Cordes Fin. Corp. v. Commissioner , 73 T.C.M. 2493 ( 1997 )

T.C. Memo. 1997-162
UNITED STATES TAX COURT
CORDES FINANCE CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 27258-93. Filed April 1, 1997.
O. Christopher Meyers, for petitioner.
Gary Bloom, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHALEN, Judge: Respondent determined the following
deficiency and penalties with respect to petitioner's 1990
taxable year:
Penalties
Deficiency Sec. 6662(a) Sec. 6663(a)
$1,530,128 $303,025.86 $32,726.25
All section references are to the Internal Revenue Code
as amended and in effect during 1990. All Rule references
are to the Tax Court Rules of Practice and Procedure.
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After concessions, the issues for decision are: (1)
Whether respondent abused her discretion under section
446(b) in computing an adjustment to change petitioner's
method of accounting for interest income from its
automobile finance business; (2) whether petitioner is
entitled to deduct a loss of $336,912 that was claimed on
its amended return; (3) whether petitioner is liable for
the civil fraud penalty under section 6663(a); and (4)
whether petitioner is liable for the accuracy-related
penalty under section 6662(a) due to a substantial
understatement of income tax.
FINDINGS OF FACT
Some of the facts have been stipulated by the parties.
The stipulation of facts, the supplemental stipulation of
facts, and the exhibits attached thereto are incorporated
herein by this reference.
Petitioner was incorporated in Oklahoma on January 24,
1964, for the purpose of engaging in the business of
automobile financing. At the time its petition was filed
in this Court, petitioner's principal place of business
was in Lawton, Oklahoma. Petitioner reported income and
expenses for Federal income tax purposes on the basis of
the accrual method of accounting and used the calendar year
as its taxable year.
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During 1990, Mr. Edmund J. Cordes was
petitioner's president. He oversaw all of petitioner's
activities.
His education included high school and 2 years of college.
He had studied accounting and business law in college and
had received instruction in accounting while serving in the
military.
During 1990, Mr. Cordes owned or controlled, directly
or indirectly, all of the stock of petitioner and four
other corporations: Cordes Building Corp., Edmund Cordes,
Inc., John Cordes, Inc., and Eddie Cordes, Inc. These
corporations were engaged in the business of selling and
financing the sale of automobiles, except for Cordes
Building Corp., which was engaged in the business of buying
real property and constructing buildings for rental.
During 1990, petitioner's stock was owned by Mr. Cordes'
wife, daughter, and son as follows:
Owner Shares
June J. Cordes 334
Jean Ann Cordes Rigby 333
Johnny J. Cordes 333
Total 1,000
Mr. Cordes' automobile dealerships referred their
customers to petitioner to provide financing for the
purchase of automobiles. If the customer was credit-
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worthy, petitioner would issue a check to the dealership
for the purchase price of the car, and the customer would
issue a promissory note to petitioner under which the
customer would agree to pay the principal amount of the
note plus interest. Payment of the customer's promissory
note was secured by a mortgage on the automobile that was
being financed.
Petitioner's employees maintained a ledger card for
every lending transaction. Each ledger card contained the
customer's name, the vehicle identification number of the
automobile that was being financed, the principal amount of
the loan, and the total interest that would accrue during
the life of the loan. During the life of the loan,
petitioner's employees would record the date and amount of
each payment on the appropriate ledger card. Petitioner
did not maintain a list of all loans outstanding, and
there was no way of knowing if a ledger card was lost or
misplaced, unless the borrower subsequently made a payment
on the loan.
Since its inception as a finance company in 1964,
through and including the year in issue, petitioner has
used the same method of accounting to record loan
transactions on its books and records. At the time
petitioner made a loan, petitioner's employees debited
petitioner's "Loan Receivable" account in an amount equal
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to the sum of the principal amount of the loan and the
total interest that would accrue over the life of the loan.
They credited petitioner's "Cash" account in an amount
equal to the principal of the loan and credited "Deferred
Interest Income" in an amount equal to the interest to be
paid by the customer over the term of the loan.
