SYSCO CORPORATION v. COMMISSIONER OF REVENUE
Case Information:
Docket/Court: C282656; C283182, Massachusetts Appellate Tax Board
Date Issued: 10/20/2011
Tax Type(s): Corporate Income Tax
These are appeals filed under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39 from the refusal of the appellee, the Commissioner of Revenue (“Commissioner”), to grant an abatement of corporate excise sought by the appellant (“Sysco” or “appellant”) for its fiscal years ended June 29, 1996, June 28, 1997, June 27, 1998, July 3, 1999, July 1, 2000, and June 30, 2001 (“tax years at issue”). 1
Commissioner Scharaffa heard these appeals and was joined by Chairman Hammond and Commissioners Egan, Rose and Mulhern in the decision for the appellee.
These findings of fact and report are made at the requests of the appellant and the appellee pursuant to G.L. c. 58A, § 13 and 831 CMR 1.32.
Philip S. Olsen, Esq., Craig B. Fields, Esq., and Roberta Moseley Nero, Esq. for the appellant.
Christopher M. Glionna, Esq., Andrew P. O'Meara, Esq., Brett M. Goldberg, Esq., and Thomas J. Leonardo, Esq. for the appellee.
OPINION
FINDINGS OF FACT AND REPORT
These appeals were presented through a Stipulation of Facts and stipulated exhibits, and the testimony and exhibits entered into evidence at the hearing of the appeals. The appellant offered five witnesses, who were called in the following order: George Mitchell Elmer, Senior Vice President, Controller and Chief Accounting Officer; 2 David Lee Brown, Vice President of Finance, Sysco San Diego; Ms. Jill Weise, Managing Director, Ceteris U.S., LLC; Dr. Brian Cody, Principal, KPMG LLP; and Richard D. Pomp, Professor of Law, University of Connecticut, School of Law. The Commissioner offered the testimony of Michael Johnson, Audit Manager, Multi-State Audit Bureau, Massachusetts Department of Revenue (“DOR”), and Robert W. Alltop, Head of Transfer Pricing Practice, Charles River Associates.
On the basis of the foregoing, the Appellate Tax Board (“Board”) made the following findings of fact.
Procedural History
Throughout the tax years at issue, Sysco was a Delaware corporation that maintained its principal place of business in Houston, Texas. Sysco filed Combined Massachusetts Corporate Excise Returns for each of the tax years at issue. 3 Based on the results of an audit initiated by the DOR, the Commissioner issued a Notice of Intention to Assess Corporate Excise (“NIA”) to Sysco dated February 15, 2004, for the tax years 1996 through 1998. The Commissioner subsequently issued an NIA dated August 14, 2005, for the tax years 1999 through 2001.
On March 16, 2004, Sysco filed a Form DR-1, Appeals Form, seeking a pre-assessment conference with DOR's Office of Appeals for the tax years 1996 through 1998. Following a conference which was held on May 12, 2004, the Office of Appeals issued a letter of determination dated March 23, 2005, upholding the proposed assessment in full. Sysco did not seek a pre-assessment conference for the tax years 1999 through 2001.
The Commissioner issued a Notice of Assessment (“NOA”) dated April 27, 2005, relating to the tax years 1996 through 1998 and an NOA dated September 27, 2005, for the tax years 1999 through 2001. Sysco protested the NOAs by filing Applications for Abatement on May 27, 2005, for the tax years 1996 through 1998 and on December 8, 2005, for the tax years 1999 through 2001. The Commissioner denied Sysco's Applications for Abatement by Notices of Abatement Determination dated September 15, 2005, for the tax years 1996 through 1998 and February 22, 2006, for the tax years 1999 through 2001.
Sysco filed a Petition Under Formal Procedure relating to the tax years 1996 through 1998 on November 10, 2005, and a Petition Under Formal Procedure relating to the tax years 1999 through 2001 on April 14, 2006. As originally filed, Sysco's petitions set forth several issues for consideration by the Board. During February of 2009, the parties executed a settlement agreement resolving all of the contested issues with the exception of the Commissioner's adjustments relating to the operation of Sysco's cash-management system. The adjustments included disallowance of interest deductions claimed by Sysco on purported loans resulting from intercompany advances. The Commissioner characterized claimed loan amounts to Sysco as dividends and characterized claimed interest income received by the “loaning” entities from Sysco as capital contributions from Sysco. The amount of taxes remaining at issue for each tax year, exclusive of interest, is as follows:
1996: $ 423,059.37 1999: $1,462,314.50
1997: $ 597,955.00 2000: $ 700,452.48
1998: $3,309,464.63 2001: $ 717,090.76
Total: $7,210,336.74
Based on the foregoing, the Board found and ruled that it had jurisdiction to hear and decide these appeals.
Factual Background
A. Sysco
Sysco was formed in 1969 when nine local food distributors operating in markets across the United States combined their businesses in exchange for Sysco common stock. The new company was taken public and commenced operations in 1970. Over time, Sysco expanded its own operations and acquired smaller family-owned businesses. Through its wholly owned subsidiaries and divisions (the “operating companies”), Sysco distributed food and related products to establishments such as restaurants, nursing homes, hospitals, hotels, motels, schools, colleges, cruise ships, sports parks and summer camps.
All of Sysco's revenue was generated from the activities of the operating companies. Each operating company that was a corporation had a board of directors and each company that was a limited liability company had a board of managers. Each operating company had its own officers, and the presidents of the operating companies had responsibility for hiring and dismissing employees. While the management of Sysco made suggestions regarding operating company personnel, the operating companies were not obligated to follow Sysco's suggestions. Sysco's chief operating officer was responsible for hiring and dismissing the operating companies' presidents.
Each operating company paid its own operating expenses, made its own purchasing decisions, placed its own orders for supplies and equipment and was responsible for its own operating results. The operating companies were required to obtain approval from Sysco prior to making capital expenditures exceeding fifty thousand dollars, such as major equipment purchases, expansion of a company's business, or expansion of operating facilities.
B. The Cash-Management System
Soon after its formation in 1969, Sysco implemented a cash-management system in which all of the operating companies were obligated to participate. Mr. Elmer testified extensively about the cash-management system, which he stated was implemented and maintained to function as a “corporate bank” and to achieve various efficiencies including reduction of banking costs and the cost of debt capital.
The cash-management system, which was managed by Sysco's treasury department, had several components. Each operating company maintained bank accounts with commercial third-party banks, including a main depository account and a disbursement account. The companies deposited all revenue generated from operations into their respective depository accounts. At the daily close of business, Sysco initiated a transfer of funds from the depository accounts to what Sysco referred to as its “concentration accounts.” While cash receipts were transferred on a daily basis, the depository accounts were not left with a zero balance because sums reflected in accounts as a result of check deposits were not transferred to the concentration accounts until the checks had cleared.
The disbursement accounts, through which the operating companies paid their expenses, were “zero balance accounts.” Operating company checks presented for payment on a given day were funded by Sysco, which initiated a transfer of funds from the concentration accounts to the disbursement accounts sufficient to cover the checks. Thus, the disbursement accounts were left with a zero balance at the end of each day. An operating company that desired capital expansion requiring approval from Sysco submitted a capital investment proposal (“CIP”), which Sysco in its sole discretion could approve or reject. If approved, an operating company might receive a fixed interest rate and term for the amount approved. Purported payments relating to the capital funding were made through the accounts comprising the cash-management system.
The difference between the sums swept up to Sysco and the amounts transferred from its concentration accounts to the operating companies' disbursement accounts was recorded in Sysco's and each operating company's books and records, which included an “intercompany account.” Weekly and monthly intercompany statements were generated reflecting amounts transferred to and from Sysco to compare Sysco's records to those of the operating companies.
During the tax years at issue, when Sysco had disbursed less to an operating company than it received from the company, the excess received by Sysco was accounted for as a loan from the operating company to Sysco, placing Sysco in a “net borrowing position” relative to the operating company. Conversely, when Sysco had disbursed more than it collected from an operating company, it accounted for the excess received by the operating company as a loan from Sysco to the company, placing Sysco in a “net lending position” relative to the company.
Interest was calculated daily on all intercompany account ending balances. Operating companies that were in a net lending position relative to Sysco were “paid” interest at the prime rate minus one percent by Sysco on outstanding balances. Operating companies in a net borrowing position relative to Sysco “paid” interest at the prime rate to Sysco on the balances. Payments of interest were made by accounting entries on a monthly basis, and sums representing interest payments to the operating companies from Sysco were immediately swept up to the concentration accounts. Consistent with this accounting treatment, Sysco deducted interest paid to the operating companies and reported income received from the companies on its state tax returns. Similarly, the operating companies reported interest income received from Sysco and interest paid to Sysco on their tax returns.
The cash-management system was operated according to procedures set forth in an internal guide called the Financial and Accounting Methods Manual (“FAMM”), which was in force before and during the tax years at issue. 4 The FAMM described in detail the various elements of the cash-management system and, inter alia, set forth methods of accounting for transactions, intercompany and otherwise, as well as generating intercompany reports and accounting for the accrual of interest on intercompany balances. The FAMM consistently and explicitly referred to the various intercompany transactions and balances relating to the cash-management system as reflecting “borrowing” and “lending” between Sysco and the operating companies.
Mr. Elmer maintained that the FAMM provided substantial evidence of a debtor/creditor relationship between Sysco and the operating companies. However, while the FAMM provided detailed guidelines relating to operation of the cash-management system, it did not evidence a legal obligation to repay sums it stated were borrowed from or lent to the operating companies. In particular, the FAMM did not provide for execution of any agreements relating to the purported debt. Nor did the FAMM provide for amortization schedules, default or collateral provisions, or any type of security mechanism to ensure timely repayment. Mr. Elmer acknowledged that no such documents existed.
While Sysco in theory could enforce repayment of balances due from the operating companies by virtue of its 100% ownership of the entities, the operating companies had no such ability and were left without recourse should they have sought to enforce Sysco's claimed obligation to repay outstanding balances. Thus, the Board found that Sysco had no legal obligation to repay transfers of outstanding sums due to the operating companies.
The Board also found that full repayment of purported loans was not intended to and did not in fact occur. In support of its assertion that repayment was intended, Sysco noted that a portion of the funds advanced to Sysco were repaid on a daily basis through disbursements to the operating companies and that a given operating company could go from a net borrowing to a net lending position or the reverse. Mr. Brown testified that Sysco San Diego did just that, having borrowed extensively from Sysco to meet capital needs associated with establishing company operations, thereby placing the company in a net borrowing position. Later, Sysco San Diego achieved profitability, which led it to be in a net lending position. These facts, however, do not indicate that Sysco intended to or did repay the outstanding balances received from the operating companies.
Sysco made payments to the operating companies on the purported loans only on an as-needed basis by funding the companies' disbursement accounts for the purpose of paying daily operating expenses or by funding approved CIPs. Mr. Elmer confirmed this fact when he responded to the question “[d]oes Sysco Corporation intend to repay the operating companies in any other way besides funding of disbursements?” by answering “I would say no.” Transcript Volume I, pp. 64-65. Further, a substantial portion of sums advanced to Sysco, which Sysco claimed to have intended to repay, was used to pay dividends to shareholders. More specifically, during the tax years at issue, not one of the operating companies paid a dividend to Sysco, but Sysco paid dividends to its shareholders as follows:
1996: $ 87,721,000 1999: $126,691,000
1997: $ 99,574,000 2000: $145,418,000
1998: $ 110,928,000 2001: $173,701,000
Moreover, Mr. Elmer testified that “the cash-management system functions as the conduit through which the cash flow from the operating subsidiaries is concentrated into Sysco [] so that it can be used for general corporate purposes such as making acquisitions of new companies ...” Transcript Volume II, p. 20.
Given the structure of the cash-management system, any profitable operating company that did not seek funds from Sysco for capital expansion such that it would revert to a net borrowing position would perpetually be in a net lending position relative to Sysco. In fact, Mr. Elmer, who equated a lending operating company with a “profitable business,” testified that “Sysco expects all of its operating subsidiaries to be profitable companies in the long run and so certainly once a company has become profitable and is able to generate a positive cash flow, the expectation is that the positive cash flow will continue forever and ever and ever ...” Transcript, Volume II, pp. 13-14. Under these circumstances, which Mr. Elmer characterized as not only desirable but expected, operating companies could not expect return of advanced funds that exceeded disbursements (“excess cash advances”) which had been swept up to Sysco through operation of the cash-management system. Indeed, sums purportedly due from Sysco to the operating companies were never fully repaid during the tax years at issue. To the contrary, not only was Sysco in a net borrowing position relative to the operating companies during these years, its stated obligations to the companies grew significantly. At the end of tax year 1996, Sysco's net borrowing position was slightly in excess of $700,000,000 and by the end of tax year 2001, it had exceeded $1,800,000,000. Further, not a single operating company requested or received a return of excess cash advances from Sysco.
As previously noted, Sysco's entire income stream was derived from the operating companies, which according to Sysco contributed their receipts to the cash-management system in the form of loans. Sysco thus paid its dividends and made use of funds for general corporate purposes from the purported loans received from the operating companies. These payments depleted the income pool available for repayment of the loans. The sole source of repayment was excess cash advances from the operating companies, which were accounted for as loans to Sysco. These facts substantially undermine Sysco's assertion that it intended to repay its outstanding debts to the operating companies.
Sysco's Expert Testimony
Ms. Jill Weise
Ms. Weise, whom the Board qualified as an expert in transfer pricing, testified that she examined the interest rates utilized in Sysco's cash-management system and found them to be arm's length. To arrive at this conclusion, Ms. Weise applied standards articulated under Internal Revenue Code (“I.R.C.”) § 482 and the associated regulations. In particular, with respect to the interest rate charged on sums outstanding from the operating companies to Sysco, Ms. Weise considered Sysco's AA-bond rating and prevailing market rates and derived upper and lower bounds for Sysco's interest rate. In this manner, she determined that prime minus one percent was an appropriate rate to pay the operating companies. For sums owing to Sysco, Ms. Weise assumed that each operating company was at least “investment grade” and concluded that the prime rate represented an arm's-length interest rate. Ms. Weise did not, however, provide a foundation for her assumption that each of the operating companies was investment grade. Nor did she examine or take into account the creditworthiness of the individual operating companies, which Mr. Elmer had explicitly testified would result in varying credit ratings and associated costs of credit.
In her expert report, Ms. Weise also likened Sysco's cash-management system to a bank, stating that the activities associated with the cash-management system “are the very definition of a bank.” Weise Expert Report, p. 13. However, Ms. Weise failed to note that a bank, unlike Sysco, is legally bound to return deposits as well as accumulated interest to its customers, and absent anomalous circumstances, does so. Consequently, the Board did not credit this portion of Ms. Weise's opinion.
Finally, Ms. Weise concluded that the intercompany transactions resulted in creation of bona-fide debt. Noting that she “believ[ed] the existence of comparable third party cash management services is ample evidence to support Sysco's treatment of its cash management system as bona fide indebtedness,” Ms. Weise focused her analysis in large measure on factors cited in Roth Steel Tube Company v. Commissioner of Internal Revenue, 800 F.2d, 625 (6 th Cir. 1986) relating to a multi-factor debt/equity analysis. Weise Expert Report, p. 16. 5 These factors had been cited by DOR Audit Manager Michael Johnson in a determination letter to Sysco dated February 14, 2004, relating to the tax years 1996 through 1998, which preceded the issuance of the NIA for those years. The Board found that in her analysis and ultimate opinion, Ms. Weise failed to address sufficiently whether Sysco intended to and in fact did return excess cash advances to the operating companies. Thus, the Board was not persuaded by Ms. Weise's observations that the intercompany transactions at issue resulted in the creation of bona-fide debt.
Dr. Brian J. Cody
The Board qualified Dr. Cody as an expert in the field of economics. Dr. Cody addressed the question of whether, from an economic perspective, advances made by the operating companies to Sysco and from Sysco to the operating companies during the tax years at issue should be characterized as debt or equity. Like Ms. Weise, Dr. Cody's analysis focused largely upon the factors articulated in Roth Steel Tube Company, and based on his analysis, Dr. Cody concluded that the intercompany advances between Sysco and the operating companies within the context of the cash-management system were properly characterized “from an economic point of view” as debt. Also like Ms. Weise, however, Dr. Cody's analysis failed to address sufficiently whether Sysco intended to and in fact did return excess cash advances to the operating companies.
Finally, Dr. Cody made his own comparison between Sysco's cash-management system and a bank, likening excess cash advances to an overdraft on a personal account, which is not secured. Similar to Ms. Weise, Dr. Cody ignored that repayment of outstanding sums relating to bank overdrafts and credit lines is compelled by depository agreements and law. On the basis of the referenced flaws in Dr. Cody's analysis, the Board afforded little weight to his testimony.
Professor Richard Pomp
Professor Pomp, whom the Board qualified as an expert in the field of tax policy, gave his opinion regarding the intercompany transactions at issue “from a tax policy perspective.” Acknowledging that “every tax system .... needs to guard against situations in which a taxpayer may try to disguise a nondeductible expenditure as a business deduction for interest,” such as a corporation's attempt to disguise “an otherwise nondeductible dividend as a deductible payment of interest,” Professor Pomp opined that there was no such attempt evident in the present appeals. Pomp Expert Opinion, p.3. Professor Pomp also stated that “[o]ne overriding rule is that for interest to be deductible there must be 'indebtedness,' that is, an unconditional and legally enforceable obligation for the payment of money.” Id. at p.4.
As did Ms. Weise and Dr. Cody, Professor Pomp spent a considerable portion of his analysis applying the factors employed in Roth Steel Tube Company. At the conclusion of his analysis, Professor Pomp stated that the parties intended to create debt, and that the cash-management system had a business purpose and economic substance and was not implemented for tax-minimization purposes.
Regardless of the presence or absence of business purpose and economic substance and the absence of tax motivation, in his analysis, Professor Pomp failed to demonstrate the existence of “an unconditional and legally enforceable obligation for the payment of money” in the context of Sysco's cash-management system. As previously noted, Professor Pomp characterized this obligation as fundamental to whether interest is deductible. Further, Professor Pomp failed to address relevant facts indicating that excess cash advances were not intended to be returned to the operating companies. For these reasons, the Board did not credit Professor Pomp's opinion as it related to the nature of the intercompany transactions within the cash-management system.
The Commissioner's Expert Testimony
Robert W. Alltop
The Board qualified Mr. Alltop as an expert in transfer pricing. Mr. Alltop's testimony centered upon Ms. Weise's opinion and report. In particular, Mr. Alltop stated that he disagreed with Ms. Weise's decision not to examine the creditworthiness of the operating companies when deciding on an appropriate interest rate to be paid by the companies because in an arm's-length transaction, creditworthiness of the borrowing entity would be reflected in the interest rate. Mr. Alltop also indicated that for Ms. Weise's analysis regarding the nature of the intercompany transactions to be complete, he would have expected a focus on facts which demonstrated a reasonable expectation of repayment on the part of the operating companies, a focus which was not present either in Ms. Weise's testimony or her report. Finally, having noted that legal decisions shape what is done by economists, Mr. Alltop questioned why Ms. Weise failed to draw a distinction between the facts in the present case and those considered in New York Times Sales, Inc. v. Commissioner of Revenue, 40 Mass. App. Ct. 749, 753 (1996) , in which the Massachusetts Appeals Court found that intercompany transfers effected within the context of a cash-management system did not constitute indebtedness. Summary
On the basis of the evidence presented and reasonable inferences drawn therefrom, the Board found that intercompany transfers associated with Sysco's cash-management system during the tax years at issue did not give rise to bona-fide debt. The Board's finding was based on an examination of the specific facts and circumstances of these appeals, with particular focus on various facts which inexorably led to the inference that the structure and operation of Sysco's cash-management system indicated Sysco did not intend, nor did the operating companies expect, repayment of the excess cash advances, which therefore were permanent in nature. These facts included, but were not limited to: the absence of a legal obligation to repay advanced funds; Sysco's expectation that the operating companies would be profitable and therefore, yield a perpetual stream of excess cash advances; the substantial increase in Sysco's stated liability to the operating companies during the tax years at issue; Sysco's failure to repay excess cash advances in full; Sysco's payment of dividends to shareholders from advances made by the operating companies and its use of the advances for its general corporate purposes; the lack of instruments evidencing debt; the absence of limits on the amounts upstreamed to Sysco from the operating companies; the absence of repayment schedules or fixed dates of maturity; the lack of security, default or collateral provisions associated with the purported debt; and the operating companies' failure to request repayment of excess cash advances made to Sysco.
Accordingly, and for the reasons discussed in the following Opinion, the Board decided these appeals for the appellee.
OPINION
Pursuant to G.L. c. 63, § 30(4) , a corporation's net income generally consists of gross income less the deductions, but not credits, allowed under the I.R.C. Pursuant to I.R.C. § 163(a) , a corporation may deduct “all interest paid or accrued within the taxable year on indebtedness.” Sysco argued that for each of the tax years at issue, intercompany transactions associated with its cash-management system gave rise to bona-fide debt and consequent interest expenses for Sysco and interest income for its subsidiaries. The Commissioner responded that the facts and circumstances of the appeals, taken as a whole, indicated that the transactions did not constitute true indebtedness. The Board agreed with the Commissioner.
