Benavides & Co., P.C. v. Commissioner , 2019 T.C. Memo. 115 ( 2019 )

T.C. Memo. 2019-115UNITED STATES TAX COURT
BENAVIDES & CO., P.C., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
AL BENAVIDES AND LOUISE A. BENAVIDES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 6761-14, 6840-14. Filed September 9, 2019.
Al Benavides (an officer), for petitioner Benavides & Co., P.C.
Al Benavides and Louise A. Benavides, pro sese.
David W. Sorensen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PUGH, Judge: In these consolidated cases respondent determined the
following deficiencies and penalties in notices of deficiency issued to Benavides
-2-
[*2] & Co., P.C. (BCO), and Mr. and Mrs. Benavides (petitioners) on January 3,
2014:1
Docket No. 6761-14
Penalty
Year Deficiency sec. 6663(a)
2003 $46,725 $35,044
2004 86,402 64,802
2005 92,962 69,722
Docket No. 6840-14
Penalty
Year Deficiency sec. 6663(a)
2003 $77,597 $27,029
2004 81,092 19,221
2005 91,173 27,170
The issues for decision are whether: (1) BCO had unreported income from
an accounting and tax preparation business of $195,359, $102,584, and $215,580
for tax years 2003, 2004, and 2005, respectively; (2) BCO is entitled to a net
operating loss (NOL) carryforward from 2003; (3) petitioners received
1
Unless otherwise indicated, section references are to the Internal Revenue
Code of 1986, as amended, in effect for the years in issue. Rule references are to
the Tax Court Rules of Practice and Procedure, and monetary amounts are rounded
to the nearest dollar.
-3-
[*3] constructive dividends of $195,359, $132,584,2 and $215,580 for tax years
2003, 2004, and 2005, respectively, to account for gross receipts that were
“diverted” from BCO to other accounts or entities they owned and controlled;
(4) petitioners had unreported income from Sunrise, a partnership that they owned,
of $123,931, $88,593, and $66,628 for tax years 2003, 2004, and 2005,
respectively; (5) Mr. Benavides had self-employment income to reflect his shares
of partnership income from Sunrise of $42,219, $110,332, and $82,591 for tax
years 2003, 2004, and 2005, respectively; (6) Mrs. Benavides had self-
employment income to reflect her shares of partnership income from Sunrise of
$40,564, $106,006, and $79,352 for tax years 2003, 2004, and 2005, respectively;
(7) BCO is liable for fraud penalties under section 6663(a) of $35,044, $64,802,
and $69,722 for tax years 2003, 2004, and 2005, respectively, with respect to its
unreported taxable income; (8) petitioners are liable for fraud penalties under
section 6663(a) of $27,029, $19,221, and $27,170 for tax years 2003, 2004, and
2005, respectively, with respect to unreported constructive dividends from BCO;
2
The difference between BCO’s unreported income and petitioners’
constructive dividends determined by respondent for 2004 is attributable to
respondent’s failure to include in BCO’s unreported income a payment of $30,000
from Jeff Sorg that petitioners reported on a different entity’s return (Sunrise
Management and Development, LLC (Sunrise), discussed below). Respondent
determined that this was a payment to BCO but failed to include it in unreported
income when calculating BCO’s deficiency.
-4-
[*4] and (9) assessment and collection of the tax deficiencies are barred by the
statute of limitations.
FINDINGS OF FACT
I. Background
Some of the facts have been stipulated, and the stipulated facts are
incorporated in our findings by this reference. BCO’s principal office was in
Montana during the years in issue. Petitioners lived in Washington when they
timely filed their petition.
Mr. Benavides graduated from Washington State University with a degree
in accounting in 1971 and became a certified public accountant (C.P.A.) in 1976.
He was engaged in the business of preparing income tax returns and providing tax
advice from 1976 through the years in issue. Petitioners married before the years
in issue and remained married at the time of trial.
Mr. Benavides organized BCO as a professional services corporation in
1991 under the laws of Montana and was the sole owner and manager. A
subchapter C corporation, BCO filed Forms 1120, U.S. Corporation Income Tax
Return, since its organization. During the years in issue it offered various tax and
accounting services, including the preparation and filing of Federal income tax
returns, accounting and advisory services, and tax advisory services. These
-5-
[*5] services were performed by Mr. Benavides and three staff accountants who
worked under him and at his direction during the years in issue. Mrs. Benavides
performed clerical work at BCO, including data entry and some bookkeeping.
Petitioners formed Sunrise in 2000 as a partnership under the laws of
Montana with Mr. Benavides as a 51% partner and Mrs. Benavides as a 49%
partner. Sunrise was a real estate management and development business in
Kalispell, Montana. It also acted as a bill-paying entity for three or four of BCO’s
clients. They would pay Sunrise, and Sunrise would pay vendors and contractors
for services related to those individuals. Sunrise reported the payments it received
as income and the payments it made as business expenses. Sunrise performed this
same function for petitioners when they remodeled and made improvements to
their home and obtained other services, paying the personal service providers for
petitioners and deducting the payments as business expenses. But petitioners did
not reimburse Sunrise for these expenses. Respondent determined that Sunrise
paid vendors and other third parties $190,045, $208,156, and $268,609 in 2003,
2004, and 2005, respectively, for goods and services provided to petitioners or for
their personal residence and for other items determined to be for petitioners’
personal use or personal expenses.
-6-
[*6] Mr. Benavides also owned or controlled other LLCs and partnerships that
held real property in and around the Kalispell area, including an entity called La-
Jam Properties, L.P. (La-Jam). La-Jam was a partnership owned by petitioners
that acquired eight acres of land adjacent to petitioners’ residence in 2004. In
2004 Sunrise paid for construction of a 3,500-square-foot shop on La-Jam’s land
that petitioners used for storage. Apart from holding the land, La-Jam did not
conduct any business activities.
In 2011 Mr. Benavides entered a guilty plea to one count of assisting in the
preparation of a false or fraudulent income tax return in violation of section
7206(2). The offer of proof filed by the U.S. Attorney for the District of Montana
in Mr. Benavides’ criminal case stated that Mr. Benavides, through BCO,
collected “fees for services” from a client, purchased a personal item for the client,
and then assisted in preparing the client’s tax return claiming a business expense
deduction for the cost of the personal item mischaracterized as “fees.” Mr.
Benavides was imprisoned for 12 months and one day, was on supervised release
for one year, and paid a $25,000 fine.
II. BCO’s Tax Returns and Respondent’s Determinations
BCO filed Forms 1120 for the years in issue. Sunrise filed Forms 1065,
U.S. Return of Partnership Income, for the years in issue. Mr. Benavides or a
-7-
[*7] BCO employee working at his direction prepared the Forms 1120 and 1065
for 2003 and 2004; Brien Kreps, a C.P.A. who worked for BCO as its chief
financial officer, prepared the Forms 1120 and 1065 for 2005. BCO reported
income and expenses on the cash basis for income tax purposes. It used the
accounting software Practice Time Billing Software (PACS) to account for all
accounts receivable and payments. It used the Accountant’s Trial Balance (ATB)
program to determine its income for tax purposes.
BCO did not report as taxable income all of the payments it received for the
services it provided to clients. It reported payments that were deposited into BCO
accounts and entered into the ATB program; it did not report payments allocated
to Mr. Benavides individually or to Sunrise or other entities that Mr. Benavides
owned or controlled.
The mechanics of the payment allocations were simple. First, Mr.
Benavides would decide what a client should be billed for that month (for what
work and at what rate). When payments were received, Mr. Kreps would record
them in PACS. Mr. Benavides reviewed all payments received and decided which
payments were to be deposited into BCO accounts and which payments were to be
deposited into other accounts owned or controlled by petitioners. Amounts
deposited into BCO accounts then were recorded in the ATB program, typically by
-8-
[*8] Mrs. Benavides. She also typically would prepare deposit slips for the
various accounts although sometimes other clerical staff prepared them.