As mentioned above, after the loan was initially
recorded, petitioner's employees entered the date and
amount of each payment made by the customer on the ledger
card for the loan. Under petitioner's method of account-
ing, however, petitioner did not accrue interest income
while the loan was outstanding and the customer was making
payments. Interest was not accrued until the principal
amount of the loan was fully paid or petitioner repossessed
the automobile securing the loan. At that time, petitioner
recognized for book and tax purposes all of the interest
that had been paid on the loan.
As of the end of 1990, petitioner had approximately
1,300 loans outstanding. According to petitioner's balance
sheet at the end of 1990, there was a debit balance of
$17,315,315.59 in petitioner's loan receivable account and
a credit balance of $7,772,543 in petitioner's deferred
interest income account. Thus, at the close of 1990,
petitioner's balance sheet reflected interest of $7,772,543
to be realized after 1990 on petitioner's portfolio of
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loans. The balances of petitioner's deferred interest
account for the years 1984 through 1990, as reported on
the balance sheets attached as Schedule L to petitioner's
Federal income tax returns, are as follows:
Deferred Interest
Year Per Schedule L
1984 $5,045,821.33
1985 5,354,536.83
1986 5,799,020.10
1987 6,564,988.00
1988 7,569,183.00
1989 7,485,966.00
1990 7,772,543.00
Prior to respondent's audit, petitioner's employees had
not reconciled the deferred interest income account with
the customer ledger cards for approximately 20 years.
Mr. Robert Hinman, the managing principal of the
Lawton office of an accounting firm, was responsible for
the preparation of petitioner's tax returns from 1987
through the year in issue. At no time did Mr. Hinman
examine petitioner's method of accounting for interest
income to determine whether it was consistent with
generally accepted accounting principles, the Internal
Revenue Code, or applicable Treasury regulations.
Petitioner reported interest income for Federal income
tax purposes for the years and in the amounts as follows:
Year Amount
1984 $923,185.00
1985 1,007,549.50
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1986 1,132,417.73
1987 1,065,843.73
1988 995,475.00
1989 959,489.00
1990 855,861.00
During respondent's audit of petitioner's 1990 return,
respondent's agent learned of petitioner's practice of
recording interest income on its books and records only at
the time a loan was paid off or at the time an automobile
was repossessed. In order to recompute petitioner's
interest income for Federal tax purposes, the agent
sought and obtained from petitioner's representatives the
customer ledger cards for all loans outstanding at the
end of 1990. From the documents supplied by petitioner's
representatives, including the ledger cards and certain
loan documents that had been prepared at the time the
loans were made, the agent computed the amount of deferred
interest on each outstanding loan, the interest that
should have been reported on that loan using the accrual
method of accounting, and the amount of deferred interest
with respect to that loan at the end of 1990. The totals
computed by the agent for all the loans outstanding are as
follows:
Aggregate deferred interest
per ledger cards $6,175,575.00
Interest earned
through end of 1990 3,084,179.12
Ending deferred interest 3,091,395.88
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In passing, we note the stipulation of the parties that
the ending deferred interest as calculated by respondent
in the amount of $3,091,395.88 should be increased by
$437,800. We also note the stipulation that the earned
interest as calculated by respondent in the amount of
$3,084,170 should be increased by $295,200. In this
opinion, we shall continue to refer to the amounts
originally calculated by respondent and used in the notice
of deficiency in order to avoid confusion.
Based upon the agent's analysis, respondent determined
that petitioner's interest income had been understated in
the amount of $3,084,179.12. Respondent also determined
that petitioner's interest income had been understated by
the difference between the aggregate deferred interest
computed from the ledger cards as shown above, $6,175,575,
and the deferred interest shown on petitioner's books and
records, $7,772,543, or $1,596,968. Accordingly,
respondent determined that petitioner's interest income
had been understated in the aggregate amount of $4,681,147
(i.e., $3,084,179 plus $1,596,968).
During the audit, respondent's agent asked Mr. Cordes
to provide certain information pertaining to petitioner's
bank deposits at Citizens Bank in Lawton, Oklahoma.
