WHERRY, Judge.
These consolidated cases are before the Court on petitions for redetermination of four determinations by respondent, in notices of deficiency, that petitioners owe Federal income tax deficiencies for the 2005 and 2006 taxable years.
Respondent determined a Federal income tax deficiency and a penalty for petitioner BanCard Solutions, LLC's (Bancard Solutions) 2005 taxable fiscal year as follows:
Respondent determined Federal income tax deficiencies, penalties, and an addition to tax for petitioner Merchants Payment Processing, Inc.'s (Merchants, Inc.) 2005 and 2006 taxable calendar years as follows:
After concessions by petitioners and respondent,
Some of the facts have been stipulated and are so found. The stipulations of the parties with accompanying exhibits are incorporated herein by this reference.
At all relevant times throughout the years in issue, at the time the petitions in these cases were filed, and at the time of trial, petitioners resided or had their principal office in California.
Mr. Carreon graduated with a business degree from National University, where he had taken one accounting course and no tax courses. He later attended the San Diego Regional Sheriff's Department Sheriff's Academy and completed a nine-month training program. He then volunteered as a reserve deputy sheriff until 1996. In 1999 Mr. Carreon married Ms. Portugal. Throughout the 2005 and 2006 taxable years Mr. Carreon and Ms. Portugal were married.
In 1999 Mr. Carreon and Ms. Portugal were introduced by a mutual friend to Clementine Estrada. Ms. Estrada provided advice to Mr. Carreon and Ms. Portugal on how to set up entities for their business. Ms. Estrada also gave them advice about asset management protection and a financial strategy referred to as the "agent-principal" relationship. Mr. Carreon understood that the concept was set up to operate by taking the net gross receipts from their credit card processing business (which, starting in 1999, they had conducted through Merchant Payment Processing L.L.C., which changed its name on December 31, 1999, to Bancard Solutions LLC) after business expenses including their salaries and put those funds into other entities such as a trust. These other entities were to be designated as a business trust, a charitable trust, and a management trust. There was also to be a "living trust" to hold and protect their property, such as their home, personal property, etc.
Additionally, Ms. Estrada explained that the management trust would be managed by a company called Builders, which would charge a fee for services of 11% of the first $70,000 of credit card processing receipts and 6% for any excess money managed beyond $70,000. Ms. Estrada also referred Mr. Carreon and Ms. Portugal to Robert Holcomb in order to hear more about the "agent-principal" relationship, since they were equal owner members of the business and Ms. Portugal was the managing member.
Mr. Holcomb elaborated on the "agent-principal" relationship to Mr. Carreon and Ms. Portugal. Mr. Holcomb described the relationship as having held up in several cases with the Internal Revenue Service (IRS) and stated that there were even tax rulings that condoned the relationship. Mr. Holcomb, like Ms. Estrada, condoned the relationship as a legal one. Mr. Carreon and Ms. Portugal decided to employ the "agent-principal" relationship. Mr. Carreon and Ms. Portugal had about four meetings with Mr. Holcomb.
In 2000 Mr. Holcomb referred Mr. Carreon and two other taxpayers to John Betts, a California certified public accountant (C.P.A.). There is no evidence in the record that, other than the three referrals, Mr. Betts had any professional or untoward business relationship with Mr. Holcomb or that they shared any fees or paid anything to one another. Mr. Betts, at that time, had over 20 years of practice experience and had previously worked for 2 years as an IRS auditor. Mr. Betts had no previously known professional disciplinary actions and was in good standing with the State of California. Mr. Carreon and Ms. Portugal hired Mr. Betts for their personal and business Federal income tax preparation. During this period they also began to use the "agent-principal" relationship. Mr. Betts prepared Mr. Carreon and Ms. Portugal's joint Federal tax returns for the calendar years 2000 through 2005 and Bancard Solutions' Federal income tax return for the fiscal years July 31, 2000 through 2005. Once a month Mr. Betts would receive from Mr. Carreon the QuickBooks accounts for Bancard Solutions and Merchants, Inc. Once a month Mr. Betts would also receive from Mr. Holcomb the agent-principal relationship records in the form of the chart of accounts for Bancard Solutions and Merchants, Inc. Mr. Holcomb had discussed this "agent-principal" relationship with Mr. Betts and had assured him about its validity.
