Tax Court in Brief | Kohout v. Commissioner | Reconstructing Accounting, Voluminous Writings, and Passthrough Loss
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The recent Tax Court case of Kohout v. Commissioner addresses several common evidentiary issues in the context of tax disputes. A summary, chart, or calculation to prove the content of voluminous records may be appropriate and admissible, but the Tax Court, as seen in the Kohout opinion, is quite comfortable with the financial data in, for example, bank statements that are 58-pages in length. A summary of voluminous records must be an accurate compilation of the underlying data; thus, a constructed summary of reconstructed accounting data is a recipe for evidence that lacks credibility or that will be deemed inadmissible by the Tax Court. And, an accounting “reconstructionist” may attempt to reconstruct a taxpayer’s return through the taxpayer’s testimony or word, but the underlying records—bank statements and evidence of transfers—are a better and more probative source for the substance of a taxable transaction. We dive into more detail below:
Kohout v. Comm’r, T.C. Memo. 2022-37 |April 18, 2022 |Jones, J. | Dkt. No. 11958-17
Short Summary: Todd and Lisa Kohouts had a medical funding and real estate business through a wholly-owned S corporation, Cornerstone Enterprises, Inc. (Cornerstone). Mr. Kohout was the sole shareholder. On its 2013 Form 1120S, U.S. Income Tax Return for an S Corporation, Cornerstone reported gross receipts of $1,829,524. Mr. Kohout signed Cornerstone’s 2013 return and the Kohouts’ personal return, although he was unaware of how Cornerstone’s gross receipts were calculated as reported. For the 2013 tax year, the IRS notified the Kohouts of a $923,280 deficiency and accuracy-related penalties, under section 6662(a), in the amount of $184,676. The Kohouts petitioned for review of the deficiency, and the Kohouts and the IRS eventually resolved and stipulated to all substantive tax issues in the Kohouts’ petition until the Kohouts filed an amended petition, alleging that they overstated the gross receipts of Cornerstone for the 2013 taxable year by $955,599. The Kohouts also alleged that Cornerstone and Mr. Kohout had sufficient bases in one of Cornerstone’s subsidiaries, Preferred Medical Funding, LLC (PMF), to deduct pro rata shares of PMF’s loss for the 2013 taxable year. None of the agreements related to Cornerstone’s operations were presented to the IRS, and the record was void of any evidence of income that Cornerstone received from the operations. Mr. Kohout testified that he altered the QuickBooks computer files on multiple occasions after Cornerstone’s 2013 returns were prepared, including during the IRS audit, and due to a computer crash, computer files for Cornerstone and its subsidiaries were destroyed. However, the evidence did show that Cornerstone made and received money transfers to and from its many disregarded subsidiaries, and those transfers—and evidence of the many bank accounts used by Cornerstone for the transfers—were at issue in this case. But, the Kohouts—after engaging an accountant to reconstruct Cornerstone’s books—believed that Cornerstone’s income was overstated when he signed and filed Cornerstone’s and their personal returns. The reconstruction expert prepared, and the Kohouts sought to admit summaries of Cornerstone’s bank statements, some of which were near 60 pages in length.
- Gross receipts reported on a return are admissions that must be overcome by cogent evidence, and the Kohouts did not meet the higher burden of overcoming those admissions. Not only were Cornerstone’s QuickBooks records altered after the 2013 tax returns were filed, they were also destroyed when the Kohouts’ computer crashed before trial. Thus, the Kohouts failed to keep adequate records as required by section 6001.
Key Points of Law:
- Rule 1006 – Voluminous Writings, Records, or Photographs. The Tax Court applies the Federal Rules of Evidence when deciding evidentiary issues. See 26 U.S.C § 7453. Under Rule 1006, “[t]he proponent [of evidence] may use a summary, chart, or calculation to prove the content of voluminous writings, recordings, or photographs that cannot be conveniently examined in court.” Pursuant to Rule 1006, courts have, for example, allowed a proponent (1) to present summary charts as testimonial aids during testimony, (2) to support closing arguments on issues of computations in a bank deposits analysis, and (3) to fairly summarize testimony already introduced. Rule 1006 presumes that the summary document will not be offered as independent evidence by the proponent. See Kapp v. Commissioner, T.C. Memo. 2019-84, at *87. To comply with Rule 1006, a summary must be “an accurate compilation of the voluminous records sought to be summarized.” United States. v. Janati, 374 F.3d 263, 272 (4th Cir. 2004).
- With regard to Rule 1006, the Tax Court in Kohout noted: “After review of the record, we do not find that any of the bank statements that Exhibits 66–P through 69–P purport to summarize are so voluminous as to make their comprehension “difficult and inconvenient.” The largest statement is 58 pages long, which is not so voluminous as to necessitate a summary for our comprehension. Moreover, it appears that Exhibits 66–P through 69–P contain more than mere summaries of the entities’ bank account statements.” Moreover, when accounting records purporting to summarize lost data are not contemporaneously maintained but are created in anticipation of trial and go beyond the scope of the underlying documents they summarize, the Tax Court may refuse to admit such summaries. See Thunstedt v. Commissioner, T.C. Memo. 2013-280.