Mr. Cordes refused the agent's request. Accordingly, the
agent issued an administrative summons to obtain the
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information directly from Citizens Bank. Pursuant to the
summons, the bank produced petitioner's deposit records for
the months of January, November, and December 1990. After
comparing petitioner's deposits during these 3 months with
the cash amounts recorded in petitioner's cash receipts
journal, the agent found that petitioner had omitted
$127,889 of income from its 1990 return. Respondent's
agent found the following omitted amounts:
Month Omitted Amount
January $56,893
November 38,246
December 32,750
Total 127,889
Respondent's agent also found that the above-omitted
income had been posted to a liability account, account
312, characterized as a shareholder loan account, as if
petitioner's stockholders, members of the Cordes family,
had advanced funds to petitioner. Mr. Cordes had
instructed petitioner's bookkeeper to post certain receipts
as credits to account 312 and not as income. This was true
for bankruptcy collections with respect to debts that had
been written off, late charge fees related to outstanding
loans, and sundry other receipts. Mr. Cordes and his
family were able to draw upon account 312 to pay personal
expenses. Petitioner concedes that it omitted the above
amounts from its 1990 return.
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Sometime after respondent's agent brought the above-
omitted amounts and certain disallowed deductions to
Mr. Cordes' attention during the audit, petitioner filed
Form 1120X, Amended U.S. Corporation Income Tax Return,
with the Internal Revenue Service Center, Austin, Texas.
On that return, petitioner reported additional gross
receipts in the aggregate amount of $425,955, composed
of the following items:
Deposits to account No. 312 $179,005.00
Late charges & collection fees 56,712.00
Bankruptcy collections 15,745.15
American Express payments 168,854.36
Martin's Restaurant payments 5,638.94
Total 425,955.45
The above items designated as payments to American
Express and Martin's Restaurant are payments for personal
expenses of Edmund J. Cordes and his family that were
deducted on petitioner's 1990 return as "Repossession
Costs".
Petitioner's amended return for 1990 claims a loss
in the amount of $336,912 to offset the additional
income reported on the return, and it makes reference to
an adding machine tape to explain the nature of the loss.
In substance, the adding machine tape states as
follows:
Cordes Finance Corp.
12-31-90
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Cash in Bank (31,446.70)
Notes Rec. 9,542,772.59
Notes Payable:
E & June Cordes (4,108,408.00)
Edmund Cordes, Inc (600,000.00)
Bldg Corp (100,000.00)
Capital Stock (100,000.00)
Surplus (4,000,000.00)
Retained Earnings (939,829.92)
Loss (336,912.03)
Interest Earned 855,861.00
Chg off & Rep Loss 796,073.50
Salaries 77,750.00
Payroll Taxes 6,172.88
Repo Exp 266,424.55
Legal & acctg 17,489.33
Postage 4,205.00
Misc 2,374.77
Taxes 7,056.25
Int. Paid 2,772.60
Group Ins. 12,454.15
(0.00)
The amount of the loss identified on the adding
machine tape is the same as the "Net income per books"
reported on Schedule M-1, Reconciliation of Income per
Books With Income per Return, of petitioner's 1990
return. According to Schedule M-1, petitioner's loss
of $336,912.03 was offset by income in the amount of
$344,827.64 attributable to changing petitioner's method
of accounting for bad debts from the reserve method to
the specific charge method. The difference between those
amounts, $7,915.61, is the taxable income reported by
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petitioner for 1990. Thus, the loss of $336,912 claimed
by petitioner on its amended return for 1990 had already
been claimed on petitioner's return for 1990.
On May 5, 1992, petitioner issued a check to itself in
the amount of $246,950.45, as reimbursement for the amounts
paid from account 312 for the personal expenses referred to
above. On September 14, 1992, petitioner issued a second
check to itself in the amount of $179,005, as reimbursement
for the receipts that had been misclassified as funds
contributed to petitioner by Edmund J. Cordes and deposited
to account 312 during 1990. Both of these checks, in the
aggregate amount of $425,955.45, were charged to
petitioner's account 312.