On August 25, 1999, Mr. Carreon and Ms. Portugal started Merchants Payment Processing, L.L.C. (Merchants Processing). Merchants Processing provided credit card processing services to businesses, primarily in the restaurant industry. Bancard Solutions was taxed as a corporation for its 2005 taxable fiscal year. Mr. Carreon and Ms. Portugal were Bancard Solutions' only members. Mr. Carreon served as the secretary and treasurer, Ms. Portugal was the manager, and they were the only individuals with bank account signature authority.
Per his Form W-2, Wage and Tax Statement, Mr. Carreon received compensation of $12,137 from Bancard Solutions during his 2005 taxable year. Bancard Solutions reported gross receipts of $225,040 for the taxable fiscal year ending July 31, 2005.
In the 2005 taxable fiscal year, Bancard Solutions issued and Mr. Carreon signed checks in the total amount of $159,000 to the Mission Federal Credit Union (MFCU). Using these funds, Mr. Carreon obtained and then transferred $159,000 in cashier's checks from MFCU payable to "Builders". Bancard Solutions issued and Mr. Carreon signed two checks numbered 1558
Bancard Solutions underreported its taxable income for its 2005 taxable fiscal year by the $215,000, which was paid to Builders. Had Bancard Solutions reported the $215,000, it would have incurred an additional income tax liability of $72,457 for its 2005 fiscal taxable year. On Bancard Solutions' general ledger the amounts transferred to Builders were deducted from gross income and treated, in effect, as an expense for money going to "Builders". The checks for payments to Builders were described on the memo line of the general ledger as going to "Builders", "Builders-Principle", "Principle-Builders", "Builders Principle MFCU Bank CK", "Builders/Principle", "To Principle", "Form [sic] Builders", "for Builders/ Principle", "To Principle Bank CK", or "To BUILDERS on Behalf of BANCard". In late March or early April 2005 Mr. Carreon started to use Merchants, Inc. as the entity for his credit card service company. Bancard Solutions dissolved on March 31, 2005.
On December 30, 2004, Merchants, Inc. was incorporated. Mr. Holcomb was Merchants, Inc.'s incorporator. According to Merchants, Inc.'s statement of information, Mr. Carreon was the chief executive officer and chief financial officer for Merchants, Inc. Ms. Portugal served as the secretary. Mr. Carreon and Ms. Portugal held these positions during the entire 2005 and 2006 taxable years. Mr. Carreon and Ms. Portugal each owned 50% of Merchants, Inc. and were the only individuals with signature authority on its accounts.
Mr. Carreon was issued a Form W-2 from Merchants, Inc. for his 2005 taxable calendar year reflecting wage income of $32,366. Merchants, Inc. reported gross receipts of $279,352 for the 2005 calendar taxable year. For calendar year 2005 Merchants, Inc. underreported its income by $270,000, which is the amount Merchants, Inc. transferred to Builders. Merchants, Inc. underpaid its Federal income tax by $89,899 for its 2005 calendar taxable year.
During 2006 Mr. Carreon had signature control of all Merchants, Inc.'s accounts. Ms. Portugal also had signature control during this year of all the bank accounts except Merchants, Inc.'s checking account No. 5595. Mr. Carreon was issued a Form W-2 for the 2006 taxable year from Merchants, Inc. reflecting wage income of $49,134. For its 2006 calendar year Merchants, Inc. underreported its income by $202,000, which is the amount Merchants, Inc. paid to Builders during that year. Merchants, Inc. underpaid its Federal income tax by $75,074 for its taxable calendar year 2006.