For a transaction to give rise to a valid interest deduction, the transaction must constitute true indebtedness. Knetsch v. United States, 364 U.S. 361, 364-65 (1960) . True indebtedness requires, at the time funds are transferred, both “'an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment.'” Schering-Plough Corporation v. United States, 651 F.Supp. 2d 219, 244 (D.N.J. 2009) (quoting Geftman v. Commissioner of Internal Revenue, 154 F.3d 61, 68 (3 rd Cir. 1998) ).
“Related but separate corporations can freely enter into contracts including debt transactions, like any corporations or individuals.” Overnite Transportation Company v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1999-353, 370, aff'd, 54 Mass. App. Ct. 180 (2002) (citing Bordo Products Co. v. United States, 476 F.2d 1312, 1323 (Ct. Cl. 1973) ). However, courts examine these transactions with greater scrutiny because the transactions “do not result from arm's length bargaining.” Overnite Transportation Company, Mass. ATB Findings of Fact and Reports at 1999-370 (citing Kraft Foods Co. v. Commissioner, 232 F.2d 118, 123-24 (2 nd Cir. 1956) ); see also, Overnite Transportation Company, 54 Mass. App. Ct. at 186 (“When 'the same persons occupy both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of the transaction, for the parties may mold it at their will with no countervailing pull'”) (quoting Fin Hay Realty Co v. United States, 398 F.2d 694, 697 (3d Cir. 1968) ). Furthermore, “the method by which two related businesses account for cash transfers on their internal financial records is not deemed to be a controlling factor in determining the nature of the transaction” as such records are a product of the parties and therefore “do not necessarily constitute a reliable reflection of the true nature of the transaction.” New York Times Sales, Inc. v. Commissioner of Revenue, 40 Mass. App. Ct. at 753 (citing Alterman Foods, Inc. v. United States, 505 F.2d 873, 878 (5 th Cir. 1974) (“Alterman I”) ; J.A. Tobin Const. Co. v. Commissioner of Internal Revenue, 85 T.C. 1005, 1022 (1985) ).
“Although the issue of whether transfers between a subsidiary and its parent constitute debt has been extensively litigated, courts have not established a bright-line rule for making such a determination but have instead employed a case-by-case analysis based on the specific facts and circumstances of a particular case.” The TJX Companies, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 2007-790, 881, aff'd in part, remanded in part on other grounds, Mass. App. Ct., No. 07-P-1570, Memorandum and Order under Rule 1:28 (April 3, 2009), aff'd, Mass. App. Ct., No. 09-P-1841, Memorandum and Order under Rule 1:28 (July 23, 2010) . Consequently, “[t]he Board must review the facts and circumstances surrounding a purported inter-company loan to determine whether a true debt obligation exists.” Id. at 882.
Within the context of this review, “[i]t is well settled that a distribution by a subsidiary corporation to its parent is a loan and not a dividend if, at the time of its payment, the parties intended it to be repaid. Whether the parties actually intended the transaction to be a loan or dividend is an issue of fact. To resolve the issue, the courts apply a multi-factor analysis. No single factor is determinative; rather, all the factors must be considered to determine whether repayment or indefinite retention is intended.”
Kimberly-Clark Corporation & Kimberly-Clark Global Sales, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 2011-1, 43 (quoting New York Times Sales, 40 Mass. App. Ct. at 752 ). (internal citations omitted).
In New York Times Sales, the Massachusetts Appeals Court upheld the Board's decision that sums transferred from a subsidiary to its parent in the context of a cash-management system were not loans but dividends. The Board had determined that the parties did not intend the transactions to be loans in light of several factors which had previously been set forth in Alterman I, and Alterman Foods, Inc. v. U.S., 611 F.2d 866 (Ct. Cl. 1979) (“Alterman II”) . See The New York Times Sales, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1995-137, aff'd., 40 Mass. App. Ct. 749 (1996) . On appeal, the Appeals Court endorsed the Board's reasoning relating to:
several factors [which] demonstrated that the parties intended that the cash transactions be dividends and not loans. They included (1) the amounts transferred were not limited in any manner; (2) there was no repayment schedule and no fixed dates of maturity; (3) the amounts 'upstreamed' to Times Company were intended to remain with the Times Company for use in fulfilling its various corporate purposes; (4) no interest was charged; (5) no notes or other evidences of indebtedness existed; (6) the transferred cash was not secured in any manner; (7) at no time did Times Sales request repayment; (8) there was no evidence that Times Sales had any expectations of repayment; and (9) at no time did Times Company make any effort to repay the amounts transferred to it by Times Sales.
New York Times Sales, 40 Mass. App. Ct. at 752 .
In the present appeals, the facts of the case and the factors cited by the Appeals Court in New York Times Sales weigh heavily against Sysco. In New York Times Sales, the Times Company and its subsidiaries, like Sysco, maintained a cash-management system designed to foster certain efficiencies within a corporate group. Like the operating companies in these appeals, the relevant subsidiary in New York Times Sales participated in the cash-management system and its receipts were upstreamed on a daily basis to Times Company's concentration account. As did Sysco, Times Company paid its subsidiaries' expenses from funds that had been advanced to Times Company by the subsidiaries and which were subsequently deposited in the subsidiaries' disbursement accounts. Finally, Sysco, like Times Company, retained excess cash advances and used the advances for general corporate purposes. Against this backdrop, the Appeals Court considered the factors cited above, each of which the Board addressed as follows.
(1) The operating companies deposited all their revenue into their depository account, from which the deposits were swept up to Sysco's concentration accounts on a daily basis. Thus the Board found that “the amounts transferred were not limited in any manner.” New York Times Sales, 40 Mass. App. Ct. at 752 . Curiously, Sysco argues that the transfers were “limited” by the amount of the operating companies' revenue. Not only is this argument counter-intuitive, but in New York Times Sales, as in the present appeals, the Appeals Court reviewed a cash-management system like Sysco's in which the only limit on the amounts advanced to the parent corporation was dictated by the ability of the subsidiaries to generate revenue. If such a “limit” were dispositive, the Appeals Court would have overturned the Board's prior determination that cash transfers limited only by the financial success of a subsidiary are, in fact, unlimited. See The New York Times Sales, Inc., Mass. ATB Findings of Fact and Reports at 1995-148 .
(2) In the present appeals, there were no repayment schedules or fixed dates of maturity in the day-to-day operation of the cash-management system.
(3) The Board's conclusion that the structure and operation of Sysco's cash-management system indicated that excess cash advances were not intended to be returned to the operating companies and thus were permanent in nature equates to a finding that “the amounts upstreamed to [Sysco] were intended to remain with [Sysco] for use in fulfilling its various corporate purposes.” New York Times Sales, 40 Mass. App. Ct. at 752 .
Regardless, Sysco asserted that repayment was intended, and in fact occurred through daily disbursements and acceptance of requests for capital CIPs. As a threshold matter, the Board, embracing the holdings in Alterman I and Alterman II, has rejected the notion that “a parent's payment of its subsidiary's expenses constituted a repayment of the cash transferred to it.” The New York Times Sales, Inc., Mass. ATB Findings of Fact and Reports at 1995-149 .
Further, according to Sysco, full repayment of outstanding sums was evident in those instances in which an operating company went from being a net lender to net borrower of funds from Sysco. Notwithstanding Sysco's assertions, the Board found that repayment of purported loans was not intended and did not occur.
All revenue received by the operating companies was swept up to Sysco on a daily basis. Having issued disbursements to the companies only to satisfy their operating and intermittent capital needs, excess balances remained with Sysco indefinitely. Within the structure of the cash-management system, a profitable operating company that did not receive funds for capital expansion such that it would revert to a net borrowing position remained indefinitely in a net lending position. Mr. Elmer, who equated a lending operating company with a “profitable business,” explicitly confirmed Sysco's expectation that all of the operating companies would be profitable, and that a profitable entity would generate positive cash flow into the indefinite future. Further, Sysco was in a growing net borrowing position relative to the operating companies during the tax years at issue and used excess cash advances received from the operating companies to pay shareholder dividends and for general corporate purposes. These facts, taken together, amply support the Board's finding that Sysco did not intend to return excess cash advances to the operating companies.
(4) Unlike the taxpayer in New York Times Sales, Sysco made daily calculations of interest and accounting entries for interest accrued on intercompany accounts. However, as noted, supra, Sysco's transfer-pricing expert, Ms. Weise, failed to establish that the interest rate charged by Sysco to operating companies that were in a net borrowing position was arm's length. More importantly though, interest accounting entries were just that, and amounts credited to operating companies as interest were immediately swept up to Sysco forming part of a rapidly growing net liability from Sysco to the companies during the tax years at issue. As previously noted, the Board found that the operating companies could not expect or require repayment of this liability, therefore, in practice, interest was not “paid” as it would be in a third-party lending transaction.
(5) There were no promissory notes or formal agreements of any type evidencing the purported debt in these appeals. Sysco contended that the FAMM provided substantial evidence that a debtor/creditor relationship had been established, but the Board found this argument unpersuasive. The FAMM was an internal manual, which provided guidelines relating to operation of the cash-management system. It did not, however, evidence a legal obligation to repay sums it stated were borrowed from or lent to the operating companies. In particular, the FAMM did not provide for execution of agreements relating to the purported debt. Nor did the FAMM provide for amortization schedules, default or collateral provisions, or any type of security mechanism to ensure timely repayment. Finally, although the FAMM referred to the various intercompany transactions and balances relating to the cash-management system as reflecting “borrowing” and “lending” between Sysco and the operating companies, the FAMM's instructions and the resultant internal accounting entries are not controlling in the context of intercompany transactions. New York Times Sales, 40 Mass. App. Ct. at 753 .
(6) During the hearing of these appeals, Sysco's executives acknowledged that the purported loans were not secured in any manner. Sysco, however, asserted that this factor is immaterial. For example, Dr. Cody compared the flow of excess cash advances to Sysco with an over-drafted bank account, noting that when an account holder withdraws funds in excess of the value of his personal bank account, the bank has made an unsecured loan to its customer. Dr. Cody (as did Ms. Weise) ignored, however, that repayment of outstanding sums relating to bank deposits or overdrafts is compelled by depository agreements and law. Moreover, repayment of third-party unsecured debt taken on by Sysco would be similarly compelled. There is no such compulsion attendant to the advances made by the operating companies to Sysco. Thus, security in the present matters takes on importance it does not have in the context of certain third-party lending transactions.
(7-9) Two of the last three New York Times Sales factors relate to the operating companies' requests for and expectation of repayment and the final factor is whether Sysco, as the parent corporation, made any effort toward repayment. The record reflects that at no time did the operating companies request repayment of excess cash advances from Sysco. With regard to the operating companies' expectation of repayment, the facts that indicate that Sysco did not intend to repay excess advances to the operating companies, which are discussed in detail above, compel the conclusion that the companies had no expectation of repayment. These facts indicate as well that Sysco made no systematic effort toward repayment of the excess cash advances.
In sum, consideration of the various factors articulated in New York Times Sales, with particular focus on those indicating that repayment of excess cash advances to Sysco was neither intended nor expected, was central to the Board's finding that the advances did not constitute bona-fide debt.
Although not a factor considered in New York Times Sales or any other case cited by Sysco, Sysco placed great emphasis on the business purpose underlying formation and operation of its cash-management system, as well as the absence of a tax motive, arguing that these factors are “crucial” to a determination of whether the intercompany transactions at issue in these appeals qualify as bona-fide debt. The Board does not agree that business purpose and absence of tax avoidance substantially support an assertion that intercompany transfers constitute debt. In fact, in New York Times Sales, the court explicitly described the business purpose underlying the operation of the taxpayer's cash-management system, stating that its “primary purpose .... was to increase the efficient use of available cash from all of the members of the Times Company group. One significant benefit of the system was that it reduced Times Company's banking fees by consolidating banking arrangements and eliminating individual bank loans for working capital, thereby reducing interest expenses.” New York Times Sales, 40 Mass. App. Ct. at 752 . Moreover, there was no assertion of tax avoidance as a motive for implementation of Times Company's cash-management system. Consequently, the Board found Sysco's arguments relating to the import of business purpose and absence of a tax avoidance motive unpersuasive.
Finally, in its post-hearing brief, Sysco argued that if the Board were to determine that the intercompany advances at issue did not qualify as loans, the Commissioner's proposed adjustments would be in violation of the Commerce Clause and the Due Process Clause of the United States Constitution. Sysco correctly noted that a state cannot tax extraterritorial values. See, e.g. Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992) . However, “[i]t remains the case that 'in order to exclude certain income from the apportionment formula, the company must prove that “'the income was earned in the course of activities unrelated to [those carried out in the taxing] State.'”'” Allied-Signal, Inc., 504 U.S. at 787 (quoting Exxon Corp. v. Department of Revenue of Wis., 447 U.S. 207, 223 (1980) (quoting Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425, 439 (1980) ); see also Gillette Co. v. Commissioner of Revenue, 425 Mass. 670, 680 (1997) (quoting Container Corporation of America v. Franchise Tax Board., 463 U.S. 159, 164 (1983) ) (holding that “the taxpayer has the 'distinct burden of showing by “clear and cogent evidence” that [the State tax] results in extraterritorial values being taxed.'”).
In the current appeals, Sysco offered only its unsubstantiated argument that the Commissioner's adjustments would result in constitutionally impermissible taxation. During the hearing of these appeals, Sysco did not support this argument with substantive evidence or analysis establishing that the adjustments resulted in taxation of extraterritorial values. Thus, the Board found that Sysco's contentions regarding the constitutionality of the Commissioner's adjustments were unavailing.
Conclusion
Having considered the specific facts and circumstances of Sysco's cash-management system, and mindful that related entities can enter into debt transactions, the Board found and ruled that the intercompany transfers at issue in these appeals did not give rise to bona-fide debt. The Board reached its determination with particular focus on facts indicating that the excess cash advances made within Sysco's cash-management system were not intended or expected to be repaid. Accordingly, the Board decided these appeals for the appellee.
THE APPELLATE TAX BOARD
By: _______
Thomas W. Hammond, Jr., Chairman
A true copy,
Attest: _______
Clerk of the Board
1
Pursuant to G.L. c. 63 § 30 , Sysco's fiscal years were deemed ended on June 30 th of each of the tax years at issue.
2
Mr. Elmer stated that he was employed by Sysco Services, LP, a limited partnership that “leased professional services” to Sysco. Although not employed directly by Sysco, Mr. Elmer was responsible for all of Sysco's financial reporting, corporate credit management and tax compliance functions.
3
Included in the returns were The Sygma Network, Inc. and The Sygma Network of Ohio, Inc., the only two of Sysco's wholly owned subsidiaries that had taxable nexus with the Commonwealth.
4
Although Sysco did not establish that the portion of the FAMM introduced into evidence was identical to the FAMM employed during the tax years at issue, there was no indication that it had been altered in a manner that would affect the outcome of these appeals.
5
The Court in Roth Steel Tube Company identified and applied the following factors “to be used in making the capital contribution versus loan determination: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation's ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments.” Roth Steel Tube Company, 800 F.2d, at 630 .
Saturday, October 29, 2011
Kansas
Brian S. Richmond v. Commissioner, TC Memo 2011-251 , Code Sec(s) 61; 6651; 6020.
BRIAN STEVEN RICHMOND, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 61; 6651; 6020
Docket: Docket No. 7397-10.
Date Issued: 10/27/2011
Judge: Opinion by PARIS
HEADNOTE
XX.
Reference(s): Code Sec. 61 ; Code Sec. 6651 ; Code Sec. 6020
Syllabus
Official Tax Court Syllabus
Counsel
Brian Steven Richmond, pro se.
Christina L. Holland, for respondent.
Opinion by PARIS
MEMORANDUM FINDINGS OF FACT AND OPINION
On December 28, 2009, respondent sent to Brian Steven Richmond (petitioner 1 ) a notice of deficiency determining a deficiency in Federal income tax for taxable year 2008 of $4,095 and additions to tax for failure to file and pay tax under section 6651(a)(1) 2 and (2), respectively. The issues for decision are: (1) Whether petitioner received gross income for taxable year 2008 and (2) whether petitioner is liable for additions to tax pursuant to section 6651(a)(1) and (2) for taxable year 2008.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At the time the petition was filed, petitioner's mailing address was in Kansas.
During 2008 petitioner received income in the form of wages of $31,211 from Sprint United Management Co. (Sprint) and $7,160 from Top Cellars Wine & Spirits, LLC (Top Cellars). He additionally received interest income of $44 from First National Bank (First National) and $11 from Commerce Bank NA (Commerce Bank). Finally, he received income of $500 from the Maxine E. Richmond Testamentary Trust (Trust).
Petitioner submitted a “zero” income tax return for the 2008 taxable year. It stated that petitioner earned no income in the 2008 taxable year and sought a refund of $3,447. Petitioner submitted several Forms 4852, Substitute for Form W-2, Wage andTax Statement, or Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., with the return. The forms indicated that no income was received. Petitioner argued that he received no income as he was engaged in voluntary activities within the private sector and such activities do not generate taxable amounts.
Respondent did not treat petitioner's zero return as a proper return. Rather, pursuant to section 6020(b), he prepared a substitute for return (SFR). On December 28, 2009, respondent issued a notice of deficiency for petitioner's outstanding tax liability. Petitioner timely filed a petition with the Court.
OPINION
Tax Deficiency The Commissioner's determinations in the notice of deficiency are presumed correct, and the taxpayer bears the burden of demonstrating otherwise. Rule 142; New Colonial Ice. Co. v. Helvering, 292 U.S. 435, 440 [13 AFTR 1180] (1934); Welch v. Helvering, 290 U.S. 111, 112 [12 AFTR 1456] (1933).
Petitioner argues that he is a citizen of the “Sovereign State of Kansas” and not a citizen of the United States. Consequently, petitioner argues that he does not have to pay Federal income taxes. Petitioner's argument that he is not a citizen of the United States is a frivolous argument of the sort that this Court and other courts have consistently rejected. See United States v. Gerads, 999 F.2d 1255, 1256 [72 AFTR 2d 93-5506] (8th Cir. 1993); Bland-Barclay v. Commissioner, T.C. Memo. 2002-20 [TC Memo 2002-20].
Petitioner acknowledges receiving wages, interest income, and trust income as reported by respondent. However, he alleges that payment of income tax is optional and that he has opted to be a nontaxpayer.
Wages and other compensation received in exchange for personal services constitute gross income. Funk v. Commissioner, 687 F.2d 264, 265 [50 AFTR 2d 82-5697] (8th Cir. 1982), affg. T.C. Memo. 1981-506 [¶81,506 PH Memo TC]. For Federal income tax purposes, “gross income” means all income from whatever source derived and includes compensation for services and interest income. Sec. 61(a).
Petitioner performed services for Sprint and Top Cellars. Petitioner received interest from First National and Commerce Bank. Petitioner also received income from the Trust. Therefore, the amounts petitioner received are taxable as gross income under section 61(a). Section 6651(a)(1) and (2) Additions to Tax Section 6651(a)(1) authorizes the imposition of an addition to tax for failure to file a timely return unless the taxpayer proves that such failure was due to reasonable cause and not due to willful neglect. See United States v. Boyle, 469 U.S. 241, 245 [55 AFTR 2d 85-1535] (1985). Respondent has met the burden of production under section 7491(c) as petitioner's “return” was a list of zeros.
To determine whether a taxpayer has filed a valid tax return, the Court looks to the test in Beard v. Commissioner, 82 T.C. 766, 777 (1984), affd. 793 F.2d 139 [58 AFTR 2d 86-5290] (6th Cir. 1986). “First, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury.” Id. Petitioner's return fails this test in two ways. First, the zero return does not have “sufficient data to calculate a tax liability”, and second, it does not constitute “an honest and reasonable attempt to satisfy the tax law.” Petitioner did not file a valid return, and he did not show his failure to file was due to reasonable cause. Therefore the failure-to-file addition to tax is sustained.
Section 6651(a)(2) imposes an addition to tax “In case of failure *** to pay the amount shown as tax on any return”. Because this addition does not accrue unless a tax amount is “shown on” a return, the Commissioner must introduce evidence that tax was shown on a Federal income tax return to satisfy the burden of production under section 7491(c). See Cabirac v. Commissioner, 120 T.C. 163, 169 (2003). When a taxpayer has not filed a return, the section 6651(a)(2) addition to tax may be imposed if the Commissioner prepared an SFR that meets the requirements of section 6020(b). Sec. 6651(g)(2); Wheeler v. Commissioner, 127 T.C. 200, 208-209 (2006), affd. 521 F.3d 1289 [101 AFTR 2d 2008-1696] (10th Cir. 2008).
Section 6020(b)(1) provides that “If any person fails to make any return required *** or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information”. Such a return “shall be prima facie good and sufficient for all legal purposes.” Sec. 6020(b)(2). Respondent has shown the SFR was prepared from information respondent obtained from the payors and was signed by an agent of the Secretary. Respondent has met his burden of production, petitioner has not shown his failure to pay was due to reasonable cause and not willful neglect, and the addition to tax under section 6651(a)(2) is sustained.
In reaching the foregoing holdings, the Court has considered all the parties' arguments, and, to the extent not addressed herein, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing, Decision will be entered for respondent.
1
Although the petition was filed by petitioner and his wife, Candi Jo Richmond, it was dismissed as to Candi Jo on June 1, 2010, for lack of jurisdiction.