Respondent mailed a notice of deficiency pertaining
to petitioner's 1990 return in which respondent determined
the deficiency in income tax and penalties set out at the
beginning of this opinion. In computing the subject
deficiency, respondent made the following three adjustments
to petitioner's 1990 return:
Other income $5,107,102
Other deductions-- 175,104
repossession costs
Bad debts (736,331)
Total adjustments 4,545,875
The adjustment labeled other income is composed of the
following items:
Additional interest income $3,084,179
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Reconciliation of deferred
interest account 1,596,968
Additional income reported
on amended return 425,955
Other income 5,107,102
Parenthetically, we note that the tax deficiency determined
by respondent was computed without taking into account the
limitation in tax provided by section 481(b), and
petitioner has not raised that as an issue in this case.
In reference to the additional income reported on
petitioner's amended return, $425,955, respondent concedes
that two of the items of additional income, the aggregate
payments to American Express of $168,854.36 and the
aggregate payments to Martin's Restaurant of $5,638.93,
duplicate the "Repossession Costs" adjustment of $175,104
determined in the notice of deficiency. We note that the
sum of the payments to American Express and Martin's
Restaurant is $174,493.29, or $610.71 less than the
adjustment for repossession costs. Petitioner concedes
that the remaining items reported on its amended return in
the aggregate amount of $251,462.15 are additional income.
OPINION
Change of Method of Accounting for Interest Income
The first issue for decision in this case involves
petitioner's method of accounting for the interest earned
on its portfolio of car loans. At the time each loan was
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made, petitioner credited its deferred interest income
account by the full amount of the interest to be earned
over the term of the loan. However, petitioner did not
debit that account or otherwise take interest income into
account for book or tax purposes until the loan was paid
off or it repossessed the automobile securing the loan.
In effect, petitioner did not accrue interest with respect
to any loan that was outstanding at the end of the year.
Respondent determined that petitioner's method of
accounting for interest income did not clearly reflect
income. Pursuant to respondent's authority under section
446(b), respondent further determined an increase in the
income reported by petitioner in 1990 in the amount of
$4,681,147 to effect a change in petitioner's method of
accounting for interest.
As described above, respondent's adjustment is
composed of two elements. First, based upon petitioner's
records of all loans outstanding at the end of 1990,
respondent determined that the interest earned on those
loans through the end of 1990 is $3,084,179. Respondent
computed this amount by taking interest into account
ratably over the life of each of the subject loans. The
parties have stipulated that the following is a summary
of the earned interest on loans outstanding at the end of
1990 as computed by respondent:
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Year Amount
1990 $1,440,821
1989 923,274
1988 488,357
1987 179,881
1986 43,181
1985 8,470
1984 195
3,084,179
Petitioner's trial memorandum makes the following statement
concerning this element of respondent's adjustment:
Respondent's schedule indicates it totals
$3,084,179, but it actually foots to $3,079,767.
Aside from this small difference, petitioner
agrees that if a change in accounting method is
required here, this is the correct method to use
and that it arrives at the correct starting point
to compute 1990 income.
Petitioner did not specifically take issue with this
element of respondent's adjustment, either at trial or
in its post-trial briefs.
The second element of respondent's adjustment is based
upon the discrepancy in petitioner's deferred interest
account. On the one hand, the balance sheet submitted
with petitioner's 1990 return as Schedule L reports
$7,772,543 as the balance of petitioner's deferred interest
account at the end of 1990. On the other hand, the
aggregate deferred interest recorded on the ledger cards
for all of the loans outstanding at the end of 1990 is
$6,175,575. Thus, petitioner's balance sheet reports
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deferred interest of $1,596,968 more than the amount
recorded on petitioner's loan ledger cards. In order to
reconcile this discrepancy, and to bring the balance of
petitioner's deferred interest account in line with the
ending balance computed by respondent from petitioner's
loan ledger cards, viz $3,091,395.88, respondent increased
petitioner's income in the amount of $1,596,968. The
effect of both elements of respondent's adjustment on
petitioner's deferred interest account can be summarized
as follows:
Deferred interest--ending
balance per tax return $7,772,543.00
Less: Earned interest
per respondent 3,084,179.12
Less: Amount to reconcile
discrepancy in deferred
interest amount 1,596,968.00
Deferred interest--ending
balance per loan ledger cards 3,091,395.88
Petitioner objects to the second element of
respondent's adjustment. Petitioner's position is that
this element has the effect of requiring petitioner to
include in its income for 1990 interest that would
otherwise not accrue until after 1990. Petitioner's
post-trial brief states as follows:
The Commissioner's proposed method of accounting
requires that any interest which has not already
been recognized and which could possibly be
earned at any time in the future on any contract
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outstanding at the end of 1990 be recognized as
income in 1990. [Petitioner] objected to this
proposed change in accounting because it required
the inclusion in income in 1990 of interest on
installment note payments that are not due at
the end of 1990 and won't be due for months or
even years in the future.
