Paul L. Caron
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Monday, July 31, 2023

Lesson From The Tax Court: An Object Lesson On Adequate Business Records

Camp (2021)[Author’s Note: this past week I joined the 77.5% of Americans who been infected with COVID.  So tired .... zzzzz ** what?  So this week’s lesson may reflect my COVID-fogged brain.  If you find more errors than usual, I humbly apologize and promise to do better next week.]

Some of my Lessons From Tax Court address substantive tax rules.  Some are about practice and procedure.  Today we have an object lesson: when a taxpayer has a bona fide business but fails to keep adequate records of their business activity, bad things happen.

We all know that taxpayer’s need good records to substantiate claimed deductions. See e.g. Lesson From The Tax Court: Receipts Are Not Enough, TaxProf Blog (Sept. 21, 2020).

This week we also learn that: (1) the failure to keep records allows the IRS to use the bank deposits method to determine income and (2) the same failure also gives the IRS a slam-dunk basis to impose §6662(a) accuracy-related penalties.

The case is Greg A. Ninke and Jane M. Ninke v. Commissioner, T.C. Memo. 2023-88 (July 19, 2023) (Judge Halpern).  Again, nothing really new here.  But it's a useful object lesson. Details below the fold.

Law:  Bad Records Leads To IRS Reconstruction of Income
Section 6001 creates the duty to keep decent records. Treas. Reg. 1.6001-1(a) explains further: 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.”

Revenue Agents (RAs) are directed to start their examination of income items by looking at the taxpayer’s own records  See IRM 4.10.4.3.3.  Sure, part of these records are bank records, but RA’s use them only to reconcile with the taxpayers own business records.  IRM 4.10.4.3.7  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 sometimes the RA finds that a taxpayer either has no records that support asserted income and deduction items, or has really sucky records that practically scream “we’re bogus!”  In those situations, RA’s are authorized to use indirect methods to determine unreported income. IRM 4.10.4.6.2.1.  The RA can choose from a number of  indirect methods, listed in IRM 4.10.6.  Perhaps the most common 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 4.10.4.6.4.2.  The Tax Court has long held that bank deposits analyses can be a legitimate tool to identify unreported income.  See  Hague Estate v. Commissioner, 132 F.2d 775 (2d Cir. 1943), aff’g 45 B.T.A. 104 (1941); Estate of Mason v. Commissioner, 64 T.C. 651, 656 (1975), aff’d 566 F.2d 2 (6th Cir. 1977).

An RA using a bank deposits method will not only look at regular old-fashioned bank accounts, but will also look for other sources of stored value, such as prepaid debit cards or peer to peer payment systems.  The RA identifies all deposits, then subtracts from that any identifiable nontaxable sources of deposits, such as transfers from other accounts or Social Security disability payments or documented gifts.

What makes the bank deposit method difficult for taxpayers is the presumption that all deposits are income.  It is totally up to the taxpayer to prove the nontaxable nature of any deposit.  Parks v. Commissioner, 94 T.C. 654, 658 (1990). When you don’t keep records, or your records suck, that can be tricky.

What constitutes inadequate records can be squishy. 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).  Still, ya gotta have something to rebut a bank deposits analysis.

Law: Bad Records Leads to Negligence Penalty
Section 6662(a) imposes an accuracy-related penalty of 20% of any underpayment of tax when that underpayment arises from one of a number of listed causes listed in §6662(b).  Section 6662(b) that is caused by a variety of listed actions.  The very first listed action is “Negligence or disregard of rules or regulations.”  §6662(b)(1).

For penalty purposes, negligence is broadly defined as any failure to make a reasonable attempt to comply with the provisions of this title....”  §6662(c) (emphasis supplied).  Well, as we have seen, §6001 imposes the duty to keep adequate records!  And Treas Reg. 1.6662-3(b) explicitly explains that “Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly.”

Let’s see how this all works out in the two cases.

Lesson 1: Inadequate Records Lead To Bank Deposit Analysis
The years at issue in Ninke were 2015, 2016, and 2017.  In those years both Mr. and Ms. Ninke were involved in the porn business.  He created websites and “other forms of adult entertainment.”  Op. at 3.  For 2015 he also ran a publishing company.  In 2016 and 2017 he also drove for Uber and Lyft.  During 2017 Ms. Ninke worked as a model for one of Mr. Ninke’s websites.

