T.C. Memo. 2017-48



                            UNITED STATES TAX COURT



     MUHIEDDIN A. GHAZAWI AND GHADA GHAZAWI, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 4750-15.                              Filed March 22, 2017.



      Charles A. Rose, Stephen A. Sherman, and James B. Martin, Jr., for

petitioners.

      Diana N. Wells and Denise A. Diloreto, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: Respondent issued a notice of deficiency to petitioners

determining deficiencies in income tax, an addition to tax, and accuracy-related

penalties as follows:1


      1
          Unless otherwise indicated, all section references are to the Internal
                                                                           (continued...)
                                           -2-

          [*2]                                Addition to tax       Penalty
                 Year         Deficiency      sec. 6651(a)(1)     sec. 6662(a)
                 2011          $300,834           $60,167           $60,167
                 2012           137,354              ---             27,471

      The threshold issues for decision are whether Ghada, Inc. (Ghada),

Muhieddin Ghazawi’s (Mr. Ghazawi) wholly owned S corporation, failed to report

$222,818 of gross receipts for 2012 and is entitled to reduce gross receipts by

$2,126,954 and $1,936,558 of cost of goods purchased for resale (COGS) for 2011

and 2012, respectively.2 The additional issues for decision are whether

petitioners: (1) failed to report $876,952 and $373,522 of nonpassive income

from Ghada for 2011 and 2012, respectively; (2) are entitled to deduct $69,104

and $71,148 of mortgage interest expenses reported on Schedules E, Supplemental

Income and Loss, for 2011 and 2012, respectively; and (3) are liable for accuracy-

related penalties under section 6662(a) for 2011 and 2012.3

      1
       (...continued)
Revenue Code (Code) in effect for the taxable years at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure. All monetary
amounts are rounded to the nearest dollar.
      2
      These are the amounts of COGS petitioners claimed; they exceed the
amounts respondent determined in the notice of deficiency of $1,298,219 and
$1,779,449 for 2011 and 2012, respectively.
      3
          At trial respondent conceded that Ghada did not fail to report $171,101 of
                                                                          (continued...)
                                        -3-

[*3]                           FINDINGS OF FACT

       Some of the facts are stipulated and are so found. The stipulation of facts

and the attached exhibits are incorporated herein by this reference. Petitioners

resided in Kentucky when the petition was filed.

       During 2011 and 2012, the taxable years at issue, Mr. Ghazawi was the sole

owner of Ghada. Ghada operated a convenience store, Dino’s Food Mart 2

(Dino), which sold gasoline, lottery tickets, and groceries. On October 31, 2012,

Ghada sold all of its assets (including Dino) to Samer, LLC (Samer), Ghada

Ghazawi’s wholly owned S corporation. Ghada filed Forms 1120S, U.S. Income

Tax Return for an S Corporation, for the taxable years at issue and on the forms

indicated that it reported income and expenses on an accrual basis for Federal

income tax purposes. During the taxable years at issue Ghada maintained two

checking accounts at Republic Bank, accounts ending in 4136 and 4144

(hereinafter account 4136 or account 4144). Both accounts were held open in

Ghada’s name for the duration of the taxable years at issue, notwithstanding

Ghada’s sale of assets to Samer.

       3
        (...continued)
sec. 1231 gain for 2012. After trial petitioners conceded: (1) in their opening
brief that Ghada failed to report $11,793 of income from lottery commissions for
2011 and (2) in their answering brief that they are liable for an addition to tax
under sec. 6651(a)(1) for 2011.
                                        -4-

[*4] Petitioners filed joint returns for the taxable years at issue and reported

$61,446 and $36,553 of nonpassive income from Ghada’s Schedules K-1,

Shareholder’s Share of Income, Deductions, Credits, etc., for 2011 and 2012,

respectively. Petitioners’ returns were prepared by Monger & Co., an accounting

and bookkeeping firm. Nyenatee Monger, an accountant, bookkeeper, and owner

of Monger & Co., was either the preparer or the third-party designee of

petitioners’ returns for the taxable years at issue. Mr. Monger generated profit and

loss summaries for petitioners using Ghada’s bank statements and monthly cash

register tapes.