According to petitioner, respondent has, in effect, placed
petitioner on an erroneous method of accounting to the
extent that respondent computes petitioner's income by
reference to unearned interest and has, thus, exceeded her
authority to change petitioner's method of accounting under
section 446(b).
We disagree. Neither the purpose nor the necessary
effect of respondent's adjustment is to include in
petitioner's gross income for 1990 interest that will
accrue after 1990. As described above, petitioner treated
interest as having been earned only when a loan was fully
paid off or petitioner repossessed the automobile securing
the loan and the loan was closed on petitioner's books.
The change of accounting method that was made by respondent
is to require interest to be ratably included in
petitioner's income over the life of the loan. Based upon
petitioner's records of loans outstanding at the end of
1990, respondent's agent found that interest in the amount
of $3,084,179 had been earned through the end of 1990.
Petitioner does not attack that computation.
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Under petitioner's method of accounting, the amount of
interest earned during the year is reflected as a decrease
(debit) in the balance of the deferred interest account.
The ending balance of the deferred interest account is
nothing more than the interest that potentially will be
earned on petitioner's portfolio of loans in the future.
Therefore, it was necessary for respondent's agent to
decrease the ending balance of petitioner's deferred
interest account by the additional earned interest that she
computed for the year. However, respondent's agent found
that there was a discrepancy in the ending balance of
petitioner's deferred interest account. According to
petitioner's balance sheet, the balance was $7,772,543 but,
according to petitioner's loan ledger cards, the balance
was $6,175,575, or $1,596,968 less. Obviously, the same
discrepancy is found after the account is reduced by the
amount of additional earned interest computed by
respondent, as shown in the following schedule:
Petitioner Respondent Difference
Deferred interest--ending balance $7,772,543 $6,175,575 $1,596,968
Additional interest (3,084,179) (3,084,179) --
Deferred interest--corrected balance 4,688,364 3,091,396 1,596,968
The above difference of $1,596,968 is the amount of
petitioner's deferred interest that is not substantiated by
petitioner's loan ledger cards. Respondent determined that
this amount represents additional interest that petitioner
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had failed to take into income. To overcome respondent's
determination as to this accounting adjustment, petitioner
bears a heavy burden of proof in that it must show that
respondent's determination is arbitrary and unsupported by
any basis in law. RCA Corp. v. United States, 664 F.2d
881, 886 (2d Cir. 1981); Prabel v. Commissioner, 91 T.C.
1101, 1112 (1988), affd. 882 F.2d 820 (3d Cir. 1989).
Petitioner's position that respondent's adjustment
does not comport with the accrual method of accounting
and is an erroneous method of accounting is based upon
the premise that the above difference is interest that
did not accrue in 1990 or in any prior year. However,
petitioner has not introduced any evidence to rebut
respondent's determination or to explain the difference.
Contrary to the premise of petitioner's argument, the
ledger cards for loans outstanding at the end of 1990
substantiate deferred interest of $1,596,968 less than
the ending balance of the deferred interest account as
shown on petitioner's balance sheet. We find that
petitioner has not proven that respondent abused her
discretion by determining that the difference described
above is interest that accrued prior to 1991. Accordingly,
we hereby sustain respondent's determination. See Prabel
v. Commissioner, supra.
Before leaving this issue, we note that petitioner
made a halfhearted attempt at trial to argue that its
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method of accounting for interest income is an
"appropriate" method of accounting. In support of that
argument, petitioner noted that it had consistently used
the method for over 30 years, and it alleged that
historically it suffers an "unusually high incidence of
repossessions". Petitioner did not prove the allegation
of a high incidence of repossessions and appears to have
abandoned the argument that its method of accounting was
appropriate. Notwithstanding the abandonment of this
argument, it is clear that petitioner's method of
accounting for interest income did not clearly reflect
income. Furthermore, it is well within respondent's
discretion under section 446(b) to change a taxpayer's
method of accounting which, although consistently used
over a period of years, is erroneous and does not
clearly reflect income. E.g., Electric & Neon, Inc. v.