BCO also received merchandise or services from clients in exchange for its
accounting services. The merchandise or services were used by Mr. Benavides or
other staff members. These were referred to as “trades” and were recorded in
PACS as reductions in the client’s account receivable. They were not recorded in
the ATB program.
Monthly and annually, Mr. Kreps prepared spreadsheets that reconciled the
accounts receivable from the two accounting systems to each client’s payments.
He recorded all cash receipts that were not deposited into corporate accounts but
instead were deposited elsewhere or cashed. And he tracked the payments via
trades and whether the trades were used by petitioners or BCO staff.
On January 3, 2014, respondent issued a notice of deficiency to BCO for tax
years 2003, 2004, and 2005. Respondent determined that BCO understated its
gross income by failing to report the funds diverted from BCO to petitioners and
entities they owned or controlled, as well as the trade items petitioners converted
to personal use, in the following amounts: $195,359 for 2003, at least $102,584
-9-
[*9] for 2004,3 and $215,580 for 2005 (collectively, diverted gross receipts).
Respondent determined the amounts of the diverted gross receipts by performing a
bank deposit analysis of BCO’s bank records, reviewing its corporate and
financial records, and interviewing its clients and employees. BCO’s adjusting
journal entries from its general ledger showed that it had retained earnings of at
least $49,977 for 2003 and $65,639 for 2004 without taking into account the
diverted gross receipts.
BCO claimed NOL deductions of $114,280 and $50,026 for 2004 and 2005,
respectively. At the beginning of 2002 BCO reported accumulated NOL
carryovers of $70,822 attributable to NOLs in 1996 and 1997. BCO claimed
increases in NOLs of $43,513 for 2002 and $61,859 for 2003. Through a bank
deposit analysis respondent determined that BCO had underreported its income by
$131,994 for 2002, which would have eliminated the NOL that BCO claimed for
that year and also extinguished the accumulated NOL carryovers from 1996 and
1997. Likewise the underreported income for 2003 from the diverted gross
receipts would have eliminated the NOL that BCO claimed for that year. In the
notice of deficiency respondent disallowed the NOL carryover deductions claimed
3
Respondent did not seek to increase the deficiency to include in BCO’s
2004 unreported income the $30,000 payment from Jeff Sorg to BCO that was
diverted to Sunrise.
- 10 -
[*10] for 2004 and 2005. Additionally, respondent determined section 6663(a)
fraud penalties of $35,044, $64,802, and $69,722 for 2003, 2004, and 2005,
respectively.
The largest recipient of BCO’s diverted gross receipts was Sunrise.
Respondent, in the notices of deficiency issued to petitioners, reduced Sunrise’s
income by $98,986, $136,648, and $203,489 for 2003, 2004, and 2005,
respectively, to remove the amounts he determined had been diverted from BCO
to Sunrise. Respondent did not remove deposits from clients using Sunrise as a
bill-paying entity or disallow business expense deductions for Sunrise’s payments
on behalf of those individuals.
III. Petitioners’ Tax Returns and Respondent’s Determinations
Petitioners timely filed Forms 1040, U.S. Individual Income Tax Return, for
the years in issue. Mr. Benavides prepared those returns, and petitioners signed
them under penalty of perjury. Petitioners reported adjusted gross income of
$157,656, $194,882, and $236,032 for tax years 2003, 2004, and 2005,
respectively. Petitioners did not report the diverted gross receipts from BCO as
qualified dividends on their joint returns.
The Internal Revenue Service (IRS) audited petitioners’ joint returns for the
years in issue. In the course of the audit the agent examining petitioners’ returns
- 11 -
[*11] determined that section 6663(a) fraud penalties were warranted and prepared
a Form 11661, Fraud Development Recommendation--Examination,
recommending fraud penalties for 2003, 2004, and 2005.4 The Form 11661
describes the alleged fraud, including that Mr. Benavides “purposefully did not
report the income * * * [diverted from BCO] on the appropriate tax returns in
order to evade the personal service corporate tax and the additional tax on
dividends to him from the corporation.” The “Plan of Action” on the Form 11661
was to “[c]omplete 30 day letter writeup, including civil fraud penalty.” The Form
11661 referred only to Mr. Benavides. The agent prepared a separate Form 11661
for BCO although it does not specify preparation of a 30-day letter as a part of the
action plan.
On October 26, 2011, the examining agent’s supervisor signed the Forms
11661, indicating approval of the recommended fraud penalties. Respondent
issued revenue agent reports (RARs) on January 25, 2012, to BCO and to
petitioners, communicating the section 6663(a) fraud penalties. Those RARs were
later amended.
4
We explain why we are reopening the record to include certain exhibits
relevant to respondent’s penalty determination infra pp. 40-47.
- 12 -
[*12] On January 3, 2014, respondent issued the notice of deficiency to petitioners
for tax years 2003, 2004, and 2005. Respondent determined that petitioners
understated their gross income by failing to report the diverted gross receipts from
BCO as dividends of $195,359, $132,584, and $215,580 for the tax years 2003,
2004, and 2005, respectively. In addition respondent determined that petitioners
understated their income from Sunrise, making four adjustments: (1) decreasing
Sunrise’s gross income by the amounts determined to be diverted to Sunrise from
BCO, (2) disallowing Sunrise’s depreciation deductions that respondent
determined were for assets not shown to be used in an active trade or business,
(3) disallowing Sunrise’s section 179 expense deductions for 2004 and 2005
because the assets were not shown to be used in conducting an active trade or
business, and (4) disallowing certain business expense deductions claimed by
Sunrise that respondent identified as petitioners’ personal expenses paid by
Sunrise. Together these adjustments resulted in increased flowthrough income
from Sunrise to petitioners. Respondent then adjusted petitioners’ self-
employment income to account for these adjustments in ordinary income flowing
from Sunrise to petitioners. Respondent also made corresponding computational
adjustments to petitioners’ adjusted gross income, itemized deductions, and
exemptions. Lastly, respondent determined section 6663(a) fraud penalties of
- 13 -
[*13] $27,029, $19,221, and $27,170, for tax years 2003, 2004, and 2005,
respectively, with respect to the unreported constructive dividends from BCO.
OPINION
I. Burden of Proof
The taxpayer generally bears the burden of proving that the Commissioner’s
determinations in a notice of deficiency are erroneous. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). For unreported income, however, the Court
of Appeals for the Ninth Circuit, where these cases are appealable absent a
stipulation to the contrary, generally requires that the Commissioner introduce
some evidence linking the taxpayer with income-producing activity or demonstrate
that the taxpayer actually received unreported income. See Rapp v.
Commissioner, 774 F.2d 932, 935 (9th Cir. 1985); Edwards v. Commissioner, 680
F.2d 1268, 1270 (9th Cir. 1982). Once the Commissioner makes this required
threshold showing, the taxpayer must prove by a preponderance of the evidence
that the Commissioner’s determinations are arbitrary or erroneous. Helvering v.
Taylor, 293 U.S. 507, 515 (1935); Rapp v. Commissioner, 774 F.2d at 935;
Tokarski v. Commissioner, 87 T.C. 74 (1986). Taxpayers also bear the burden of
proving entitlement to any deductions claimed. INDOPCO, Inc. v. Commissioner,
503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
- 14 -
[*14] (1934). BCO and petitioners do not contend, and the evidence does not
establish, that the burden of proof should shift to respondent under section 7491(a)
as to any issue of fact.
