Kikalos, Nick v. United States ( 2005 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 04-1613
NICK KIKALOS and HELEN KIKALOS,
Plaintiffs-Appellants,
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
____________
Appeal from the United States District Court
for the Northern District of Indiana, Hammond Division.
No. 2:98CV618 PS—Philip P. Simon, Judge.
____________
ARGUED DECEMBER 2, 2004—DECIDED MAY 24, 2005
____________
Before BAUER, POSNER, and ROVNER, Circuit Judges.
POSNER, Circuit Judge. The plaintiffs brought suit for a
refund of federal income taxes, had a jury trial that resulted
in a verdict for the government, and appeal, complaining
about the jury instructions and the exclusion of much of
their evidence.
The plaintiffs, husband and wife, own three retail stores
in Hammond, Indiana. The stores operate under the name
“Nick’s Liquor” but sell cigarettes, beer, wine, soft drinks,
2 No. 04-1613
potato chips, and other snack food as well as hard liquor.
Most sales are cash sales; the stores do not accept credit
cards. Nick Kikalos, the husband, does the bookkeeping. He
testified that at the close of business each day he determines
the total receipts of each store from the cash-register
tape—the “Z” tape, as it is called—records the total in a log
book, then destroys the tape. The total receipts shown in the
log book are the amount that Kikalos reports to his accoun-
tant for use in preparing the plaintiffs’ tax return. Kikalos’s
stubborn refusal to retain the Z tapes has precipitated a
protracted struggle with the Internal Revenue Service. See
Kikalos v. Commissioner, 190 F.3d 791 (7th Cir. 1999); Kikalos
v. Commissioner, Tax Memo 2004-82, 87 T.C.M. 1146
(2004); Kikalos v. Commissioner, T.C. Memo 1998-92, 75
T.C.M. 1924 (1998).
The plaintiffs acknowledge that the Z tapes are the best
evidence of the stores’ receipts. The tapes record the actual
transactions with the customers, and, because they are
marked sequentially by the cash register, underreporting of
sales is often revealed just by gaps in the numbering.
Kikalos’s log book is a human copy that could deliberately
or accidentally underreport the totals on the Z tapes.
Taxpayers are required to maintain such “permanent books
of account or records, including inventories, as are sufficient
to establish the amount of gross income, deductions, credits,
or other matters required to be shown by such person in any
return of such tax or information.” 26 C.F.R. § 1.6001-1(a).
The records must “include the taxpayer’s regular books of
account and such other records and data as may be necessary to
support the entries on his books of account and on his return. . . .”
§ 1.446-1(a)(4) (emphasis added). Given the simple alterna-
tive of retaining the Z tapes and the inherently greater
reliability of the tapes, the plaintiffs’ records do not comply
with the requirement that we have italicized. E.g., Merritt v.
No. 04-1613 3
Commissioner, 301 F.2d 484, 485-86 (5th Cir. 1962);
Schwarzkopf v. Commissioner, 246 F.2d 731, 732-34 (3d Cir.
1957);Varjabedian v. United States, 339 F. Supp. 2d 140, 158-59
(D. Mass. 2004); 2121 Arlington Heights Corp. v. United States,
1996 WL 435051, at *2 (N.D. Ill. July 31, 1996), affirmed
under the name 2121 Arlington Heights Corp. v. IRS, 109 F.3d
1221 (7th Cir. 1997); Edgmon v. Commissioner, T.C. Memo
1993-486, 66 T.C.M. 1093 (1993). The government was
therefore entitled to estimate the plaintiffs’ total receipts and
the income that those receipts yielded (gross receipts minus
cost of goods sold) indirectly. Mendelson v. Commissioner, 305
F.2d 519 (7th Cir. 1962); Choi v. Commissioner, 379 F.3d 638,
640 (9th Cir. 2004); Stuart v. United States, 337 F.3d 31, 35 (1st
Cir. 2003). To determine net taxable income, other
costs—overhead costs like rent and salary—would have to be
deducted, 26 U.S.C. §§ 162(a)(1), (3); 26 C.F.R. § 1.162-1(a),
but that computation is not in issue.
Employing the “percentage markup” method of estima-
tion, commonly used in cases involving retailers, Cebollero
v. Commissioner, 967 F.2d 986, 989 (4th Cir. 1992); Lambaiso
v. Commissioner, T.C. Memo 1999-343, 78 T.C.M. 593
(1999); Rataiczak v. Commissioner, T.C. Memo 1999-285, 78
T.C.M. 362 (1999), the government assessed deficien-
cies, including penalties and interest, against the plaintiffs
for 1988 and 1989 of some $900,000. (The plaintiffs paid, and
brought this refund suit under 28 U.S.C. § 1346(a)(1) and 26
U.S.C. § 7422(a).) At trial, the government’s economic expert
witness explained how he had applied the percentage
markup method. He had first estimated from the stores’
purchase invoices the total amount and cost of the goods
that the plaintiffs had purchased. Those goods that the
stores advertised at stated prices he assumed were sold to
customers at those prices, and he determined the markup on
those sales by first subtracting the cost of the goods (that is,
4 No. 04-1613
what the plaintiffs had paid for them) from the advertised
price to yield an average percentage markup and then
multiplying the number of sales of price-advertised goods
by that percentage. He estimated on the basis of the stores’
total cost of goods sold and other data that only about 20
percent of sales were made at advertised prices. The markup
on other sales would be higher because stores tend to
advertise their best bargains; he estimated the markup from
data concerning stores similar to the plaintiffs’ stores.