Commissioner, 56 T.C. 1324, 1333 (1971), affd. without
published opinion 496 F.2d 876 (5th Cir. 1974).
Loss Deduction From Amended Return
The stipulation of facts states as follows:
As an offset to the amounts reported in its
amended return as increases to taxable income
for 1990, the petitioner claimed a loss in
the amount of $336,912.00. Said claimed loss
remains in dispute between the parties.
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As discussed in the findings of fact, and as acknowledged
by petitioner's accountant during his testimony at trial,
the loss claimed on petitioner's amended return for
1990 duplicates the deductions claimed on petitioner's
original return for the year. There is no basis on which
petitioner is entitled to deduct the same amounts twice,
and we reject petitioner's claim to deduct the loss, as
reserved in the above-quoted stipulation.
Fraud Penalty
Respondent determined that petitioner fraudulently
omitted income in the amount of $127,889 from its 1990
return and determined that petitioner is liable for a
civil fraud penalty under section 6663 in the amount of
$32,726.25. The omitted amounts arise from the fact that,
upon Mr. Cordes' instructions, petitioner's bookkeeper
recorded bankruptcy receipts, late charge fees, and other
miscellaneous receipts as increases in account 312, a
shareholder loan account, rather than as income. Although
petitioner admits the omission of $127,889 from income,
petitioner contends that it should not be subject to the
fraud penalty for two reasons. First, petitioner contends
that it acted in good faith and with reasonable cause
because it "relied on the advice of [its] firm of Certified
Public Accountants." Second, petitioner contends that
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there is no underpayment of tax as defined by section
6664(a).
Section 6663(a) provides that if any part of an
underpayment 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. The
Commissioner bears the burden of proving fraud by clear
and convincing evidence. Sec. 7454(a); Rule 142(b).
If the Commissioner establishes that any portion of an
underpayment is attributable to fraud, then the entire
underpayment shall be treated as attributable to fraud,
except as to any portion of the underpayment which the
taxpayer establishes, by a preponderance of the evidence,
is not attributable to fraud. Sec. 6663(b).
In this case, we construe respondent's statements at
trial and in her post-trial briefs to concede that the only
portion of the underpayment attributable to fraud is the
portion attributable to the omission of $127,889, as
determined in the notice of deficiency. Accordingly, we
limit our discussion of the fraud penalty to the omission
of income in the amount of $127,889.
To prove fraud, the Commissioner must show that an
underpayment exists, and that the taxpayer intended to
evade taxes known to be owing by conduct intended to
conceal, mislead, or otherwise prevent the collection of
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taxes. Stoltzfus v. United States, 398 F.2d 1002, 1004
(3d Cir. 1968); Rowlee v. Commissioner, 80 T.C. 1111,
1123 (1983). The issue is one of fact to be determined
upon a consideration of the entire record. Rowlee v.
Commissioner, supra; Beaver v. Commissioner, 55 T.C. 85,
92 (1970).
In view of the fact that fraudulent intent can
seldom be established by direct proof of the taxpayer's
intention, fraud is usually established by drawing
inferences from the taxpayer’s entire course of conduct.
Parks v. Commissioner, 94 T.C. 654, 664 (1990); Estate of
Beck v. Commissioner, 56 T.C. 297, 363 (1971). The courts
have developed several indicia or "badges" of fraudulent
behavior. These “badges of fraud” include conduct such
as consistently understating income, Estate of Upshaw v.
Commissioner, 416 F.2d 737 (7th Cir. 1969); Parks v.
Commissioner, supra; failing to cooperate with tax
authorities, Zell v. Commissioner, 763 F.2d 1139, 1146
(10th Cir. 1985), affg. T.C. Memo. 1984-152; and any other
conduct likely to mislead or conceal, see Estate of
Schneider v. Commissioner, 29 T.C. 940, 954-955 (1958).
