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

A few of my Classes From Tax Court docket tackle substantive tax guidelines.  Some are about observe and process.  At this time we now have an object lesson: when a taxpayer has a bona fide enterprise however fails to maintain sufficient information of their enterprise exercise, unhealthy issues occur.

Everyone knows that taxpayer’s want good information to substantiate claimed deductions. See e.g. Lesson From The Tax Court docket: Receipts Are Not Sufficient, TaxProf Weblog (Sept. 21, 2020).

This week we additionally be taught that: (1) the failure to maintain information permits the IRS to make use of the financial institution deposits technique to find out revenue and (2) the identical failure additionally offers the IRS a slam-dunk foundation to impose §6662(a) accuracy-related penalties.

The case is Greg A. Ninke and Jane M. Ninke v. Commissioner, T.C. Memo. 2023-88 (July 19, 2023) (Decide Halpern).  Once more, nothing actually new right here.  However it’s a helpful object lesson. Particulars beneath the fold.

Regulation:  Dangerous Data Leads To IRS Reconstruction of Earnings
Part 6001 creates the responsibility to maintain first rate information. Treas. Reg. 1.6001-1(a) explains additional: taxpayers should “preserve such everlasting books of account or information, together with inventories, as are ample to ascertain the quantity of gross revenue, deductions, credit, or different issues required to be proven by such individual in any return of such tax or info.”

Income Brokers (RAs) are directed to begin their examination of revenue gadgets by trying on the taxpayer’s personal information  See IRM 4.10.4.3.3.  Certain, a part of these information are financial institution information, however RA’s use them solely to reconcile with the taxpayers personal enterprise information.  IRM 4.10.4.3.7  Put one other approach, the RA will first try to search out direct proof of revenue and expenditures utilizing the taxpayer’s information as the essential supply of knowledge.

However typically the RA finds {that a} taxpayer both has no information that help asserted revenue and deduction gadgets, or has actually sucky information that virtually scream “we’re bogus!”  In these conditions, RA’s are licensed to make use of oblique strategies to find out unreported revenue. IRM 4.10.4.6.2.1.  The RA can select from quite a few  oblique strategies, listed in IRM 4.10.6.  Maybe the commonest of these oblique strategies is the financial institution deposits technique.

The IRM says RAs can use a financial institution deposits technique when, amongst different issues, “the taxpayer’s books and information are unreliable, unavailable, withheld, or incomplete,” and “the taxpayer makes periodic deposits of funds into checking account(s) which look like generated from an income-producing exercise.”  IRM 4.10.4.6.4.2.  The Tax Court docket has lengthy held that financial institution deposits analyses could be a reliable software to determine unreported revenue.  See  Hague Property v. Commissioner, 132 F.second 775 (second Cir. 1943), aff’g 45 B.T.A. 104 (1941); Property of Mason v. Commissioner, 64 T.C. 651, 656 (1975), aff’d 566 F.second 2 (sixth Cir. 1977).

An RA utilizing a financial institution deposits technique is not going to solely take a look at common old style financial institution accounts, however will even search for different sources of saved worth, reminiscent of pay as you go debit playing cards or peer to look fee programs.  The RA identifies all deposits, then subtracts from that any identifiable nontaxable sources of deposits, reminiscent of transfers from different accounts or Social Safety incapacity funds or documented items.

What makes the financial institution deposit technique tough for taxpayers is the presumption that every one deposits are revenue.  It’s completely as much as the taxpayer to show the nontaxable nature of any deposit.  Parks v. Commissioner, 94 T.C. 654, 658 (1990). If you don’t preserve information, or your information suck, that may be difficult.

What constitutes insufficient information might be squishy. See e.g. Westby v. Commissioner, T.C. Memo. 2004-179 (2004) (rejecting “simplistic financial institution deposits analyses” in mild of contemporaneous handwritten ledgers and financial institution statements taxpayer supplied to her return preparer to arrange return).  Nonetheless, ya gotta have one thing to rebut a financial institution deposits evaluation.

Regulation: Dangerous Data Results in Negligence Penalty
Part 6662(a) imposes an accuracy-related penalty of 20% of any underpayment of tax when that underpayment arises from one in all quite a few listed causes listed in §6662(b).  Part 6662(b) that’s brought on by quite a lot of listed actions.  The very first listed motion is “Negligence or disregard of guidelines or laws.”  §6662(b)(1).

For penalty functions, negligence is broadly outlined as “any failure to make an affordable try to adjust to the provisions of this title….”  §6662(c) (emphasis provided).  Effectively, as we now have seen, §6001 imposes the responsibility to maintain sufficient information!  And Treas Reg. 1.6662-3(b) explicitly explains that “Negligence additionally contains any failure by the taxpayer to maintain sufficient books and information or to substantiate gadgets correctly.”

Let’s see how this all works out within the two circumstances.

Lesson 1: Insufficient Data Lead To Financial institution Deposit Evaluation
The years at difficulty in Ninke have been 2015, 2016, and 2017.  In these years each Mr. and Ms. Ninke have been concerned within the porn enterprise.  He created web sites and “different types of grownup leisure.”  Op. at 3.  For 2015 he additionally ran a publishing firm.  In 2016 and 2017 he additionally drove for Uber and Lyft.  Throughout 2017 Ms. Ninke labored as a mannequin for one in all Mr. Ninke’s web sites.