      On November 20, 2014, respondent sent petitioners a notice of deficiency

for tax years 2011 and 2012 that made no adjustment to Ghada’s 2011 reported

gross receipts but determined by using a bank deposits analysis of Ghada’s

accounts 4136 and 4144 that Ghada had failed to report $222,818 of gross receipts

for 2012. The notice of deficiency also disallowed $828,735 and $157,109 of

Ghada’s reported COGS for 2011 and 2012, respectively.4 On the basis of

respondent’s adjustments to Ghada’s gross receipts and COGS, the notice of

deficiency determined that petitioners had failed to report income from Ghada.


      4
      As stated supra note 2, respondent determined COGS of $1,298,219 and
$1,779,449 for 2011 and 2012, respectively.
                                         -5-

[*5] For the taxable years at issue petitioners claimed mortgage interest expense

deductions for interest paid on two loans, loan accounts 5906 and 5907

(hereinafter loan 5906 or loan 5907). Petitioners claimed Schedule E expense

deductions of $69,104 for “mortgage interest paid to banks, etc.” for 2011.

Petitioners claimed deductions of $71,148 on Schedule A, Itemized Deductions,

for “Points not reported to you on Form 1098” (hereinafter Schedule A points) for

2012. Respondent’s notice of deficiency allowed $42,641 of petitioners’ interest

paid for 2011--$34,357 and $8,284 for interest paid on loans 5906 and 5907,

respectively--and disallowed all of petitioners’ Schedule A points for 2012.

Petitioners timely filed a petition for redetermination of the deficiencies.

      Petitioners did not introduce documentation, other than bank statements, to

verify Ghada’s reported gross receipts for 2012. We will discuss the gross receipts

issue later in our opinion. Petitioners introduced documents to substantiate

Ghada’s claimed COGS for the taxable years at issue. Petitioners’ documentation

included bank statements for accounts 4136 and 4144 from 2011 and 2012 with

images of checks written from those accounts; copies of deposits made to accounts

4136 and 4144 for 2012; A&M Oil Co.’s (A&M Oil) customer ledgers for Dino

from 2011 and 2012; statements from Lambert’s Distributors, Inc. (Lambert),

reflecting various transactions with Dino during 2010-13; invoices from Anheuser
                                         -6-

[*6] Busch for 2011-13; and modified copies of Ghada’s QuickBooks reports for

account 4136. We find that petitioners’ documentation substantiates that Ghada

incurred $1,717,571 and $1,490,651 of COGS for 2011 and 2012, respectively.5

These amounts are less than the amounts petitioners claimed, and only COGS for

2011 is more than the amount respondent determined; COGS for 2012 is less than

the amount respondent determined.

      Before trial petitioners stipulated that they were not entitled to a $71,148

Schedule A points deduction for 2012. After trial on March 9, 2016, petitioners

made a motion to conform the pleadings to the evidence to assert a Schedule E

interest paid deduction. On May 12, 2016, this Court under Rule 41(b)(1) granted

petitioners’ motion to conform the pleadings to the evidence, which allowed

petitioners to assert, as though pleaded on their original petition, that they were

entitled to a $71,148 Schedule E interest paid deduction for 2012.

      Petitioners introduced the following documentation to support their claimed

interest paid deductions for 2011 and 2012: (1) loan master reports for loans 5906

and 5907 from 2011 and 2012 showing the transaction dates, principal and interest


      5
       COGS for 2011 comprises $1,035,865 from A&M Oil, $565,000 from
Lambert, and $116,706 from Anheuser Busch; and COGS for 2012 comprises
$921,515 from A&M Oil, $494,067 from Lambert, and $75,069 from Anheuser
Busch.
                                        -7-

[*7] amounts, and a description of the payments; (2) various monthly bank

statements from petitioners’ personal bank account for 2011; and (3) a variety of

check images in conjunction with those bank statements (hereinafter collectively

loan documentation). Petitioners did not introduce any additional documentation

for their claimed interest paid deductions for 2012. We find that petitioners’ loan

documentation substantiates that they made the following payments in 2011:

         Loan master report     Bank account 9757      Interest allocated to
          transaction date         check No.            loan account 

, 2011                101                  $5,218
            May 4, 2011                 115                    5,210
            July 11, 2011               142                    5,206
            Aug. 4, 2011                144                    5,202
            Sept. 12, 2011              222                    5,197
            Dec. 9, 2011                225                    5,185

      No documentation was introduced to substantiate that petitioners were the

payors of the remaining interest payments--some payments were made in cash

(and were not substantiated), and other payments came from check numbers

associated with Ghada’s bank accounts. Accordingly, we find as fact that

petitioners paid interest of $31,218 and zero for 2011 and 2012, respectively.
                                        -8-