We note that since petitioner is a corporation, it can
act only through its officers. Federbush v. Commissioner,
34 T.C. 740, 749 (1960), affd. 325 F.2d 1 (2d Cir. 1963).
In this case, respondent has proven that $127,889 of
petitioner's income in 1990 was diverted to the personal
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benefit and use of Mr. Cordes and his family. Petitioner
concedes that it omitted gross receipts in the amount of
$251,462.15 from its 1990 return, including the $127,889
with respect to which respondent determined the fraud
penalty. Respondent has also proven that the omission of
income in the amount of $127,889 was accomplished through
a scheme designed by petitioner's president, Mr. Cordes, to
divert petitioner's collection of late charges, bankruptcy
receipts, and miscellaneous other receipts to shareholder
loan account 312, and thereby to disguise the omitted
income as loans or advances from Mr. Cordes and his family.
Mr. Cordes instructed petitioner's bookkeeper to book the
subject receipts to account 312, rather than to an income
account.
Furthermore, during the audit, respondent's agent
asked Mr. Cordes for petitioner's bank records in order
to make a bank deposits analysis. Mr. Cordes refused the
agent's request and forced the agent to obtain the records
directly from the bank. Mr. Cordes' refusal to cooperate
with respondent's agent suggests that he intended to
conceal petitioner's omission of the income in account
312. Cf. Zell v. Commissioner, supra at 1146.
We reject petitioner's contention that it relied in
good faith on the professional advice of its accountants.
There is no evidence in the record that petitioner's
outside accountants were aware of the omitted receipts or
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that they advised petitioner or any of its employees to
book the omitted receipts to account 312 rather than to
an income account. This was done on the instructions of
Mr. Cordes. Under these circumstances, petitioner's
claim of reliance on its accountants is without merit.
Moreover, even if petitioner's certified public accountants
had given such advice with knowledge of all of the relevant
facts, the advice would have been so clearly wrong that we
could not find that petitioner relied upon the advice in
good faith. See Laverne v. Commissioner, 94 T.C. 637,
652-653 (1990), affd. 956 F.2d 274 (9th Cir. 1992), affd.
without published opinion sub nom. Cowles v. Commissioner,
949 F.2d 401 (10th Cir. 1991); Horn v. Commissioner, 90
T.C. 908, 942 (1988). Accordingly, we sustain respondent's
determination of the fraud penalty under section 6663(a) as
to the underpayment attributable to $127,889 of omitted
income.
Finally, we reject petitioner's argument that the
fraud penalty under section 6663(a) should not be
imposed because there is no "underpayment". The term
"underpayment" is defined by section 6664(a), as follows:
the term "underpayment" means the amount by which
any tax imposed by this title exceeds the excess
of--
(1) the sum of--
(A) the amount shown as the tax
by the taxpayer on his return, plus
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(B) amounts not so shown
previously assessed (or collected
without assessment), over
(2) the amount of rebates made.
See also sec. 1.6664-2(a), Income Tax Regs. Petitioner
argues that there is no underpayment because "(exclusive
of the accounting change issue) there were actually more
adjustments in Taxpayer's favor than adjustments which
would result in additional tax." In effect, petitioner is
arguing that for purposes of determining the amount of the
underpayment, the "tax imposed", as that phrase is used in
section 6664(a), does not include the tax attributable to
the "accounting change issue". Petitioner cites no
authority in support of that argument, and we reject it as
contrary to the statute and the regulations. In this case,
respondent has proven that there is an underpayment of tax
and that a portion of the underpayment is attributable to
fraud.
Penalty for Substantial Understatement of Income Tax
Respondent determined that petitioner is liable for
the accuracy-related penalty under section 6662(a) in the
amount of $303,025.86 with respect to petitioner's 1990
taxable year. Respondent determined that the penalty
applied to the entire underpayment, except for the portion
attributable to the omission of $127,889 with respect to
which respondent determined the fraud penalty.
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In general, section 6662(a) imposes a penalty equal
to 20 percent of the portion of an underpayment of tax
which is attributable to one or more of the items listed
in section 6662(b), including any substantial understate-
ment of income tax. Sec. 6662(b)(2). For this purpose,
an understatement of tax is defined as the excess of the
amount of the tax which is required to be shown on the
return for the taxable year over the amount of the tax
which is shown on the return, reduced by any rebates.
