William M. Hawkins and Laura C. Hawkins v. Commissioner ( 2003 )

T.C. Summary 2003-154
UNITED STATES TAX COURT
WILLIAM M. HAWKINS AND LAURA C. HAWKINS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11334-99S. Filed October 21, 2003.
William M. Hawkins, pro se.
Ronald T. Jordan, for respondent.
CARLUZZO, Special Trial Judge: This case was heard pursuant
to the provisions of section 7463 of the Internal Revenue Code in
effect at the time the petition was filed. Unless otherwise
indicated, subsequent section references are to the Internal
Revenue Code in effect for the years in issue. Rule references
are to the Tax Court Rules of Practice and Procedure. The
decision to be entered is not reviewable by any other court, and
this opinion should not be cited as authority.
- 2 -
Respondent determined deficiencies in petitioners’ Federal
income taxes, additions to tax, and penalties as follows:
Additions to Tax Penalties
Year Deficiency Sec. 6651(a)(1) Sec. 6662
1992 $25,952 $5,929 $5,190
1993 5,914 870 1,183
1994 12,751 2,597 2,550
The issues for decision for each year in issue are: (1)
Whether petitioners underreported income; (2) whether petitioners
are entitled to depreciation deductions greater than those
respondent allowed; (3) whether petitioners are entitled to a
deduction for charitable contributions; (4) whether petitioners
had reasonable cause for their failure to file a timely Federal
income tax return; and (5) whether the underpayment of tax
required to be shown on petitioners’ Federal income tax return is
due to negligence.
Background
Some of the facts have been stipulated and are so found.
Petitioners are husband and wife. They filed an untimely Federal
income tax return for each year in issue. At the time the
petition was filed, they resided in Indianapolis, Indiana.
William M. Hawkins (petitioner) is an attorney. He has
practiced law since 1971 and did so as a sole practitioner during
the years in issue. Petitioners’ Federal income tax return for
each year in issue includes a Schedule C, Profit or Loss From
Business, on which income and expenses attributable to
- 3 -
petitioner’s law practice are reported. Petitioner maintained a
checking account for his law practice (the business account),
kept individual client records, and saved receipts for expenses
incurred in his law practice. Otherwise he kept no formal books
of account or other accounting records to track income earned and
expenses incurred in his law practice.
Petitioners own numerous residential real estate properties
that were held for rent or rented during the years in issue (the
rental properties). Some of the rental properties were rented
pursuant to Federal or State rent subsidy programs. Petitioners’
Federal income tax return for each year in issue includes a
Schedule E, Supplemental Income and Loss, on which income and
expenses attributable to the rental properties are reported.
Petitioner used the business account to pay expenses incurred in
connection with the rental properties. He also saved expense
receipts. Other than the business account and the expense
receipts, petitioner kept no formal books of account or other
accounting records to track income earned and expenses incurred
in connection with the rental properties.
Petitioners also maintained a joint checking account during
the years in issue (the joint account). Expenses related to
petitioner’s law practice and the rental properties were not paid
from the joint account. However, some personal expenses were
paid with checks drawn on the business account.
- 4 -
Petitioners’ joint 1992 Federal income tax return was filed
on April 19, 1995, their 1993 return was filed on April 16, 1996,
and their 1994 return was filed on April 16, 1997. Petitioner
prepared each of these returns. Items reported on the Schedules
C are summarized as follows:
Year Gross Income Total expenses Profit/(Loss)
1992 $28,850 $46,719 ($17,869)
1993 29,500 46,505 (17,005)
1994 24,500 45,318 (20,818)
Items reported on the Schedules E are summarized as follows:
Year Rents received Total expenses Income/(Loss)
1992 $85,820 $151,975 ($66,155)
1993 101,968 140,733 (38,765)
1994 128,216 120,482 7,734
The examination of petitioners’ returns began in March
1996.1 Petitioner failed to provide the revenue agent with all
of the documents that she requested from him. As best can be
determined from the record, the revenue agent did not issue any
summonses to petitioners or third parties. Business account bank
statements and canceled checks were provided to the revenue
agent, as was petitioner’s check register for the business
account. Petitioner also provided a check register for the joint
account, but the register included only entries made from April
through December 1992. The revenue agent concluded that
petitioners’ income could not be determined from the books and
1
Sec. 7491 is therefore inapplicable.
- 5 -
records with which she was provided. She decided to reconstruct
petitioners’ income using the cash T-account method and computed
petitioners’ unreported income for each year in issue as follows:
Year Income per return Expenses Unreported income
1992 $171,718 $311,882 $140,164
1993 191,844 239,445 47,601
1994 180,735 215,195 34,460
Using a ratio derived from the incomes reported on the
Schedules C and E, the revenue agent allocated the unreported
income between those schedules as follows:
Year Schedule C Schedule E Total
1992 $35,041 $105,123 $140,164
1993 10,472 37,129 47,601
1994 5,514 28,946 34,460
The revenue agent relied on depreciation schedules that
were apparently created in connection with an examination of
petitioners’ returns for years preceding 1992 and brought the
schedules forward to the years in issue. As a result,
petitioners’ depreciation deductions were adjusted (reduced) as
follows:
Year Schedule C Schedule E Total
1992 $11,629 $13,239 $24,868
1993 11,916 14,105 26,021
1994 16,011 14,594 30,605
The revenue agent did not question the charitable
contribution deduction claimed for any year in issue.
