on the notice of deficiency, it appears as
though Barrow agrees only with the reduction in his charitable
contributions to the extent of $4750.
Since Barrow makes no
argument with regard to any other of these changes, we find that
he doesn't meet his burden of proof.
The Commissioner also adds
imputed interest income, which we uphold for the same reasons we
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did for the similar 1987 adjustment.
Finally, the Commissioner
denies Barrow a loss on the sale of an asset because Barrow
failed to prove it was a loss he sustained.
Barrow makes no
additional showing here, so we must also uphold the
Commissioner's adjustment of this item.
III. Fraud Penalty
We've held that Barrow is collaterally estopped from denying
fraud for 1985, 1987, and 1988 for purposes of former section
6653 (b).
This makes for an interesting question:
to what extent
can we determine the portion of the deficiency subject to this
penalty for these years?
In 1985,
section 6653 (b)
SEC 6653 (b) .
read as follows:
Fraud --
(1)
In general.--If any part of any
underpayment (as defined in subsection
(c))of tax required tó be shown on a
return is due to fraud, there shall
be added to the tax an amount equal
to 50 percent of the underpayment.
(2) Additional amount for portion
attributable to fraud.--There shall be
added to the tax (in addition to the
amount determined under paragraph (1))
an amount equal to 50 percent of the
interest payable under section 6601--
(A) with respect to the portion of
the underpayment described in
paragraph(1) which is attributable
to fraud, and
(B)
for the period beginning on
the last day prescribed by law for
payment of such underpayment
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(determining without regard to any
extension)and ending on the date of
the assessment of the tax (or, if
earlier, the date of the payment of
the tax).
The 1985 statute leaves no room to determine that some part of
the deficiency was not due to fraud.
We also must address the issue of the computational
adjustments made to Barrow's 1985 tax liability for the AMT and
self-employment tax.
The Commissioner will recalculate Barrow's
1985 tax liability after we file this opinion and adjust the AMT
and self-employment tax calculations based on our findings, so we
need not settle disputes over the correct amounts of those
calculations now.
But because we are bound by the 1985 version
of section 6653(b) to apply the fraud penalty to the entire
underpayment for that year, the question arises:
Does the fraud
penalty also attach to adjustments that are purely computational
in nature?
We begin with the language of the Code:
SEC.6653 (c). Definition of Underpayment.-For purposes of the section,the term
"underpayment" means-(1)
Income, estate, gift, and certain
excise taxes.--In the case of a tax to
which section 6211 (relating to income,
estate, gift, and certain excise taxes)
is applicable, a deficiency as defined
in that section (except that, for this
purpose, the tax shown·on a return
referred to in section 6211(a) (1) (A)
shall be taken into account only if such
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return was filed on or before the last
day prescribed for the filing of such
return, determined with regard to any
extension of time for such filing)***
*
*
*
*
*
*
*
This tells us that an underpayment for purposes of section
6653(b) equals the deficiency as defined in section 6211.
And
section 6211 provided:
SEC. 6211(a).
In General.--For purposes of
this title in the case of income, estate, and
gift taxes imposed by subtitles A and B and
excise taxes imposed by chapters 41, 42, 43,
44, and 45 the term "deficiency" means the
amount by which the tax imposed by subtitle A
or B, or chapter 41,.42, 43, 44, or 45
exceeds the excess of-(1)
the sum of
(A)
the amount shown as the tax by
the taxpayer upon his return, if a
return was made by the taxpayer and
an amount was shown as the tax by
the taxpayer thereon, plus
(B)
the amounts previously
assessed (or collected without
assessment) as a deficiency, over-(2)
the amount of rebates, as defined
in subsection (b) (2), made.
Because the Commissioner included the AMT and self-employment tax
in the notice of deficiency, we find that if they still exist
after the computations called for by Rule 155, they are part of
the underpayment for purposes of the fraud penalty in 1985.
In 1987,
the Code provided:
SEC. 6653 (b). Fraud.--
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(1)
In general.--If any part of any
underpayment (as defined in subsection
(c)) of tax required to be shown on a
return is due to fraud, there shall be
added to the tax an amount equal to the
sum of-(A)
75 percent of the portion of
the underpayment which is
attributable to fraud, and
()B) an amount equal to 50 percent
of the interest payable under
section 6601 with respect to such
portion for the period beginning on
the last day prescribed by law for
payment of such underpayment
(determined without regard to any
extension) and ending on the date
of the assessment of the tax or, if
earlier, the date of the payment of
the tax.
(2) 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 is not attributable to
fraud.
(Emphasis added).
The 1987 statute may leave room for a
determination of which part of the underpayment is due to fraud.
In 1988, the statute read as follows:
SEC. 6653 (b). Fraud.--
(1)
In general.--If any part of any
underpayment (as defined in subsection
(c)) of tax required to be shown on a
- 68 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.
(2)
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 is not attributable to
fraud.
(Emphasis added).
As with 1987's, the 1988 fraud section also
allows a more precise determination of the amount of the
underpayment due to fraud.
The question remains:
can we
determine that there is no deficiency due to fraud for 1987 and
1988 in the light of our application of collateral estoppel in
this case?
We find the answer in our opinion in Franklin v.
Commissioner, T.C. Memo. 1993-184.
In that case, we found that
while the Commissioner had proven that the taxpayer had underpaid
his taxes, and that he had underpaid with fraudulent intent,
neither the taxpayer nor the Commissioner provided evidence of
the specific amount of that underpayment.
We said that "to
adjudicate an addition to tax under section 6653 (b) (2),
first we
must examine the evidence and satisfy ourselves as to the amount
that clearly and convincingly is an underpayment.
Then, we must
determine whether any or all of such amount clearly and
convincingly is due to fraud."
Id.
We also recognized that
estimating the taxpayer's underpayment at zero or a nominal
amount would be inconsistent with a guilty plea by the same
taxpayer to obtaining "substantial income" from certain illegal
activities.
Instead, we estimated the underpayment due to fraud
for each of the years at issue.
We face a similar task in this case.
While we acknowledge
that in the criminal case the government.proved beyond a
reasonable doubt that some part of Barrow's underpayments for
1987 and 1988 were due to fraud, the Commissioner in this case
failed to prove to us that any particular underpayments were
actually due to fraud.
We recognize that it would be
inconsistent to hold no part of the underpayment due to fraud, so
as we did in Franklin, we estimate that $500 in 1987 and 1988 was
due to fraud for purposes of applying the fraud penalty.
Conclusion
No part of any underpayment of Barrow's 1984 or 1986, or
BACO's 1988 and 1989, deficiencies was due to fraud and so we do
not sustain the Commissioner's determination for those years.
The parties will, however, need to compute Barrow's 1985,
1987,
and.1988 deficiencies,
so
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Decisions will be entered under
Rule 155..
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.