II. BCO’s Arguments
A. Unreported Income of BCO
The first issue is whether BCO had unreported income from its accounting
and tax preparation business of $195,359, $102,584, and $215,580 for tax years
2003, 2004, and 2005, respectively. Respondent asserts that Mr. Benavides
diverted gross receipts from BCO in these amounts during the respective years in
issue and therefore BCO failed to report and pay Federal corporate income tax on
these amounts.
A C corporation is a separate entity for Federal income tax purposes so long
as it engages in some legitimate business activity. Moline Props., Inc. v.
Commissioner, 319 U.S. 436, 438-439 (1943). As an independent taxable entity, a
C corporation is subject to Federal income tax on its taxable income. Sec. 11(a).
The C corporation’s taxable income is its gross income--which includes fees for
services--less allowable deductions. Secs. 61(a)(1) and (2), 63(a).
Petitioners do not dispute that the gross receipts were BCO’s income; Mr.
Benavides readily admits he “redirected” gross receipts from BCO to put “right
- 15 -
[*15] away” into his other entities. Thus, the diverted income--$195,359,
$102,584, and $215,580 for 2003, 2004, and 2005, respectively--in the form of
checks, cash payments, or trades is gross income of BCO.
Mr. Benavides argues, however, that we should ignore these transfers
because he would have “stripped” the profits out anyway as deductible
compensation. We disagree. While BCO could have taken the gross receipts into
account as income and paid them out as compensation, by Mr. Benavides’ own
admission it did not. The diverted gross receipts therefore are properly
characterized as distributions, not compensation.
A taxpayer may not avoid Federal income tax on earned income simply by
assigning it to another. Helvering v. Horst, 311 U.S. 112, 119 (1940) (“The
dominant purpose of the revenue laws is the taxation of income to those who earn
or otherwise create the right to receive it and enjoy the benefit of it when paid.”);
Floyd v. Scofield, 193 F.2d 594, 596 (5th Cir. 1952) (holding a corporation liable
for corporate tax on income from the sale of oil and gas despite liquidation plan
that distributed accounts receivable to shareholders when checks were delivered
before dissolution). We hold that the diverted gross receipts were the unreported
taxable income of BCO for the years in issue. See, e.g., United Mercantile
Agencies, Inc. v. Commissioner, 23 T.C. 1105, 1112 (1955) (“[D]iverted funds are
- 16 -
[*16] taxable as income to the corporation and are taxable as dividends to the
extent of earnings and profits to the officer-stockholders receiving them.”),
remanded on other grounds sub nom. Drybrough v. Commissioner, 238 F.2d 735(6th Cir. 1956); Mazzocchi Bus Co. v. Commissioner, T.C. Memo. 1993-43(sustaining the Commissioner’s deficiency determination when the controlling
shareholder diverted corporate income to himself that the corporation failed to
report on its tax return), aff’d, 14 F.3d 923 (3d Cir. 1994).
B. BCO’s Claimed NOL Deductions
A taxpayer generally may deduct, as an NOL for a taxable year, an amount
equal to the sum of the NOL carryforwards and carrybacks to that year. Sec.
172(a). An NOL is the excess of deductions over gross income, computed with
certain modifications specified in section 172(d). Sec. 172(c). Absent an election
under section 172(b)(3), an NOL for any taxable year first must be carried back 2
years and then carried forward 20 years. Sec. 172(b)(1)(A), (2) and (3).
Taxpayers bear the burden of establishing both the existence of NOLs from
prior years and the amounts that may be carried forward to the tax years in issue.
See Rule 142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000). We have
jurisdiction to determine the correct amount of taxable income or NOL for a year
not in issue as a preliminary step in determining the correct NOL carryover to a
- 17 -
[*17] year before us. Lone Manor Farms, Inc. v. Commissioner, 61 T.C. 436, 440
(1974), aff’d without published opinion, 510 F.2d 970 (3d Cir. 1975).
The only evidence BCO offered to substantiate its NOLs consisted of its tax
returns for the tax years in issue with attached statements briefly describing how it
calculated its NOL carryovers, a handwritten summary of its historical gross
receipts and NOLs that Mr. Benavides prepared shortly before trial, and Mr.
Benavides’ vague testimony that he disagreed with respondent’s position.
We did not find Mr. Benavides’ testimony credible in any respect. And
BCO’s tax returns for the years in issue are merely statements of its position.
They cannot be used to substantiate a claimed deduction including the amount of
an NOL to be carried forward. See Sparkman v. Commissioner, 509 F.3d 1149,
1156-1157 (9th Cir. 2007), aff’g T.C. Memo. 2005-136; Wilkinson v.
Commissioner, 71 T.C. 633, 639 (1979); Hawks v. Commissioner, T.C. Memo.
2005-155, 2005 WL 1503686, at *3. BCO therefore failed to substantiate the
NOLs for 1996, 1997, and 2002. Nor did BCO show that these alleged NOLs
were not already exhausted before the years in issue. See Jones v. Commissioner,
25 T.C. 1100, 1104 (1956), rev’d and remanded on other grounds, 259 F.2d 300(5th Cir. 1958); Power v. Commissioner, T.C. Memo. 2016-157, at *13-*14
(“Petitioners must prove not only that Mr. Power incurred NOLs in 1999-2002 but
- 18 -
[*18] also that the NOLs were not absorbed during the period beginning with
1997 (the earliest carryback year) and ending with 2006 (the last year before the
first taxable year in issue).”); Leitgen v. Commissioner, T.C. Memo. 1981-525,
1981 WL 10937 (“The burden is on petitioners to prove their incomes for 1969,
1970, and 1971 in order to show that there was any part of the alleged 1972 loss
that would not have been absorbed in the three preceding years and that could
have been carried over to the years in issue.”), aff’d, 691 F.2d 504 (8th Cir. 1982).
The evidence shows that BCO’s diverted gross receipts, if reported for 2003,
would have produced taxable income, not an NOL. The IRS examiner’s bank
deposit analysis showed that BCO had unreported gross receipts for 2002 as well
that, if reported, would have produced taxable income for 2002, even after fully
exhausting the claimed--but unsubstantiated--NOL carryovers from 1996 and
1997. Accordingly, we sustain respondent’s disallowance of BCO’s NOL
carryover deductions to 2004 and 2005.
III. Petitioners’ Arguments
A. Diverted Gross Receipts as Constructive Dividends
When a C corporation distributes money or property to a shareholder out of
the corporation’s earnings and profits (E&P), the amount of the distribution
constitutes a dividend that must be included in the shareholder’s taxable income.
- 19 -
[*19] Secs. 61(a)(7), 63, 301(a), (c), 316. If the distribution exceeds the
corporation’s E&P, the excess generally represents a nontaxable return of capital
to the extent of the shareholder’s basis in the stock, and any remaining amount is
taxable to the shareholder as a gain from the sale or exchange of property. Sec.
301(c); Truesdell v. Commissioner, 89 T.C. 1280, 1294-1295 (1987).
Dividends for tax purposes are not always declared in the formal sense;
courts have identified constructive dividends when a C corporation confers an
economic benefit upon a shareholder without a corresponding expectation of
repayment. See Hood v. Commissioner, 115 T.C. 172, 179-180 (2000); Cordes v.
Commissioner, T.C. Memo. 2002-124, 2002 WL 1023173, at *10 (citing Ireland v.
United States, 621 F.2d 731, 735 (5th Cir. 1980) (“There is no requirement that the
dividend be formally declared or even intended by the corporation.”) and
Wortham Mach. Co. v. United States, 521 F.2d 160, 164 (10th Cir. 1975)).
Similarly, when a shareholder diverts earned income from his closely held C
corporation for his personal use, courts have held that the diverted income
constitutes a constructive distribution to the shareholder. Simon v. Commissioner,
248 F.2d 869, 876-877 (8th Cir. 1957) (“The corporation is liable for a substantial
tax upon the diverted income it failed to report. Further tax will be collected from
- 20 -
[*20] taxpayers under the constructive dividend theory.”), rev’g T.C. Memo.