- 6 -
Respondent issued a notice of deficiency to petitioners on
March 19, 1999. For each year in issue, respondent: (1)
Increased petitioners’ income by the unreported income amount
listed above; (2) reduced depreciation deductions claimed on the
Schedule C and Schedule E; (3) made statutory adjustments to
petitioners’ self-employment tax, self-employment tax deduction,
and itemized deductions; (4) imposed an addition to tax for
petitioners’ failure to file a timely return; and (5) imposed an
accuracy-related penalty for negligence or disregard of rules or
regulations.
Discussion
Section 6001 requires a taxpayer to maintain sufficient
records to allow for the determination of the taxpayer’s correct
tax liability. Petzoldt v. Commissioner, 92 T.C. 661, 686
(1989). If a taxpayer fails to maintain or does not produce
adequate books and records, the Commissioner is authorized to
reconstruct the taxpayer’s income, sec. 446(b); Petzoldt v.
Commissioner, supra at 686-687, and it is well settled that
indirect methods may be used to do so, Holland v. United States,
348 U.S. 121 (1954). The Commissioner’s reconstruction need only
be reasonable in light of all the surrounding facts and
circumstances. Petzoldt v. Commissioner, supra at 687; Giddio v.
Commissioner, 54 T.C. 1530, 1533 (1970); Schroeder v.
Commissioner, 40 T.C. 30, 33 (1963).
- 7 -
In this case, petitioners’ unreported income for each year
in issue was determined by use of the cash transactions method,
commonly referred to as a “cash T analysis”, which includes a
table with income items (debits) on the left side of the “T”
account and expenses (credits) on the right side of the “T”
account. See, e.g., Owens v. Commissioner, T.C. Memo. 2001-143.
This method in some ways resembles the source and application of
funds method. Balken v. Commissioner, T.C. Memo. 1994-375, affd.
without published opinion 72 F.3d 133 (8th Cir. 1995). Its
purpose is “to measure a taxpayer’s reported income against
expenditures to determine whether more was spent than was
reported.” Rifkin v. Commissioner, T.C. Memo 1998-180, affd.
without published opinion 225 F.3d 663 (9th Cir. 2000). The
suggestion is, of course, that the excess of expenditures over
reported income represents unreported income. Id.According to respondent’s long-ago-published training
materials, the cash T-account analysis is used as a preliminary
to one of the more commonly used and more sophisticated indirect
methods of reconstructing a taxpayer’s income, such as the net
worth method, bank deposits method, source and application of
funds method, or specific item method. See, e.g., Rifkin v.
Commissioner, supra; 60 Stand. Fed. Tax Rept. (CCH) (1973).
In this case, petitioners’ failure to maintain adequate
books and records justified the use of an indirect method to
- 8 -
reconstruct their income. According to petitioner, the excess of
expenditures over reported income for each year is accounted for
by a cash hoard that he maintained in a safe in his house. The
revenue agent rejected petitioner’s claim, and we do likewise.
See, e.g., Parks v. Commissioner, 94 T.C. 654, 663 (1990).
Rejecting petitioner’s cash hoard claim, however, does not
require us to accept respondent’s computation. Although we find
that respondent’s use of an indirect method is appropriate, the
analysis itself is not without problems. For example, the
revenue agent acknowledged that her analysis might have
overstated petitioners’ unreported income for each year insofar
as she included in her analysis expenditures that petitioners
paid by check, plus all itemized deductions, without adjusting
for duplications for those itemized deductions that were paid by
check.
Other problems exist with respect to the revenue agent’s
analysis. For example, her analysis for 1992 includes an
expenditure of $26,600 for new roofs for one or more of the
rental properties. With respect to this item, the revenue agent
relied on handwritten entries on the above-referenced
depreciation schedules but could not identify who made the
notations or why they were made. Petitioner denied that any
amount was expended for new roofs on any of his rental properties
during 1992, and we accept his testimony on the point.
- 9 -
We are also troubled by assumptions the revenue agent made
on account of a lack of records from the joint account. The
check register that the revenue agent used covered only 9 months
of 1992. She averaged the monthly expenditures made during those
9 months and applied that amount to the 3 remaining months not
covered by the check register. She then applied the average
monthly expenditures for 1992 to 1993 and 1994. We consider this
inappropriate and unreasonable given that petitioners’ joint
checking account records could have been obtained from
petitioners’ bank.