2
All section references are to the Internal Revenue Code in effect for the year in issue and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
BRIAN STEVEN RICHMOND, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 61; 6651; 6020
Docket: Docket No. 7397-10.
Date Issued: 10/27/2011
Judge: Opinion by PARIS
HEADNOTE
XX.
Reference(s): Code Sec. 61 ; Code Sec. 6651 ; Code Sec. 6020
Syllabus
Official Tax Court Syllabus
Counsel
Brian Steven Richmond, pro se.
Christina L. Holland, for respondent.
Opinion by PARIS
MEMORANDUM FINDINGS OF FACT AND OPINION
On December 28, 2009, respondent sent to Brian Steven Richmond (petitioner 1 ) a notice of deficiency determining a deficiency in Federal income tax for taxable year 2008 of $4,095 and additions to tax for failure to file and pay tax under section 6651(a)(1) 2 and (2), respectively. The issues for decision are: (1) Whether petitioner received gross income for taxable year 2008 and (2) whether petitioner is liable for additions to tax pursuant to section 6651(a)(1) and (2) for taxable year 2008.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At the time the petition was filed, petitioner's mailing address was in Kansas.
During 2008 petitioner received income in the form of wages of $31,211 from Sprint United Management Co. (Sprint) and $7,160 from Top Cellars Wine & Spirits, LLC (Top Cellars). He additionally received interest income of $44 from First National Bank (First National) and $11 from Commerce Bank NA (Commerce Bank). Finally, he received income of $500 from the Maxine E. Richmond Testamentary Trust (Trust).
Petitioner submitted a “zero” income tax return for the 2008 taxable year. It stated that petitioner earned no income in the 2008 taxable year and sought a refund of $3,447. Petitioner submitted several Forms 4852, Substitute for Form W-2, Wage andTax Statement, or Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., with the return. The forms indicated that no income was received. Petitioner argued that he received no income as he was engaged in voluntary activities within the private sector and such activities do not generate taxable amounts.
Respondent did not treat petitioner's zero return as a proper return. Rather, pursuant to section 6020(b), he prepared a substitute for return (SFR). On December 28, 2009, respondent issued a notice of deficiency for petitioner's outstanding tax liability. Petitioner timely filed a petition with the Court.
OPINION
Tax Deficiency The Commissioner's determinations in the notice of deficiency are presumed correct, and the taxpayer bears the burden of demonstrating otherwise. Rule 142; New Colonial Ice. Co. v. Helvering, 292 U.S. 435, 440 [13 AFTR 1180] (1934); Welch v. Helvering, 290 U.S. 111, 112 [12 AFTR 1456] (1933).
Petitioner argues that he is a citizen of the “Sovereign State of Kansas” and not a citizen of the United States. Consequently, petitioner argues that he does not have to pay Federal income taxes. Petitioner's argument that he is not a citizen of the United States is a frivolous argument of the sort that this Court and other courts have consistently rejected. See United States v. Gerads, 999 F.2d 1255, 1256 [72 AFTR 2d 93-5506] (8th Cir. 1993); Bland-Barclay v. Commissioner, T.C. Memo. 2002-20 [TC Memo 2002-20].
Petitioner acknowledges receiving wages, interest income, and trust income as reported by respondent. However, he alleges that payment of income tax is optional and that he has opted to be a nontaxpayer.
Wages and other compensation received in exchange for personal services constitute gross income. Funk v. Commissioner, 687 F.2d 264, 265 [50 AFTR 2d 82-5697] (8th Cir. 1982), affg. T.C. Memo. 1981-506 [¶81,506 PH Memo TC]. For Federal income tax purposes, “gross income” means all income from whatever source derived and includes compensation for services and interest income. Sec. 61(a).
Petitioner performed services for Sprint and Top Cellars. Petitioner received interest from First National and Commerce Bank. Petitioner also received income from the Trust. Therefore, the amounts petitioner received are taxable as gross income under section 61(a). Section 6651(a)(1) and (2) Additions to Tax Section 6651(a)(1) authorizes the imposition of an addition to tax for failure to file a timely return unless the taxpayer proves that such failure was due to reasonable cause and not due to willful neglect. See United States v. Boyle, 469 U.S. 241, 245 [55 AFTR 2d 85-1535] (1985). Respondent has met the burden of production under section 7491(c) as petitioner's “return” was a list of zeros.
To determine whether a taxpayer has filed a valid tax return, the Court looks to the test in Beard v. Commissioner, 82 T.C. 766, 777 (1984), affd. 793 F.2d 139 [58 AFTR 2d 86-5290] (6th Cir. 1986). “First, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury.” Id. Petitioner's return fails this test in two ways. First, the zero return does not have “sufficient data to calculate a tax liability”, and second, it does not constitute “an honest and reasonable attempt to satisfy the tax law.” Petitioner did not file a valid return, and he did not show his failure to file was due to reasonable cause. Therefore the failure-to-file addition to tax is sustained.
Section 6651(a)(2) imposes an addition to tax “In case of failure *** to pay the amount shown as tax on any return”. Because this addition does not accrue unless a tax amount is “shown on” a return, the Commissioner must introduce evidence that tax was shown on a Federal income tax return to satisfy the burden of production under section 7491(c). See Cabirac v. Commissioner, 120 T.C. 163, 169 (2003). When a taxpayer has not filed a return, the section 6651(a)(2) addition to tax may be imposed if the Commissioner prepared an SFR that meets the requirements of section 6020(b). Sec. 6651(g)(2); Wheeler v. Commissioner, 127 T.C. 200, 208-209 (2006), affd. 521 F.3d 1289 [101 AFTR 2d 2008-1696] (10th Cir. 2008).
Section 6020(b)(1) provides that “If any person fails to make any return required *** or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information”. Such a return “shall be prima facie good and sufficient for all legal purposes.” Sec. 6020(b)(2). Respondent has shown the SFR was prepared from information respondent obtained from the payors and was signed by an agent of the Secretary. Respondent has met his burden of production, petitioner has not shown his failure to pay was due to reasonable cause and not willful neglect, and the addition to tax under section 6651(a)(2) is sustained.
In reaching the foregoing holdings, the Court has considered all the parties' arguments, and, to the extent not addressed herein, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing, Decision will be entered for respondent.
1
Although the petition was filed by petitioner and his wife, Candi Jo Richmond, it was dismissed as to Candi Jo on June 1, 2010, for lack of jurisdiction.
2
All section references are to the Internal Revenue Code in effect for the year in issue and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
Music
BOSAMIA v. COMM, Cite as 108 AFTR 2d 2011-XXXX, 10/24/2011
RAMESH J. BOSAMIA; PRAGATI BOSAMIA Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE Respondent-Appellee.
Case Information:
Code Sec(s):
Court Name: IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT,
Docket No.: No. 10-60921,
Date Decided: 10/24/2011.
Disposition:
HEADNOTE
.
Reference(s):
OPINION
IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT,
Appeal from the Decision of the United States Tax Court
Before REAVLEY, GARZA, and GRAVES, Circuit Judges.
Judge: EMILIO M. GARZA, Circuit Judge:
This case presents a question of first impression under the Internal Revenue Code, 26 U.S.C. § 1 et seq. (“the Code”): 1 whether the Commissioner of Internal Revenue effects a change in a taxpayer's method of accounting for the purposes of § 481 when he requires that taxpayer to postpone a deduction from gross income pursuant to § 267(a)(2). Because we conclude that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting under § 481, we AFFIRM the judgment of the Tax Court.
I
Petitioners-Appellants, Ramesh and Pragati Bosamia, are the sole shareholders of two Subchapter S corporations, India Music and HRI, engaged in the business of importing and selling music, making those entities related parties under § 267. Because the two entities are related parties under the Code, subsection 267(a)(2) bars the entities from deducting payments owed to the other party from income until the related party includes the payments in its income. Summit Sheet Metal Co. v. Comm'r, T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11 (1996). Nonetheless, from 1998 to 2004, India Music purchased most of its inventory from HRI on account, yet India Music and HRI accounted for those payments using different methods of accounting. India Music was an accrual-basis taxpayer, deducting the yearly increase in the accounts payable from its gross income as costs of goods sold when its liability became fixed. Burks v. United States, 633 F.3d 347, 358 [107 AFTR 2d 2011-824] (5th Cir. 2011) (“Under the Code, gross income of a trade or business is usually calculated by subtracting the cost of goods sold from the gross receipts of the sale.”) (citing 26 U.S.C. § 61(a)). Meanwhile, HRI was a cash-based taxpayer, opting not to include the payments owed to it by India Music in income until it actually received those payments.
From 1998 to 2003, India Music claimed accounts payable deductions for payments owed to HRI totaling $877,579, even though it never made a payment to HRI and HRI did not include the payments in its income. Because India Music is a Subchapter S corporation, all of its income passes through to its shareholders for tax purposes. Nail v. Martinez, 391 F.3d 678, 683 (5th Cir. 2004). Accordingly, the Commissioner issued the Bosamias a notice of deficiency in August 2008, informing them that India Music was not entitled to claim deductions for the payments to HRI from 1998–2004 until HRI included those payments in income. The Commissioner then disallowed India Music's claimed account payable deduction of $23,351 for payments to HRI it accrued in tax year 2004.
When the Commissioner issued his notice, the Code's three year statute of limitations for assessing income tax deficiencies barred him from assessing deficiencies against the Bosamias for the 1998 through 2002 tax years. 26 U.S.C. § 6501(a). However, because the Commissioner determined that his disallowance of India Music's year 2004 account payable deduction amounted to a change in India Music's method of accounting under § 481, he upwardly adjusted India Music's 2004 income to prevent the omission of income from tax by result of the change in accounting method. Specifically, the Commissioner made an upward adjustment of $877,581 to India Music's 2004 income to ensure that India Music's claimed accounts payable deductions from 1998 to 2003 did not escape taxation. These adjustments to India Music's year 2004 income created a corresponding deficiency in the Bosamias' 2004 income tax. Hence, the Commissioner determined that the Bosamias were liable for a tax deficiency of $295,818 and an accuracy-related penalty of $59,163.60.
The Taxpayers petitioned the Tax Court for a redetermination of the deficiency in tax and penalty determined in the notice of deficiency. They argued that the Commissioner's § 267(a)(2) disallowance did not constitute a § 481 change in method of accounting, thereby prohibiting the Commissioner from adjusting their 2004 income to account for the improper deductions claimed in the closed years from 1998–2002. The Tax Court upheld the Commissioner's notice of deficiency and penalty, holding that the § 267(a)(2) disallowance effected a change in India Music's method of accounting under § 481 because the disallowance amounted to a change in its treatment of a material item by postponing the timing of its cost of goods sold deduction. This appeal followed.
II
A
On appeal, the Taxpayers contend that the Tax Court erred as a matter of law by deciding that the Commissioner's § 267(a)(2) disallowance constituted a § 481 change in India Music's method of accounting. Instead, the Taxpayers assert that the Commissioner's § 267(a)(2) disallowance was only an “audit adjustment” to correct India Music's “erroneous deductions” for the 2004 tax year. In essence, they submit that the disallowance did not amount to a § 481 change in India Music's method of accounting because it neither (a) changed that entity's overall method of accounting nor (b) effected a change in that entity's treatment of a material item. The Commissioner, however, counters that the § 267(a)(2) disallowance effected a change in India Music's treatment of a material item because it postponed the proper time for the taking of the entity's account payable deduction for the 2004 tax year. In short, the Commissioner contends that by disallowing India Music's 2004 account payable deduction until HRI includes the underlying payments in income, it changed India Music's year 2004 method of accounting for accounts payable owed to HRI from the accrual method of accounting to the cash method of accounting. Because the Tax Court's decision rests on a pure question of law, we review its decision de novo. Arevalo v. Comm'r, 469 F.3d 436, 438 [98 AFTR 2d 2006-7676] (5th Cir. 2006).
The parties stipulated in the tax court that if the Commissioner's § 267(a)(2) disallowance amounted to a change in India Music's method of accounting for tax year 2004, the Commissioner properly adjusted that entity's 2004 income to include the improper deductions from 1998–2003. The parties also stipulated that India Music and HRI were related parties under the Code and that India Music improperly deducted payments to HRI from its income for the tax years 1998–2004 because HRI did not include those payments in its income. Lastly, the parties stipulated that the Commissioner properly disallowed India Music's claimed account payable deduction for tax year 2004 for payments owed to HRI.
Thus, the only question before us is whether the Commissioner's § 267(a)(2) disallowance of India Music's account payable deduction for tax year 2004 effected a change in India Music's method of accounting for the purposes of § 481. If it did, § 481 required the Commissioner to adjust India Music's 2004 income upward to prevent the amounts erroneously deducted from 1998–2003 from escaping taxation. If it did not, the Code's statute of limitations barred the Commissioner from assessing any deficiency based on erroneous deductions claimed by India Music in closed years.
B
Section 481 requires the Commissioner to adjust a taxpayer's taxable income to ensure accurate computation of income when that taxpayer changes its method of accounting from one year to the next. It provides, in relevant part:
In computing the taxpayer's taxable income for any taxable year (referred to ... as the “year of the change”)—
((1)) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then
((2)) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted ....
26 U.S.C. § 481(a)(1)–(2).
Under § 481, “if income escapes taxation because of a change in accounting method, the Commissioner may make an adjustment by including the omitted income in the year of the change.” Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 570 [15 AFTR 2d 647] (5th Cir. 1965). The section “authorizes “necessary” adjustments “to prevent amounts from being duplicated or omitted,” in the “year of change” whether “initiated” by the taxpayer or the Commissioner.”Id. at 572. Morever, there is “no necessary conflict between section 481 and the [Code's] statute of limitations.” Id. Instead, the very purpose of § 481 is to allow the Commissioner to adjust a taxpayer's income for open years to reflect amounts attributable to closed years that would otherwise escape taxation due to a change in method of accounting. Id. (“ Section 481 is designed to prevent a distortion of taxable income and a windfall to the taxpayer stemming from a change in accounting at a time when the statute of limitations bars reopening the taxpayer's returns for earlier years.”).
Meanwhile, § 267(a)(2), as amended in 1984, “provides for a matching of [expenses] deductions and income where, in the case of related persons, the payor is an accrual-basis taxpayer and the payee is on a cash method of accounting.” Ronald Moran Cadillac, Inc. v. United States, 385 F.3d 1230, 1233 [94 AFTR 2d 2004-6291] (9th Cir. 2004). The provision “prevent[s] the use of differing methods of reporting income [by related parties] for Federal income tax purposes in order to obtain artificial deductions for interest and business expenses.” Id. (quotingMetzger v. Comm'r , 76 T.C. 42, 75 (1981) (describing purpose of the predecessor of § 267(a)(2)). Specifically, § 267(a)(2) “bars a taxpayer from deducting a payment to a related taxpayer before the related taxpayer includes the payment in income.” Summit Sheet Metal Co., T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11.
C
The first step in statutory interpretation “is to determine whether the language at issue has a plain and unambiguous meaning with regard to the particular dispute in the case.”Robinson v. Shell Oil Co. , 519 U.S. 337, 340 (1997). “The plainness or ambiguity of statutory language is determined by reference to the language itself, the specific context in which that language is used, and the broader context of the statute as a whole.” Id. at 341 (citations omitted). Although neither the language of § 267(a)(2) nor § 481 explicitly provides that a disallowance under § 267(a)(2) amounts to a change in a taxpayer's method of accounting, we still conclude that Congress plainly intended that a § 267(a)(2) disallowance effectuates a change in a taxpayer's method of accounting given the specific context in which the language in that subsection is used.
The applicable Treasury Regulations define a “change in the method of accounting” as including either “a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” Treas. Reg. § 1.446–1(e)(2)(ii)(a);see Huffman v. Comm'r , 518 F.3d 357, 364 [101 AFTR 2d 2008-1078] (6th Cir. 2008) (finding that § 1.446–1(e)(2)(ii)(a) defines changes in methods of accounting for the purposes of § 481). 2 The Commissioner agrees that India Music never changed its overall plan of accounting; therefore, in order for the § 267 disallowance to constitute a change in method of accounting, it must have effected a change in the treatment of a material item.
The applicable regulations define a “material item” as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Treas. Reg. § 1.446–1(e)(2)(ii)(a); Huffman, 518 F.3d at 364–65. The Commissioner contends that by disallowing India Music's 2004 account payable deduction until HRI included the underlying payment in income, it effectively changed India Music's treatment of a material item. We agree.
From 1998 to 2004, India Music accounted for the accounts payable owed to HRI on an accrual basis, deducting the payments from income each year as they became fixed. But since HRI was a cash-basis taxpayer, it could not include the payments from India Music in its income until it received those payments.See Arnwine v. Comm'r , 696 F.2d 1102, 1111 [51 AFTR 2d 83-644] (5th Cir. 1983) (“Cash basis taxpayers are required to include items of income in the taxable year in which such item is actually or constructively received.”) (citations omitted). Thus, by “matching” the time at which India Music could deduct its accounts payable owed to HRI with the time at which HRI could include those payments as income, the Commissioner's § 267(a)(2) disallowance effectively changed India Music's accounting method for its account payable deduction in the 2004 taxable year from an accrual basis to a cash basis. That is, the Commissioner effected a change in India Music's treatment of a material item in 2004 by postponing the proper time for taking its account payable deduction. See Summit Sheet Metal Co., T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11 (holding that an “item is material ... if the time for including it in income or deducting it is at issue”). Accordingly, the disallowance constituted a change in accounting method for the purposes of § 481 because it forced India Music to “comput[e]” its taxable income for the tax year 2004 “under a method of accounting different from the method under which [India Music's] taxable income for the preceding taxable year was computed.” 26 U.S.C. § 481; see Graff Chevrolet, 343 F.2d at 572 (holding that § 481 authorizes necessary adjustments to income in the year of change whether the change in method of accounting was initiated by the taxpayer or the Commissioner).
Therefore, we find that the language of §§ 267(a)(2) and 481 plainly provides that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting for the purposes of § 481, given the definition in the applicable Treasury Regulations. In essence, when Congress enacted the current language in § 267(a)(2), empowering the Commissioner to postpone a related party payor's deduction until its related party payee included the underlying payment in its gross income,see Deficit Reduction Act of 1984, Pub. L. 98-369, § 174(a), 98 Stat 494 (1984), the applicable Treasury Regulations explicitly provided that a change in method of accounting included a change in the treatment of any material item—i.e., “any item which involves the proper time for the inclusion of the item in income or the taking of a deduction.” Treas. Reg. § 1.446-1(e)(2)(ii)(a). Accordingly, by requiring the Commissioner to postpone the proper time at which taxpayers could take certain deductions arising from related party transactions pursuant to § 267(a)(2), Congress evinced a clear intent that applications of § 267(a)(2) necessarily change a taxpayer's method of accounting.
Further, the Tax Court's holding in Summit Steel Co., supra at 2, supports our holding that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting under § 481. In that case, the taxpayer argued that it had not changed its accounting method when it sought to change the year it deducted its officers' bonuses from the year it authorized them to the year in which the officers received and reported them. Summit Steel Co., 1996-563, 72 T.C.M. (CCH) 1606, 1996 [1996 RIA TC Memo ¶96,563] WL 740748, at 11. The taxpayer argued that the change did not effect a change in its method of accounting because it was only a “correction required to comply with section 267(a).” Id. The Tax Court rejected that contention, finding that even if § 267(a)(2) required the taxpayer to change the year it deducted its bonus payments, the postponement of the bonus deductions constituted a change in the taxpayer's method of accounting under § 446(e). Id. The Taxpayers contend thatSummit Steel Co. does not support the Commissioner's position in this case because that case concerned a change in method of accounting under § 446(e), which requires a taxpayer to “secure the consent of the Secretary” before it changes its method of accounting. But we find this distinction immaterial for deciding the case before us because the Taxpayers have failed to offer a persuasive rationale for why a § 267(a)(2) disallowance causes a change in a taxpayer's method of accounting for the purposes of § 446, but not § 481.
D
The Taxpayers make three main arguments challenging our holding, which we find all lack merit. First, they submit that although the § 267(a)(2) disallowance had the potential to delay India Music's deductions, it could also “preclude ultimate deductibility” if India Music were to go out of business before paying its accrued expenses to HRI. But that contingency is precisely the reason why the disallowance amounts to a change in India Music's method of accounting from an accrual basis to a cash basis. When parties account for expenses on a cash basis, as opposed to an accrual basis, they necessarily bear the risk that they will be unable to deduct those expenses if they never actually pay them. Arnwine, 696 F.2d at 1111. Thus, by postponing the time at which India Music could deduct its account payable and then upwardly adjusting its income to capture the improper deductions, the Commissioner only placed India Music in the same position it would have been had it properly accounted for its accounts payable on a cash basis from 1998–2004 as required by § 267(a)(2).
Second, the Taxpayers assert that the Commissioner has failed to provide any examples where he previously found that a § 267(a)(2) disallowance involves timing issues invoking a § 481 adjustment. This lack of authority, they contend, supports their argument that the two provisions “are not to be read together.” They submit that the requirements of § 481 are mandatory, providing that the Commissioner “shall” make “necessary” adjustments to a taxpayer's income to avoid the “omission” of income from tax. Thus, the Taxpayers maintain that we would expect to find precedent for the proposition that a § 267(a)(2) disallowance constitutes a change in a taxpayer's accounting method necessitating a § 481 adjustment if that has been the Commissioner's consistent position.