1955-194; Truesdell v. Commissioner, 89 T.C. at 1300-1301.
Petitioners bear the burden of proving that BCO had insufficient E&P to
support the amounts of constructive dividends respondent determined for the tax
years in issue. E.g., Truesdell v. Commissioner, 89 T.C. at 1295-1296; Pittman v.
Commissioner, T.C. Memo. 1995-243, 1995 WL 329854, at *12, aff’d, 100 F.3d
1308 (7th Cir. 1996). They failed to present credible evidence showing that BCO
lacked sufficient E&P to support dividend treatment. At trial petitioners pointed
to a handwritten summary of BCO’s retained earnings from 1996 to 2008, and Mr.
Benavides testified, consistent with that summary, that BCO never had retained
earnings during that period. We did not find Mr. Benavides credible, and we are
not required to accept his self-serving testimony. See Ruark v. Commissioner, 449
F.2d 311, 312 (9th Cir. 1971), aff’g T.C. Memo. 1969-48; Monahan v.
Commissioner, 109 T.C. 235, 257 (1997). Moreover, other evidence refutes his
bald assertion.
Adjusting journal entries in 2003 and 2004 showed that BCO had retained
earnings of at least $49,977 as of 2003 and $65,639 as of 2004 even without
taking into account the diverted gross receipts. This, coupled with the bank
deposit analysis showing that BCO had significant unreported income for 2002, is
- 21 -
[*21] persuasive evidence that BCO began the tax years in issue with accumulated
E&P. And the diverted gross receipts, if properly reported as BCO’s income for
the years in issue, would have generated current E&P during those years. See sec.
1.312-6(b), Income Tax Regs. Therefore, we hold that the diverted gross receipts
from BCO of $195,359, $132,584, and $215,580 are taxable to petitioners as
constructive dividends for 2003, 2004, and 2005, respectively. See sec. 316;
Pittman v. Commissioner, 1995 WL 329854, at *13-*14.
B. Unreported Income From Sunrise
Next, respondent determined that petitioners had unreported income from
Sunrise of $123,931, $88,593, and $66,628 for tax years 2003, 2004, and 2005,
respectively, arising from four adjustments. We consider each adjustment in turn.
1. Gross Receipts Adjustments
Respondent determined that Sunrise erroneously reported the diverted gross
receipts from BCO as its own gross income for each tax year, which then flowed
through to petitioners as partners. To avoid double-counting, respondent reduced
the gross income flowing from Sunrise to petitioners for each year by the amount
determined to be BCO’s gross receipts. At trial Mr. Benavides admitted to
diverting gross receipts from BCO to Sunrise for each tax year but stated that the
amounts diverted were different from respondent’s determination, asserting that
- 22 -
[*22] respondent gave petitioners too much of a reduction in income from Sunrise.
Mr. Benavides was not a credible witness, and no credible evidence supports a
change to respondent’s determinations.
2. Disallowed Deductions
A taxpayer may deduct “all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business”. Sec. 162.
But personal, living, and family expenses are not deductible. Sec. 262. For an
expenditure to be an ordinary and necessary business expense, generally the
taxpayer must show a bona fide business purpose for the expenditure and a
proximate relationship between the expenditure and the business of the taxpayer.
See Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 660-661 (1962); see also
sec. 1.162-1(a), Income Tax Regs.
Taxpayers are required to maintain sufficient records to establish the
amount and purpose of any deduction. Sec. 6001; Higbee v. Commissioner, 116
T.C. 438, 440 (2001); sec. 1.6001-1(a), (e), Income Tax Regs. At trial Mr.
Benavides made a disorganized and confusing presentation that often left us
struggling to identify the specific expenditure he intended to explain. He
presented the general ledgers of Sunrise and depreciation schedules but did not
offer any supporting records for any of the expenses or deductions. See Lyseng v.
- 23 -
[*23] Commissioner, T.C. Memo. 2011-226, 2011 WL 4389644, at *3 (“In
general, taxpayers must substantiate claimed deductions with evidence such as
invoices or receipts that establish that the expenses were actually incurred[.]”).
Repeatedly, Mr. Benavides challenged adjustments made by the IRS in RARs that
predated the notice of deficiency (and had been conceded in that notice) instead of
directing the Court to evidence of the remaining expenses. He fell back on his
excuse that he was not represented by counsel, yet when confronted by questions
from respondent he demonstrated a sophisticated appreciation for the issues. And,
as noted above, in general, we did not find Mr. Benavides to be a credible witness.
a. Disallowed Depreciation and Section 179 Expenses
Petitioners assert that respondent incorrectly disallowed depreciation
deductions that flowed through to their returns from Sunrise of $32,872, $17,085,
and $11,498 for 2003, 2004, and 2005, respectively, and section 179 deductions
that flowed through from Sunrise of $34,961 and $55,016 for 2004 and 2005,
respectively.
A reasonable depreciation deduction may be allowed for the “exhaustion,
wear and tear” of property used in a trade or business. Secs. 161, 167(a)(1). To
substantiate entitlement to a depreciation deduction, a taxpayer not only has to
show that the property was used in a business but also must establish the
- 24 -
[*24] property’s depreciable basis by showing the cost of the property, its useful
life or recovery period, and its previously allowable depreciation. See, e.g., Cluck
v. Commissioner, 105 T.C. 324, 337 (1995). A taxpayer with no capital
investment in property has no right to depreciation deductions with respect to that
capital asset. Miller v. Commissioner, 68 T.C. 767, 775 (1977).
Certain taxpayers may elect instead to treat the cost of certain property used
in an active trade or business as a current expense in the year that property is
placed in service. Sec. 179(a), (d). If the property is used for both business and
other purposes, then the portion of the cost that is attributable to the business use
is eligible for expensing under section 179 but only if more than 50% of the use is
for business purposes (predominant use requirement). See sec. 1.179-1(d), Income
Tax Regs.
Heightened substantiation requirements apply to deductions for certain
assets. Sec. 274(d); see, e.g., Mears v. Commissioner, T.C. Memo. 2013-52,
at *22 (considering section 274(d) “listed property” requirements with respect to
applicable section 167 deductions); Singh v. Commissioner, T.C. Memo. 2009-36,
2009 WL 349745, at *1 (considering listed property requirements with respect to
an applicable section 179 deduction). Passenger automobiles and other property
used as a means of transportation are listed property. Sec. 280F(d)(4)(A)(i)
- 25 -
[*25] and (ii). Listed property also broadly includes any property of a type
generally used for entertainment, recreation, or amusement. Sec.
280F(d)(4)(A)(iii). To deduct expenses related to listed property taxpayers must
support their own statements with additional substantiation that adequately
establishes the amount, time, place, and business purpose of each expenditure.
Sec. 274(d)(4); see also sec. 1.274-5T(b)(6), (c)(1) and (2), Temporary Income
Tax Regs., 50 Fed. Reg. 46016-46017 (Nov. 6, 1985).
At trial petitioners presented a depreciation schedule that summarized assets
depreciated or expensed under section 179 for the tax years in issue. The assets
include several trucks, an all-terrain vehicle (ATV), lawn maintenance equipment,
a camping trailer, and assorted equipment. Petitioners offered no documentary
evidence to support their depreciation schedule. For instance, no evidence before
us establishes who purchased the assets, when they were purchased, what they
cost, and whether depreciable bases remained during the tax years in issue.
What is more, petitioners failed to establish that these assets were
predominantly used in Sunrise’s real estate management and development
business. Mr. Benavides was vague. He testified, for instance, that the ATV was
used to show real property for sale, but there is no evidence that Sunrise ever
marketed, showed, or even listed property for sale during the years in issue. Mr.
