Paul L. Caron

Monday, March 20, 2023

Lesson From The Tax Court: Another Reason To Keep Good Records

Camp (2017)Last week’s Lesson looked at the inherent unreliability of third-party information returns.  Taxpayers need to keep good records to refute those errors.  This week’s Lesson continues that theme: keeping good records can help avoid a bank deposits analysis.  When the IRS is forced to reconstruct income using the bank deposits method, it puts taxpayers in the hard place of having to prove why every bank deposit should not be counted as gross income for that year.

A pair of opinions issued by Judge Buch on the same day gives us a lesson on the unhappy consequences to taxpayers when their poor record-keeping leads the IRS to use a bank deposits method to reconstruct income.  In both Kevin B. Cheam and Julie Lim v. Commissioner, T.C. Memo. 2023-23 (Feb. 27, 2023), and Lundy Nath and Tanya Nath, T.C. Memo. 2023-22 (Feb. 27, 2023), the taxpayers’ failure to keep adequate books and records forced the IRS to conduct a bank deposits analysis, thus putting the burden on the taxpayers to show which bank deposits represented something other than gross income.  In neither case could the taxpayers show the Court nontaxable sources of income for the deposits the IRS asserted were unreported income.  And their record-keeping failures also hurt them in the usual way on the deduction side as well.  Details below the fold.

Background:  What Triggers an IRS Bank Deposits Analyais
Section 61 provides—somewhat circuitously—that gross income consists of all income from whatever source derived.  When the IRS is inquiring about income items—especially income from Schedule C businesses such as grocery stores and construction companies—the IRS will generally want to examine the taxpayer’s business records to review income items.

But it is up to the taxpayer to actually have business records.  As Treas. Reg. 1.6001-1(a) puts it:  taxpayers must “keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.”

More importantly, as a practical matter, Revenue Agents (RA’s) and other IRS employees are directed to start their examination of income items by looking at the taxpayer’s own records, as part of a series of what the IRM calls “minimal income probes.”  See IRM  Sure, part of these minimal income probes involves looking at bank records, but only to reconcile those with the taxpayers own business records.  IRM  Put another way, the RA will first attempt to find direct evidence of income and expenditures using the taxpayer’s records as the basic source of information.

But some taxpayers have no records that directly track income and expenses, or have really lousy records that practically scream “don’t trust us!”  In those situations, RA’s are authorized to perform what are called indirect methods to determine unreported income. IRM  The RA can choose from a number of indirect methods, listed in IRM 4.10.6.  One of those indirect methods is the bank deposits method.  The IRM says RAs can use a bank deposits method when, among other things, “the taxpayer’s books and records are unreliable, unavailable, withheld, or incomplete,” and “the taxpayer makes periodic deposits of funds into bank account(s) which appear to be generated from an income-producing activity.”  IRM

The Tax Court has long held that bank deposits analyses can be a legitimate tool to identify unreported income.  Judge Buch cites to Clayton v. Commissioner, 102 T.C 632 (1994).  Note, however, when the taxpayer does have adequate records, records that were used to prepare their tax returns the Tax Court is not quite so ready to accept a bank deposits analysis.  See e.g. Westby v. Commissioner, T.C. Memo. 2004-179 (2004) (rejecting “simplistic bank deposits analyses” in light of contemporaneous handwritten ledgers and bank statements taxpayer provided to her return preparer to prepare return).

So ya gotta have something to rebut a bank deposits analysis.  Let’s take a look at two sets of taxpayers who, somewhat surprisingly, failed to track millions of dollars of deposits.

Facts and Lessons From Cheam
In the Cheam/Lim case the years at issue were 2013-2016.  The taxpayers operated Lions Supermarket in Stockton California.  They timely filed returns for those years.  Importantly, the return for 2016 was prepared by a different return preparer than the returns for 2013-2015.  Each year they reported a total tax due, based on the following information in the returns (rounded):

Tax Year

Gross Receipts

Cost of Goods Sold


















You would think that taxpayers who operate a grocery store with that amount of gross receipts would have good records!  You would think wrong.  When the IRS audited, the taxpayers “failed to provide books and records sufficient to substantiate their reported income and expenses.  Because of that failure, the Commissioner computed their taxable income through a bank deposits analysis.” Op. at 3.  The IRS eventually issued three NODs: one for 2013, one for 2014-2015 and one for 2016.

The NODs dinged the taxpayers for some $2 million of unreported gross receipts each year.  Also, because the taxpayers failed to substantiate their expenses, the NODs disallowed all costs of goods sold and all Schedule C deductions.  Ouch.

The taxpayers timely petitioned the Tax Court in response to each of the NODs, filing petitions in 2017, 2018 and 2020.  In their petitions the taxpayers claimed that the IRS did not give them enough time to gather the relevant records and they asserted they actually had supporting records.  However, as Judge Buch notes: “Although more than five years lapsed between the filing of Mr. Cheam and Ms. Lim’s first Petition and the trial of these cases, they provided little...documentary support for their positions.” Op. at 4.