In essence, the Taxpayers' argument amounts to a claim that the Commissioner has changed his interpretation of the Code and relevant Treasury Regulations with retroactive effect.See Microcomputer Tech. Inst. v. Riley , 139 F.3d 1044, 1050 (5th Cir. 1998) (holding that when an agency changes its policy with retroactive effect, a reviewing court must determine the reasonableness of the new interpretation and whether application of the new policy to a party who relied on the old is so unfair as to be arbitrary and capricious). But our review does not reveal any case where the Commissioner previously adopted an explicit position on this question. Moreover, even if that doctrine applied to this case, we would find that the Commissioner was justified in changing its policy with retroactive effect because (1) his interpretation is plainly reasonable and (2) “the detrimental effect of prospectivity—partial frustration of what we have now determined is the proper statutory interpretation”—outweighs “the disadvantages of retroactivity—frustration of parties' expectations.” Id. at 1051. That is, the Taxpayers cannot establish that they justifiably relied on the Commissioner's alleged implicit prior position when they violated § 267(a)(2), because it would amount to asserting that they violated the Code believing that they would be protected by the Code's statute of limitations if the Commissioner failed to disallow their improper deductions before the relevant tax years became closed.
Lastly, the Taxpayers maintain that the statute of limitations should bar the Commissioner from adjusting India Music's 2004 income to reflect improper deductions claimed in closed years; holding otherwise, they contend, would not serve our rationale for concluding that the application of § 481 did not conflict with the Code's statute of limitations in Graff Chevrolet, supra at 5. In that case, we found:
There is no necessary conflict between section 481 and the statute of limitations. Until the year of the accounting change, the Commissioner has no claim against the taxpayer for amounts which the taxpayer should have reported in prior years. The statute of limitations is directed toward stale claims. Section 481 deals with claims which do not even arise until the year of the accounting change.
343 F.2d at 572. In this case, however, the Taxpayers submit that the purpose of the statute of limitations and the application of § 481 do conflict because nothing prevented the Commissioner from immediately correcting the § 267(a)(2) violations while the closed years were still open.
But, although the Commissioner had the authority to correct India Music's improper deductions in an earlier tax year if he had discovered them, we nevertheless find that applying § 481 here does not conflict with the Code's statute of limitations for the very reasons stated in Graff Chevrolet: ““[w]hen a taxpayer uses an accounting method which reflects an expense before it is proper to do so ..., he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income ....””Graff Chevrolet , 343 F.2d at 572 (quoting Note,Problems Arising from Changes in Tax-Accounting Methods , 733 Harv. L. Rev. 1564, 1576 (1960). Therefore, as in Graff Chevrolet, applying § 481 to this case ““does not hold the taxpayer to any income which he has any reason to believe he has avoided, and does not frustrate the policy that men should be able, after a certain time, to be confident that past wrongs are set at rest.””Id. (quoting Note, 733 Harv. L. Rev. at 1576.
III
For the foregoing reasons, we affirm the judgment of the Tax Court, finding that the Taxpayers are liable for the deficiency and § 6662(a) accuracy-related penalty.
1
All statutory references herein are to the Code unless otherwise indicated.
2
The Taxpayers are not asserting that the definition in Treas. Reg. § 1.446–1(e)(2)(ii)(a) fails to comport with § 481; instead, their appeal appears to be limited to whether a § 267(a)(2) disallowance constitutes a change in method of accounting under the definition in Treas. Reg. § 1.446–1(e)(2)(ii)(a).
RAMESH J. BOSAMIA; PRAGATI BOSAMIA Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE Respondent-Appellee.
Case Information:
Code Sec(s):
Court Name: IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT,
Docket No.: No. 10-60921,
Date Decided: 10/24/2011.
Disposition:
HEADNOTE
.
Reference(s):
OPINION
IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT,
Appeal from the Decision of the United States Tax Court
Before REAVLEY, GARZA, and GRAVES, Circuit Judges.
Judge: EMILIO M. GARZA, Circuit Judge:
This case presents a question of first impression under the Internal Revenue Code, 26 U.S.C. § 1 et seq. (“the Code”): 1 whether the Commissioner of Internal Revenue effects a change in a taxpayer's method of accounting for the purposes of § 481 when he requires that taxpayer to postpone a deduction from gross income pursuant to § 267(a)(2). Because we conclude that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting under § 481, we AFFIRM the judgment of the Tax Court.
I
Petitioners-Appellants, Ramesh and Pragati Bosamia, are the sole shareholders of two Subchapter S corporations, India Music and HRI, engaged in the business of importing and selling music, making those entities related parties under § 267. Because the two entities are related parties under the Code, subsection 267(a)(2) bars the entities from deducting payments owed to the other party from income until the related party includes the payments in its income. Summit Sheet Metal Co. v. Comm'r, T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11 (1996). Nonetheless, from 1998 to 2004, India Music purchased most of its inventory from HRI on account, yet India Music and HRI accounted for those payments using different methods of accounting. India Music was an accrual-basis taxpayer, deducting the yearly increase in the accounts payable from its gross income as costs of goods sold when its liability became fixed. Burks v. United States, 633 F.3d 347, 358 [107 AFTR 2d 2011-824] (5th Cir. 2011) (“Under the Code, gross income of a trade or business is usually calculated by subtracting the cost of goods sold from the gross receipts of the sale.”) (citing 26 U.S.C. § 61(a)). Meanwhile, HRI was a cash-based taxpayer, opting not to include the payments owed to it by India Music in income until it actually received those payments.
From 1998 to 2003, India Music claimed accounts payable deductions for payments owed to HRI totaling $877,579, even though it never made a payment to HRI and HRI did not include the payments in its income. Because India Music is a Subchapter S corporation, all of its income passes through to its shareholders for tax purposes. Nail v. Martinez, 391 F.3d 678, 683 (5th Cir. 2004). Accordingly, the Commissioner issued the Bosamias a notice of deficiency in August 2008, informing them that India Music was not entitled to claim deductions for the payments to HRI from 1998–2004 until HRI included those payments in income. The Commissioner then disallowed India Music's claimed account payable deduction of $23,351 for payments to HRI it accrued in tax year 2004.
When the Commissioner issued his notice, the Code's three year statute of limitations for assessing income tax deficiencies barred him from assessing deficiencies against the Bosamias for the 1998 through 2002 tax years. 26 U.S.C. § 6501(a). However, because the Commissioner determined that his disallowance of India Music's year 2004 account payable deduction amounted to a change in India Music's method of accounting under § 481, he upwardly adjusted India Music's 2004 income to prevent the omission of income from tax by result of the change in accounting method. Specifically, the Commissioner made an upward adjustment of $877,581 to India Music's 2004 income to ensure that India Music's claimed accounts payable deductions from 1998 to 2003 did not escape taxation. These adjustments to India Music's year 2004 income created a corresponding deficiency in the Bosamias' 2004 income tax. Hence, the Commissioner determined that the Bosamias were liable for a tax deficiency of $295,818 and an accuracy-related penalty of $59,163.60.
The Taxpayers petitioned the Tax Court for a redetermination of the deficiency in tax and penalty determined in the notice of deficiency. They argued that the Commissioner's § 267(a)(2) disallowance did not constitute a § 481 change in method of accounting, thereby prohibiting the Commissioner from adjusting their 2004 income to account for the improper deductions claimed in the closed years from 1998–2002. The Tax Court upheld the Commissioner's notice of deficiency and penalty, holding that the § 267(a)(2) disallowance effected a change in India Music's method of accounting under § 481 because the disallowance amounted to a change in its treatment of a material item by postponing the timing of its cost of goods sold deduction. This appeal followed.
II
A
On appeal, the Taxpayers contend that the Tax Court erred as a matter of law by deciding that the Commissioner's § 267(a)(2) disallowance constituted a § 481 change in India Music's method of accounting. Instead, the Taxpayers assert that the Commissioner's § 267(a)(2) disallowance was only an “audit adjustment” to correct India Music's “erroneous deductions” for the 2004 tax year. In essence, they submit that the disallowance did not amount to a § 481 change in India Music's method of accounting because it neither (a) changed that entity's overall method of accounting nor (b) effected a change in that entity's treatment of a material item. The Commissioner, however, counters that the § 267(a)(2) disallowance effected a change in India Music's treatment of a material item because it postponed the proper time for the taking of the entity's account payable deduction for the 2004 tax year. In short, the Commissioner contends that by disallowing India Music's 2004 account payable deduction until HRI includes the underlying payments in income, it changed India Music's year 2004 method of accounting for accounts payable owed to HRI from the accrual method of accounting to the cash method of accounting. Because the Tax Court's decision rests on a pure question of law, we review its decision de novo. Arevalo v. Comm'r, 469 F.3d 436, 438 [98 AFTR 2d 2006-7676] (5th Cir. 2006).
The parties stipulated in the tax court that if the Commissioner's § 267(a)(2) disallowance amounted to a change in India Music's method of accounting for tax year 2004, the Commissioner properly adjusted that entity's 2004 income to include the improper deductions from 1998–2003. The parties also stipulated that India Music and HRI were related parties under the Code and that India Music improperly deducted payments to HRI from its income for the tax years 1998–2004 because HRI did not include those payments in its income. Lastly, the parties stipulated that the Commissioner properly disallowed India Music's claimed account payable deduction for tax year 2004 for payments owed to HRI.
Thus, the only question before us is whether the Commissioner's § 267(a)(2) disallowance of India Music's account payable deduction for tax year 2004 effected a change in India Music's method of accounting for the purposes of § 481. If it did, § 481 required the Commissioner to adjust India Music's 2004 income upward to prevent the amounts erroneously deducted from 1998–2003 from escaping taxation. If it did not, the Code's statute of limitations barred the Commissioner from assessing any deficiency based on erroneous deductions claimed by India Music in closed years.
B
Section 481 requires the Commissioner to adjust a taxpayer's taxable income to ensure accurate computation of income when that taxpayer changes its method of accounting from one year to the next. It provides, in relevant part:
In computing the taxpayer's taxable income for any taxable year (referred to ... as the “year of the change”)—
((1)) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then
((2)) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted ....
26 U.S.C. § 481(a)(1)–(2).
Under § 481, “if income escapes taxation because of a change in accounting method, the Commissioner may make an adjustment by including the omitted income in the year of the change.” Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 570 [15 AFTR 2d 647] (5th Cir. 1965). The section “authorizes “necessary” adjustments “to prevent amounts from being duplicated or omitted,” in the “year of change” whether “initiated” by the taxpayer or the Commissioner.”Id. at 572. Morever, there is “no necessary conflict between section 481 and the [Code's] statute of limitations.” Id. Instead, the very purpose of § 481 is to allow the Commissioner to adjust a taxpayer's income for open years to reflect amounts attributable to closed years that would otherwise escape taxation due to a change in method of accounting. Id. (“ Section 481 is designed to prevent a distortion of taxable income and a windfall to the taxpayer stemming from a change in accounting at a time when the statute of limitations bars reopening the taxpayer's returns for earlier years.”).
Meanwhile, § 267(a)(2), as amended in 1984, “provides for a matching of [expenses] deductions and income where, in the case of related persons, the payor is an accrual-basis taxpayer and the payee is on a cash method of accounting.” Ronald Moran Cadillac, Inc. v. United States, 385 F.3d 1230, 1233 [94 AFTR 2d 2004-6291] (9th Cir. 2004). The provision “prevent[s] the use of differing methods of reporting income [by related parties] for Federal income tax purposes in order to obtain artificial deductions for interest and business expenses.” Id. (quotingMetzger v. Comm'r , 76 T.C. 42, 75 (1981) (describing purpose of the predecessor of § 267(a)(2)). Specifically, § 267(a)(2) “bars a taxpayer from deducting a payment to a related taxpayer before the related taxpayer includes the payment in income.” Summit Sheet Metal Co., T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11.
C
The first step in statutory interpretation “is to determine whether the language at issue has a plain and unambiguous meaning with regard to the particular dispute in the case.”Robinson v. Shell Oil Co. , 519 U.S. 337, 340 (1997). “The plainness or ambiguity of statutory language is determined by reference to the language itself, the specific context in which that language is used, and the broader context of the statute as a whole.” Id. at 341 (citations omitted). Although neither the language of § 267(a)(2) nor § 481 explicitly provides that a disallowance under § 267(a)(2) amounts to a change in a taxpayer's method of accounting, we still conclude that Congress plainly intended that a § 267(a)(2) disallowance effectuates a change in a taxpayer's method of accounting given the specific context in which the language in that subsection is used.
The applicable Treasury Regulations define a “change in the method of accounting” as including either “a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” Treas. Reg. § 1.446–1(e)(2)(ii)(a);see Huffman v. Comm'r , 518 F.3d 357, 364 [101 AFTR 2d 2008-1078] (6th Cir. 2008) (finding that § 1.446–1(e)(2)(ii)(a) defines changes in methods of accounting for the purposes of § 481). 2 The Commissioner agrees that India Music never changed its overall plan of accounting; therefore, in order for the § 267 disallowance to constitute a change in method of accounting, it must have effected a change in the treatment of a material item.
The applicable regulations define a “material item” as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Treas. Reg. § 1.446–1(e)(2)(ii)(a); Huffman, 518 F.3d at 364–65. The Commissioner contends that by disallowing India Music's 2004 account payable deduction until HRI included the underlying payment in income, it effectively changed India Music's treatment of a material item. We agree.
From 1998 to 2004, India Music accounted for the accounts payable owed to HRI on an accrual basis, deducting the payments from income each year as they became fixed. But since HRI was a cash-basis taxpayer, it could not include the payments from India Music in its income until it received those payments.See Arnwine v. Comm'r , 696 F.2d 1102, 1111 [51 AFTR 2d 83-644] (5th Cir. 1983) (“Cash basis taxpayers are required to include items of income in the taxable year in which such item is actually or constructively received.”) (citations omitted). Thus, by “matching” the time at which India Music could deduct its accounts payable owed to HRI with the time at which HRI could include those payments as income, the Commissioner's § 267(a)(2) disallowance effectively changed India Music's accounting method for its account payable deduction in the 2004 taxable year from an accrual basis to a cash basis. That is, the Commissioner effected a change in India Music's treatment of a material item in 2004 by postponing the proper time for taking its account payable deduction. See Summit Sheet Metal Co., T.C. Memo 1996-563 [1996 RIA TC Memo ¶96,563], 72 T.C.M. (CCH) 1606, 1996 WL 740748, at 11 (holding that an “item is material ... if the time for including it in income or deducting it is at issue”). Accordingly, the disallowance constituted a change in accounting method for the purposes of § 481 because it forced India Music to “comput[e]” its taxable income for the tax year 2004 “under a method of accounting different from the method under which [India Music's] taxable income for the preceding taxable year was computed.” 26 U.S.C. § 481; see Graff Chevrolet, 343 F.2d at 572 (holding that § 481 authorizes necessary adjustments to income in the year of change whether the change in method of accounting was initiated by the taxpayer or the Commissioner).
Therefore, we find that the language of §§ 267(a)(2) and 481 plainly provides that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting for the purposes of § 481, given the definition in the applicable Treasury Regulations. In essence, when Congress enacted the current language in § 267(a)(2), empowering the Commissioner to postpone a related party payor's deduction until its related party payee included the underlying payment in its gross income,see Deficit Reduction Act of 1984, Pub. L. 98-369, § 174(a), 98 Stat 494 (1984), the applicable Treasury Regulations explicitly provided that a change in method of accounting included a change in the treatment of any material item—i.e., “any item which involves the proper time for the inclusion of the item in income or the taking of a deduction.” Treas. Reg. § 1.446-1(e)(2)(ii)(a). Accordingly, by requiring the Commissioner to postpone the proper time at which taxpayers could take certain deductions arising from related party transactions pursuant to § 267(a)(2), Congress evinced a clear intent that applications of § 267(a)(2) necessarily change a taxpayer's method of accounting.
Further, the Tax Court's holding in Summit Steel Co., supra at 2, supports our holding that a § 267(a)(2) disallowance constitutes a change in a taxpayer's method of accounting under § 481. In that case, the taxpayer argued that it had not changed its accounting method when it sought to change the year it deducted its officers' bonuses from the year it authorized them to the year in which the officers received and reported them. Summit Steel Co., 1996-563, 72 T.C.M. (CCH) 1606, 1996 [1996 RIA TC Memo ¶96,563] WL 740748, at 11. The taxpayer argued that the change did not effect a change in its method of accounting because it was only a “correction required to comply with section 267(a).” Id. The Tax Court rejected that contention, finding that even if § 267(a)(2) required the taxpayer to change the year it deducted its bonus payments, the postponement of the bonus deductions constituted a change in the taxpayer's method of accounting under § 446(e). Id. The Taxpayers contend thatSummit Steel Co. does not support the Commissioner's position in this case because that case concerned a change in method of accounting under § 446(e), which requires a taxpayer to “secure the consent of the Secretary” before it changes its method of accounting. But we find this distinction immaterial for deciding the case before us because the Taxpayers have failed to offer a persuasive rationale for why a § 267(a)(2) disallowance causes a change in a taxpayer's method of accounting for the purposes of § 446, but not § 481.
D
The Taxpayers make three main arguments challenging our holding, which we find all lack merit. First, they submit that although the § 267(a)(2) disallowance had the potential to delay India Music's deductions, it could also “preclude ultimate deductibility” if India Music were to go out of business before paying its accrued expenses to HRI. But that contingency is precisely the reason why the disallowance amounts to a change in India Music's method of accounting from an accrual basis to a cash basis. When parties account for expenses on a cash basis, as opposed to an accrual basis, they necessarily bear the risk that they will be unable to deduct those expenses if they never actually pay them. Arnwine, 696 F.2d at 1111. Thus, by postponing the time at which India Music could deduct its account payable and then upwardly adjusting its income to capture the improper deductions, the Commissioner only placed India Music in the same position it would have been had it properly accounted for its accounts payable on a cash basis from 1998–2004 as required by § 267(a)(2).
Second, the Taxpayers assert that the Commissioner has failed to provide any examples where he previously found that a § 267(a)(2) disallowance involves timing issues invoking a § 481 adjustment. This lack of authority, they contend, supports their argument that the two provisions “are not to be read together.” They submit that the requirements of § 481 are mandatory, providing that the Commissioner “shall” make “necessary” adjustments to a taxpayer's income to avoid the “omission” of income from tax. Thus, the Taxpayers maintain that we would expect to find precedent for the proposition that a § 267(a)(2) disallowance constitutes a change in a taxpayer's accounting method necessitating a § 481 adjustment if that has been the Commissioner's consistent position.
In essence, the Taxpayers' argument amounts to a claim that the Commissioner has changed his interpretation of the Code and relevant Treasury Regulations with retroactive effect.See Microcomputer Tech. Inst. v. Riley , 139 F.3d 1044, 1050 (5th Cir. 1998) (holding that when an agency changes its policy with retroactive effect, a reviewing court must determine the reasonableness of the new interpretation and whether application of the new policy to a party who relied on the old is so unfair as to be arbitrary and capricious). But our review does not reveal any case where the Commissioner previously adopted an explicit position on this question. Moreover, even if that doctrine applied to this case, we would find that the Commissioner was justified in changing its policy with retroactive effect because (1) his interpretation is plainly reasonable and (2) “the detrimental effect of prospectivity—partial frustration of what we have now determined is the proper statutory interpretation”—outweighs “the disadvantages of retroactivity—frustration of parties' expectations.” Id. at 1051. That is, the Taxpayers cannot establish that they justifiably relied on the Commissioner's alleged implicit prior position when they violated § 267(a)(2), because it would amount to asserting that they violated the Code believing that they would be protected by the Code's statute of limitations if the Commissioner failed to disallow their improper deductions before the relevant tax years became closed.
Lastly, the Taxpayers maintain that the statute of limitations should bar the Commissioner from adjusting India Music's 2004 income to reflect improper deductions claimed in closed years; holding otherwise, they contend, would not serve our rationale for concluding that the application of § 481 did not conflict with the Code's statute of limitations in Graff Chevrolet, supra at 5. In that case, we found:
There is no necessary conflict between section 481 and the statute of limitations. Until the year of the accounting change, the Commissioner has no claim against the taxpayer for amounts which the taxpayer should have reported in prior years. The statute of limitations is directed toward stale claims. Section 481 deals with claims which do not even arise until the year of the accounting change.
343 F.2d at 572. In this case, however, the Taxpayers submit that the purpose of the statute of limitations and the application of § 481 do conflict because nothing prevented the Commissioner from immediately correcting the § 267(a)(2) violations while the closed years were still open.
But, although the Commissioner had the authority to correct India Music's improper deductions in an earlier tax year if he had discovered them, we nevertheless find that applying § 481 here does not conflict with the Code's statute of limitations for the very reasons stated in Graff Chevrolet: ““[w]hen a taxpayer uses an accounting method which reflects an expense before it is proper to do so ..., he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income ....””Graff Chevrolet , 343 F.2d at 572 (quoting Note,Problems Arising from Changes in Tax-Accounting Methods , 733 Harv. L. Rev. 1564, 1576 (1960). Therefore, as in Graff Chevrolet, applying § 481 to this case ““does not hold the taxpayer to any income which he has any reason to believe he has avoided, and does not frustrate the policy that men should be able, after a certain time, to be confident that past wrongs are set at rest.””Id. (quoting Note, 733 Harv. L. Rev. at 1576.