During its 2005 taxable calendar year Merchants, Inc. transferred $270,000 to MFCU and Builders by checks signed by Mr. Carreon. During its 2006 taxable calendar year Merchants, Inc. transferred $202,000 to MFCU and Builders by checks signed by Mr. Carreon. The $202,000 that went to MFCU in 2006 was used for cashier's checks payable to Builders. All $472,000 was not reported on either Merchants, Inc.'s or Mr. Carreon's Federal income tax return for the 2005 or 2006 taxable year. On Merchants, Inc.'s general ledger money going to Builders was debited, thereby reducing income. The checks for payment to Builders were described on Merchants, Inc.'s memo line of the general ledger as going to "Builders", "Builders-Principle", "Principle-Builders", "Builders Principle MFCU Bank CK", "Builders/Principle", "To Principle", "Form [sic] Builders", "For Builders/ Principle", "To Principle Bank CK", and "To BUILDERS on Behalf of BANCard". Mr. Betts prepared Merchant's, Inc.'s Federal income tax return for the 2006 taxable calendar year.
Bancard Solutions and/or Merchants, Inc. transferred portions of their income to Builders starting in 2000 and continuing through the years at issue. Mr. Carreon maintained a very detailed QuickBooks account record of transfers going to the Builders account. During the taxable years at issue Mr. Holcomb had signature authority over Builders' account.
On March 14, 2000, Mr. Carreon and Ms. Portugal opened an account at MFCU under the account name Western Hill Valley Inc. d.b.a. Angel High Group (AHG), account no. xxxxxx405-0 (AHG 405-0 account). Mr. Carreon and Ms. Portugal each had signature authority over the AHG 405-0 account. In the calendar year 2005 Builders issued checks payable to the AHG 405-0 account totaling $342,250.
On April 24, 2006, Mr. Carreon opened an account at MFCU under the account name Western Hill Valley Inc. d.b.a. AHG, account no. xxxxxx 568-1 (AHG 568-1 account). Mr. Carreon had sole signature authority over the AHG 568-1 account. During the calendar year 2006 Builders paid $197,700 to the AHG 568-1 account. During the years at issue the AHG 568-1 account issued checks under the name "Angel High Group, David Carreon". During the taxable calendar year 2006 Mr. Carreon paid personal expenses using funds deposited into the AHG 568-1 account. Mr. Carreon and Ms. Portugal did not report as Federal taxable income any of the amounts deposited in either the AHG 405-0 or AHG 568-1 account during the calendar years 2005 and 2006.
During 2006 Builders issued checks to Helping Hand, Jubilee, and Brother's Keeper totaling $55,200 which were deposited into the Boot Peak Hill (Boot) checking account No. xxxxx-x3252 (Boot 3252 account). Mr. Carreon had signature authority on the Boot 3252 account during the taxable years at issue. Mr. Carreon endorsed and deposited checks into the Boot 3252 account during the year 2006. During 2006 checks from the Boot 3252 account were issued under the name "Boot Peak Hills, David Carreon". Petitioners did not report as Federal taxable income any of the money transferred into the Boot 3252 account.
Funds in the AHG 405-0, AHG 568-1, and Boot 3252 accounts were used by Mr. Carreon and Ms. Portugal to pay some of their personal expenses during the calendar year 2006. There were no QuickBooks account entries set up for transfers going from Builders into the AHG or Boot accounts. Checks issued from the Builders accounts displayed the names "Agape", "Jubilee", and "Helping Hand", and were deposited into either the AHG or the Boot accounts. The checks issued from Builders were signed by Mr. Holcomb.
Mr. Carreon and Ms. Portugal received rental income of $9,300 from jointly held property during the 2005 taxable year. Mr. Carreon deposited $9,300 into the AHG 405-0 account. Mr. Carreon and Ms. Portugal did not report the $9,300 as income on their joint Federal income tax return for the calendar year 2005.
In the 2006 calendar taxable year, Mr. Carreon and Ms. Portugal received rental income of $31,850 from their jointly held property. Mr. Carreon deposited $15,700 and $16,100
Mr. Betts helped maintain the QuickBooks file on a monthly basis and reconciled Mr. Carreon's, Bancard Solutions', and Merchants, Inc.'s bank accounts every month. Mr. Betts testified that to his then-current knowledge Mr. Carreon provided records sufficient to determine his tax liability. Mr. Betts also testified that to his knowledge all of the tax returns he prepared using the "agent-principal" relationship were correct. Mr. Holcomb had discussed this "agent-principal" relationship with Mr. Betts, Mr. Carreon, and Ms. Portugal and had assured them about its validity. Mr. Carreon relied on Mr. Betts and Mr. Holcomb in his determination and review for accuracy of his Federal income tax returns for himself and for his businesses.