[*8]                                 OPINION

I.     Burden of Proof

       The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer ordinarily bears the burden of proving those

determinations erroneous. Rule 142(a); Welch v. Helvering, 

, 115

(1933). For cases appealable to the Court of Appeals for the Sixth Circuit, such as

the current case, the Commissioner may not rely on the presumption of correctness

with regard to a determination of unreported income unless that determination is

supported by a “minimal evidentiary foundation”. United States v. Walton, 

, 919 (6th Cir. 1990) (quoting Weimerskirch v. Commissioner, 

, 361 (9th Cir. 1979), rev’g 

(1977)); see Golsen v. Commissioner,

, 757 (1970), aff’d, 

(10th Cir. 1971).

       Respondent has met this burden by introducing a bank deposits analysis for

Ghada’s bank accounts that indicates Ghada received unreported income. Thus

respondent’s determinations in the notice of deficiency are entitled to their general

presumption of correctness; and petitioners bear the burden of proving by a

preponderance of the evidence that respondent’s determinations of unreported

income are arbitrary or erroneous. See Helvering v. Taylor, 

, 515

(1935); Estate of Mason v. Commissioner, 

, 656-657 (1975), aff’d, 566
                                           -9-

[*9] F.2d 2 (6th Cir. 1977). The taxpayer may prove that the Commissioner’s

reconstruction of his income is in error, in whole or in part, by proving that a

deposit is nontaxable. See Clayton v. Commissioner, 

, 645 (1994).

The evidence does not establish that the burden of proof shifts to respondent under

section 7491(a) as to any issue of fact.

      Deductions are a matter of legislative grace; the taxpayer bears the burden

of proving entitlement to deductions allowed by the Code and of substantiating

expenses underlying claimed deductions by keeping and producing records

sufficient to enable the Commissioner to determine the correct tax liability. Sec.

6001; INDOPCO, Inc. v. Commissioner, 

, 84 (1992); New Colonial

Ice Co. v. Commissioner, 

, 440 (1935); sec. 1.6001-1(a), (e), Income

Tax Regs.

      The Commissioner bears the burden of production with respect to any

accuracy-related penalties under section 6662. See sec. 7491(c); Higbee v.

Commissioner, 

, 446 (2001). Once the burden of production is met,

the taxpayer bears the burden of proof, including the burden of proving reasonable

cause for his or her underpayment of Federal income tax. See Rule 142(a); Higbee

v. Commissioner, 

.
                                       - 10 -

[*10] II.   Ghada’s Returns

      A.    Gross Receipts

      Section 61(a) defines “gross income” as “all income from whatever source

derived”, including “[g]ross income derived from business”. Sec. 61(a)(2). This

definition is construed broadly and has “been held to encompass all ‘accessions to

wealth, clearly realized, and over which the taxpayers have complete dominion.’”

James v. United States, 

, 219 (1961) (quoting Commissioner v.

Glenshaw Glass Co., 

, 431 (1955)). A taxpayer has dominion and

control over an account when the taxpayer has the freedom to use its funds at will.

See Rutkin v. United States, 

, 136-137 (1952).

      Petitioners were required, but failed, to maintain adequate books and

records establishing the amounts of their gross income. See sec. 6001; Petzoldt v.

Commissioner, 

, 686 (1989); sec. 1.446-1(a)(4), Income Tax Regs.

When a taxpayer fails to keep adequate books and records, the Commissioner is

authorized to determine the existence and amount of the taxpayer’s income and

may appropriately employ the bank deposits method to estimate the taxpayer’s

income. Sec. 446(b); Petzoldt v. Commissioner, 

; Estate of Mason

v. Commissioner, 

. The Commissioner has great latitude in

reconstructing a taxpayer’s income, and the reconstruction need only be
                                       - 11 -

[*11] reasonable in the light of all surrounding facts and circumstances. Petzoldt

v. Commissioner, 

.

      Bank deposits are prima facie evidence of income. Tokarski v.

Commissioner, 

, 77 (1986); Estate of Mason v. 

. The bank deposits method assumes that all deposits into a taxpayer’s

account are taxable unless the taxpayer can show that the deposits are nontaxable,

and “the Government must take into account any non-taxable source * * * of

which it has knowledge.” Price v. United States, 

, 677 (5th Cir.