- 26 -
[*26] Benavides also asserted that the trucks on the depreciation schedule were
related to Sunrise’s business because people “don’t buy big trucks just for sport”.
That assertion defies logic. He admitted to personal use of some of the assets,
such as the lawn equipment and the camping trailer. Not only did petitioners fail
to satisfy the strict substantiation requirements for their listed property; they failed
to offer enough evidence to substantiate their deductions under a general standard.
We, therefore, sustain respondent’s disallowance of the depreciation and section
179 expense deductions.
b. Disallowed Business Expense Deductions
Respondent disallowed other business expense deductions claimed by
Sunrise that respondent identified as expenditures for petitioners’ personal use or
as unsubstantiated. The amounts disallowed were $190,045, $208,156, and
$268,609 for 2003, 2004, and 2005, respectively.
Petitioners argue that respondent incorrectly disallowed deductions for
Sunrise’s legitimate operating expenses and expenses incurred for paying bills for
others (bill-paying expenses). All we have in support of petitioners’ claims are
Mr. Benavides’ muddled testimony and Sunrise’s general ledgers, which contain
limited information and are unsupported by any other evidence. The record is
devoid of receipts, invoices, canceled checks, or other business records to
- 27 -
[*27] substantiate the reported deductions or petitioners’ claimed reimbursements
even though Mr. Benavides’ demeanor at trial indicated that he understood the
need to have such backup. Frustrating us further, petitioners repeatedly tried to
prove their entitlement to these deductions by pointing out problems with RARs
that preceded the notice of deficiency and were addressed in the notice of
deficiency.
First, petitioners assert that respondent incorrectly disallowed some of
Sunrise’s operating expense deductions for each year, including automobile
expenses, insurance, property taxes, and payroll expenses. Petitioners did not
describe in sufficient detail the specific nature of the various operating expenses,
let alone substantiate them with any records. For example, Mr. Benavides testified
to paying wages to an employee, but the individual worked for BCO, not Sunrise.
Without credible records, we cannot conclude that petitioners are entitled to claim
deductions for any of these alleged expenses.
Second, petitioners assert that Sunrise was paying the construction costs for
some of BCO’s clients, for La-Jam, and for petitioners themselves, for which
Sunrise would be reimbursed but would not profit. Petitioners argue that
respondent incorrectly disallowed some of Sunrise’s bill-paying expense
deductions because Sunrise later would be reimbursed, reimbursement income and
- 28 -
[*28] expenses for the years in issue “should wash”, and respondent failed to
match up all income and expenses in the audit. Mr. Benavides testified that some
of Sunrise’s expenses that respondent identified as petitioners’ personal expenses
and disallowed as deductions for 2004 were amounts that Sunrise paid for the
construction of La-Jam’s shop, but he did not identify the exact expenditures or
their amounts or provide credible evidence that Sunrise was reimbursed by La-Jam
or petitioners.
The evidence shows that respondent allowed the bill-paying expense
deductions except as they relate to petitioners’ personal expenses or to La-Jam’s
expenses. And there is no evidence that petitioners (or La-Jam) reimbursed
Sunrise. In any event, petitioners’ argument that everything “should wash” is not
a substitute for showing that they did wash or substantiating the business expenses
Sunrise reported. Petitioners provided no documentary evidence to prove what
these alleged expenses were, their various amounts, or when, or even if, they were
actually incurred. Moreover, petitioners failed to show that the disallowed bill-
paying expense deductions bore any relation to Sunrise’s trade or business. Many
of the bill-paying expenses are personal, such as the hundreds of thousands of
dollars spent to remodel petitioners’ principal residence, as well as the money
spent to build La-Jam’s shop directly adjacent to petitioners’ home. Accordingly,
- 29 -
[*29] we will sustain respondent’s disallowance of Sunrise’s business expense
deductions of $190,045, $208,156, and $268,609 for tax years 2003, 2004, and
2005, respectively.
C. Self-Employment Income Adjustments
The next issue is whether Mr. Benavides had unreported self-employment
income in the amounts of his shares of partnership income from Sunrise of
$42,219, $110,332, and $82,591 for tax years 2003, 2004, and 2005, respectively;
and similarly, whether Mrs. Benavides had unreported self-employment income in
the amounts of her shares of partnership income from Sunrise of $40,564,
$106,006, and $79,352 for tax years 2003, 2004, and 2005, respectively.
Section 1401 imposes a tax upon a taxpayer’s self-employment income.
Self-employment income means the “net earnings from self-employment” derived
by an individual during the taxable year. Sec. 1402(b). Subject to exceptions, the
“net earnings from self-employment” include a partner’s distributive share of
partnership trade or business income. Sec. 1402(a).
Because Mr. and Mrs. Benavides own Sunrise as partners (51% and 49%,
respectively), all of Sunrise’s trade or business income flows to them on account
of their partnership interests. Secs. 701 and 702(a). Accordingly, all such income
for any taxable year generally, subject to limitations of section 1402(b), would be
- 30 -
[*30] subject to self-employment taxes. Secs. 1401(a) and (b), 1402(a) and (b);
Norwood v. Commissioner, T.C. Memo. 2000-84, 2000 WL 267779, at *1 (citing
Cokes v. Commissioner, 91 T.C. 222, 229-230 (1988)). At trial petitioners agreed
that the adjustments to self-employment income would depend upon our rulings
with respect to the other joint return determinations and did not advance any
separate argument--at trial, on brief, or otherwise--concerning their self-
employment income or respondent’s determinations. As we have sustained
respondent’s determinations that petitioners had additional income from Sunrise
for each year in issue, that additional income constitutes self-employment income.
See secs. 1401(a) and (b), and 1402(a) and (b). Accordingly, we will sustain
respondent’s determinations concerning self-employment taxes for each year.
IV. Fraud
A. Section 6663(a) Fraud Penalty
Section 6663(a) provides: “If any part of any underpayment of tax required
to be shown on a return is due to fraud, there shall be added to the tax an amount
equal to 75 percent of the portion of the underpayment which is attributable to
fraud.” Fraud, for Federal tax purposes, is an intentional wrongdoing on the part
of a taxpayer with the specific purpose to evade a tax believed to be owed. Sadler
v. Commissioner, 113 T.C. 99, 102 (1999). The fraud penalty is a civil sanction
- 31 -
[*31] provided primarily as a safeguard for protection of revenue and to reimburse
the Government for the heavy expense of investigation and the loss resulting from
the taxpayer’s fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938); Sadler v.
Commissioner, 113 T.C. at 102.
Respondent determined section 6663(a) fraud penalties of $35,044,
$64,802, and $69,722 for 2003, 2004, and 2005, respectively, with respect to
BCO’s unreported taxable income for those years. Respondent determined section
6663(a) fraud penalties of $27,029, $19,221, and $27,170 for 2003, 2004, and
2005, respectively, with respect to petitioners’ failure to report dividends from
BCO for those years. Respondent bears the burden of proving fraud by clear and
convincing evidence. See sec. 7454(a); Rule 142(b). Respondent must satisfy his
burden separately for each petitioner filing the joint returns. See sec. 6663(c);
Hicks Co. v. Commissioner, 56 T.C. 982, 1030 (1971), aff’d, 470 F.2d 87 (1st Cir.
1972); Said v. Commissioner, T.C. Memo. 2003-148, 2003 WL 21205252, at *6
(“Under section 6663(c), the fraud penalty is imposed on each spouse separately,
even when a joint return is filed[.]”), aff’d, 112 F. App’x 608 (9th Cir. 2004).
To carry his burden of proof, respondent must show, for each year, that:
(1) an underpayment of tax exists and (2) some portion is attributable to fraud.