The plaintiffs, while not doubting that the percentage
markup method is one of the methods legitimately used to
estimate taxable income indirectly, wanted to be allowed to
present their own expert testimony. Their expert would have
testified that the application to the plaintiffs’ business of
two other common methods of estimating taxable income
indirectly—the bank-deposits method, whereby receipts are
estimated from the bank deposits made by the taxpayer,
Estate of Kanter v. Commissioner, 337 F.3d 833, 859 (7th Cir.
2003) (per curiam), reversed in part on other grounds,
Ballard v. Commissioner, 125 S. Ct. 1270 (2005); Choi v.
Commissioner, supra, 379 F.3d at 639-40, and the net-worth
method, whereby income in a given period is inferred from
the increase in the taxpayer’s net worth between the begin-
ning and the end of the period, United States v. Marrinson,
832 F.2d 1465, 1469-70 (7th Cir. 1987); United States v. Shetty,
130 F.3d 1324, 1332 (9th Cir. 1997); Estate of Spear v.
Commissioner, 41 F.3d 103, 105 (3d Cir. 1994)—would
produce a more accurate estimate of the stores’ income. The
two methods, bank deposits and net worth, yield similar
estimates of the plaintiffs’ taxable income; and this concor-
dance, the expert opined, demonstrated the superior
robustness of the methods. We note that these are methods
used by the government to estimate a taxpayer’s income; their
use by a taxpayer’s expert witness is highly questionable
No. 04-1613 5
(and is not supported by any of the cited cases) since the ex-
pert will perforce base his calculations only on the docu-
mentation concerning banks, expenditures, etc. that the
taxpayer chooses to show him.
The district judge excluded the expert testimony not on
grounds of unreliability, however, but on the ground that
the government’s choice of the method of indirect estima-
tion to use in a particular case is conclusive. 313 F. Supp. 2d
876 (N.D. Ind. 2003). He excluded Kikalos’s log books on the
same ground. He further ruled that the plaintiffs could
prevail only by proving that the government’s assessment
of deficiencies was arbitrary. And so he instructed the jury
that the plaintiffs had the burden of proving not only “the
amount of the refund to which they are entitled” but also
“that the assessment by the Internal Revenue Service was
arbitrary.” He defined “arbitrary” for the jury as meaning
“without any rational basis” and he further instructed the
jury that “the question is not whether the IRS assessment
was accurate, but whether the IRS assessment was without
a rational basis or was arbitrary.” (No wonder the plaintiffs
lost.)
These instructions were incorrect (as well as confusing—
what would a term like “without any rational basis” mean
to the average juror? Cf. Gehring v. Case Corp., 43 F.3d 340,
343-45 (7th Cir. 1994); Gordon v. New York City Board of
Education, 232 F.3d 111, 118 (2d Cir. 2000)). The judge was
telling the jury that it was not enough for the plaintiffs to
prove that the government’s estimate of their tax deficien-
cies was incorrect. They had to prove that it was irrational.
In so ruling, the judge added an element to the statutory
entitlement to a refund. All the statute requires is that the
taxpayer prove that he overpaid his taxes. It doesn’t require
him to prove that the government’s assessment was not only
inaccurate but irrational. Suppose Nick Kikalos was a highly
6 No. 04-1613
credible witness and the jury believed he’d been scrupulous
about transferring the data in the Z tapes to his log book, a
belief the jury might find corroborated by the results of the
alternative indirect methods used by the plaintiffs’ expert.
We do not see on what basis a jury would be required to
disbelieve Kikalos’s testimony in favor of a rough method
of estimation, just because the estimation could not be
deemed irrational. There is nothing in the Internal Revenue
Code or its implementing regulations to suggest the imposi-
tion of so insuperable a burden on a refund plaintiff.
