Tax Court Affirms Net-Worth Method Used to Support Fraud Determination Against Surf Shop Owners

If you think that by keeping sloppy records, the IRS cannot determine how much income you earned – think again.

The Worth family, Donald, Marie, and their son, Frank, operated a chain of seven surf and skateboard shops across California, called White Sands. Their business was selected for audit by the IRS. In the course of the audit the IRS learned that Frank was responsible for about half of the stores and Donald and Marie operated the other half. Marie also managed the books and prepared tax returns. As manager of the heavily cash-based business, Frank had the authority to write checks on certain White Sands bank accounts, wrote checks or used cash to pay vendors for merchandise as it came in, and wrote checks to reimburse himself for business expenses he paid. Frank also supervised inventory and receipts from store branches. There were no formal ownership arrangements; however, Donald and Frank held themselves out as joint owners, and Frank testified in previous cases that he was a part-owner. Frank reported income from the business on his Form 1040 Schedule C and never received a Form W-2 from White Sands.

As the civil IRS audit progressed the auditor uncovered certain banking irregularities that lead the IRS and state authorities to institute a criminal investigation into the business, resulting in Frank pleading guilty to willfully making and subscribing to a false return for 2000, and Donald and Marie pleading the same for 1998 to 2000. All three admitted to knowingly and willfully understating the business’ gross receipts to decrease tax liability.

The IRS then determined deficiencies for Donald and Marie and for Frank based on unreported income using the net-worth method, because the lack of complete and reliable records precluded using the simpler bank-deposit method and sought to defend its civil assessment for taxes, penalties and interest in the U.S. Tax Court.

IRS Reconstruction Of Taxpayer’s Income.

The IRS has great latitude in reconstructing a taxpayer’s income, and the reconstruction need only be reasonable in light of all surrounding facts and circumstances. The net-worth approach is a permissible method that seeks an approximation, rather than a precise determination, of the taxpayer’s gross income.

Under the net-worth method, the IRS reconstructs a taxpayer’s income by determining net-worth at the beginning and end of each year in issue. The net worth increase (or decrease) for each year is then adjusted by adding nondeductible expenses (such as everyday living costs) and subtracting receipts from nontaxable sources (such as gifts, inheritances, and loans).  

An increase in net worth for a given year creates an inference of additional gross income for that year, provided that the IRS: (1) establishes the taxpayer’s opening net worth with reasonable certainty and (2) either shows a likely source of unreported income or negates possible nontaxable sources. Brooks v. Commissioner, 82 T.C. 413 (1984).

Battle In Tax Court.

But for the Worth’s case the primary issue before the Tax Court was whether the Worth’s failed to report income for 1998 to 2000 as determined by the IRS using the net-worth method of reconstructing income. The court’s decision was published recently – see Worth v. Comm’r, T.C. Memo 2014-232 (11/13/2014).

The court determined that the net-worth method was computed correctly and that the family was liable for the deficiencies. The court reasoned that the Worth’s failed to maintain accurate books or records from which tax liabilities could be computed and did not present any affirmative case to rebut the IRS’s arguments.

The court rejected the Worth’s arguments that the IRS agent was not a qualified expert, thus making her testimony inadmissible, finding that that the IRS agent was not testifying as an expert, but permissibly providing factual information as to how the audit was conducted and how net-worth was calculated. Moreover, the IRS audit properly investigated and accounted for alleged cash-hoards as well as other alleged loans from Donald and Marie to Frank, which could have lowered the taxpayers’ AGI. Lastly, the court determined that based on the IRS audit, criminal investigation, and admissions, Frank was a 50% owner of White Sands during the years at issue and thus half of the assets of White Sands was properly allocated to him for purposes of the net-worth analysis.

The Tax Court ultimately upheld the IRS’s deficiencies and determined the family members were liable for the civil fraud penalty (which is 75% of the underlying increase in tax) because of the understatements of income, false statements, lack of credible testimony, insufficient records, and attempts to conceal income by structuring bank deposits to fall under the reporting limit required for banks.

Don’t Take The Chance And Lose Everything You Have Worked For.

Protect yourself. If you are selected for an audit, stand up to the IRS by getting representation. Tax problems are usually a serious matter and must be handled appropriately so it’s important to that you’ve hired the best lawyer for your particular situation. The tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Los Angeles, San Diego San Francisco and elsewhere in California are highly skilled in handling tax matters and can effectively represent at all levels with the IRS and State Tax Agencies including criminal tax investigations and attempted prosecutions, undisclosed foreign bank accounts and other foreign assets, and unreported foreign income.

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