See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983). An underpayment for a
- 32 -
[*32] year is attributable to fraud if petitioners intended to conceal, mislead, or
otherwise prevent the collection of taxes known or believed to be owing. See Katz
v. Commissioner, 90 T.C. 1130, 1143 (1988). If respondent establishes that any
portion of the underpayment for a year is attributable to fraud, the entire
underpayment for that year shall be attributable to fraud and subject to a 75%
penalty, except with respect to any portion that petitioners establish (by a
preponderance of the evidence) is not attributable to fraud. See sec. 6663(a)
and (b).
1. Underpayment of Tax
First, respondent must meet his burden of showing an underpayment of tax
for each of the years in issue. Respondent alleges fraudulent underpayments of tax
by BCO and petitioners with respect to tax owed as a consequence of the diverted
gross receipts from BCO. At trial Mr. Benavides admitted to diverting $100,489,
$92,764, and $167,225 of BCO’s gross receipts to Sunrise in 2003, 2004, and
2005, respectively,5 and we have held supra pp. 14-16 (BCO) and pp. 18-21
5
We note that Mr. Benavides admitted to diverting gross receipts in
amounts slightly different from those determined by respondent (and found by this
Court), but the critical point is that petitioners did not dispute BCO’s diverted
gross receipts. Computations attached to the notices of deficiency show that those
diverted gross receipts resulted in some underpayments of tax at the corporate and
shareholder levels. Form 4549B, Income Tax Examination Changes, issued to
(continued...)
- 33 -
[*33] (petitioners) that those diverted gross receipts are taxable income to BCO
and taxable constructive dividends to petitioners. Hence it is not difficult to
conclude that respondent has carried his burden of showing some underpayments
of tax with respect to BCO and petitioners. Specifically, respondent showed that
BCO understated its taxable income by failing to report the diverted gross receipts
as corporate income of $195,359, $102,584, and $215,580 for 2003, 2004, and
2005, respectively, and by erroneously claiming NOL carryforward deductions for
2004 and 2005; and petitioners understated their taxable income by failing to
report the diverted gross receipts from BCO as constructive dividends of
$195,359, $132,584, and $215,580 for 2003, 2004, and 2005, respectively.
Consequently, respondent has established that both BCO and petitioners underpaid
their tax for 2003, 2004, and 2005.
2. Fraudulent Intent
Next, we must determine whether BCO and petitioners had fraudulent
intent. The existence of fraud is a factual question, resolved upon consideration of
the entire record. King’s Court Mobile Home Park, Inc. v. Commissioner, 98 T.C.
5(...continued)
petitioners shows that even after reducing Sunrise’s gross receipts by the amounts
of the diverted dividends petitioners underreported income flowing through from
Sunrise. That underreported income was added to the underreported income from
the constructive dividends from BCO.
- 34 -
[*34] 511, 516 (1992). Fraud may not be presumed or based upon mere suspicion.
Petzoldt v. Commissioner, 92 T.C. 661, 699-700 (1989). But because direct
evidence of fraudulent intent is seldom available, fraud may be proven by
circumstantial evidence and reasonable inferences drawn from the facts. Bradford
v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601;
Niedringhaus v. Commissioner, 99 T.C. 202, 210 (1992). The taxpayer’s entire
course of conduct may be indicative of fraudulent intent. DiLeo v. Commissioner,
96 T.C. 858, 874 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); Stone v.
Commissioner, 56 T.C. 213, 224 (1971).
Courts routinely consider whether the following “badges of fraud” are
present: (1) understating income, (2) maintaining inadequate records, (3) failing
to file tax returns, (4) giving implausible or inconsistent explanations of behavior,
(5) concealing assets, (6) failing to cooperate with tax authorities, (7) engaging in
illegal activities, (8) attempting to conceal illegal activities, (9) dealing in cash,
and (10) failing to make estimated payments. See, e.g., Spies v. United States, 317
U.S. 492, 499 (1943); Bradford v. Commissioner, 796 F.2d at 307; Recklitis v.
Commissioner, 91 T.C. 874, 910 (1988); see also McGraw v. Commissioner, 384
F.3d 965, 971 (8th Cir. 2004) (citing Spies, 317 U.S. at 499, and Bradford v.
Commissioner, 796 F.2d at 307-308), aff’g Butler v. Commissioner, T.C. Memo.
- 35 -
[*35] 2002-314. This list is nonexclusive, and no single factor is dispositive,
although the combination of several factors may constitute persuasive evidence of
fraud. Petzoldt v. Commissioner, 92 T.C. at 700.
A corporation acts only through its officers and cannot escape responsibility
for their acts in that capacity. DiLeo v. Commissioner, 96 T.C. at 875. Whether
BCO’s intent was fraudulent therefore depends upon the intent of Mr. Benavides,
its sole owner and manager. See Ruidoso Racing Ass’n, Inc. v. Commissioner,
476 F.2d 502, 506 (10th Cir. 1973) (fraud of majority shareholder imputed to
corporation because corporation received tax benefit from shareholder’s
fraudulent acts to understate corporate gross income), aff’g in part, remanding in
part T.C. Memo. 1971-194; DiLeo v. Commissioner, 96 T.C. at 875; Federbush v.
Commissioner, 34 T.C. 740, 749 (1960) (fraud of shareholder-officers in diverting
corporate income to evade corporate tax imputed to corporation when officers
owned five-sixths of stock), aff’d, 325 F.2d 1 (2d Cir. 1963); Door Control Servs.
Inc. v. Commissioner, T.C. Memo. 1996-508 (corporate taxpayer fraudulently
intended to underpay taxes when it substantially understated its tax liability by
failing to report income diverted to its only two shareholders who were also its
only officers).
- 36 -
[*36] a. BCO and Mr. Benavides
We now turn to the badges of fraud. First, the diverted gross receipts from
BCO demonstrate a pattern of consistent underreporting of income by both BCO
and Mr. Benavides, evidencing their intent to evade both corporate tax and tax on
dividends. And while a “mere understatement of income alone is not sufficient to
prove fraud, the consistent and substantial understatement of income is, by itself,
strong evidence of fraud.” Truesdell v. Commissioner, 89 T.C. at 1302 (finding
fraud when sole shareholder diverted corporate funds to shareholder’s personal
use during three tax years and failed to report on corporate or individual returns);
Otsuki v. Commissioner, 53 T.C. 96, 107-108 (1969) (holding that a pattern of
omission of gross receipts for five years was “strong evidence of an attempt to
defraud the Government”); see also Potter v. Commissioner, T.C. Memo. 2014-18,
at *9 (“A pattern of substantially underreporting income for multiple years is
strong evidence of fraud[.]”) (citing Vanover v. Commissioner, T.C. Memo. 2012-
79, 2012 WL 952871, at *4).
Second, BCO and petitioners failed to maintain adequate records. BCO
maintained two sets of books to track payments BCO received--one for tracking
accounts receivable and one for tax reporting--and the diverted amounts were not
reported on the books used for BCO’s tax reporting or BCO’s tax returns. Mr.
- 37 -
[*37] Benavides was instrumental in BCO’s double bookkeeping practices and its
failure to deposit all of its gross receipts into BCO accounts and petitioners’
failure to report the resulting dividends from BCO.
Third, the two sets of books also indicate an effort to conceal taxable
income. Potter v. Commissioner, at *11 (stating that double bookkeeping at
corporate taxpayer was used to conceal shareholder’s diverting corporate receipts
and was “clear circumstantial evidence of fraudulent intent”).