On July 12, 2011, notices of deficiency were issued to Mr. Carreon and Ms. Portugal for the 2005 taxable calendar year; to Mr. Carreon for the 2006 taxable calendar year; to Bancard Solutions for the taxable fiscal year ending July 31, 2005; and to Merchants, Inc. for the 2005 and 2006 taxable calendar years.
In any case involving the issue of fraud with intent to evade tax, the Commissioner bears the burden of proof as to that issue. Sec. 7454(a). That burden of proof must be carried by "clear and convincing evidence". Rule 142(b). Section 6663(a) imposes a penalty of "an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud." Section 6663(b) specifies that if "any portion of an underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud, except" to the extent "the taxpayer establishes (by a preponderance of the evidence) [that some part] is not attributable to fraud."
Respondent must prove, for each year, by clear and convincing evidence that (1) petitioners underpaid their tax for that year, and (2) that some part of that underpayment for that year was due to fraud.
The first prong of the fraud test mandates that the Commissioner prove the existence of an underpayment of tax for the year. In doing so, the Commissioner may not simply rely on the taxpayer's failure to prove error in the deficiency determination.
To satisfy the second prong of the fraud test, the Commissioner must show that a portion of the underpayment is attributable to fraud. The determination of whether civil fraud exists "is a question of fact to be resolved upon consideration of the entire record."
As direct proof of a taxpayer's intent is seldom available, fraud may be established by circumstantial evidence and reasonable inference drawn from the record.
Other factors looked at by courts include: engaging in illegal activities; dealing in cash; failure to make estimated payments; offering false or incredible testimony; and filing false documents.
This Court has held that consistent understatements of income in substantial amounts over a number of years by knowledgeable taxpayers, standing alone, may be considered persuasive evidence of fraud.
The failure to maintain adequate business records supports a finding of fraud.
Mr. Carreon maintained an extensive QuickBooks file showing where his personal account, Bancard Solutions', and Merchants, Inc.'s checks and credit card transactions were being sent. The QuickBooks file was maintained to show not only where the money was going, but also the type of expense. This file was maintained by Mr. Carreon or Ms. Portugal throughout the years at issue. The QuickBooks accounts contained profit and loss statements, general ledgers, and balance sheets for petitioners.
Mr. Carreon followed detailed instructions from Mr. Holcomb on how to maintain the QuickBooks account, which did not include keeping any records or books on the AHG or Boot bank accounts. Because of the failure to record and provide AHG or Boot bank accounts information to the Commissioner, we conclude Mr. Carreon did not clearly maintain a complete set of books. Therefore, this factor weighs slightly in favor of a finding of civil fraud.
Failure to file tax returns is a badge of fraud.
Implausible or inconsistent explanations of a taxpayer's behavior can constitute circumstantial evidence of fraudulent intent.
We are, however, suspicious of Mr. Carreon's failure to prepare any record for AHG or Boot, the use of checks with charitable-sounding names, and the too-good-to-be-true tax result obtained; but suspicious circumstances alone do not sustain a finding of fraud.
An intent to evade tax may be inferred from concealment of assets or covering up sources of income.
A taxpayer's failure to cooperate with revenue agents during an investigation is a badge of fraud.
Mr. Carreon, however, was not helpful in establishing the links between Builders and the AHG 405-0 account, the AHG 568-1 account, and the Boot 3252 account. The revenue agent requested documents about these transfers and never received them from Mr. Carreon. Mr. Carreon did provide other information requested and went in person to meet with the revenue agent. Accordingly, this factor is neutral.
There is no evidence that Mr. Carreon was performing any outside unlawful activities. Accordingly, this factor weighs against a finding of civil fraud.
Dealing in cash to prevent scrutiny of a taxpayer's finances is a badge of fraud.