III
For the foregoing reasons, we affirm the judgment of the Tax Court, finding that the Taxpayers are liable for the deficiency and § 6662(a) accuracy-related penalty.
1
All statutory references herein are to the Code unless otherwise indicated.
2
The Taxpayers are not asserting that the definition in Treas. Reg. § 1.446–1(e)(2)(ii)(a) fails to comport with § 481; instead, their appeal appears to be limited to whether a § 267(a)(2) disallowance constitutes a change in method of accounting under the definition in Treas. Reg. § 1.446–1(e)(2)(ii)(a).
Tuesday, October 25, 2011
Mass Gambler
CLARANCE W. JONES v. COMMISSIONER OF REVENUE
Case Information:
Docket/Court: C287780; C299046, Massachusetts Appellate Tax Board
Date Issued: 10/05/2011
Tax Type(s): Personal Income Tax
These are appeals filed under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39 from the refusal of the Commissioner of Revenue (“Commissioner” or the “appellee”), to abate income taxes assessed against Clarance W. Jones (“Mr. Jones” or the “appellant”) for the tax years 2001 through and including 2007 (“tax years at issue”).
Commissioner Scharaffa heard these appeals and was joined by Chairman Hammond and Commissioners Egan, Rose, and Mulhern in decisions for the appellant.
These findings of fact and report are made by the Appellate Tax Board (“Board”) on its own motion under G.L. c. 58A, § 13 and 831 CMR 1.32.
Domenic Finelli, Esq. for the appellant.
John J. Connors, Jr., Esq. for the appellee.
OPINION
FINDINGS OF FACT AND REPORT
On the basis of the Statement of Agreed Facts and Stipulated Exhibits and the testimony and exhibits offered at the hearing of these appeals, the Board made the following findings of fact.
At all times relevant to these appeals, the appellant was a Massachusetts resident. The appellant timely filed his Massachusetts Resident Income Tax Returns (“Forms 1”) for tax years 2001, 2002, 2003 and 2004, and timely filed Forms 1 pursuant to valid extensions for tax years 2005, 2006 and 2007. On Schedule C of Form 1 for each tax year at issue, the appellant reported that he was a “professional gambler.”
Jurisdictional facts for tax years 2001 through 2006.
The appellant's Forms 1 for tax years 2001 through 2006 showed no tax due and requested refunds as follows:
-----------------------------------------------------------------------
2001 2002 2003 2004 2005 2006
-----------------------------------------------------------------------
$1,055.00 $4,075.00 $9,844.00 $19,932.00 $86,449.00 $112,642.00
-----------------------------------------------------------------------The Commissioner issued refunds to the appellant in the following amounts:
------------------------------------------------------
2001 2002 2003 2004 2005 2006
------------------------------------------------------
$1,055.00 $4,074.60 $0 $0 $0 $0
------------------------------------------------------On February 4, 2004, the Commissioner sent to the appellant a Notice of Change to Your 2003 Income Tax Return informing the appellant that the Commissioner had changed the tax due on the 2003 Form 1 to $49,976.00 based on an alleged erroneous reporting of Massachusetts Lottery winnings and the elimination of the Limited Income Credit. By Notice of Assessment (“NOA”) dated May 18, 2004, the Commissioner notified the appellant that she had assessed the tax of $49,976.00 as reported on the Notice of Change to Your 2003 Income Tax Return.
Pursuant to validly executed consents extending the time to assess, the Commissioner sent the appellant a Notice of Intent to Assess (“NIA”) dated July 20, 2005, notifying the appellant of her intent to assess additional income taxes, exclusive of interest and penalties, as follows:
--------------------------------------------------------
2001 2002 2003 2004
--------------------------------------------------------
$33,665.00 $53,872.00 $8,470.00<1> $77,545.00
--------------------------------------------------------
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<1>This amount is in addition to the $49,976.00 assessment referred to in
the NOA dated May 18, 2004.The appellant requested a conference with respect to the July 20, 2005 NIA. The Commissioner's Office of Appeals and the appellant and his representatives held a conference by telephone regarding the NIA on December 1, 2005. Following the conference, the Office of Appeals issued its letter of disposition on February 20, 2006. The Commissioner subsequently sent to the appellant an NOA dated March 7, 2006, notifying the appellant of the assessment on March 5, 2006 of additional income taxes, exclusive of interest and penalties, as follows:
----------------------------------------------------
2001 2002 2003 2004
----------------------------------------------------
$33,665.00 $53,872.00 $8,470.00<2> $77,545.00
----------------------------------------------------
---------------------------------------------------------------------------
<2> See note 1, supra.On March 31, 2006, the appellant timely filed an abatement application regarding the above assessments for tax years 2001 through 2004, in which he also requested a hearing. By letter dated December 1, 2006, the Commissioner denied the request for a hearing because “[y]our Application for Abatement raises no new relevant factual information or new legal precedent that was not available at the time of the pre-assessment conference.” By Notice of Abatement Determination dated December 8, 2006, the Commissioner informed the appellant that the abatement applications for tax years 2001 through 2004 had been denied. The appellant filed a Petition Under Formal Procedure with the Board on January 24, 2007 for tax years 2001 through 2004. Based on these facts, the Board found and ruled that it had jurisdiction over the appeals for tax years 2001 through and including 2004.
The Commissioner issued an NIA dated October 29, 2007 for tax year 2005 and an NIA dated May 11, 2008 for tax year 2006. The Commissioner's Office of Appeals held a conference by telephone with the appellant's representatives regarding the October 29, 2007 NIA and the May 11, 2008 NIA on October 2, 2008. By NOA dated October 16, 2008, the Commissioner assessed additional income taxes against the appellant for tax year 2006, in the amount of $140,002.00, exclusive of interest and penalties. By NOA dated October 21, 2008, the Commissioner assessed additional income taxes against the appellant for tax year 2005, in the amount of $102,214.00, exclusive of interest and penalties. On November 10, 2008, the appellant filed an abatement application for tax year 2006, and on November 11, 2008, the appellant filed an abatement application for tax year 2005. The appellant did not request hearings regarding the abatement applications for the 2005 and 2006 tax years. By Notice of Abatement Determination dated January 7, 2009, the Commissioner informed the appellant that the abatement applications for tax years 2005 and 2006 had been denied. On February 26, 2009, the appellant filed a Petition Under Formal Procedure with the Board for tax years 2005 and 2006. Based on these facts, the Board found and ruled that it had jurisdiction over the appeals for tax years 2005 and 2006.
Jurisdictional facts for tax year 2007.
Pursuant to a valid extension, the appellant timely filed his Form 1 for tax year 2007. On Schedule C of the 2007 Form 1, the appellant reported that his gross receipts were $2,888,386, his costs of goods sold were $2,839,686, his total expenses were $23,309, and his gross profits were $25,391. Gambling profits of $25,391 were reported on line 6 of the return, while line 8b for “Mass. lottery profits” was blank. The appellant reported a tax due of $984 and withholdings of $129,329, and he requested a refund of $128,345.00.
The Commissioner sent the appellant a Notice of Change to Your 2007 Income Tax Return, dated September 30, 2008, in which the Commissioner stated:
The Massachusetts Lottery Commission has reported to the Department of Revenue that you received $258,759,150.00 3 of lottery winnings for the tax year 2007. You reported $0.00 of winnings on your tax return. Consequently, we have adjusted your tax return as detailed in this notice. This resulted in change to the amount of tax due for this year.
Following are the “Reason(s) for Change:”
Line 8B — Lottery Claimed Does Not Agree With Lottery Winnings On File
The Commissioner thus changed the appellant's tax to $13,715,219.00 and also changed the amount of withholdings to $388,087.00.
By NOA dated October 6, 2008, the Commissioner notified the appellant of the assessment, on September 29, 2008, of income taxes for tax year 2007 in the amount of $13,715,219.00 as shown on the Notice of Change to Your 2007 Income Tax Return. The appellant filed an abatement application for tax year 2007 with the Commissioner on October 14, 2008 and a second abatement application on November 4, 2008. The appellant subsequently requested that the Commissioner deny both abatement applications for 2007 so that he could join the 2007 appeal with those from the previous tax years at issue. By Notice of Abatement Determination dated January 27, 2009, the Commissioner informed the appellant that “[y]our application had been denied.” On February 26, 2009, the appellant seasonably filed his Petition Under Formal Procedure for tax year 2007 with the Board.
Prior to the hearing of these appeals, the Commissioner admitted that the assessment for fiscal year 2007 was erroneous because of a misplaced decimal point. 4 Then, after the commencement of these appeals, the Commissioner purported to abate the erroneous assessment by issuing an Abatement Approval Notice, which was unsigned. The following is excerpted from the Board's Decision dated August 16, 2010:
On February 6, 2010, two days before the hearing of these appeals, the Commissioner's Customer Service Bureau issued an Abatement Approval Notice, stating that the appellant's “application filed on [his] INCOME tax account has been approved.” The notice was unsigned and did not state the amount of the abatement. The Commissioner has agreed that the $13,715,219.00 assessment was an error attributable to the placement of a decimal point on the Notice of Change regarding the taxpayer's lottery winnings.
The Board finds and rules that the so-called Abatement Approval Notice was not sufficient to abate the erroneous assessment. Appellant had previously received a denial of his abatement request, dated January 27, 2009, and was therefore a person aggrieved under G.L c. 62C, § 39 when he filed his appeal with the Board. Although the Commissioner may abate an erroneously assessed tax after the commencement of an appeal to the Board, the February 6, 2010 notice was unsigned and contained no abatement amount and therefore did not constitute a valid abatement.
Because the Board found that the so-called Abatement Approval Notice was not sufficient to abate the Commissioner's erroneous assessment and that the appellant was still a person aggrieved under G.L. c. 62C, § 39 , the Board found and ruled that it had jurisdiction over the appeal for tax year 2007.
Findings with respect to tax years 2001 through 2006.
The appellant claimed that, at all times relevant to these appeals, he was and held himself out as a professional gambler. The appellant's gambling activities consisted of betting at various horse- and dog-racing tracks where he engaged in both live and simulcast betting, casino betting, and Lottery ticket betting. He explained that during tax year 2004 onward, his business consisted of more Lottery gambling than any other form. The appellant's gambling revenue constituted his main source of income, aside from Social Security payments and minimal bank interest.
The parties stipulated that the appellant maintained numerous boxes of losing dog and horse racing tickets from both live and simulcast races, along with programs, losing Foxwoods Keno tickets, and losing Massachusetts Lottery tickets, including scratch tickets and various numbers games including, among others, Keno, Daily Numbers Games, Mega Bucks, Mega Millions, Mass Millions, Cash Windfall, Big Game, Powerball and Daily Race Game. The appellant testified that he maintained at least 200 boxes at a storage facility in Lynn, Massachusetts. A sample, as agreed to by both parties, of about fifteen boxes of those records, was submitted to the Board. The boxes were filled with various losing Lottery tickets, losing Foxwoods Casino Keno tickets, losing racing tickets and racetrack programs. All items were bagged and/or bound together in groups and labeled by notations which either included dates, places, number of tickets and total cost of tickets, or a number corresponding to the appellant's personal numbering system from his records where that same information would be listed.
The appellant presented his case-in-chief through his own testimony as well as the testimony of: Harold Litchfield, a fellow gambler; Louis Ristaino, a racetrack employee; and Edward Sherman, CPA, his accountant.
Mr. Litchfield testified to the appellant's gambling activities. He testified that the appellant was regularly engaged in gambling, attending the dog or horse racetrack from about eleven in the morning until about midnight, either four or five days a week. He testified that he witnessed the appellant engaging in racetrack betting as well as Keno. Mr. Litchfield also testified that he had placed bets for the appellant. He explained that this was common practice among friends, particularly at a busy gambling establishment with long lines. But Mr. Litchfield emphasized that he always used the appellant's money, that he followed the express direction of the appellant and that he never accepted compensation from the appellant to place these bets. The Commissioner did not meaningfully challenge Mr. Litchfield's testimony on cross-examination, and the Board found his testimony credible.
Mr. Ristaino then testified as to how a gambler could place a bet while avoiding a long line at a busy gambling establishment. He explained that regular gamblers curry favor with racetrack window tellers by tipping generously. Then, instead of waiting in line, the gambler calls in the favor by surreptitiously giving the teller a hand signal, which the teller will interpret and then place the bet accordingly. Through the use of hand signals, a regular gambler can thus place multiple bets quickly, using his own money, without having to wait in long lines. Again, the Commissioner did not meaningfully challenge Mr. Ristaino's testimony on cross-examination, and the Board found his testimony credible.
Mr. Sherman offered detailed testimony with respect to the sufficiency of the appellant's records. He explained that the appellant maintained more than 200 boxes of records in a storage facility and that he had seen these records and had advised the appellant on his record keeping. Mr. Sherman testified that the appellant had been audited previously by the Commissioner for tax years 1988, 1994 and 1995, as well as by the Internal Revenue Service (“IRS”) in 1994. He stated that for the previous audit conducted by the Commissioner, he and the appellant provided the prior auditor, Jim Reynolds, with 11 boxes of documents. He noted that each of the federal and state audits had resulted in no change to the appellant's returns.
Mr. Sherman explained that, after the prior audits, the appellant continuously attempted to improve his record-keeping system and to keep more extensive information throughout the years at issue. Mr. Sherman testified further that he had a discussion with the appellant sometime during early 2004 about the new directive issued by the Commissioner with respect to record keeping, Department Directive 03-3 (“DD 03-3”), and that in his opinion, the appellant's records were in keeping with that directive. For example, Mr. Sherman explained that the appellant maintained personal calendars detailing his gambling activities, and his race track programs, with all of his losing tickets inside the program and a summary on the outside of all of the losing tickets. Mr. Sherman further testified that the appellant also maintained so-called “tax organizers” that listed his income and expenses and the information from the Forms W-2G Certain Gambling Winnings (“W-2G”), the forms issued by the Massachusetts State Lottery to gamblers for reporting lottery winnings over $600. Mr. Sherman explained that the appellant used the tax organizers to organize his tax information for the current tax year based on the income and deductions that he had had for the previous tax year. The appellant maintained tax organizers for each of the tax years at issue, and the stipulated exhibits included each of those tax organizers. The stipulated exhibits also included copies of the contents of three-ring binders that the appellant maintained for each of the tax years at issue, what the appellant and his representatives referred to as his “tax books,” which included: various correspondence between the appellant or his representatives and the auditors; copies of the appellant's tax returns; listings of the appellant's gambling losses; and his calendars. Mr. Sherman explained that the entries in these “tax books” corresponded to the receipts that the appellant maintained in storage.
Mr. Sherman next testified to the disagreements between the appellant and the Commissioner's auditors with respect to the examination of his records during the course of the audit for the tax years at issue. Mr. Sherman explained that the auditor originally assigned to the appellant's case was replaced by another auditor, Judith D'Auteuil, midway through the audit. He also testified that he had repeatedly requested that the Commissioner's auditors come to see the appellant's records at the storage facility, but that the auditors refused all requests for examination. He explained that the auditors sent out form requests seeking certain types of records, such as logs of the appellant's gambling activities, but that the appellant did not maintain his records in the specific format requested. Mr. Sherman explained, however, that he had advised the appellant to retain all of his racetrack tickets and programs and Lottery tickets because they collectively contained all of the information required for completing and verifying a tax return. Particularly with respect to a Lottery ticket, Mr. Sherman explained that “[a]ll of the information is on the ticket,” including the date and location of purchase and the amount of the wager.
The stipulated evidence contained correspondence between the parties, including a letter dated November 3, 2004 sent by the Commissioner's Tax Examiner, Sandra Sparrock, requesting, among other items: a daily log or journal showing the name and location of each gambling establishment visited, the dates gambled, and travel times with mileage to and from each gambling activity; records of wagers and winnings and programs from race tracks; names of individuals that participated in his gambling; receipts for food, lodging and air travel; bank records; Forms W-2G; gambling research materials; and losing scratch tickets grouped together by purchase date and locations and correlated to the daily log. By letter dated December 3, 2004, Mr. Sherman sent copies of the appellant's tax returns for tax years 2001, 2002 and 2003, and representative samples of the appellant's bank statements. Mr. Sherman's letter listed the documents that the appellant maintained in storage. These documents included lottery ticket stubs for cashed tickets, which identified the location of the establishment where the ticket was purchased, and twenty-five to thirty boxes per year which contained every program purchased and “all the losing tickets sorted by race number” as well as a list of all losses by date, track and box, and all losing scratch tickets. Mr. Sherman's letter then offered, “[y]ou may examine this information on site or, if requested, Mr. Jones will make arrangements to deliver them to you.” Mr. Sherman reiterated that, while the appellant's records were not necessarily maintained in the exact form as requested by the auditors, the information sought by the auditors was nonetheless contained in the records maintained by the appellant.
The stipulated exhibits also included further correspondence between Ms. Sparrock and Mr. Sherman in which Ms. Sparrock requested materials in specific form — business records in chronological order and daily records for all lottery transactions showing date and location of purchase, amount spent and amount of winnings — and Mr. Sherman informed her that the appellant's records were not maintained in the form requested, but that the information requested could be deduced from an examination of the numerous records that the appellant maintained in storage. At the hearing, Mr. Sherman posited that it was because the records were not in the form requested that the auditors refused to examine them. When asked directly by the Presiding Commissioner whether someone from the Department of Revenue (“DOR”) had actually refused to look at the appellant's records because they were not maintained as specified by the auditors' requests, Mr. Sherman responded affirmatively and testified that it was Ms. D'Auteuil who had made this statement to him. The stipulated exhibits also included correspondence between Ms. Sparrock and the appellant's former attorney, Peter Otis, including one letter in which Attorney Otis specifically suggested to Ms. Sparrock that a field audit be conducted, meaning that the auditor would come to the appellant's representative's office “to review the 100 or so boxes” at that location. The Commissioner's auditors, however, never accepted the appellant's invitation.
Next, the appellant testified in detail to the types and regularity of his gambling activities. He testified that, since selling his industrial cleaning company in 1986 and up to the tax years at issue, his only source of business income had been gambling. He testified that in a typical week, he would spend between 60 to 80 hours on gambling activities and that Lottery gambling had been his primary activity since about 2004. When asked where he gambled, the appellant responded, “I do the whole state,” as well as out of state. He testified that, in his opinion, Massachusetts has “the easiest lottery system” for a regular gambler to successfully play. He explained some of his methodologies, like buying Lottery tickets in the middle of a pack where, he believed, the winning tickets were grouped, and purchasing tickets at stores that have had recent large winnings, because, in his opinion, those stores have a higher chance of selling winning tickets. The appellant submitted into evidence a manual that he had written entitled “The Gambler,” which contained some of the observations and “trade secrets” for successful gambling that he has accumulated over his gambling career. The appellant also corroborated Mr. Litchfield's and Mr. Ristaino's testimony, explaining how he was able to place numerous bets at a racetrack without waiting in line, either through the use of hand signals or by asking a friend to place bets on his behalf. He emphasized that he used his own money to place bets and that he did not compensate anyone to place bets for him. The Commissioner did not meaningfully challenge Mr. Jones' testimony on cross-examination, and the Board found the appellant's testimony to be credible.
The appellant next described his system of keeping records. He testified that he recognized that he was not an expert in taxes, and he thus hired an accountant to assist him with his filing and record-keeping duties. He also testified that he heeded his accountant's advice and that he continuously tried to improve his record-keeping system, particularly after his accountant advised him about DD 03-3. He emphasized that his records contained all of the information required to discern how much he expended on wagers and where he gambled during each tax year. The appellant testified that he maintained three storage rooms at a storage facility in Lynn and that the files in his boxes — which included ticket stubs, programs and his calendars marked with the amounts of small winnings for which no Forms W-2G would have been generated, which he used to compile ledgers of small winnings — corresponded to entries in his “tax books.” On direct examination, the appellant was asked to trace his records from a random date — January 17, 2002 — to his “tax book” for that year. The appellant was able to locate the entry using his entry system. The appellant's explanations of some of his short-hand entries — for example, “Sam means something to me. Sam to me is Summit Variety.... It's in Peabody, Mass.” — indicated that his entry system was not self-explanatory but was personal to him.
The appellant also reiterated Mr. Sherman's testimony that the Commissioner's auditors refused to examine his voluminous records, despite his requests. He explained that no auditor had ever taken the records from the storage facility to inspect them, nor did they ever ask to look through them at their offices. With respect to his “tax books,” the appellant testified that “they refused my lawyer to even submit them.” In preparation for the hearing, the attorney for the Commissioner accompanied the appellant and his attorney to the storage facility to choose the sample of records which were brought to the hearing. Prior to that, the appellant explained, no representative of the Commissioner had ever agreed to examine his records. The Board also found this part of the appellant's testimony to be credible.
The Commissioner presented its case through the testimony of Brian Taylor, a director within the Massachusetts State Lottery, and of Judith D'Auteuil, a tax auditor within the Department of Revenue's Audit Division.