Every year the Ninkes filed returns.  For all years they reported modest web income from Mr. Nike’s web site enterprise.  For 2015 they reported minimal revenue from Mr. Nike’s publishing enterprise.  They didn’t report revenue from Ms. Nike’s modeling nor does it seem they reported revenue from Mr. Nike’s facet hustle driving for Uber and Lyft.  The Opinion doesn’t say that explicitly however I infer it as a result of the Opinion recites that they filed Schedule C’s just for the porn stuff.

Throughout the years at difficulty, the Ninkes “had between 12 and 20 accounts at numerous banks…” Op. at 3.  In addition they maintained pay as you go debit card accounts with numerous monetary service firms reminiscent of Paxum and Netspend.  These accounts permitted peer to look cash transfers, like Paypal or Venmo.  Satirically, one of many options touted for pay as you go debit playing cards is that they simplify record-keeping.  For instance, Netspend’s web site says its card makes it “simple to remain on prime of your cash with easy to make use of instruments like Spending Tracker and Anytime Alerts.”  Customers of Paxum reward its capability to assist them “have full management over the statistics and revenue of my funds.” That’s from this evaluation web site.

So the Ninkes had loads of information of account transactions.  And apparently they actively moved cash round between numerous accounts.  However when audited they’d no information of their enterprise actions to help the quantity of revenue they reported.  So the RA did a financial institution deposits evaluation.  Decide Halpern explains the method, which could be of curiosity to these readers unfamiliar with how the IRS does it:

“RA Smith carried out a financial institution deposits evaluation, evaluating reported Schedule C receipts to financial institution deposits. He handled the pay as you go debit card accounts as in the event that they have been checking accounts. He reviewed the account statements that petitioners supplied to him. He created spreadsheets, whereby he listed all deposits made within the respective accounts, recognized the supply of every deposit, and categorized every (i.e., switch, deposit, mortgage, refund, adjustment, and so forth.). He then created a abstract sheet for every year, on which he entered the yr’s deposits, subtracted deposits from identifiable nontaxable sources, e.g., bank-to-bank transfers, counter credit, and gadgets reminiscent of Social Safety incapacity funds, and in contrast the distinction with the gross revenue petitioners reported for the yr. For every year, the distinction exceeded petitioners’ reported gross revenue, and he handled the distinction as unreported gross receipts from petitioners’ Schedule C companies.”

The Ninkes didn’t agree with RA Smith’s evaluation and petitioned Tax Court docket.  In Court docket they argued that RA Smith did not account for transfers from a bunch of different accounts…that they’d not disclosed till Tax Court docket! “Petitioners conceded at trial at the least eight financial institution accounts or pay as you go debit card accounts for which they’d supplied no info to RA Smith.”  Op. at 9.  “They spend roughly half of their transient itemizing particular person money deposits and withdrawals from their financial institution accounts and pay as you go debit card accounts in the course of the years at difficulty. They present deposits totaling $28,550 and withdrawals totaling $44,639.”  Id.

Their total argument was that their complete withdrawals every year exceeded their complete deposits.  In order that meant they might not presumably have had any unreported revenue.

I confess I don’t comply with that final argument.  Simply since you spend greater than you deposit doesn’t in some way make the deposits not revenue.  Heck, my son does that frequently!

At any charge, Decide Halpern teaches us the lesson: it’s not sufficient to point out a bunch of monetary information.  To refute a financial institution deposits evaluation, he defined, the Ninkes wanted “to tie deposits that respondent had not handled as coming from an excludable supply to a switch or a withdrawal from an account beforehand recognized to respondent. … Displaying that money withdrawals exceeded money deposits for the years at difficulty doesn’t show that any deposit was of money withdrawn from the identical account or every other account of petitioners. And … their introduction at trial of…financial institution accounts and pay as you go debit card accounts that they’d not disclosed to RA Smith raises the opportunity of unreported revenue.”  Op. at 12.

Backside Line: Failure to maintain sufficient enterprise information might set off a financial institution deposits audit, the outcomes of which can at all times put the taxpayer right into a gap of getting to show a damaging: that every deposit was not revenue.  However that’s a gap of the taxpayer’s personal making.

Lesson 2: Dangerous Data Lead To Accuracy-Associated Penalties
The truth that the Ninkes had no enterprise information additionally created an extra downside for them.  It subjected them to the §6662(a) accuracy-related penalty.  Decide Halpern notes that their failure creates “a prima facie case for the accuracy-related penalties on the grounds that, for every year at difficulty, petitioners’ underpayment of tax resulted from negligence.”  Op. at 14.

The Ninkes have been now on the hook to point out some affordable trigger for his or her underpayments.  They may not.  They thew up the argument that they relied on third occasion info returns to report their revenue.  It didn’t stick.  Decide Halpern writes “Petitioners ignore that RA Smith discovered unreported revenue for every year at difficulty nicely in extra of money deposits that petitioners declare have been redeposits of transfers or withdrawals from their numerous financial institution accounts and pay as you go debit card accounts.” Op. at 15.

Backside Line: The dearth of sufficient enterprise information to refute the financial institution deposits evaluation additionally undermines any try to point out an affordable trigger for a ensuing underpayment.

An object lesson for us and for our shoppers. 

Bryan Camp is the George H. Mahon Professor of Regulation at Texas Tech College Faculty of Regulation. He invitations readers to return every Monday (or Tuesday if Monday is a federal vacation) for an additional Lesson From The Tax Court docket.

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