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Tax Court Corner: How the Court Reconstructs Income

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When a taxpayer has an all-cash business or the IRS thinks that all income isn’t being reported, the IRS and the US Tax Court can reconstruct income. This is usually done by bank deposits and cash expenditures; however, it can also be done using a cash-flow analysis.

One of the other ways to reconstruct income is the “net worth method” where the increase in the taxpayer’s net worth is added to the living expenses and taxes paid, and compared to the reported income. Another way is the “cash expenditure method,” a variation of the net worth method, where all ascertainable cash is added to the cash receipts and all cash disbursements are deducted.

Still another method is the “bank deposit method” under which bank deposits are compared to reported income. Also, the “percentage mark-up method” where the taxpayer’s income is determined by applying certain percentages (such as gross profit to sales, or net income to gross income, or gross profit to sales) derived from other taxpayers in the same business to the taxpayer’s gross sales or purchases.

In Charles Y. Choi; Jin Yi Choi, Petitioners v. Commissioner, the Commissioner used the “bank deposits plus cash expenditures” method of reconstructing income and assessed a deficiency of $59,106 for 1991 and $49,624 for 1992. The Commissioner found fraudulent intent and imposed a penalty. Indeed, the Chois, in 1996, pled guilty to criminal tax evasion for the 1992 tax year.

In challenging the deficiency and civil penalty determinations in the Tax Court, the Chois argued that the Commissioner was not allowed to use the “bank deposits plus cash expenditures” method to reconstruct their income. The Chois provided expert testimony to prove that by using a different method of reconstructing income, the Commissioner would not have assessed a deficiency for either tax year. They also challenged the fraud finding.

The Tax Court upheld the Commissioner’s use of the “bank deposits plus cash expenditures” method of income reconstruction and rejected the Chois’ alternative method while imposing a civil fraud penalty for 1991. The Tax Court ruled that the Chois were barred by collateral estoppel from challenging the merits of the 1992 fraud penalty.

The Chois appealed. In Tax Court, the principal challenge was the use of the “bank deposits plus cash expenditures” method of income reconstruction. Under this method, gross income is derived by adding together all bank deposits made by the taxpayer during the tax year in question, subtracting nontaxable amounts, and adding expenditures made from cash that was never deposited into the bank. The court used as its position United States v. Brickey.

The Chois challenged the use of this method, arguing that the Commissioner did not properly subtract all nontaxable amounts. They contended that many of the bank deposits consisted of nontaxable amounts because the grocery store cashed payroll checks for its customers without charging a fee when the customer also purchased groceries; thus, depositing these checks into the grocery store’s bank account.

Therefore, the portion of each check that was returned to customers in cash was clearly not taxable income. Thus, the Commissioner could not permissibly include the full amount that was deposited into the store’s bank account in the calculation of income.

The Commissioner, however, did not include all of the store’s deposits in the calculation of the Chois’ income. Rather, the Commissioner correctly subtracted “identifiable nonincome” and properly presumed the remainder of the deposits was taxable income.

As the Tax Court determined, there were only two sources of cash that supplied the registers at the Chois’ store:

1. Cash from customers who bought groceries.

2. Cash returned from the store’s bank account after checks were deposited.

Any money received from the sale of groceries was clearly taxable. The only nontaxable activity that the store owners engaged in was the cashing of payroll checks for customers.

In 1991, the Chois deposited $2,066,381 into their bank account, none of it in cash. They then returned approximately $1,420,200 in cash to the register after processing the checks through their bank. Without additional cash entering the register from the sale of groceries, this $1,420,200 was the maximum amount available in the register to give to customers cashing payroll checks.

Because they could only have cashed more than $1,420,200 in payroll checks if they received additional cash from customers who bought groceries, $1,420,200 is also the maximum amount of nontaxable money the Chois could have deposited into their bank account in 1991. The Commissioner properly subtracted the entire $1,420,200 from the calculation of the Chois’ income. Thus, the Chois lost on appeal.

In Roberto Insolera and Angela Insolera, Petitioners-Appellants v. Commissioner, the Insoleras were found liable for deficiencies in their 1968 and 1969 income tax and for an additional 50 percent fraud penalty for each of the two years. The decision and judgment – after examination of the record, reading of the parties’ briefs on appeal, and hearing oral arguments by counsel – were affirmed by the court.

The court stated there was ample evidence to sustain the finding of a deficiency for the year 1968. The Commissioner determined the deficiency by relying on the “bank deposits method” of reconstructing income. He started with the total deposits in the appellants’ various bank accounts and then subtracted loans received, interbank transfers, cash redeposits, and income reported on the appellants’ tax returns to arrive at “unexplained bank deposits” in the amount of $27,524, which constitutes the amount by which the taxpayers understated their income for the year 1968.

Although the taxpayers argued that the “unexplained deposits” could, in fact, be explained as resulting from the taxpayers’ practice of redepositing cash previously withdrawn from their various bank accounts (i.e., “churning”), it was not unreasonable for the Tax Court to disbelieve that theory and the appellants’ testimony, particularly in light of the presumption of correctness which attaches to the Commissioner’s determination of a deficiency. Nor was it unreasonable for the Commissioner, in determining the deficiency, to refuse to credit the petitioners’ testimony regarding cash redeposits in the absence of corroborative evidence of deposits, such as deposit slips.

The fact that the taxpayers had withdrawn a large amount of money does not mean that they redeposited the withdrawals. In short, the failure to show that the “unexplained deposits” were not income was the fault of the taxpayer, not the Commissioner.

There was also ample evidence to sustain the Commissioner’s determination, under the same “bank deposits method” of reconstructing income, of a deficiency of $23,739 for the year 1969. Although the appellants correctly argued that the statute of limitations bars the assessment of a deficiency with respect to the 1969 return unless fraud is shown, the Commissioner had shown by clear and convincing evidence that the understatement of income for the year 1969 was due to fraud.

Aside from the substantial unexplained deposits, there was proof that the taxpayers destroyed important relevant records during the Commissioner’s criminal investigation. These were well-educated and sophisticated people quite competent in maintaining financial records when it was to their advantage, and the pattern of underreporting extended over a two-year period.

Under the circumstances, the Commissioner’s determination was not arbitrary, and even assuming that the Commissioner had the burden of proving fraud with respect to the 1969 deficiency, that burden was satisfied. The presumption of correctness as to the deficiencies thus remained undisturbed.

As you can see, the Tax Court can and will reconstruct income.

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