Sec. 6662(d)(2)(A). In the case of a corporation, an
understatement is considered substantial if it exceeds
the greater of 10 percent of the tax required to be shown
on the return for the taxable year, or $10,000. Sec.
6662(d)(1).
Petitioner argues that the accuracy-related penalty
should not apply for the same two reasons that the fraud
penalty should not be imposed. Petitioner argues, first,
that it acted in good faith and with reasonable cause
because it relied on the advice of its accountants and,
second, that there is no underpayment of tax because
"(exclusive of the accounting charge issue) there were
actually more adjustments in Taxpayer's favor than
adjustments which would result in additional tax."
Petitioner does not cite the reasonable cause exception
contained in section 6664(c)(1), but its argument that
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it acted in good faith is consistent with an argument
under that provision.
At the outset, we note that the deficiency determined
in the notice of deficiency is based upon the following
adjustments:
Other income
Earned interest $3,084,179
Amount to reconcile
discrepancy in deferred
interest account 1,596,968
Income reported on
1
amended return 425,955
Other deductions
Repossession costs 175,104
Bad debts (736,331)
4,545,875
1
We note that respondent has conceded $174,494 of this
amount and that $127,889 of this amount is subject to the
fraud penalty.
In general, "The determination of whether a taxpayer
acted with reasonable cause and in good faith is made on a
case-by-case basis, taking into account all pertinent facts
and circumstances." Sec. 1.6664-4(b)(1), Income Tax Regs.
In making this determination, the most important factor
is the extent of the taxpayer's effort to assess its
proper tax liability. Id. Circumstances that may
indicate reasonable cause and good faith include an honest
misunderstanding of fact or law that is reasonable in light
of the experience, knowledge and education of the taxpayer.
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Id. Reliance on a qualified professional such as an
attorney or accountant may demonstrate reasonable cause
and good faith, if the evidence shows that the taxpayer
contacted a competent tax adviser and provided the adviser
with all necessary and relevant information. See Patin
v. Commissioner, 88 T.C. 1086, 1130 (1987), affd. without
published opinion 865 F.2d 1264 (5th Cir. 1989), affd. sub
nom. Gomberg v. Commissioner, 868 F.2d 865 (6th Cir. 1989),
affd. sub nom. Skeen v. Commissioner, 864 F.2d 93 (9th Cir.
1989), affd. without published opinion sub nom. Hatheway
v. Commissioner, 856 F.2d 186 (4th Cir. 1988); Freytag v.
Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011
(5th Cir. 1990), affd. 501 U.S. 868 (1991).
We acknowledge that petitioner had a longstanding
relationship with the same firm of certified public
accountants who had initially advised petitioner concerning
the creation of its accounting system. However, in this
case, there is no evidence that the errors in petitioner's
1990 income tax return resulted from advice given to it by
its certified public accountants. Mr. Hinman, who assumed
primary responsibility for petitioner's tax returns in
1987, testified that he did not review petitioner's method
of accounting for interest. Similarly, there is no
evidence that he advised petitioner to omit income by
booking receipts to account 312 or in any other fashion,
or that he advised petitioner to deduct personal expenses
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of Mr. Cordes as repossession costs. Mr. Hinman was the
only member of petitioner's firm of outside certified
public accountants to testify at trial. Moreover, none of
petitioner's employees who testified at trial attributed
the errors in petitioner's return to advice received from
its accountants. Therefore, we reject petitioner's
contention that it acted with reasonable cause and in good
faith.
We also reject petitioner's contention that the
accuracy-related penalty should not be imposed because
there was no underpayment. As discussed above in
connection with the fraud penalty, petitioner cites no
authority for its contention that the underpayment in this
case must be determined "exclusive of the accounting change
issue". The definition of underpayment contained in
section 6664(a) and the regulations promulgated thereunder,
section 1.6664-2(a), Income Tax Regs., requires otherwise.
In light of the foregoing and concessions by the
parties,
Decision will be entered
under Rule 155.