Mr. Betts had testified that Bancard Solutions and Merchants, Inc. never dealt in cash. Mr. Carreon primarily used checks and credit cards in order to make payments. Mr. Carreon on occasion made large transfers using cashier's checks from Bancard Solutions and Merchants, Inc. to Builders. This Court has on occasion held that the use of cashier's checks can be a badge of fraud.
Filing a document intending to conceal, mislead, or prevent the collection of tax is an indicium of civil fraud.
Respondent does not allege that Mr. Carreon filed any false documents with the IRS. A fictitious business name was registered for Merchants, Inc. with the State of California, but respondent did not allege that this had any bearing on Mr. Carreon's income tax. Mr. Carreon did file incorrect and thereby false returns when he did not report or disclose that Builders paid his personal expenses. Accordingly, this factor weighs in favor of a finding of civil fraud.
Mr. Carreon asserts when he filled out the relevant tax returns he believed that the "agent-principal" relationship described and explained by Mr. Holcomb and accepted as viable by Mr. Betts was a legal relationship that justified his tax reporting position although the Builders payments of some of his expenses were not included, or fully disclosed to Mr. Betts. Further, Mr. Carreon's course of conduct gives credence to his belief. Respondent has failed to convincingly rebut Mr. Carreon's assertion and has failed to show the requisite specific fraudulent intent. Accordingly, this factor weighs heavily against a finding of civil fraud.
The Court concludes three factors weigh in favor of civil fraud, one factor is neutral, and six factors weigh against civil fraud as applied to Mr. Carreon. Additionally, Mr. Carreon placed a great deal of reliance on his C.P.A. Mr. Betts and believed the agent-principal relationship complied with Federal tax law. Mr. Carreon does not possess the education or experience in tax law that would allow him to know that he should have reported the additional income. Even though the reliance on Mr. Betts and Mr. Holcomb was misplaced and three badges of fraud exist, respondent has not carried his substantial burden of proving by clear and convincing evidence that Mr. Carreon committed fraud.
Accordingly, the Court concludes that respondent has failed to prove the second prong of the fraud test with respect to Mr. Carreon for the years 2005 and 2006.
Respondent contends Bancard Solutions and Merchants, Inc. are liable for the civil fraud penalty. Fraud must be proven by independent evidence of fraudulent intent.
Bancard Solutions and Merchants, Inc. conceded that they underreported their income for the years in issue. Merchants, Inc. conceded that it underreported gross receipts for the taxable years 2005 and 2006 by $270,000 and $202,000, respectively. Bancard Solutions conceded that it failed to report gross receipts of $215,000 for the taxable year ending July 31, 2005. However, the reason for the underreporting was its management's reliance on the validity of the agent-principal relationship. Mr. Carreon and Ms. Portugal were assured by Mr. Holcomb and their C.P.A. Mr. Betts of the validity of this relationship. While Mr. Carreon and Ms. Portugal's reliance on Mr. Holcomb may not have been reasonable, their reliance was not fraudulent.
Bancard Solutions and Merchants, Inc. filed all their tax returns for the years at issue. Therefore, this factor weighs against fraud. Respondent does not allege that Bancard Solutions or Merchants, Inc. was engaged in any illegal activities. Therefore, this factor weighs against a finding of civil fraud. Respondent does not allege that Bancard Solutions or Merchants, Inc. filed any false documents with the IRS. Therefore, this factor also weighs against a finding of civil fraud.
The Court concludes that respondent has again failed to carry his burden of establishing by clear and convincing evidence the second prong of the fraud test for the years 2005 and 2006 as applied to Bancard Solutions and Merchants, Inc.
On the basis of the record as a whole and particularly in light of the advice provided to petitioners by Mr. Holcomb and most importantly by their C.P.A. Mr. Betts, who testified at the trial and whose testimony was credible, the Court rejects respondent's determination of the section 6663 civil fraud penalty as to any of petitioners. Mr. Betts testified at the trial, and the Court found his testimony credible even though, as to the tax law as applied to the "agent-principal relationship," incorrect and naive.
To reflect the foregoing,