1964); see DiLeo v. Commissioner, 

, 868 (1991), aff’d, 

(2d Cir. 1992).

      Respondent’s revenue agent employed the bank deposits method to

reconstruct Ghada’s income because she determined Ghada’s records were

incomplete as a result of Ghada’s significant use of cash. The revenue agent used

Ghada’s bank account statements (which are part of the record) to prepare a bank

deposits analysis, excluding all nontaxable receipts of which she was aware.

Respondent reasonably relied on the bank deposits method to determine Ghada’s

taxable income on which petitioners’ resulting income tax deficiencies are based.

      Petitioners contend that they did not fail to report $222,818 of gross receipts

for 2012: They maintain that the deposits received in November and December
                                       - 12 -

[*12] 2012 are not attributable to Ghada because Ghada sold all of its assets to

Samer on October 31, 2012, and therefore those gross receipts are properly

attributable to Samer. Petitioners did not introduce any documentation, such as

proof of signatory authority over the Ghada bank accounts, a sales contract, or any

other credible evidence, to prove that the gross receipts received in November and

December 2012 are attributable to Samer or were properly included on Samer’s

2012 tax return. Further, accounts 4136 and 4144 were both held open in Ghada’s

name from January 1, 2011, until December 31, 2012, including after Ghada’s sale

of assets to Samer on October 31, 2012. Ghada had complete dominion and

control over the accounts for the taxable years at issue. Accordingly, petitioners

failed to prove that respondent’s reconstruction of Ghada’s income was in error.

All taxable deposits into accounts 4136 and 4144 for 2012 are therefore properly

included in the calculation of Ghada’s 2012 gross receipts, and we sustain

respondent’s determinations of unreported income consistent with the revenue

agent’s bank deposits analysis.

      B.     COGS

      Section 162(a) allows as a deduction “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business”. An accrual basis taxpayer, such as Ghada, is allowed a deduction
                                         - 13 -

[*13] during the taxable year in which the expenses are incurred. The cost of

goods purchased for resale, with proper adjustment for opening and closing

inventories as determined in accordance with the taxpayer’s method of accounting,

“is not a deduction within the meaning of sec. 162(a) but is subtracted from gross

receipts in determining a taxpayer’s gross income.” Olive v. Commissioner, 

, 20 n.2 (2012), aff’d, 

(9th Cir. 2015); see sec. 1.162-1(a),

Income Tax Regs.

       Petitioners’ documentation substantiates that they incurred $1,717,571 and

$1,490,651 of COGS for 2011 and 2012, respectively. We do not find the

modified copy of the QuickBooks to be credible documentation of petitioners’

COGS. We therefore hold that petitioners substantiated and are thus entitled to

$1,717,571 of COGS for 2011; petitioners have not substantiated COGS in excess

of respondent’s determination for 2012 and are therefore entitled to the amount of

COGS respondent determined in the notice of deficiency for 2012.

III.   Petitioners’ Unreported Gross Income for 2011 and 2012

       Section 1366(a)(1) provides that an S corporation shareholder determines

his or her tax liability by taking into account his or her pro rata share of the S

corporation’s income, losses, deductions, and credits for the S corporation’s

taxable year ending with or in the shareholder’s taxable year.
                                        - 14 -

[*14] We hold that petitioners received unreported nonpassive income from

Ghada as will be determined under Rule 155, taking into consideration: (1)

respondent’s concession as to Ghada’s section 1231 gain for 2012, (2) petitioners’

concession as to Ghada’s income from lottery commissions for 2011, and (3) our

holdings regarding Ghada’s gross receipts for 2012 and COGS for 2011 and 2012.

IV.   Petitioners’ Schedule E Mortgage Interest Expense for 2011 and 2012

      Section 163(a) generally permits a deduction for all interest paid or accrued

within the taxable year on indebtedness. Cash basis taxpayers, such as petitioners,

are allowed a deduction for interest paid during the taxable year in cash or its

equivalent. See Don E. Williams Co. v. Commissioner, 

, 577-578

(1977); Heyman v. Commissioner, 

, 485 (1978), aff’d, 

(6th Cir. 1980).