Mr. Taylor testified regarding the computer system by which the State Lottery tracked frequent cashers of lottery tickets. He testified that the appellant was the highest or second-highest casher of winning tickets in the Commonwealth during each tax year at issue. He next explained that this computer system gleans crucial information from the bar code located on each Lottery ticket, which enables the State Lottery to determine the type of Lottery game played and where the ticket was purchased:
Well, we know it when we scan the ticket. There's a lot of intelligence on that bar code and that will tell our cashing system immediately where the ticket was issued.
Mr. Taylor's testimony thus corroborated Mr. Sherman's testimony that the Lottery tickets contain the relevant information for verifying tax return data.
Mr. Taylor also explained that the odds of winning for each Massachusetts Lottery game and whether a winner had claimed the grand prize were published on the Massachusetts Lottery's website. Mr. Taylor, however, presented no evidence relating to the odds of any of the particular Massachusetts Lottery games, including those played by the appellant.
Next, Ms. D'Auteuil testified as to her conduct of the audit of the tax years at issue, beginning on October 29, 2007. Ms. D'Auteuil conducted a “correspondence audit” of the appellant, that is, one in which the auditor conducts the audit by seeking records from the taxpayer through remote correspondence, usually form letters. Ms. D'Auteuil explained that she audited tax year 2006 and a portion of tax year 2005 after the file had been to the Office of Appeals. She testified that the audit file was transferred to her after she had been assigned to replace the previous auditor, Zlatan Caticz, and that she received the case after the Office of Appeals had made its determination on tax year 2005. Ms. D'Auteuil testified that she had reviewed the files for tax years 2001 through 2004 in preparation for the hearing at the Board.
The stipulated exhibits included Ms. D'Auteuil's first letter to the appellant, dated October 29, 2007, requesting certain records from the appellant, including daily logs or journals showing dates when and places where the appellant gambled, losing tickets, and any “patron data logs” from gambling casinos. Ms. D'Auteuil testified that she reviewed the Commissioner's audit files concerning the appellant, which included the documents that his representative had submitted to the Commissioner's auditors, and from these she determined “[t]hat Mr. Jones was not in the trade or business of professional gambling.” When asked the reason for her determination, Ms. D'Auteuil replied, “[i]nadequate, incomplete, insufficient records.” Ms. D'Auteuil admitted, however, that she did not look through a single box maintained by the appellant in storage. She claimed that she was willing to pick up the documents but that her offer was refused by the appellant's prior attorney, Peter Otis. According to Ms. D'Auteuil:
I wanted the tickets at my office and he said the boxes were voluminous. I offered to go out there with someone and a two-wheeled dolly to get them and bring them back to my office. And he told me, no, I had to go out by myself and I had to look at them, but I couldn't touch them. So I told him, “I can't do that. I want them in the office as I requested.”
Attorney Otis was not brought into the hearing as a witness to corroborate or deny the above statements. However, his letter in response to Ms. D'Auteuil's request was admitted into evidence. By letter dated November 28, 2007, Attorney Otis explained that the appellant required additional time to compile his records into the daily-log format requested by Ms. D'Auteuil. The letter further offered to Ms. D'Auteuil that “[a]ll losing scratch tickets amounting to approximately 33 cases of paper can be made available at our office or delivered to you.” Nowhere in the letter did Attorney Otis deny Ms. D'Auteuil access to any records that she had requested, nor did he restrict her access to the appellant's storage facility where, according to her, she would be permitted to merely “look” but not “touch.” Moreover, Ms. D'Auteuil's audit log, otherwise very detailed and including notations about other telephone calls with Attorney Otis, contained no notation indicating that Attorney Otis ever refused her access to, or delivery of, the appellant's records.
Ms. D'Auteuil further admitted that she did not fully understand the records which she received from the appellant pursuant to her request. As the appellant demonstrated on direct examination, the appellant's entry system consisted of numerous shorthand terms that were not self-explanatory. However, Ms. D'Auteuil never attempted to conduct a “desk audit,” that is, to have the appellant meet with her at her office to allow him the opportunity to explain his record-keeping methods, nor did she conduct a “field audit,” that is, look through the appellant's boxes at the storage facility or at his attorney's office to examine the records of his losses. Ms. D'Auteuil also admitted that she did not suggest a sampling of the appellant's voluminous records as permitted by G.L. c 62C, § 24. She testified that she did not request a sampling because she did not understand the records, so “you didn't need to do a sampling when you didn't even know what he had in the boxes based on the file.” However, the Board found that it was impossible for the auditor to make a determination of the sufficiency of the appellant's records without actually examining the records that he maintained in storage or requesting a sample of those records. When asked on cross-examination, “[h]ow do you know they tie into his records?” Ms. D'Auteuil replied simply, “I don't.”
On the basis of the testimony and evidence, the Board found that the appellant was engaged in the trade or business of gambling and was thus entitled to take wagering losses as deductions on Schedule C of his Form 1. The Board found that the testimony of the appellant, as well as that of Mr. Litchfield and Mr. Ristaino, established that the appellant was regularly engaged in gambling, that he used his own money to gamble, and that he was the person who paid for and played (either himself or through a friend who played the ticket on the appellant's direction using the appellant's money) the tickets for racetracks and Lottery games that he maintained in storage.
The Board further found that the appellant's records, such as tickets, personal calendars, racetrack programs and his tax books, contained the information needed to substantiate his tax returns, specifically: the dates and places where the appellant gambled; the types and amounts of his wagers; and the amounts that he won and lost. Although the Commissioner alleged, for the first time in her post-trial brief, that the appellant was simply collecting losing Lottery tickets to support fraudulent deductions, the Commissioner failed to support that allegation with any evidence. Given the volume of tickets, programs and other records maintained by the appellant, and the fact that they contained many shorthand notations that were not self-explanatory, the Board found that the auditors could not assume that the records were not adequate based on the extraordinarily small portion of records that they reviewed, particularly when no auditor ever conducted a desk audit with the appellant in order to give the appellant an opportunity to explain those records.
Finally, the Board did not find credible Ms. D'Auteuil's assertions that the appellant or his representatives were uncooperative with respect to submitting records to the Commissioner during the course of the audit. Ms. D'Auteuil's claims that Attorney Otis refused to transport any documents to her and that she would be permitted to “look at them but [not] touch them,” amounted to mere uncorroborated statements that were undocumented in her own otherwise detailed audit log. Moreover, these statements were contradicted by a letter by Attorney Otis and by the appellant's and Mr. Sherman's testimony, which the Board found credible, that the appellant repeatedly requested a meeting with the Commissioner's auditors in order to submit and explain his records, but the auditors refused to conduct a field audit or even a desk audit.
Therefore, on the basis of the evidence of record, and as will be explained in the Opinion, the Board found that the appellant's records and his credible testimony and the credible testimony of his witnesses were sufficient to prove that the appellant was engaged in the trade or business of gambling and thus entitled to take deductions for the cost of his losing wagers and other related business expenses.
Findings with respect to tax year 2007.
The Board found that the unsigned so-called Abatement Approval Notice was not sufficient to abate the Commissioner's erroneous assessment for tax year 2007. The Commissioner admitted that the amount of the assessment was an error attributable to the misplacement of a decimal point, and the Board so found. The Board further found that the appellant met his burden of proving that he was engaged in the trade or business of gambling for all tax years at issue, including tax year 2007, and that he was thus entitled to take deductions for the cost of his losing wagers and other related business expenses on his return for tax year 2007.
On the basis of its findings for the tax years at issue, the Board issued decisions for the appellant and granted abatements of tax, exclusive of interest and penalties, in the following amounts:
Tax year Abatement
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2001 $33,665.00
2002 $53,872.00
2003 $58,272.00
2004 $77,545.00
2005 $102,214.00
2006 $140,002.00
2007 $13,715,912.00OPINION
For Massachusetts income tax purposes, “[r]esidents shall be taxed on their taxable income.” G.L. c. 62, § 4 . The starting point for determining Massachusetts taxable income is Massachusetts gross income, which is “federal gross income” with certain modifications not relevant to these appeals. G.L. c. 62, § 2(a) . Federal gross income includes income “from whatever source derived,” and thus includes gambling income. See Internal Revenue Code (“Code”) § 61 . Thus, gambling winnings are included in Massachusetts gross income. Id.; see also Technical Information Release (“TIR”) 79-6, DD 86-24 and DD 03-3.
In the present appeals, the appellant claimed deductions for his gambling losses. Massachusetts adopts the deductions allowed in Code § 62, with certain modifications not relevant to these appeals. See G.L. c. 62, § 2(d)(1) . Code § 62(a)(1) provides for “deductions allowed by this chapter (other than by part VII of this subchapter) [namely, Code §§ 161 through 199] which are attributable to a trade or business carried on by the taxpayer.” In particular, Code § 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” As a deduction allowed under Code § 62(a)(1), the trade or business deduction is in turn allowed to arrive at Massachusetts Part B adjusted gross income under G.L. c. 62, § 2(d)(1) . Accordingly, a Massachusetts taxpayer may deduct all ordinary and necessary expenses paid or incurred in carrying on the trade or business of gambling, including wagering losses subject to the limitation of Code § 165(d) discussed below.
In contrast to federal law, Massachusetts has not adopted Code § 212, which allows a deduction for ordinary and necessary expenses paid or incurred for the production or collection of income, even though not connected with a trade or business. Code § 212 is found at part VII of subchapter B, which is explicitly excluded from the deductions allowed under Code § 62(a)(1) and, therefore, not deductible for Massachusetts purposes under G.L. c. 62, § 2(d)(1) . Accordingly, a Massachusetts taxpayer may deduct only gambling expenses that constitute ordinary and necessary expenses in the conduct of the trade or business of gambling. See DiCarlo v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1989-119 .
In addition, Code § 165(d) specifically allows the deduction of wagering losses but only to the extent of gains from wagering transactions. However, the gambling loss deduction for Massachusetts purposes is subject to the basic restriction of G.L. c. 62, § 2(d)(1) and Code § 62(a)(1) that such losses are deductible only if they are incurred in a trade or business.
Accordingly, gambling expenses are deductible in Massachusetts only if: (1) the taxpayer demonstrates that he or she is in the “trade or business” of gambling; (2) the expenses constitute ordinary and necessary expenses in the conduct of the trade or business of gambling; and (3) gambling losses do not exceed gains from gambling.
In the present appeals, the taxpayer has claimed deductions for his gambling losses which do not exceed his gambling winnings. The parties do not dispute that gambling losses would be “ordinary and necessary” expenses in a gambling trade or business. Accordingly, the only issue in dispute is whether the appellant was engaged in the trade or business of gambling.
The United States Supreme Court has articulated the standard for determining whether a taxpayer is engaged in the trade or business of gambling: “if one's gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and it is not a mere hobby, it is a trade or business ....” Commissioner of Internal Revenue v. Groetzinger, 480 U.S. 23, 35 (1987) . For Massachusetts tax purposes, the Commissioner has promulgated DD 03-3, which provides a list of factors which are “not exclusive” but are intended to “provide illustrative guidance” in determining whether a taxpayer meets the criteria to qualify as being engaged in the trade or business of gambling. These factors are as follows:
•gambling activities are entered into and carried on in good faith for the purpose of making a profit;
•gambling activities are carried on with regularity;
•gambling activities are pursued on a full-time basis, or to the fullest extent possible if taxpayer is engaged in another trade or business or has employment elsewhere;
•gambling activities are solely for the taxpayer's own account and taxpayer does not function as a bookmaker;
•taxpayer maintains adequate records, including accounting of daily wagers, winnings and losses (see I.R.S. Rev. Proc. 77-29);
•the extent and nature of taxpayer's activities which further the development of a gambling enterprise; and
•taxpayer claims deductions associated with the conduct of a trade or business for gambling-related expenses.
Of these factors, the Commissioner specifically challenged only one, that is, whether the appellant “maintain[ed] adequate records, including accounting of daily wagers, winnings and losses.” The Commissioner, for the first time in her post-trial brief, also raised the suggestion that the appellant may have been a so-called “ten percenter,” an individual who cashes winning tickets on behalf of another gambler in return for a percentage — generally ten percent — of the winnings.
As indicated above, the adequate records requirement in DD 03-3 references Revenue Procedure 77-29, promulgated by the IRS (“I.R.S. Rev. Proc. 77-29”). In its description of adequate records, I.R.S. Rev. Proc. 77-29 provides in relevant part:
An accurate diary or similar record regularly maintained by the taxpayer, supplemented by verifiable documentation will usually be acceptable evidence for substantiation of wagering winnings and losses. In general, the diary should contain at least the following information:
1) Date and type of specific wager or wagering activity;
2) Name of gambling establishment;
3) Address or location of gambling establishment;
4) Name(s) of other person(s) (if any) present with taxpayer at gambling establishment; and
5) Amount(s) won or lost.
Like the factors set forth in DD 03-3, those in I.R.S. Rev. Proc. 77-29 are not to be exclusive, but rather are meant as guidelines for taxpayers.
When a taxpayer challenges an assessment made by the Commissioner, “[t]he burden is on the taxpayer to show error in the assessment and impropriety in the method used.” Allied Building Credits, Inc. v. State Tax Comm'n, 344 Mass. 503, 509 (1962) (citing State Tax Comm'n v. John H. Breck, Inc., 336 Mass. 277, 299 (1957) ). The Board has previously ruled that that burden “extends only to persuading the Board that the sales reported on his returns are more probable than those calculated by the appellee.” Suprenant v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1991-209, 219 . Thus, if the Commissioner's assessments were based on speculative assumptions, they will not be upheld. For example, in Food Service Associates, Inc. and Dennis G. Maxwell v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports, 2001-341, 349-51, 354 , the auditor made such glaring errors as presuming that all credit card receipts reflected taxable sales (and thus failing to consider nontaxable sales and tips) and presuming that all cash was taxable revenue (and thus failing to consider any cash on hand at the beginning of an analysis period). The Board thus favored the taxpayer's analysis of tax due over the auditor's analysis, ruling that the auditor's conclusion “was predicated on impermissible presumptions and dubious assumptions and was thus unreliable and invalid.” Id. at 2001-363.
Furthermore, the auditor must make a good faith effort to review all of the taxpayer's records, or at minimum, a sample of those records, before making a determination. For example, in Trodes, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1988-230 , the Commissioner's auditor disregarded the taxpayer's records of its alcoholic beverage sales, because the taxpayer failed to produce itemized sales records. The auditor based his audit on purchase invoices for liquor, and then assumed that each drink sold contained a one-and-one-half ounce “pour” measure, contrary to the taxpayer's actual “free pour” method. Id. at 232, 236. The Board found that the records submitted by the taxpayer, while not in strict compliance with the Commissioner's regulatory record-keeping requirements, nonetheless were “sufficient to satisfy the requirements of record-keeping” imposed by G.L. c. 62C, § 25 and 830 CMR 62C.24 (8)(g) on registered vendors of meals and thus “constituted a full compliance with the appellee's request for books, records and other materials.” Id. at 235. Therefore, on the basis of the witnesses' credible testimony as to the taxpayer's business practices and the taxpayer's business records, the Board found that the taxpayer met its burden of proving that the deficiency assessments were improper. Id. at 239.
In Chef Chang's House, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1996-738 , another appeal pertaining to the sales tax on cash sales of bar liquor, the auditor completely disregarded the restaurant taxpayer's records because daily records, rather than cash register tapes, were used to record cash transactions at the bar. Id. at 743. The auditor made his assessments using speculative data and unjustified assumptions, such as assuming that all alcohol purchased was sold at retail, thereby ignoring factors like breakage, spillage and complimentary drinks. Id. at 746-48. Comparing the Commissioner's audit records with the data supplied by the taxpayer, the Board found that “the method used by the Commissioner's auditor was not justified,” while the records maintained by the taxpayer “were reliable and complete in most respects.” Id. at 756. The Board thus ruled that the amount of sales tax on the appellant's returns was more probable than the amount as calculated by the auditor. Id. at 758.
“Evidence of a party having the burden of proof may not be disbelieved without an explicit and objectively adequate reason .... If the proponent has presented the best available evidence, which is logically adequate, and is neither contradicted nor improbable, it must be credited ....” New Boston Garden Corp. v. Board of Assessors of Boston, 383 Mass. 456, 470-471 (1981) . In the instant appeals, the Board found and ruled that the appellant's records, while not maintained in the exact manner as demanded by the auditor, were nonetheless voluminous, related to each of the tax years at issue, and contained key materials, including: personal calendars detailing his gambling activities; race track programs, with his losing ticket stubs from the day attached to the program together with a notation of the date, number of tickets and total amount of wagers; “tax organizers” that list his income and expenses and the information from the Forms W-2G; and the appellant's “tax books” for each year. These records, taken together, contained the date and type of wagering activity, the name and address of the gambling location, and the amount won or lost; they thus constituted the “diary or similar record” referred to in I.R.S. Rev. Proc. 77-29. Contrast Leite v. Commissioner, Mass. ATB Findings of Fact and Reports 2006-842, 851 (in ruling that taxpayer was not engaged in the trade or business of gambling, Board finds that taxpayer's “record-keeping with respect to his gambling was sparse, incomplete, and apparently begun after-the-fact [of audit]”).
As Ms. D'Auteuil demonstrated through her testimony, however, the Commissioner's auditors did not know what these records contained. Yet no auditor ever requested a field audit in which the auditor would go to the taxpayer's location to review the records maintained by the taxpayer, or a desk audit in which the taxpayer would be invited to the auditor's office for a meeting in order to review the records with the auditor. Instead, the auditors performed a limited correspondence audit, during which the auditors sent written requests to the appellant seeking records which were to be maintained in a certain format or else the auditors would refuse to review them. Yet nothing in DD 03-3, I.R.S. Rev. Proc. 77-29, or any relevant statute, departmental promulgation or case law required the appellant to keep records in the precise form demanded by the auditor. Each of the previous audits by the Commissioner for tax years 1988, 1994 and 1995, as well as by the IRS in 1994, had resulted in no change to the appellant's returns based on the records retained by the appellant, and the Board found that the appellant had consistently improved his record-keeping system, following the advice of his accountant after each audit, and especially after being advised of the issuance of DD 03-3. The Board found and ruled that, with a greater understanding of what the taxpayer's records contained, the auditors could have used these records to verify the appellant's returns, and therefore, the records met the record-keeping requirement of DD 03-3.
The Board also found credible the appellant's testimony, which was substantiated by Mr. Sherman's testimony and letters submitted into evidence, establishing that Mr. Sherman attempted to submit records to the auditors and that the auditors refused to examine them. On the other hand, the Board did not find credible Ms. D'Auteuil's testimony that she was refused access to the appellant's records. Therefore, the Board found and ruled that, under the facts of these appeals, the appellant's voluminous records and the testimony of the appellant and his witnesses constituted the best evidence of the appellant's regular and consistent gambling activities, which evidence was neither contradicted nor improbable. Accordingly, the Board found and ruled that this evidence established that the appellant was engaged in the trade or business of gambling and therefore was entitled to the deduction of his wagering losses, as well as other related business expenses, against his business income.
“The credibility of witnesses, the weight of the evidence, and inferences to be drawn from evidence are matters for the board.” Cummington School of the Arts, Inc. v. Assessors of Cummington, 373 Mass. 597, 605 (1977) . The appellant's voluminous records, maintained by him, were the best evidence of the gambling losses to which the appellant was entitled. The Commissioner presented no objectively adequate reason why the appellant's records should have been disbelieved, and in fact, the auditors lacked a firm understanding of what the records contained and how to interpret their notations, and they lacked a willingness to inquire further. The auditors never conducted a field audit to gain a better understanding of how thorough his records of losses were, nor even a desk audit in order to gain first-hand knowledge from the appellant as to how to interpret his records. Instead, Ms. D'Auteuil summarily deemed the appellant's records to be inadequate, and she made this arbitrary assumption based on her lack of understanding of the appellant's organizational system. The Board found and ruled that, because the Commissioner's auditors virtually ignored the appellant's records, their conclusions concerning the appellant's activities, including the Commissioner's eleventh-hour allegation that the appellant was a “ten percenter,” were not supported by the credible evidence of record.
Conclusion
On the basis of the evidence submitted, with particular weight being given to the credibility of the witnesses, the Board found and ruled that the appellant was engaged in the trade or business of gambling and thus entitled to take his gambling losses and other related expenses as deductions against his business income. The Board also found that the appellant's evidence, and not the auditor's conclusions, was the best available evidence with respect to the deductions for his gambling losses. Accordingly, the Board issued decisions for the appellant in these appeals for tax years 2001 through and including 2006.
With respect to tax year 2007, the Board found and ruled that the unsigned so-called Abatement Approval Notice was not sufficient to abate the assessment for that tax year. The Commissioner admitted that the amount of the assessment was an error attributable to the misplacement of a decimal point, and the Board so found and ruled. The Board further found and ruled that the appellant was engaged in the trade or business of gambling for tax year 2007 and was thus entitled to take his gambling losses and other related expenses as business deductions on his 2007 return. The Board thus issued a decision for the appellant for tax year 2007.