On the other hand, we reject petitioner’s implausible claim
that the source of many of the expenditures included in the
revenue agent’s analysis was a cash hoard that he kept in a safe
in his residence. See De Venney v. Commissioner, 85 T.C. 927,
933 (1985) (“[T]he existence of a cash hoard is endlessly claimed
by taxpayers to explain the existence of otherwise unexplained
sources of funds. It is rare indeed that a taxpayer successfully
proves this contention.”). After careful consideration of the
record, we accept respondent’s analysis subject to the following
adjustments. For 1992, the following expenditures must be
eliminated from respondent’s cash T-account computation: (1)
Itemized deductions; (2) personal expenditures estimated through
the use of monthly averages; and (3) the $26,600 expenditure for
new roofs. For 1993 and 1994, personal expenditures determined
- 10 -
with reference to checking account information from 1992 must be
eliminated from respondent’s computation.
Depreciation Deductions
Petitioners have failed to offer any evidence to contradict
respondent’s partial disallowance of their depreciation
deductions. Petitioner suggested he had depreciation schedules
that would support the allowance of those deductions and was
given ample time following trial to provide these schedules, but
he failed to do so. Respondent is sustained on this issue.
Charitable Contribution Deductions
Respondent disallowed the charitable contribution deduction
petitioners claimed for each year in issue. The revenue agent
testified that she did not question those deductions during the
examination of petitioners’ returns. Furthermore, the deductions
were taken into account in respondent’s cash T-account analysis.
On the basis of petitioner’s testimony, we find that petitioners
are entitled to the charitable contribution deductions as claimed
on their returns.
Section 6651 Addition to Tax
The failure to file a timely Federal income tax return
results in a mandatory addition to tax unless the taxpayer shows
that the failure was due to reasonable cause and not due to
willful neglect. Sec. 6651(a). The taxpayer bears the heavy
burden of proving both of these elements. United States v.
- 11 -
Boyle, 469 U.S. 241, 245 (1985) (defining “willful neglect” as
the conscious, intentional failure or reckless indifference on
the part of the taxpayer to file a return, and “reasonable cause”
as the inability to file a return within the prescribed period of
time, despite having exercised ordinary business care and
prudence).
Petitioners failed to file a timely Federal income tax
return for each year. The record is nearly devoid of evidence
pertaining to this issue. When prompted by this Court to explain
the untimely filing of their returns, petitioner responded as
follows:
I’ll tell you exactly. Your Honor, I found that I was
paying more taxes than I was required to pay. And I,
negligence on my side, I began to ask for an extension
because I felt like this. You don’t have to pay penalty,
you don’t have to pay no late charge, as long as you have
money coming back. And you do it within three years.
There is no evidence that petitioners exercised reasonable
business care and prudence, and the above quote suggests that the
untimely filing of petitioners’ returns was due to petitioner’s
willful neglect. Petitioners have failed to carry their burden
of proof and respondent is sustained on this issue.
Section 6662 Penalty
Under section 6662, a penalty is imposed on that portion of
an underpayment of the tax required to be shown on a return if
the underpayment is due to negligence or disregard of rules or
regulations. Sec. 6662(a) and (b)(1). Negligence is defined to
- 12 -
include any failure to make a reasonable attempt to comply with
the provisions of the Internal Revenue Code. Sec. 6662(c). It
is further defined as the failure to do what a reasonable person
with ordinary prudence would do under the same or similar
circumstances. Neely v. Commissioner, 85 T.C. 934, 947 (1985).
Disregard is defined to include any careless, reckless, or
intentional disregard. Sec. 6662(c). An accuracy-related
penalty will not be imposed with respect to any portion of an
underpayment as to which the taxpayer acted with reasonable cause
and in good faith. Sec. 6664(c)(1). Whether the taxpayer acted
with reasonable cause and in good faith depends on the pertinent
facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
Circumstances that may indicate reasonable cause and good faith
include the extent of the taxpayer’s effort to properly assess
the tax liability and an honest misunderstanding of fact or law
that is reasonable in light of the taxpayer’s experience,
knowledge, and education. Id. The taxpayer bears the burden of
proving that he or she did not act negligently or disregard rules
or regulations. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933).
Petitioner is not an unsophisticated taxpayer but an
experienced attorney, licensed since 1971. He operates his own
law practice and owns approximately 18 investment properties.
This experience is relevant in deciding whether he acted
- 13 -
negligently with respect to the underpayments of tax required to
be shown on petitioners’ returns. See Pelton & Gunther v.
Commissioner, T.C. Memo. 1999-339; Estate of Holland v.
Commissioner, T.C. Memo. 1997-302 (positions taken on return not
reasonable in light of the fact that one of the executors was an
experienced attorney). Furthermore, petitioners failed to
maintain adequate books and records from which their Federal
income tax liability could be established. See Sowards v.
Commissioner, T.C. Memo. 2003-180; Brodsky v. Commissioner, T.C.
Memo. 2001-240; sec. 1.6662-3(b)(1), Income Tax Regs. After
careful consideration of all pertinent facts and circumstances,
we find that petitioners did not act with reasonable cause and in
good faith and that the underpayments of tax required to be shown
on their returns are due to petitioners’ negligence. Respondent
is sustained on this issue.
Reviewed and adopted as the report of the Small Tax
Division.
To reflect the foregoing,
Decision will be
entered under Rule 155.