- Burdens of Proof. Generally, the IRS’s determinations are presumed correct, and the taxpayer bears the burden of proving the IRS’s determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
- Taxpayers are required to maintain records sufficient to establish the amounts of allowable deductions and to enable the IRS to determine the correct tax liability. See 26 U.S.C. § 6001; Hradesky v. Commissioner, 65 T.C. 87 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976). “A taxpayer’s self-serving declaration is generally not a sufficient substitute for records.” Fine v. Commissioner, T.C. Memo. 2013-248, at *4.
- Taxpayers bear the burden of proof on new issues raised in their amendments to petitions. See Rule 142(a); Jabari v. Commissioner, T.C. Memo. 2017-238.
- Gross Receipts. Gross receipts reported on a return are admissions that must be overcome by cogent evidence. See Estate of Hall v. Commissioner, 92 T.C. 312, 337–38 (1989); Lare v. Commissioner, 62 T.C. 739, 750 (1974), aff’d without published opinion, 521 F.2d 1399 (3d Cir. 1975).
- The Tax Court is not required to, and generally will not, rely on a taxpayer’s testimony to decide whether the taxpayer’s gross receipts are less than the amounts reported on their tax returns. Biazar v. Commissioner, T.C. Memo. 2004-270, slip op. at 5. Vague, conclusory, and contradictory testimony is generally unpersuasive to the Tax Court, and a taxpayer’s position supported solely by such testimony will, more likely than not, be insufficient to present “cogent evidence” to overcome the admissions regarding the amount of gross receipts reported on a tax return.
- Passthrough Loss for a Partner. Generally, a partner can deduct his or her share of a partnership’s loss for a taxable year only to the extent of the adjusted basis of his or her partnership interest at the end of the year. 26 U.S.C. § 704(d). A partner’s outside basis is increased in part by the partner’s distributive share of income and the partner’s contributions to the partnership. at §§ 705(a)(1), 722. Any increase in a partner’s share of liabilities or assumption of partnership liabilities also increases the partner’s outside basis. Id. at § 752(a). A partner’s basis is decreased by the partner’s distributive share of partnership losses, nondeductible expenses, and distributions. Id. at §§ 705(a)(2), 733. If the partner cannot establish his or her adjusted basis in his interest, then he or she cannot deduct any partnership losses. See id. at § 704(d); Sennett v. Commissioner, 80 T.C. 825, 829–30 (1983), aff’d, 752 F.2d 428 (9th Cir. 1985).
- “Proof of basis is a specific fact which the taxpayer has the burden of proving.” O’Neill v. Commissioner, 271 F.2d 44, 50 (9th Cir. 1959), aff’g T.C. Memo. 1957-193.
- Form Over Substance. The Tax Court generally respects the form of a transaction; however, the Court will apply the substance over form principles when warranted. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 57 (2013). Courts evaluating a transaction for economic substance and business purpose exercise common sense, looking at the totality of evidence and focusing on “the specific transactions at issue, not the activities of the entity as a whole.” Curtis Inv. Co., LLC v. Commissioner, 909 F.3d 1339, 1347 (11th Cir. 2018) (quoting Kearney Partners Fund, LLC, ex rel. Lincoln Partners Fund, LLC v. United States, 803 F.3d 1280, 1295 (11th Cir. 2015)), aff’g T.C. Memo. 2017-150. When the form of the transaction has not actually altered any cognizable economic relationships, the substance of a transaction, rather than its form, will be given effect. See Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978); Gregory v. Helvering, 293 U.S. at 469–70; Ocmulgee Fields, Inc. v. Commissioner, 613 F.3d 1360, 1368–69 (11th Cir. 2010), aff’g 132 T.C. 105 (2009).
Insights: A summary, chart, or calculation to prove the content of voluminous records may be appropriate and admissible, but the Tax Court, as seen in the Kohout opinion, is quite comfortable with the financial data in, for example, bank statements that are 58-pages in length. A summary of voluminous records must be an accurate compilation of the underlying data; thus, a constructed summary of reconstructed accounting data is a recipe for evidence that lacks credibility or that will be deemed inadmissible by the Tax Court. And, an accounting “reconstructionist” may attempt to reconstruct a taxpayer’s return through the taxpayer’s testimony or word, but the underlying records—bank statements and evidence of transfers—are a better and more probative source for the substance of a taxable transaction. Gross receipts reported on a return are admissions that must be overcome by cogent evidence. A taxpayer is unwise to attempt to reconstruct a tax return solely through testimony and while also disregarding the data in the returns that were in fact filed with the IRS. Finally, when under audit by the IRS, it is advisable to refrain from altering the taxpayer-under-audit’s tax and accounting records.