The district judge was misled by statements in refund
cases that the method of indirect estimation chosen by the
government is not to be rejected just because it enables only
a rough estimate, when it is the taxpayer, by having,
whether willfully or not, destroyed the best evidence of his
taxable income, that has forced the government to rely on a
rough estimate. E.g., Mendelson v. Commissioner, supra, 305
F.2d at 523; Stuart v. United States, supra, 337 F.3d at 35. The
courts don’t mean that the results yielded by the particular
method chosen by the government are conclusive on the
jury’s decision (or the Tax Court, when it is the trier of fact),
but only that a method doesn’t have to have a high degree
of accuracy to be admissible. For while the cases disparage
the taxpayers’ criticisms of the government’s rough methods,
they don’t rule the taxpayers’ alternative methods of compu-
tation inadmissible because irrelevant (they might of course
rule them inadmissible on some other ground). E.g., Brad-
ford v. Commissioner, 796 F.2d 303, 305-07 (9th Cir. 1986); cf.
Zuhone v. Commissioner, 883 F.2d 1317, 1327-28 (7th Cir.
1989); Choi v. Commissioner, supra, 379 F.3d at 640-41.
Analogous are cases in which the defendant’s conduct has
made it difficult for the plaintiff to determine his damages.
In an antitrust case, for example, if the defendant destroyed
the plaintiff’s business in its infancy, before it had a track
No. 04-1613 7
record from which expected profits could be inferred with
confidence, the jury is instructed that a rough estimate will
satisfy the plaintiff’s burden of production. J. Truett Payne
Co. v. Chrysler Motors Corp., 451 U.S. 557, 565-67 (1981);
Bigelow v. RKO Radio Pictures, 327 U.S. 251, 264-66 (1946);
Locklin v. Day-Glo Color Corp., 429 F.2d 873, 879-80 (7th Cir.
1970); Home Placement Service, Inc. v. Providence Journal Co.,
819 F.2d 1199, 1205-06 (1st Cir. 1987). The courts don’t mean
that the rough estimate is conclusive evidence and the
defendant can’t present his own estimate.
The analogy is not perfect. Because the government’s tax
assessment carries a presumption of correctness, Helvering
v. Taylor, 293 U.S. 507, 514 (1935); Sherwin-Williams Co. v.
United States, 403 F.3d 792, 796 (6th Cir. 2005), the taxpayer
who has failed to maintain adequate records has a deep row
to hoe in order to upset the government’s method, rough as
it necessarily is, of assessment in such a case. See, e.g.,
Pittman v. Commissioner, 100 F.3d 1308, 1313-14 (7th Cir.
1996); Zuhone v. Commissioner, supra, 883 F.2d at 1327;
Mendelson v. Commissioner, supra, 305 F.2d at 522; Page v.
Commissioner, 58 F.3d 1342, 1347-48 (8th Cir. 1995); Jones v.
Commissioner, 903 F.2d 1301, 1303-04 (10th Cir. 1990). A self-
reporting system of taxation would founder if taxpayers,
who have the best access to all relevant information, could
exploit the uncertainty created by their defiance, willful or
inadvertent, of the Tax Code’s record-keeping requirements.
But it is one thing to shift the burden of persuasion to the
taxpayer who fails to keep adequate records; it is another to
require him to prove that the government’s assessment was
not only inaccurate but downright irrational. There is no
statutory basis for shifting the burden that far.
However, the district judge excluded from evidence both
the testimony of the plaintiffs’ expert and the log books,
and if those rulings stand the plaintiffs cannot prevail at a
8 No. 04-1613
trial and the judge’s error regarding the plaintiffs’ burden
was harmless. The judge excluded both bodies of evidence
as irrelevant, as indeed they would have been had the judge
been correct that the government’s chosen method of
indirect estimation cannot be challenged. He can still, on
remand, exclude them from evidence if they are inadmissi-
ble under the federal rules of evidence; they merely are not
inadmissible as a matter of tax law. It might seem that they
fall within the hearsay exception for business records and
therefore are clearly admissible. Fed. R. Evid. 803(6). They
are indeed business records in the literal sense; but when the
record keeper, rather than being a clerical or professional
employee, is a principal with a strong motive to falsify the
records, the district judge may deem them so unreliable as
to be unworthy of consideration by the jury; in the language
of the rule, they are to be excluded if “the method or
circumstances of preparation indicate lack of trustworth-
iness.” See Wheeler v. Sims, 951 F.2d 796, 802 (7th Cir. 1992);
Bracey v. Herringa, 466 F.2d 702, 704-05 (7th Cir. 1972);
Romano v. Howarth, 998 F.2d 101, 108 (2d Cir. 1993). The
judge will have to determine whether this is such a case.
Concerning the admissibility of the plaintiffs’ expert testi-
mony, the judge will have to make the usual Daubert deter-
mination, Fed. R. Evid. 702; Kumho Tire Co. v. Carmichael, 526
U.S. 137 (1999); Daubert v. Merrell Dow Pharmaceuticals, Inc.,
509 U.S. 579 (1993), with due regard for the concern we
expressed earlier about a taxpayer’s use of the bank-deposit
and net-worth methods of income estimation.
REVERSED AND REMANDED.
No. 04-1613 9
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—5-24-05