Fourth, Mr. Benavides’ criminal conviction--while not identical to the fraud
alleged here--is nonetheless indicative of his fraudulent intent vis-a-vis the IRS
and Federal income taxes. In 2011 Mr. Benavides pleaded guilty and was
convicted of assisting in the preparation of a false or fraudulent income tax return
in violation of section 7206(2). The parties stipulated the offer of proof, which
states that Mr. Benavides used BCO to collect “fees for services” from a client,
purchased a personal item for the client, then assisted in preparing the client’s tax
return claiming a business expense deduction for the cost of the personal item
mischaracterized as “fees”. Here too Mr. Benavides intentionally used BCO’s
operations to avoid taxes--this time for BCO’s and petitioners’ benefit--diverting
BCO’s income to hide it from the IRS.
- 38 -
[*38] Lastly, BCO and Mr. Benavides provided inconsistent and implausible
explanations for their actions. For example, Mr. Benavides disavows any
fraudulent intent, arguing that, while he may have “redirected” BCO’s gross
receipts, the income was reported “somewhere”--whether on petitioners’ joint
returns or the returns of one of petitioners’ businesses. This, Mr. Benavides
argues, indicates a lack of fraudulent intent. Mr. Benavides also protests that it is
“rather silly” to suggest that petitioners were trying to evade corporate tax because
he was just paying reasonable compensation to himself--a process he described to
the Court as “stripping” the taxable income out of BCO.
Mr. Benavides admits to “hurried, short-circuited bookkeeping practices,”
but argues that he intended only to engage in legitimate tax planning by paying
himself a reasonable salary. But BCO’s principal business was tax preparation
and accounting services; Mr. Benavides--as a C.P.A. with an accounting degree
and decades of experience in tax matters--thus should know he cannot just ignore
the separate existence of BCO. See Solomon v. Commissioner, 732 F.2d 1459,
1461-1462 (6th Cir. 1984) (holding that taxpayer’s knowledge and experience as a
C.P.A. whose business was handling tax matters for others supported a finding of
fraud), aff’g per curiam T.C. Memo. 1982-603; Franke v. Commissioner, T.C.
Memo. 2011-10 (stating that taxpayer’s business experience as a tax preparer for
- 39 -
[*39] several years was a relevant consideration in determining whether he had
fraudulent intent).
To suggest that taxpayers who made a living handling the tax and
accounting matters of others should escape the fraud penalty because of sloppy
bookkeeping--itself a badge of fraud--is risible. The “reasonable compensation”
argument advanced by Mr. Benavides is a dog that will not hunt. He did not
report the diverted gross receipts on his personal returns as compensation from
BCO or pay applicable self-employment taxes. He cannot ignore reality or rewrite
history now that he has been caught out. Mr. Benavides’ intentioned steps to
lower BCO’s taxable income (as well as his own) are clear and convincing
evidence of the requisite fraudulent intent for BCO and Mr. Benavides alike. We
find ample indicia of fraud for BCO and Mr. Benavides for each of the tax years in
issue.
b. Mrs. Benavides
Although Mrs. Benavides filed joint returns with Mr. Benavides, to
establish her liability for the fraud penalties respondent must show that some
portions of the underpayments were due to her fraud. See sec. 6663(c). The
record shows that her involvement with BCO and Sunrise was more limited.
Unlike her husband, Mrs. Benavides was not a C.P.A. with decades of tax
- 40 -
[*40] experience, nor was she an owner or manager of BCO. During the years in
issue she performed clerical tasks at BCO, such as data entry and bookkeeping,
making entries in the ATB program, preparing deposit slips, and depositing funds
into BCO’s and other “various” accounts. While these tasks, together with her
relationship with Mr. Benavides, suggest that she may have known of the diverted
gross receipts, we will not presume so without additional indicia of fraud.
Therefore, we hold that respondent has not carried his burden of showing by clear
and convincing evidence that Mrs. Benavides had fraudulent intent.
B. Section 6751
For certain penalties asserted against individual taxpayers, including fraud,
the Commissioner must show that he complied with the procedural requirements
of section 6751(b)(1). Sec. 7491(c); Graev v. Commissioner (Graev III), 149 T.C.
485, 492-493 (2017), supplementing and overruling in part Graev v.
Commissioner (Graev II), 147 T.C. 460 (2016). Section 6751(b)(1) requires the
Commissioner to show that the initial determination of certain penalties was
“personally approved (in writing) by the immediate supervisor of the individual
making such determination”. See Graev III, 149 T.C. at 493; see also Chai v.
Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev’g in part T.C.
Memo. 2015-42.
- 41 -
[*41] Trial was held, and the record was closed before the issuance of our Opinion
in Graev III, which overruled in part our decision in Graev II and held that the
Commissioner’s burden of production under section 7491(c) includes showing
supervisory approval as required by section 6751(b)(1). In the light of the Court’s
decision in Graev III, we ordered the parties to address the effect of section
6751(b)(1) on these cases and to direct the Court to any evidence of section
6751(b)(1) supervisory approval in the record. Respondent was unable to direct
the Court to any evidence in the record that satisfies his burden of production with
respect to section 6751(b)(1) and filed a motion to reopen the record to include a
completed Form 11661, signed by the examining agent’s supervisor, a Penalty
Approval Form signed by the supervisor, and declarations by the revenue agent
who recommended the penalties and the revenue agent’s supervisor who approved
them. Petitioners objected to respondent’s motion.
We first must determine whether to reopen the record to admit the
additional evidence that respondent offered. The decision to reopen the record to
admit additional evidence is within our broad discretion. Zenith Radio Corp. v.
Hazeltine Research, Inc., 401 U.S. 321, 331-332 (1971); see Nor-Cal Adjusters v.
Commissioner, 503 F.2d 359, 363 (9th Cir. 1974) (“[T]he Tax Court’s ruling
[denying a motion to reopen the record] is not subject to review except upon a
- 42 -
[*42] demonstration of extraordinary circumstances which reveal a clear abuse of
discretion.”), aff’g T.C. Memo. 1971-200. We “will not grant a motion to reopen
the record unless, among other requirements, the evidence relied on is not merely
cumulative or impeaching, the evidence is material to the issues involved, and the
evidence probably would change the outcome of the case.” Butler v.
Commissioner, 114 T.C. 276, 287 (2000); see also SEC v. Rogers, 790 F.2d 1450,
1460 (9th Cir. 1986) (trial court “should take into account, in considering a motion
to hold open the trial record, the character of the additional * * * [evidence] and
the effect of granting the motion”), overruled on other grounds by Pinter v. Dahl,
486 U.S. 622 (1988). We also balance the moving party’s diligence against the
possible prejudice to the nonmoving party. In particular we consider whether
reopening the record after trial would prevent the nonmoving party from
examining and questioning the evidence as it would have during the proceeding.
Estate of Freedman v. Commissioner, T.C. Memo. 2007-61, 2007 WL 831802,
at *12; Megibow v. Commissioner, T.C. Memo. 2004-41, 2004 WL 309153, at *7.
We agree with respondent that the Form 11661 is not cumulative, is material
to the penalty issues in this case, and probably would change the outcome.
See Butler v. Commissioner, 114 T.C. at 287. Reopening the record here serves
the interests of justice because the record was closed in this case before we issued
- 43 -
[*43] Graev III and because petitioners never raised section 6751(b)(1) as an issue
before the record was closed. We also agree with respondent that the Form 11661
is a record kept in the ordinary course of business activity and is authenticated by
the declarations. See Fed. R. Evid. 803(6), 902(11). This form is the type of
evidence we routinely admit at trial solely on the basis of declarations such as
those proffered.
Petitioners objected to the granting of respondent’s motion but did not point
to any specific issues or errors with respect to the Form 11661. Rather, petitioners
argue that because Chai was decided six weeks before trial and section 7491(c)
has long put the burden of production on the Commissioner with respect to
penalties, respondent should have known that he needed to put on this evidence at
the time of trial. Petitioners also objected on equitable grounds, arguing that
respondent acted in bad faith by objecting to petitioners’ motion for continuance,
that petitioners were prejudiced by proceeding pro sese, and that respondent
proceeded in bad faith by making evidentiary objections at trial and technical legal
arguments on brief. We disagree. While the Court of Appeals for the Second
Circuit did publish its opinion in Chai a short time before the trial in these
consolidated cases, it was not binding in the Ninth Circuit and contradicted this
- 44 -
[*44] Court’s own precedent in Graev II. We do not expect parties to anticipate
when this Court will overrule its precedent.