      Petitioners’ loan documentation substantiates that they paid interest of

$31,218 and zero for 2011 and 2012, respectively. We therefore find that

petitioners are not entitled to an interest paid deduction for 2011 or 2012 in excess

of respondent’s determinations in the notice of deficiency.
                                        - 15 -

[*15] V.     Section 6662(a) Penalties for Tax Years 2011 and 2012

      Section 6662(a) and (b)(2) imposes an accuracy-related penalty on any

portion of an underpayment of Federal income tax that is attributable to the

taxpayer’s “substantial understatement of income tax”.

      An understatement of Federal income tax is substantial if the amount of the

understatement for the taxable year exceeds the greater of 10% of the tax required

to be shown on the return or $5,000. Sec. 6662(d)(1)(A). If the Rule 155

computations confirm substantial understatements for the taxable years at issue,

then respondent has met his burden of producing evidence that the penalties are

justified. See sec. 7491(c). Once respondent has met his burden, petitioners may

avoid section 6662(a) accuracy-related penalties if they can demonstrate (1)

reasonable cause for each underpayment and (2) that they acted in good faith with

respect to each underpayment. See sec. 6664(c)(1). A determination of

reasonable cause and good faith “is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.” See sec. 1.6664-4(b)(1), Income

Tax Regs.

      For purposes of section 6664(c), a taxpayer may establish reasonable cause

and good faith with respect to the amount of tax liability reported on a return,

thereby negating a section 6662 accuracy-related penalty, by showing his
                                        - 16 -

[*16] reliance on professional advice. Sec. 1.6664-4(b)(1), Income Tax Regs. We

stated in Neonatology Assocs., P.A. v. Commissioner, 

, 99 (2000),

aff’d, 

(3d Cir. 2002), that

       for a taxpayer to rely reasonably upon advice so as possibly to negate
       a section 6662(a) accuracy-related penalty determined by the
       Commissioner, the taxpayer must prove by a preponderance of the
       evidence that the taxpayer meets each requirement of the following
       three-prong test: (1) The adviser was a competent professional who
       had sufficient expertise to justify reliance, (2) the taxpayer provided
       necessary and accurate information to the adviser, and (3) the
       taxpayer actually relied in good faith on the adviser’s judgment. * * *

       Petitioners assert that they acted with reasonable cause and in good faith

with respect to their underpayment for each year by (1) hiring Mr. Monger, (2)

providing Mr. Monger with information necessary for keeping accurate records

and preparing tax filings, (3) and ultimately relying on Mr. Monger’s advice when

filing their tax returns.

       When interpreting the meaning of advice, this Court has looked to the

definition of the term in section 1.6664-4(c)(2), Income Tax Regs.:

              (2) Advice defined.--Advice is any communication, including
       the opinion of a professional tax advisor, setting forth the analysis or
       conclusion of a person, other than the taxpayer, provided to (or for
       the benefit of) the taxpayer and on which the taxpayer relies, directly
       or indirectly, with respect to the imposition of the section 6662
       accuracy-related penalty. Advice does not have to be in any
       particular form.
                                        - 17 -

[*17] See Woodsum v. Commissioner, 

, 592-593 (2011). When a

taxpayer asserts reliance on “advice” from a competent professional as an

affirmative defense to an addition to tax or a penalty, the Supreme Court has held

that advice must consist of “substantive advice” reflecting an adviser’s analysis or

conclusion, as opposed to a nonprofessional function which “requires no special

training”. See United States v. Boyle, 

, 251-252 (1985); Woodsum v.

Commissioner, 

(citing Neonatology Assocs., P.A. v.

Commissioner, 

).

      Petitioners have not proven that Mr. Monger provided substantive advice

with respect to any of the items reported on petitioners’ tax returns for the taxable

years at issue. Both Mr. Monger’s and petitioners’ relevant testimony established

that (1) Mr. Monger merely reported Ghada’s income from the information that

petitioners provided to him, (2) Mr. Monger determined Ghada’s COGS from

Ghada’s bank statements and vendor invoices/logs, and (3) petitioners told Mr.

Monger the amounts they wanted to report as rental expenses. There is no

evidence that Mr. Monger provided substantive advice setting forth an analysis or

conclusion on which petitioners relied. We find that petitioners have not

established reasonable cause and good faith as a defense to the accuracy-related

penalties. We therefore hold that if Rule 155 computations confirm substantial
                                         - 18 -

[*18] understatements of income tax, petitioners are liable for penalties for

underpayments attributable to substantial understatements of income tax under

section 6662(a) and (b)(2).

         We have considered all the other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.

         To reflect the foregoing,


                                                  Decision will be entered

                                        under Rule 155.