Accordingly, the Board granted abatements of tax, exclusive of interest and penalties, in the following amounts:
Tax year Abatement
-------- ---------
2001 $33,665.00
2002 $53,872.00
2003 $58,272.00
2004 $77,545.00
2005 $102,214.00
2006 $140,002.00
2007 $13,715,912.00THE APPELLATE TAX BOARD
By: _______
Thomas W. Hammond, Jr., Chairman
A true copy:
Attest: _______
Clerk of the Board
--------------------------------------------------------------------------------
3
In accordance with the parties' Statement of Agreed Facts, ¶ 74, and the appellant's abatement application, Form CA-6, and Amended Individual Income Tax Return (at pages 2944 to 2953 of the Stipulated Exhibits), the correct amount of lottery winnings was $2,587,591, not $258,759,150.
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4
See note 3, supra.
Case Information:
Docket/Court: C287780; C299046, Massachusetts Appellate Tax Board
Date Issued: 10/05/2011
Tax Type(s): Personal Income Tax
These are appeals filed under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39 from the refusal of the Commissioner of Revenue (“Commissioner” or the “appellee”), to abate income taxes assessed against Clarance W. Jones (“Mr. Jones” or the “appellant”) for the tax years 2001 through and including 2007 (“tax years at issue”).
Commissioner Scharaffa heard these appeals and was joined by Chairman Hammond and Commissioners Egan, Rose, and Mulhern in decisions for the appellant.
These findings of fact and report are made by the Appellate Tax Board (“Board”) on its own motion under G.L. c. 58A, § 13 and 831 CMR 1.32.
Domenic Finelli, Esq. for the appellant.
John J. Connors, Jr., Esq. for the appellee.
OPINION
FINDINGS OF FACT AND REPORT
On the basis of the Statement of Agreed Facts and Stipulated Exhibits and the testimony and exhibits offered at the hearing of these appeals, the Board made the following findings of fact.
At all times relevant to these appeals, the appellant was a Massachusetts resident. The appellant timely filed his Massachusetts Resident Income Tax Returns (“Forms 1”) for tax years 2001, 2002, 2003 and 2004, and timely filed Forms 1 pursuant to valid extensions for tax years 2005, 2006 and 2007. On Schedule C of Form 1 for each tax year at issue, the appellant reported that he was a “professional gambler.”
Jurisdictional facts for tax years 2001 through 2006.
The appellant's Forms 1 for tax years 2001 through 2006 showed no tax due and requested refunds as follows:
-----------------------------------------------------------------------
2001 2002 2003 2004 2005 2006
-----------------------------------------------------------------------
$1,055.00 $4,075.00 $9,844.00 $19,932.00 $86,449.00 $112,642.00
-----------------------------------------------------------------------The Commissioner issued refunds to the appellant in the following amounts:
------------------------------------------------------
2001 2002 2003 2004 2005 2006
------------------------------------------------------
$1,055.00 $4,074.60 $0 $0 $0 $0
------------------------------------------------------On February 4, 2004, the Commissioner sent to the appellant a Notice of Change to Your 2003 Income Tax Return informing the appellant that the Commissioner had changed the tax due on the 2003 Form 1 to $49,976.00 based on an alleged erroneous reporting of Massachusetts Lottery winnings and the elimination of the Limited Income Credit. By Notice of Assessment (“NOA”) dated May 18, 2004, the Commissioner notified the appellant that she had assessed the tax of $49,976.00 as reported on the Notice of Change to Your 2003 Income Tax Return.
Pursuant to validly executed consents extending the time to assess, the Commissioner sent the appellant a Notice of Intent to Assess (“NIA”) dated July 20, 2005, notifying the appellant of her intent to assess additional income taxes, exclusive of interest and penalties, as follows:
--------------------------------------------------------
2001 2002 2003 2004
--------------------------------------------------------
$33,665.00 $53,872.00 $8,470.00<1> $77,545.00
--------------------------------------------------------
---------------------------------------------------------------------------
<1>This amount is in addition to the $49,976.00 assessment referred to in
the NOA dated May 18, 2004.The appellant requested a conference with respect to the July 20, 2005 NIA. The Commissioner's Office of Appeals and the appellant and his representatives held a conference by telephone regarding the NIA on December 1, 2005. Following the conference, the Office of Appeals issued its letter of disposition on February 20, 2006. The Commissioner subsequently sent to the appellant an NOA dated March 7, 2006, notifying the appellant of the assessment on March 5, 2006 of additional income taxes, exclusive of interest and penalties, as follows:
----------------------------------------------------
2001 2002 2003 2004
----------------------------------------------------
$33,665.00 $53,872.00 $8,470.00<2> $77,545.00
----------------------------------------------------
---------------------------------------------------------------------------
<2> See note 1, supra.On March 31, 2006, the appellant timely filed an abatement application regarding the above assessments for tax years 2001 through 2004, in which he also requested a hearing. By letter dated December 1, 2006, the Commissioner denied the request for a hearing because “[y]our Application for Abatement raises no new relevant factual information or new legal precedent that was not available at the time of the pre-assessment conference.” By Notice of Abatement Determination dated December 8, 2006, the Commissioner informed the appellant that the abatement applications for tax years 2001 through 2004 had been denied. The appellant filed a Petition Under Formal Procedure with the Board on January 24, 2007 for tax years 2001 through 2004. Based on these facts, the Board found and ruled that it had jurisdiction over the appeals for tax years 2001 through and including 2004.
The Commissioner issued an NIA dated October 29, 2007 for tax year 2005 and an NIA dated May 11, 2008 for tax year 2006. The Commissioner's Office of Appeals held a conference by telephone with the appellant's representatives regarding the October 29, 2007 NIA and the May 11, 2008 NIA on October 2, 2008. By NOA dated October 16, 2008, the Commissioner assessed additional income taxes against the appellant for tax year 2006, in the amount of $140,002.00, exclusive of interest and penalties. By NOA dated October 21, 2008, the Commissioner assessed additional income taxes against the appellant for tax year 2005, in the amount of $102,214.00, exclusive of interest and penalties. On November 10, 2008, the appellant filed an abatement application for tax year 2006, and on November 11, 2008, the appellant filed an abatement application for tax year 2005. The appellant did not request hearings regarding the abatement applications for the 2005 and 2006 tax years. By Notice of Abatement Determination dated January 7, 2009, the Commissioner informed the appellant that the abatement applications for tax years 2005 and 2006 had been denied. On February 26, 2009, the appellant filed a Petition Under Formal Procedure with the Board for tax years 2005 and 2006. Based on these facts, the Board found and ruled that it had jurisdiction over the appeals for tax years 2005 and 2006.
Jurisdictional facts for tax year 2007.
Pursuant to a valid extension, the appellant timely filed his Form 1 for tax year 2007. On Schedule C of the 2007 Form 1, the appellant reported that his gross receipts were $2,888,386, his costs of goods sold were $2,839,686, his total expenses were $23,309, and his gross profits were $25,391. Gambling profits of $25,391 were reported on line 6 of the return, while line 8b for “Mass. lottery profits” was blank. The appellant reported a tax due of $984 and withholdings of $129,329, and he requested a refund of $128,345.00.
The Commissioner sent the appellant a Notice of Change to Your 2007 Income Tax Return, dated September 30, 2008, in which the Commissioner stated:
The Massachusetts Lottery Commission has reported to the Department of Revenue that you received $258,759,150.00 3 of lottery winnings for the tax year 2007. You reported $0.00 of winnings on your tax return. Consequently, we have adjusted your tax return as detailed in this notice. This resulted in change to the amount of tax due for this year.
Following are the “Reason(s) for Change:”
Line 8B — Lottery Claimed Does Not Agree With Lottery Winnings On File
The Commissioner thus changed the appellant's tax to $13,715,219.00 and also changed the amount of withholdings to $388,087.00.
By NOA dated October 6, 2008, the Commissioner notified the appellant of the assessment, on September 29, 2008, of income taxes for tax year 2007 in the amount of $13,715,219.00 as shown on the Notice of Change to Your 2007 Income Tax Return. The appellant filed an abatement application for tax year 2007 with the Commissioner on October 14, 2008 and a second abatement application on November 4, 2008. The appellant subsequently requested that the Commissioner deny both abatement applications for 2007 so that he could join the 2007 appeal with those from the previous tax years at issue. By Notice of Abatement Determination dated January 27, 2009, the Commissioner informed the appellant that “[y]our application had been denied.” On February 26, 2009, the appellant seasonably filed his Petition Under Formal Procedure for tax year 2007 with the Board.
Prior to the hearing of these appeals, the Commissioner admitted that the assessment for fiscal year 2007 was erroneous because of a misplaced decimal point. 4 Then, after the commencement of these appeals, the Commissioner purported to abate the erroneous assessment by issuing an Abatement Approval Notice, which was unsigned. The following is excerpted from the Board's Decision dated August 16, 2010:
On February 6, 2010, two days before the hearing of these appeals, the Commissioner's Customer Service Bureau issued an Abatement Approval Notice, stating that the appellant's “application filed on [his] INCOME tax account has been approved.” The notice was unsigned and did not state the amount of the abatement. The Commissioner has agreed that the $13,715,219.00 assessment was an error attributable to the placement of a decimal point on the Notice of Change regarding the taxpayer's lottery winnings.
The Board finds and rules that the so-called Abatement Approval Notice was not sufficient to abate the erroneous assessment. Appellant had previously received a denial of his abatement request, dated January 27, 2009, and was therefore a person aggrieved under G.L c. 62C, § 39 when he filed his appeal with the Board. Although the Commissioner may abate an erroneously assessed tax after the commencement of an appeal to the Board, the February 6, 2010 notice was unsigned and contained no abatement amount and therefore did not constitute a valid abatement.
Because the Board found that the so-called Abatement Approval Notice was not sufficient to abate the Commissioner's erroneous assessment and that the appellant was still a person aggrieved under G.L. c. 62C, § 39 , the Board found and ruled that it had jurisdiction over the appeal for tax year 2007.
Findings with respect to tax years 2001 through 2006.
The appellant claimed that, at all times relevant to these appeals, he was and held himself out as a professional gambler. The appellant's gambling activities consisted of betting at various horse- and dog-racing tracks where he engaged in both live and simulcast betting, casino betting, and Lottery ticket betting. He explained that during tax year 2004 onward, his business consisted of more Lottery gambling than any other form. The appellant's gambling revenue constituted his main source of income, aside from Social Security payments and minimal bank interest.
The parties stipulated that the appellant maintained numerous boxes of losing dog and horse racing tickets from both live and simulcast races, along with programs, losing Foxwoods Keno tickets, and losing Massachusetts Lottery tickets, including scratch tickets and various numbers games including, among others, Keno, Daily Numbers Games, Mega Bucks, Mega Millions, Mass Millions, Cash Windfall, Big Game, Powerball and Daily Race Game. The appellant testified that he maintained at least 200 boxes at a storage facility in Lynn, Massachusetts. A sample, as agreed to by both parties, of about fifteen boxes of those records, was submitted to the Board. The boxes were filled with various losing Lottery tickets, losing Foxwoods Casino Keno tickets, losing racing tickets and racetrack programs. All items were bagged and/or bound together in groups and labeled by notations which either included dates, places, number of tickets and total cost of tickets, or a number corresponding to the appellant's personal numbering system from his records where that same information would be listed.
The appellant presented his case-in-chief through his own testimony as well as the testimony of: Harold Litchfield, a fellow gambler; Louis Ristaino, a racetrack employee; and Edward Sherman, CPA, his accountant.
Mr. Litchfield testified to the appellant's gambling activities. He testified that the appellant was regularly engaged in gambling, attending the dog or horse racetrack from about eleven in the morning until about midnight, either four or five days a week. He testified that he witnessed the appellant engaging in racetrack betting as well as Keno. Mr. Litchfield also testified that he had placed bets for the appellant. He explained that this was common practice among friends, particularly at a busy gambling establishment with long lines. But Mr. Litchfield emphasized that he always used the appellant's money, that he followed the express direction of the appellant and that he never accepted compensation from the appellant to place these bets. The Commissioner did not meaningfully challenge Mr. Litchfield's testimony on cross-examination, and the Board found his testimony credible.
Mr. Ristaino then testified as to how a gambler could place a bet while avoiding a long line at a busy gambling establishment. He explained that regular gamblers curry favor with racetrack window tellers by tipping generously. Then, instead of waiting in line, the gambler calls in the favor by surreptitiously giving the teller a hand signal, which the teller will interpret and then place the bet accordingly. Through the use of hand signals, a regular gambler can thus place multiple bets quickly, using his own money, without having to wait in long lines. Again, the Commissioner did not meaningfully challenge Mr. Ristaino's testimony on cross-examination, and the Board found his testimony credible.
Mr. Sherman offered detailed testimony with respect to the sufficiency of the appellant's records. He explained that the appellant maintained more than 200 boxes of records in a storage facility and that he had seen these records and had advised the appellant on his record keeping. Mr. Sherman testified that the appellant had been audited previously by the Commissioner for tax years 1988, 1994 and 1995, as well as by the Internal Revenue Service (“IRS”) in 1994. He stated that for the previous audit conducted by the Commissioner, he and the appellant provided the prior auditor, Jim Reynolds, with 11 boxes of documents. He noted that each of the federal and state audits had resulted in no change to the appellant's returns.
Mr. Sherman explained that, after the prior audits, the appellant continuously attempted to improve his record-keeping system and to keep more extensive information throughout the years at issue. Mr. Sherman testified further that he had a discussion with the appellant sometime during early 2004 about the new directive issued by the Commissioner with respect to record keeping, Department Directive 03-3 (“DD 03-3”), and that in his opinion, the appellant's records were in keeping with that directive. For example, Mr. Sherman explained that the appellant maintained personal calendars detailing his gambling activities, and his race track programs, with all of his losing tickets inside the program and a summary on the outside of all of the losing tickets. Mr. Sherman further testified that the appellant also maintained so-called “tax organizers” that listed his income and expenses and the information from the Forms W-2G Certain Gambling Winnings (“W-2G”), the forms issued by the Massachusetts State Lottery to gamblers for reporting lottery winnings over $600. Mr. Sherman explained that the appellant used the tax organizers to organize his tax information for the current tax year based on the income and deductions that he had had for the previous tax year. The appellant maintained tax organizers for each of the tax years at issue, and the stipulated exhibits included each of those tax organizers. The stipulated exhibits also included copies of the contents of three-ring binders that the appellant maintained for each of the tax years at issue, what the appellant and his representatives referred to as his “tax books,” which included: various correspondence between the appellant or his representatives and the auditors; copies of the appellant's tax returns; listings of the appellant's gambling losses; and his calendars. Mr. Sherman explained that the entries in these “tax books” corresponded to the receipts that the appellant maintained in storage.
Mr. Sherman next testified to the disagreements between the appellant and the Commissioner's auditors with respect to the examination of his records during the course of the audit for the tax years at issue. Mr. Sherman explained that the auditor originally assigned to the appellant's case was replaced by another auditor, Judith D'Auteuil, midway through the audit. He also testified that he had repeatedly requested that the Commissioner's auditors come to see the appellant's records at the storage facility, but that the auditors refused all requests for examination. He explained that the auditors sent out form requests seeking certain types of records, such as logs of the appellant's gambling activities, but that the appellant did not maintain his records in the specific format requested. Mr. Sherman explained, however, that he had advised the appellant to retain all of his racetrack tickets and programs and Lottery tickets because they collectively contained all of the information required for completing and verifying a tax return. Particularly with respect to a Lottery ticket, Mr. Sherman explained that “[a]ll of the information is on the ticket,” including the date and location of purchase and the amount of the wager.
The stipulated evidence contained correspondence between the parties, including a letter dated November 3, 2004 sent by the Commissioner's Tax Examiner, Sandra Sparrock, requesting, among other items: a daily log or journal showing the name and location of each gambling establishment visited, the dates gambled, and travel times with mileage to and from each gambling activity; records of wagers and winnings and programs from race tracks; names of individuals that participated in his gambling; receipts for food, lodging and air travel; bank records; Forms W-2G; gambling research materials; and losing scratch tickets grouped together by purchase date and locations and correlated to the daily log. By letter dated December 3, 2004, Mr. Sherman sent copies of the appellant's tax returns for tax years 2001, 2002 and 2003, and representative samples of the appellant's bank statements. Mr. Sherman's letter listed the documents that the appellant maintained in storage. These documents included lottery ticket stubs for cashed tickets, which identified the location of the establishment where the ticket was purchased, and twenty-five to thirty boxes per year which contained every program purchased and “all the losing tickets sorted by race number” as well as a list of all losses by date, track and box, and all losing scratch tickets. Mr. Sherman's letter then offered, “[y]ou may examine this information on site or, if requested, Mr. Jones will make arrangements to deliver them to you.” Mr. Sherman reiterated that, while the appellant's records were not necessarily maintained in the exact form as requested by the auditors, the information sought by the auditors was nonetheless contained in the records maintained by the appellant.
The stipulated exhibits also included further correspondence between Ms. Sparrock and Mr. Sherman in which Ms. Sparrock requested materials in specific form — business records in chronological order and daily records for all lottery transactions showing date and location of purchase, amount spent and amount of winnings — and Mr. Sherman informed her that the appellant's records were not maintained in the form requested, but that the information requested could be deduced from an examination of the numerous records that the appellant maintained in storage. At the hearing, Mr. Sherman posited that it was because the records were not in the form requested that the auditors refused to examine them. When asked directly by the Presiding Commissioner whether someone from the Department of Revenue (“DOR”) had actually refused to look at the appellant's records because they were not maintained as specified by the auditors' requests, Mr. Sherman responded affirmatively and testified that it was Ms. D'Auteuil who had made this statement to him. The stipulated exhibits also included correspondence between Ms. Sparrock and the appellant's former attorney, Peter Otis, including one letter in which Attorney Otis specifically suggested to Ms. Sparrock that a field audit be conducted, meaning that the auditor would come to the appellant's representative's office “to review the 100 or so boxes” at that location. The Commissioner's auditors, however, never accepted the appellant's invitation.
Next, the appellant testified in detail to the types and regularity of his gambling activities. He testified that, since selling his industrial cleaning company in 1986 and up to the tax years at issue, his only source of business income had been gambling. He testified that in a typical week, he would spend between 60 to 80 hours on gambling activities and that Lottery gambling had been his primary activity since about 2004. When asked where he gambled, the appellant responded, “I do the whole state,” as well as out of state. He testified that, in his opinion, Massachusetts has “the easiest lottery system” for a regular gambler to successfully play. He explained some of his methodologies, like buying Lottery tickets in the middle of a pack where, he believed, the winning tickets were grouped, and purchasing tickets at stores that have had recent large winnings, because, in his opinion, those stores have a higher chance of selling winning tickets. The appellant submitted into evidence a manual that he had written entitled “The Gambler,” which contained some of the observations and “trade secrets” for successful gambling that he has accumulated over his gambling career. The appellant also corroborated Mr. Litchfield's and Mr. Ristaino's testimony, explaining how he was able to place numerous bets at a racetrack without waiting in line, either through the use of hand signals or by asking a friend to place bets on his behalf. He emphasized that he used his own money to place bets and that he did not compensate anyone to place bets for him. The Commissioner did not meaningfully challenge Mr. Jones' testimony on cross-examination, and the Board found the appellant's testimony to be credible.
The appellant next described his system of keeping records. He testified that he recognized that he was not an expert in taxes, and he thus hired an accountant to assist him with his filing and record-keeping duties. He also testified that he heeded his accountant's advice and that he continuously tried to improve his record-keeping system, particularly after his accountant advised him about DD 03-3. He emphasized that his records contained all of the information required to discern how much he expended on wagers and where he gambled during each tax year. The appellant testified that he maintained three storage rooms at a storage facility in Lynn and that the files in his boxes — which included ticket stubs, programs and his calendars marked with the amounts of small winnings for which no Forms W-2G would have been generated, which he used to compile ledgers of small winnings — corresponded to entries in his “tax books.” On direct examination, the appellant was asked to trace his records from a random date — January 17, 2002 — to his “tax book” for that year. The appellant was able to locate the entry using his entry system. The appellant's explanations of some of his short-hand entries — for example, “Sam means something to me. Sam to me is Summit Variety.... It's in Peabody, Mass.” — indicated that his entry system was not self-explanatory but was personal to him.
The appellant also reiterated Mr. Sherman's testimony that the Commissioner's auditors refused to examine his voluminous records, despite his requests. He explained that no auditor had ever taken the records from the storage facility to inspect them, nor did they ever ask to look through them at their offices. With respect to his “tax books,” the appellant testified that “they refused my lawyer to even submit them.” In preparation for the hearing, the attorney for the Commissioner accompanied the appellant and his attorney to the storage facility to choose the sample of records which were brought to the hearing. Prior to that, the appellant explained, no representative of the Commissioner had ever agreed to examine his records. The Board also found this part of the appellant's testimony to be credible.
The Commissioner presented its case through the testimony of Brian Taylor, a director within the Massachusetts State Lottery, and of Judith D'Auteuil, a tax auditor within the Department of Revenue's Audit Division.
Mr. Taylor testified regarding the computer system by which the State Lottery tracked frequent cashers of lottery tickets. He testified that the appellant was the highest or second-highest casher of winning tickets in the Commonwealth during each tax year at issue. He next explained that this computer system gleans crucial information from the bar code located on each Lottery ticket, which enables the State Lottery to determine the type of Lottery game played and where the ticket was purchased:
Well, we know it when we scan the ticket. There's a lot of intelligence on that bar code and that will tell our cashing system immediately where the ticket was issued.
Mr. Taylor's testimony thus corroborated Mr. Sherman's testimony that the Lottery tickets contain the relevant information for verifying tax return data.