That meant the bank deposits were prima facie proof of income.  During the course of the Tax Court proceedings the taxpayers were able to convince the IRS to reduce each year’s unreported income amount by about half, leaving them with only about $1 million in unreported income.  But note that's gross receipts.  And the IRS had not permitted any accounting for cost of goods sold.  In front of Judge Buch, they were able to do a little better because they put up one witness, their 2016 return preparer, who showed his work in preparing the 2016 return including his calculation of cost of goods sold for that year.

It is pretty well known that grocery stores in general operate on pretty thin profit margins.  They make their profit by volume of sales.  So to say that the taxpayers here had zero cost of goods sold is wildly unrealistic.  That’s where Judge Buch applied the Cohan rule.  For how that rule applies, see Lesson From The Tax Court: The Structure Of Substantiation Requirements, TaxProf Blog (June 1, 2021).  Here, Judge Buch relied on the testimony and work of the 2016 return preparer.  He decided the return preparer’s spreadsheet was reliable overall, even though “it contains obvious errors.”  Op. at 6.  After fixing those, and accounting for the unreported income the taxpayers were unable to refute, the spreadsheet showed a 31.4% cost of good sold for 2016, Judge Buch allowed that percentage for the other years as well, thus further reducing the amount of unreported income.

On the deduction side, the IRS denied almost all deductions.  But the IRS can do that.  If the taxpayer fails to substantiate claimed deductions, the IRS can make a blanket disallowance of all deductions.  That just leaves the burden where it started: on the taxpayer to prove which deductions should be allowed.  See e.g. Roberts v. Commissioner, 62 T.C. 834, 836 (1974)(“While the petitioner might have been entitled to some or all of the deductions claimed by him, he refused to furnish the Commissioner with any records or other evidence to prove his right to any of such deductions. Because of such refusal on his part, the petitioner is in no position to challenge the reasonableness of the Commissioner's determination, nor complain of the procedural or evidentiary consequences resulting therefrom.”).

Here, “beyond the amounts the Commissioner conceded for Schedule C ... Mr. Cheam and Ms. Lim failed to establish their expenses.”  Op at 8.  Yep, that is the usual way bad record-keeping will bite you.

Facts and Lesson in Nath
Like Mr. Cheam and Ms. Lim, Mr. and Ms. Nath timely filed returns for the years at issue (2014 and 2016) and on each return reported tax due, chiefly from Mr. Nath’s Schedule C business income.  He characterized is business as “consulting.”

And Like Mr. Cheam and Ms. Lim, “the Naths failed to produce books and records from which to determine their income and expenses, so the Commissioner computed their income using a bank deposits analysis. Through the bank deposits analysis, the Commissioner uncovered unreported deposits, most of which were wire transfers from Cambodia." Op. at 2.  The bank deposits analysis showed two particularly large deposits in each year that were not reflected on their returns as income: a $1.5 million wire transfer from a Cambodian bank  in 2014 and a $450,000 wire transfer from a Cambodian bank in 2016.

The IRS issued NODs for both years and the Nath’s petitioned Tax Court in 2018 and 2019.  The cases were consolidated and, “after repeated continuances,” Op. at 3, Judge Buch tried the cases in October 2022.

The only explanation that the taxpayers gave for why the $1.5 million deposit in 2014 was not income was that the transfer represented disbursement of a loan from the Cambodian construction company Mr. Nath owned in conjunction with his dad back Cambodia.  Or maybe it represented advances of future salary.  Or maybe it was a bit of both.  The problem was that Mr. Nath had no records.  Well, he DID produce two funky documents that purported to be loans (one in 2014 and one in 2016).  Each one was signed by both himself as borrower and himself as lender (on behalf of the company he owned with his dad). Op. at 6. Judge Buch gently characterized these records as “unreliable.”  Not only was Mr. Nath on both sides of the transaction, but also Judge Buch notes that the documents did not “indicate when Mr. Nath executed them.”

Mr. Nath’s testimony was no more reliable than the loan documents.  For example, he testified that he made monthly repayments of these “loans.”  But that contradicted the purported loan document provisions which provided for a single repayment on December 31, 2024.  Further, Mr. Nath “did not provide any documents evidencing those [re]payments.” Op. at 4.

Bottom Line: We tend to think about record-keeping as important for substantiating claimed deductions.  Today’s lesson reminds us of why record-keeping is also important for establishing the proper amount of income.  In both cases the taxpayer’s records here was so poor that it triggered an IRS bank deposits analysis, as a result of which the taxpayers were forced to explain away some very large deposits.  They could not do that.  Maybe not all the deposits truly represented income, but that's the presumption in a bank deposits analysis and taxpayers without records are in no position to overcome that presumption.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.

Bryan Camp, New Cases, Scholarship, Tax, Tax Practice And Procedure, Tax Scholarship | Permalink


This is why I work so hard to get the books and/or records to support the return.

Posted by: Cheryl Biondolillo | Mar 20, 2023 9:55:53 AM

Post a comment