Each year the Ninkes filed returns.  For all years they reported modest net profits from Mr. Nike’s website business.  For 2015 they reported minimal profit from Mr. Nike’s publishing business.  They did not report income from Ms. Nike’s modeling nor does it appear they reported income from Mr. Nike’s side hustle driving for Uber and Lyft.  The Opinion does not say that explicitly but I infer it because the Opinion recites that they filed Schedule C’s only for the porn stuff.

During the years at issue, the Ninkes “had between 12 and 20 accounts at various banks...” Op. at 3.  They also maintained prepaid debit card accounts with various financial service companies such as Paxum and Netspend.  Those accounts permitted peer to peer money transfers, like Paypal or Venmo.  Ironically, one of the features touted for prepaid debit cards is that they simplify record-keeping.  For example, Netspend’s website says its card makes it “easy to stay on top of your money with simple to use tools like Spending Tracker and Anytime Alerts.”  Users of Paxum praise its ability to help them “have full control over the statistics and income of my payments.” That’s from this review website.

So the Ninkes had plenty of records of account transactions.  And apparently they actively moved money around between various accounts.  But when audited they had no records of their business activities to support the amount of income they reported.  So the RA did a bank deposits analysis.  Judge Halpern explains the process, which might be of interest to those readers unfamiliar with how the IRS does it:

“RA Smith conducted a bank deposits analysis, comparing reported Schedule C receipts to bank deposits. He treated the prepaid debit card accounts as if they were checking accounts. He reviewed the account statements that petitioners provided to him. He created spreadsheets, wherein he listed all deposits made in the respective accounts, identified the source of each deposit, and categorized each (i.e., transfer, deposit, loan, refund, adjustment, etc.). He then created a summary sheet for each year, on which he entered the year’s deposits, subtracted deposits from identifiable nontaxable sources, e.g., bank-to-bank transfers, counter credits, and items such as Social Security disability payments, and compared the difference with the gross income petitioners reported for the year. For each year, the difference exceeded petitioners’ reported gross income, and he treated the difference as unreported gross receipts from petitioners’ Schedule C businesses.”

The Ninkes did not agree with RA Smith’s analysis and petitioned Tax Court.  In Court they argued that RA Smith failed to account for transfers from a bunch of other accounts...that they had not disclosed until Tax Court! “Petitioners conceded at trial at least eight bank accounts or prepaid debit card accounts for which they had provided no information to RA Smith.”  Op. at 9.  “They spend approximately half of their brief listing individual cash deposits and withdrawals from their bank accounts and prepaid debit card accounts during the years at issue. They show deposits totaling $28,550 and withdrawals totaling $44,639.”  Id.

Their overall argument was that their total withdrawals each year exceeded their total deposits.  So that meant they could not possibly have had any unreported income.

I confess I don’t follow that last argument.  Just because you spend more than you deposit does not somehow make the deposits not income.  Heck, my son does that on a regular basis!

At any rate, Judge Halpern teaches us the lesson: it’s not enough to show a bunch of financial records.  To refute a bank deposits analysis, he explained, the Ninkes needed “to tie deposits that respondent had not treated as coming from an excludable source to a transfer or a withdrawal from an account previously identified to respondent. ... Showing that cash withdrawals exceeded cash deposits for the years at issue does not prove that any deposit was of cash withdrawn from the same account or any other account of petitioners. And ... their introduction at trial of...bank accounts and prepaid debit card accounts that they had not disclosed to RA Smith raises the possibility of unreported income.”  Op. at 12.

Bottom Line: Failure to keep adequate business records may trigger a bank deposits audit, the results of which will always put the taxpayer into a hole of having to prove a negative: that each deposit was not income.  But that’s a hole of the taxpayer’s own making.

Lesson 2: Bad Records Lead To Accuracy-Related Penalties
The fact that the Ninkes had no business records also created an additional problem for them.  It subjected them to the §6662(a) accuracy-related penalty.  Judge Halpern notes that their failure creates “a prima facie case for the accuracy-related penalties on the grounds that, for each year at issue, petitioners’ underpayment of tax resulted from negligence.”  Op. at 14.

The Ninkes were now on the hook to show some reasonable cause for their underpayments.  They could not.  They thew up the argument that they relied on third party information returns to report their income.  It did not stick.  Judge Halpern writes “Petitioners ignore that RA Smith found unreported income for each year at issue well in excess of cash deposits that petitioners claim were redeposits of transfers or withdrawals from their various bank accounts and prepaid debit card accounts.” Op. at 15.

Bottom Line: The lack of adequate business records to refute the bank deposits analysis also undermines any attempt to show a reasonable cause for a resulting underpayment.

An object lesson for us and for our clients. 

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.

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