Mr. Taylor also explained that the odds of winning for each Massachusetts Lottery game and whether a winner had claimed the grand prize were published on the Massachusetts Lottery's website. Mr. Taylor, however, presented no evidence relating to the odds of any of the particular Massachusetts Lottery games, including those played by the appellant.
Next, Ms. D'Auteuil testified as to her conduct of the audit of the tax years at issue, beginning on October 29, 2007. Ms. D'Auteuil conducted a “correspondence audit” of the appellant, that is, one in which the auditor conducts the audit by seeking records from the taxpayer through remote correspondence, usually form letters. Ms. D'Auteuil explained that she audited tax year 2006 and a portion of tax year 2005 after the file had been to the Office of Appeals. She testified that the audit file was transferred to her after she had been assigned to replace the previous auditor, Zlatan Caticz, and that she received the case after the Office of Appeals had made its determination on tax year 2005. Ms. D'Auteuil testified that she had reviewed the files for tax years 2001 through 2004 in preparation for the hearing at the Board.
The stipulated exhibits included Ms. D'Auteuil's first letter to the appellant, dated October 29, 2007, requesting certain records from the appellant, including daily logs or journals showing dates when and places where the appellant gambled, losing tickets, and any “patron data logs” from gambling casinos. Ms. D'Auteuil testified that she reviewed the Commissioner's audit files concerning the appellant, which included the documents that his representative had submitted to the Commissioner's auditors, and from these she determined “[t]hat Mr. Jones was not in the trade or business of professional gambling.” When asked the reason for her determination, Ms. D'Auteuil replied, “[i]nadequate, incomplete, insufficient records.” Ms. D'Auteuil admitted, however, that she did not look through a single box maintained by the appellant in storage. She claimed that she was willing to pick up the documents but that her offer was refused by the appellant's prior attorney, Peter Otis. According to Ms. D'Auteuil:
I wanted the tickets at my office and he said the boxes were voluminous. I offered to go out there with someone and a two-wheeled dolly to get them and bring them back to my office. And he told me, no, I had to go out by myself and I had to look at them, but I couldn't touch them. So I told him, “I can't do that. I want them in the office as I requested.”
Attorney Otis was not brought into the hearing as a witness to corroborate or deny the above statements. However, his letter in response to Ms. D'Auteuil's request was admitted into evidence. By letter dated November 28, 2007, Attorney Otis explained that the appellant required additional time to compile his records into the daily-log format requested by Ms. D'Auteuil. The letter further offered to Ms. D'Auteuil that “[a]ll losing scratch tickets amounting to approximately 33 cases of paper can be made available at our office or delivered to you.” Nowhere in the letter did Attorney Otis deny Ms. D'Auteuil access to any records that she had requested, nor did he restrict her access to the appellant's storage facility where, according to her, she would be permitted to merely “look” but not “touch.” Moreover, Ms. D'Auteuil's audit log, otherwise very detailed and including notations about other telephone calls with Attorney Otis, contained no notation indicating that Attorney Otis ever refused her access to, or delivery of, the appellant's records.
Ms. D'Auteuil further admitted that she did not fully understand the records which she received from the appellant pursuant to her request. As the appellant demonstrated on direct examination, the appellant's entry system consisted of numerous shorthand terms that were not self-explanatory. However, Ms. D'Auteuil never attempted to conduct a “desk audit,” that is, to have the appellant meet with her at her office to allow him the opportunity to explain his record-keeping methods, nor did she conduct a “field audit,” that is, look through the appellant's boxes at the storage facility or at his attorney's office to examine the records of his losses. Ms. D'Auteuil also admitted that she did not suggest a sampling of the appellant's voluminous records as permitted by G.L. c 62C, § 24. She testified that she did not request a sampling because she did not understand the records, so “you didn't need to do a sampling when you didn't even know what he had in the boxes based on the file.” However, the Board found that it was impossible for the auditor to make a determination of the sufficiency of the appellant's records without actually examining the records that he maintained in storage or requesting a sample of those records. When asked on cross-examination, “[h]ow do you know they tie into his records?” Ms. D'Auteuil replied simply, “I don't.”
On the basis of the testimony and evidence, the Board found that the appellant was engaged in the trade or business of gambling and was thus entitled to take wagering losses as deductions on Schedule C of his Form 1. The Board found that the testimony of the appellant, as well as that of Mr. Litchfield and Mr. Ristaino, established that the appellant was regularly engaged in gambling, that he used his own money to gamble, and that he was the person who paid for and played (either himself or through a friend who played the ticket on the appellant's direction using the appellant's money) the tickets for racetracks and Lottery games that he maintained in storage.
The Board further found that the appellant's records, such as tickets, personal calendars, racetrack programs and his tax books, contained the information needed to substantiate his tax returns, specifically: the dates and places where the appellant gambled; the types and amounts of his wagers; and the amounts that he won and lost. Although the Commissioner alleged, for the first time in her post-trial brief, that the appellant was simply collecting losing Lottery tickets to support fraudulent deductions, the Commissioner failed to support that allegation with any evidence. Given the volume of tickets, programs and other records maintained by the appellant, and the fact that they contained many shorthand notations that were not self-explanatory, the Board found that the auditors could not assume that the records were not adequate based on the extraordinarily small portion of records that they reviewed, particularly when no auditor ever conducted a desk audit with the appellant in order to give the appellant an opportunity to explain those records.
Finally, the Board did not find credible Ms. D'Auteuil's assertions that the appellant or his representatives were uncooperative with respect to submitting records to the Commissioner during the course of the audit. Ms. D'Auteuil's claims that Attorney Otis refused to transport any documents to her and that she would be permitted to “look at them but [not] touch them,” amounted to mere uncorroborated statements that were undocumented in her own otherwise detailed audit log. Moreover, these statements were contradicted by a letter by Attorney Otis and by the appellant's and Mr. Sherman's testimony, which the Board found credible, that the appellant repeatedly requested a meeting with the Commissioner's auditors in order to submit and explain his records, but the auditors refused to conduct a field audit or even a desk audit.
Therefore, on the basis of the evidence of record, and as will be explained in the Opinion, the Board found that the appellant's records and his credible testimony and the credible testimony of his witnesses were sufficient to prove that the appellant was engaged in the trade or business of gambling and thus entitled to take deductions for the cost of his losing wagers and other related business expenses.
Findings with respect to tax year 2007.
The Board found that the unsigned so-called Abatement Approval Notice was not sufficient to abate the Commissioner's erroneous assessment for tax year 2007. The Commissioner admitted that the amount of the assessment was an error attributable to the misplacement of a decimal point, and the Board so found. The Board further found that the appellant met his burden of proving that he was engaged in the trade or business of gambling for all tax years at issue, including tax year 2007, and that he was thus entitled to take deductions for the cost of his losing wagers and other related business expenses on his return for tax year 2007.
On the basis of its findings for the tax years at issue, the Board issued decisions for the appellant and granted abatements of tax, exclusive of interest and penalties, in the following amounts:
Tax year Abatement
-------- ---------
2001 $33,665.00
2002 $53,872.00
2003 $58,272.00
2004 $77,545.00
2005 $102,214.00
2006 $140,002.00
2007 $13,715,912.00OPINION
For Massachusetts income tax purposes, “[r]esidents shall be taxed on their taxable income.” G.L. c. 62, § 4 . The starting point for determining Massachusetts taxable income is Massachusetts gross income, which is “federal gross income” with certain modifications not relevant to these appeals. G.L. c. 62, § 2(a) . Federal gross income includes income “from whatever source derived,” and thus includes gambling income. See Internal Revenue Code (“Code”) § 61 . Thus, gambling winnings are included in Massachusetts gross income. Id.; see also Technical Information Release (“TIR”) 79-6, DD 86-24 and DD 03-3.
In the present appeals, the appellant claimed deductions for his gambling losses. Massachusetts adopts the deductions allowed in Code § 62, with certain modifications not relevant to these appeals. See G.L. c. 62, § 2(d)(1) . Code § 62(a)(1) provides for “deductions allowed by this chapter (other than by part VII of this subchapter) [namely, Code §§ 161 through 199] which are attributable to a trade or business carried on by the taxpayer.” In particular, Code § 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” As a deduction allowed under Code § 62(a)(1), the trade or business deduction is in turn allowed to arrive at Massachusetts Part B adjusted gross income under G.L. c. 62, § 2(d)(1) . Accordingly, a Massachusetts taxpayer may deduct all ordinary and necessary expenses paid or incurred in carrying on the trade or business of gambling, including wagering losses subject to the limitation of Code § 165(d) discussed below.
In contrast to federal law, Massachusetts has not adopted Code § 212, which allows a deduction for ordinary and necessary expenses paid or incurred for the production or collection of income, even though not connected with a trade or business. Code § 212 is found at part VII of subchapter B, which is explicitly excluded from the deductions allowed under Code § 62(a)(1) and, therefore, not deductible for Massachusetts purposes under G.L. c. 62, § 2(d)(1) . Accordingly, a Massachusetts taxpayer may deduct only gambling expenses that constitute ordinary and necessary expenses in the conduct of the trade or business of gambling. See DiCarlo v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1989-119 .
In addition, Code § 165(d) specifically allows the deduction of wagering losses but only to the extent of gains from wagering transactions. However, the gambling loss deduction for Massachusetts purposes is subject to the basic restriction of G.L. c. 62, § 2(d)(1) and Code § 62(a)(1) that such losses are deductible only if they are incurred in a trade or business.
Accordingly, gambling expenses are deductible in Massachusetts only if: (1) the taxpayer demonstrates that he or she is in the “trade or business” of gambling; (2) the expenses constitute ordinary and necessary expenses in the conduct of the trade or business of gambling; and (3) gambling losses do not exceed gains from gambling.
In the present appeals, the taxpayer has claimed deductions for his gambling losses which do not exceed his gambling winnings. The parties do not dispute that gambling losses would be “ordinary and necessary” expenses in a gambling trade or business. Accordingly, the only issue in dispute is whether the appellant was engaged in the trade or business of gambling.
The United States Supreme Court has articulated the standard for determining whether a taxpayer is engaged in the trade or business of gambling: “if one's gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and it is not a mere hobby, it is a trade or business ....” Commissioner of Internal Revenue v. Groetzinger, 480 U.S. 23, 35 (1987) . For Massachusetts tax purposes, the Commissioner has promulgated DD 03-3, which provides a list of factors which are “not exclusive” but are intended to “provide illustrative guidance” in determining whether a taxpayer meets the criteria to qualify as being engaged in the trade or business of gambling. These factors are as follows:
•gambling activities are entered into and carried on in good faith for the purpose of making a profit;
•gambling activities are carried on with regularity;
•gambling activities are pursued on a full-time basis, or to the fullest extent possible if taxpayer is engaged in another trade or business or has employment elsewhere;
•gambling activities are solely for the taxpayer's own account and taxpayer does not function as a bookmaker;
•taxpayer maintains adequate records, including accounting of daily wagers, winnings and losses (see I.R.S. Rev. Proc. 77-29);
•the extent and nature of taxpayer's activities which further the development of a gambling enterprise; and
•taxpayer claims deductions associated with the conduct of a trade or business for gambling-related expenses.
Of these factors, the Commissioner specifically challenged only one, that is, whether the appellant “maintain[ed] adequate records, including accounting of daily wagers, winnings and losses.” The Commissioner, for the first time in her post-trial brief, also raised the suggestion that the appellant may have been a so-called “ten percenter,” an individual who cashes winning tickets on behalf of another gambler in return for a percentage — generally ten percent — of the winnings.
As indicated above, the adequate records requirement in DD 03-3 references Revenue Procedure 77-29, promulgated by the IRS (“I.R.S. Rev. Proc. 77-29”). In its description of adequate records, I.R.S. Rev. Proc. 77-29 provides in relevant part:
An accurate diary or similar record regularly maintained by the taxpayer, supplemented by verifiable documentation will usually be acceptable evidence for substantiation of wagering winnings and losses. In general, the diary should contain at least the following information:
1) Date and type of specific wager or wagering activity;
2) Name of gambling establishment;
3) Address or location of gambling establishment;
4) Name(s) of other person(s) (if any) present with taxpayer at gambling establishment; and
5) Amount(s) won or lost.
Like the factors set forth in DD 03-3, those in I.R.S. Rev. Proc. 77-29 are not to be exclusive, but rather are meant as guidelines for taxpayers.
When a taxpayer challenges an assessment made by the Commissioner, “[t]he burden is on the taxpayer to show error in the assessment and impropriety in the method used.” Allied Building Credits, Inc. v. State Tax Comm'n, 344 Mass. 503, 509 (1962) (citing State Tax Comm'n v. John H. Breck, Inc., 336 Mass. 277, 299 (1957) ). The Board has previously ruled that that burden “extends only to persuading the Board that the sales reported on his returns are more probable than those calculated by the appellee.” Suprenant v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1991-209, 219 . Thus, if the Commissioner's assessments were based on speculative assumptions, they will not be upheld. For example, in Food Service Associates, Inc. and Dennis G. Maxwell v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports, 2001-341, 349-51, 354 , the auditor made such glaring errors as presuming that all credit card receipts reflected taxable sales (and thus failing to consider nontaxable sales and tips) and presuming that all cash was taxable revenue (and thus failing to consider any cash on hand at the beginning of an analysis period). The Board thus favored the taxpayer's analysis of tax due over the auditor's analysis, ruling that the auditor's conclusion “was predicated on impermissible presumptions and dubious assumptions and was thus unreliable and invalid.” Id. at 2001-363.
Furthermore, the auditor must make a good faith effort to review all of the taxpayer's records, or at minimum, a sample of those records, before making a determination. For example, in Trodes, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1988-230 , the Commissioner's auditor disregarded the taxpayer's records of its alcoholic beverage sales, because the taxpayer failed to produce itemized sales records. The auditor based his audit on purchase invoices for liquor, and then assumed that each drink sold contained a one-and-one-half ounce “pour” measure, contrary to the taxpayer's actual “free pour” method. Id. at 232, 236. The Board found that the records submitted by the taxpayer, while not in strict compliance with the Commissioner's regulatory record-keeping requirements, nonetheless were “sufficient to satisfy the requirements of record-keeping” imposed by G.L. c. 62C, § 25 and 830 CMR 62C.24 (8)(g) on registered vendors of meals and thus “constituted a full compliance with the appellee's request for books, records and other materials.” Id. at 235. Therefore, on the basis of the witnesses' credible testimony as to the taxpayer's business practices and the taxpayer's business records, the Board found that the taxpayer met its burden of proving that the deficiency assessments were improper. Id. at 239.
In Chef Chang's House, Inc. v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1996-738 , another appeal pertaining to the sales tax on cash sales of bar liquor, the auditor completely disregarded the restaurant taxpayer's records because daily records, rather than cash register tapes, were used to record cash transactions at the bar. Id. at 743. The auditor made his assessments using speculative data and unjustified assumptions, such as assuming that all alcohol purchased was sold at retail, thereby ignoring factors like breakage, spillage and complimentary drinks. Id. at 746-48. Comparing the Commissioner's audit records with the data supplied by the taxpayer, the Board found that “the method used by the Commissioner's auditor was not justified,” while the records maintained by the taxpayer “were reliable and complete in most respects.” Id. at 756. The Board thus ruled that the amount of sales tax on the appellant's returns was more probable than the amount as calculated by the auditor. Id. at 758.
“Evidence of a party having the burden of proof may not be disbelieved without an explicit and objectively adequate reason .... If the proponent has presented the best available evidence, which is logically adequate, and is neither contradicted nor improbable, it must be credited ....” New Boston Garden Corp. v. Board of Assessors of Boston, 383 Mass. 456, 470-471 (1981) . In the instant appeals, the Board found and ruled that the appellant's records, while not maintained in the exact manner as demanded by the auditor, were nonetheless voluminous, related to each of the tax years at issue, and contained key materials, including: personal calendars detailing his gambling activities; race track programs, with his losing ticket stubs from the day attached to the program together with a notation of the date, number of tickets and total amount of wagers; “tax organizers” that list his income and expenses and the information from the Forms W-2G; and the appellant's “tax books” for each year. These records, taken together, contained the date and type of wagering activity, the name and address of the gambling location, and the amount won or lost; they thus constituted the “diary or similar record” referred to in I.R.S. Rev. Proc. 77-29. Contrast Leite v. Commissioner, Mass. ATB Findings of Fact and Reports 2006-842, 851 (in ruling that taxpayer was not engaged in the trade or business of gambling, Board finds that taxpayer's “record-keeping with respect to his gambling was sparse, incomplete, and apparently begun after-the-fact [of audit]”).
As Ms. D'Auteuil demonstrated through her testimony, however, the Commissioner's auditors did not know what these records contained. Yet no auditor ever requested a field audit in which the auditor would go to the taxpayer's location to review the records maintained by the taxpayer, or a desk audit in which the taxpayer would be invited to the auditor's office for a meeting in order to review the records with the auditor. Instead, the auditors performed a limited correspondence audit, during which the auditors sent written requests to the appellant seeking records which were to be maintained in a certain format or else the auditors would refuse to review them. Yet nothing in DD 03-3, I.R.S. Rev. Proc. 77-29, or any relevant statute, departmental promulgation or case law required the appellant to keep records in the precise form demanded by the auditor. Each of the previous audits by the Commissioner for tax years 1988, 1994 and 1995, as well as by the IRS in 1994, had resulted in no change to the appellant's returns based on the records retained by the appellant, and the Board found that the appellant had consistently improved his record-keeping system, following the advice of his accountant after each audit, and especially after being advised of the issuance of DD 03-3. The Board found and ruled that, with a greater understanding of what the taxpayer's records contained, the auditors could have used these records to verify the appellant's returns, and therefore, the records met the record-keeping requirement of DD 03-3.
The Board also found credible the appellant's testimony, which was substantiated by Mr. Sherman's testimony and letters submitted into evidence, establishing that Mr. Sherman attempted to submit records to the auditors and that the auditors refused to examine them. On the other hand, the Board did not find credible Ms. D'Auteuil's testimony that she was refused access to the appellant's records. Therefore, the Board found and ruled that, under the facts of these appeals, the appellant's voluminous records and the testimony of the appellant and his witnesses constituted the best evidence of the appellant's regular and consistent gambling activities, which evidence was neither contradicted nor improbable. Accordingly, the Board found and ruled that this evidence established that the appellant was engaged in the trade or business of gambling and therefore was entitled to the deduction of his wagering losses, as well as other related business expenses, against his business income.
“The credibility of witnesses, the weight of the evidence, and inferences to be drawn from evidence are matters for the board.” Cummington School of the Arts, Inc. v. Assessors of Cummington, 373 Mass. 597, 605 (1977) . The appellant's voluminous records, maintained by him, were the best evidence of the gambling losses to which the appellant was entitled. The Commissioner presented no objectively adequate reason why the appellant's records should have been disbelieved, and in fact, the auditors lacked a firm understanding of what the records contained and how to interpret their notations, and they lacked a willingness to inquire further. The auditors never conducted a field audit to gain a better understanding of how thorough his records of losses were, nor even a desk audit in order to gain first-hand knowledge from the appellant as to how to interpret his records. Instead, Ms. D'Auteuil summarily deemed the appellant's records to be inadequate, and she made this arbitrary assumption based on her lack of understanding of the appellant's organizational system. The Board found and ruled that, because the Commissioner's auditors virtually ignored the appellant's records, their conclusions concerning the appellant's activities, including the Commissioner's eleventh-hour allegation that the appellant was a “ten percenter,” were not supported by the credible evidence of record.
Conclusion
On the basis of the evidence submitted, with particular weight being given to the credibility of the witnesses, the Board found and ruled that the appellant was engaged in the trade or business of gambling and thus entitled to take his gambling losses and other related expenses as deductions against his business income. The Board also found that the appellant's evidence, and not the auditor's conclusions, was the best available evidence with respect to the deductions for his gambling losses. Accordingly, the Board issued decisions for the appellant in these appeals for tax years 2001 through and including 2006.
With respect to tax year 2007, the Board found and ruled that the unsigned so-called Abatement Approval Notice was not sufficient to abate the assessment for that tax year. The Commissioner admitted that the amount of the assessment was an error attributable to the misplacement of a decimal point, and the Board so found and ruled. The Board further found and ruled that the appellant was engaged in the trade or business of gambling for tax year 2007 and was thus entitled to take his gambling losses and other related expenses as business deductions on his 2007 return. The Board thus issued a decision for the appellant for tax year 2007.
Accordingly, the Board granted abatements of tax, exclusive of interest and penalties, in the following amounts:
Tax year Abatement
-------- ---------
2001 $33,665.00
2002 $53,872.00
2003 $58,272.00
2004 $77,545.00
2005 $102,214.00
2006 $140,002.00
2007 $13,715,912.00THE APPELLATE TAX BOARD
By: _______
Thomas W. Hammond, Jr., Chairman
A true copy:
Attest: _______
Clerk of the Board
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3
In accordance with the parties' Statement of Agreed Facts, ¶ 74, and the appellant's abatement application, Form CA-6, and Amended Individual Income Tax Return (at pages 2944 to 2953 of the Stipulated Exhibits), the correct amount of lottery winnings was $2,587,591, not $258,759,150.
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4
See note 3, supra.
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