Petitioners’ equitable arguments are particularly weak. Petitioners were
granted two continuances in these cases, giving them two additional years to
prepare for trial. While the Court is sympathetic to health problems faced by
petitioners’ former attorney, those health problems had been noted in the second
motion for continuance and do not excuse the lack of progress in these cases over
the two years they were continued. Objecting to a motion for continuance does
not constitute bad faith, nor do evidentiary objections or technical arguments. We
found Mr. Benavides to be a trained tax professional capable of representing
himself and BCO, and on the basis of his trial testimony we concluded that he
understood substantiation requirements. And while we reject his stripping
argument, that argument confirms that he understands the tax rules that we applied
above.
For the reasons stated above, we believe that justice favors exercise of our
discretion to reopen the record. We therefore will grant respondent’s motion in
part and reopen the record and admit the Form 11661 into evidence. We also will
admit the declarations into evidence for the purpose of authentication under rule
902(11) of the Federal Rules of Evidence. See Clough v. Commissioner, 119 T.C.
- 45 -
[*45] 183, 190-191 (2002). (As we explain below, we also will deny respondent’s
motion in part and will not admit the Penalty Approval Form.)
1. Supervisory Approval for Mr. Benavides
The Form 11661 evinces supervisory approval for the section 6663(a) fraud
penalties before the formal communication of the initial determination to assess
these penalties against Mr. Benavides. See Clay v. Commissioner,152 T.C. __,
__ - __ (slip op. at 44-45) (Apr. 24, 2019). The Form 11661 was signed by the
examining agent’s supervisor before the first RAR was issued to petitioners and
expressly contemplated that a 30-day letter would be prepared at some point. On
the record before us we conclude that the approval came before respondent sent to
BCO or petitioners any formal communication of penalties. Id. We, therefore,
hold that respondent has satisfied his burden of showing supervisory approval
under section 6751(b)(1) for the section 6663(a) fraud penalties determined
against Mr. Benavides. See Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152
T.C. __, __ - __ (slip op. at 17-18) (Feb. 28, 2019).
2. Supervisory Approval for Mrs. Benavides
With respect to Mrs. Benavides, however, we held above that respondent
has not carried his burden of showing by clear and convincing evidence that she
had fraudulent intent. Therefore, we need not address compliance with section
- 46 -
[*46] 6751(b)(1). The Penalty Approval Form will not change the result as to
Mrs. Benavides, and it is cumulative as to Mr. Benavides. We therefore will deny
respondent’s motion in part and not admit the Penalty Approval Form into the
record.
3. Supervisory Approval for BCO
Respondent does not bear the burden of showing compliance with section
6751(b)(1) for the section 6663(a) fraud penalties determined against BCO
because BCO is a corporation, not an individual. See sec. 7491(c); Dynamo
Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 231-232 (2018).
Nevertheless, with his motion to reopen the record respondent offered a similar
Form 11661 for the section 6663(a) fraud penalties determined against BCO that
was signed by the examining agent’s supervisor before an RAR was issued to
BCO. The Form 11661 was authenticated by the same declarations we have
admitted into the record. It is not clear from the record whether BCO put
supervisory approval under section 6751(b)(1) in issue, but we will deem BCO to
have done so. We will therefore admit the Form 11661 into the record for
purposes of showing requisite supervisory approval of the initial determination to
assess the section 6663(a) penalties determined against BCO. On the basis of this
- 47 -
[*47] Form 11661 and the declarations we have already admitted, we hold that
respondent complied with section 6751(b)(1) with respect to BCO.
C. Summary
Because respondent has shown by clear and convincing evidence that the
underpayments attributable to the diverted gross receipts for each of the tax years
in issue are attributable to fraud, we sustain respondent’s determinations imposing
fraud penalties under section 6663(a) on BCO’s and Mr. Benavides’
underpayments of tax relating to diverted gross receipts.6 With respect to Mrs.
Benavides, however, respondent failed to show by clear and convincing evidence
that she had fraudulent intent; therefore, Mrs. Benavides is not liable for the
section 6663(a) fraud penalties. See sec. 6663(c).
V. Limitations
Finally, petitioners also raise a statute of limitations argument, asserting that
because respondent’s fraud allegation is limited to underpayments of tax
6
Respondent determined that some portions of the underpayments of tax by
petitioners were not attributable to fraud and did not determine fraud penalties on
those amounts. These portions are attributable to the various disallowed
deductions flowing from Sunrise to petitioners that increased Sunrise’s income.
As we explain below, the mere fact that respondent determined that only a portion
of the underpayments was attributable to fraud (the constructive dividends
resulting from diverting BCO’s gross receipts) does not mean that respondent is
barred by the statute of limitations from assessing the portions of the
underpayments that were not attributable to fraud.
- 48 -
[*48] attributable to the gross receipts diverted from BCO, the other deficiencies
are outside the limitations period. A deficiency in tax generally must be assessed
within three years from the date on which the return was filed. See sec. 6501(a).
However, if a taxpayer files a false or fraudulent return with the intent to evade
tax, the tax may be assessed at any time. Sec. 6501(c)(1). And in the case of a
joint return, fraud by either taxpayer suspends the period of limitations indefinitely
for both taxpayers. See Ballard v. Commissioner, 740 F.2d 659, 663 (8th Cir.
1984), aff’g in part and rev’g in part T.C. Memo. 1982-466; Hicks Co. v.
Commissioner, 56 T.C. at 1030; Evans v. Commissioner, T.C. Memo. 2010-199,
2010 WL 3564727, at *5, aff’d, 507 F. App’x 645 (9th Cir. 2013).
Respondent bears the burden of proving by clear and convincing evidence
that this exception to the limitations period applies. See Gould v. Commissioner,
139 T.C. 418, 431 (2012), aff’d, 552 F. App’x 250 (4th Cir. 2014). Respondent’s
burden is the same as his burden under section 6663(a) to prove the applicability
of the fraud penalty: Respondent must show that there is an underpayment of tax
for each year, and that some portion of each underpayment is attributable to fraud.
Id. As discussed above, respondent has carried his burden under section 6663(a)
as to both BCO and Mr. Benavides. Therefore, we hold that he has carried his
burden under section 6501(c)(1) with respect to BCO and petitioners.
- 49 -
[*49] Because the limitations period has not closed with respect to the tax years in
issue, respondent may assess and collect the tax he determined to be owing for
those years, whether or not attributable to fraud. See sec. 6501(c)(1); Lowy v.
Commissioner, 288 F.2d 517, 520 (2d Cir. 1961) (“[I]f a return be fraudulent in
any respect with intent to evade a tax, it deprives the taxpayer of the bar of the
statute for that year, and permits a general reaudit of the return throughout, and
will toll the Statute of Limitations on the reaudit of any item of the tax.”), aff’g
T.C. Memo. 1960-32.
VI. Conclusion
In sum, because we found clear and convincing evidence of fraud with
respect to BCO’s diverted gross receipts for each year in issue, respondent’s
deficiency determinations set forth in the notices of deficiency may be assessed
against both BCO and petitioners, except that the section 6663(a) fraud penalties
may not be assessed separately against Mrs. Benavides.
We have considered all of the arguments made by the parties and, to the
extent they are not addressed herein, we find them to be moot, irrelevant, or
without merit.
- 50 -
[*50] To reflect the foregoing,
An appropriate order and decisions
will be entered.