Bedeian v. Commissioner

Sophie Bedeian, Petitioner v. Commissioner of Internal Revenue, Respondent Bedeian v. Commissioner Docket No. 6073-66 United States Tax Court 54 T.C. 295; 1970 U.S. Tax Ct. LEXIS 213; February 12, 1970, Filed *213 Decision will be entered under Rule 50. 1. Held, respondent was justified in employing the net worth increase plus nondeductible expenditures method of income reconstruction to determine the deficiencies. 2. Held, further, for purposes of computing petitioner's net worth as of the end of each of the taxable years, (1) an automobile owned by petitioner and used by her only for personal purposes is included in assets at cost, unadjusted for any decrease in value, and (2) the amount of liability on a note does not include the portion of add-on obligations (i.e., discount and filing fee) remaining unpaid. 3. Held, further, on the facts, petitioner's liabilities as of Dec. 31, 1962, included a $ 1,000 debt. James B. McGrath, for the petitioner. Roy S. Fischbeck, for the respondent. Featherston, Judge. FEATHERSTON *296 Respondent*214 determined deficiencies in and additions to petitioner's income tax for 1961 and 1962 as follows: Additions to the tax, sec. 6653(a), Year Deficiencies I.R.C. 1954 [1961] $ 728.44 $ 36.42 [1962] 510.54 25.53 Petitioner has not contested the additions to the tax. The following issues are presented for decision: (1) Whether respondent was justified in employing the net worth increase plus nondeductible expenditures method of income reconstruction to determine the deficiencies. (2) Whether petitioner's net worth as of December 31, 1961 and 1962, should be adjusted to reflect the decrease in value of an automobile used only for personal purposes. (3) Whether the amount of petitioner's liability on a note as of December 31, 1962, includes the portion of add-on obligations (i.e., discount and a filing fee) remaining unpaid. (4) Whether petitioner's liabilities as of December 31, 1962, include a debt in the amount of $ 1,000 to one Lou White. FINDINGS OF FACT At the time her petition was filed petitioner was a legal resident of Bettendorf, Iowa. She timely filed her individual income tax returns for 1961 and 1962 with the district director of internal revenue, Des*215 Moines, Iowa. Petitioner's return for 1961 reported taxable income of $ 2,081.30, based on wages of $ 3,900, less itemized nonbusiness deductions of $ 1,218.70 and a personal exemption of $ 600. Her 1962 return disclosed taxable income of $ 223.97, based on wages of $ 1,200, rental income of $ 100, a loss of $ 170.13 from the operation of a laundromat, a longterm capital gain includable in income to the extent of $ 406.50, itemized deductions of $ 712.40, and a personal exemption of $ 600. During 1961 and 1962 petitioner was employed as manager, barmaid, and waitress at Gus's Tavern (hereinafter referred to as the *297 tavern). Under the terms of her employment she received wages plus a percentage of the business profits. She and the owner of the business maintained a joint bank account in which deposits of business receipts were made periodically. As manager of the tavern petitioner was responsible for the preparation of original records of cash receipts and disbursements, as well as daily summary sheets. Three sets of these daily records were kept by petitioner, one set for herself and one set each for the owner and the bookkeeper. Other than a limited number of these *216 daily summary sheets, petitioner did not maintain any personal books or records of her wages or profits received from the tavern during 1961 and 1962. Early in 1963 petitioner's income tax returns for 1961 and 1962 were assigned to a revenue agent for examination. In response to his request for all of the books and records she used in the preparation for her returns for 1961 and 1962, petitioner produced some daily cash records of the tavern and referred the agent to the tavern's bookkeeper for other records. The agent obtained from the bookkeeper some books of original entry for daily transactions of the tavern. Examination of these records, however, disclosed the absence of ledger sheets, cash register tapes for approximately one-half of the business days, and incomplete sets of daily records. Moreover, discrepancies existed among the three sets of daily records, in that for particular days the records did not agree as to the amounts of certain expenses. The amount of the tavern profits distributed to petitioner could not be determined from the available records, and, consequently, the records could not be reconciled with the information appearing on petitioner's returns. In*217 addition, petitioner engaged in a laundromat business from February to July 1962, and no adequate records were available from this operation. Accordingly, respondent used the net worth increase plus nondeductible expenditures method of reconstructing taxable income to determine the disputed deficiencies. It is stipulated that petitioner's personal expenditures for 1961 and 1962 were $ 4,870.76 and $ 3,691.99, respectively. At the close of 1960, 1961, and 1962 petitioner's assets included the following: Item Dec. 31, 1960 Dec. 31, 1961 Dec. 31, 1962 Cash on hand $ 25.00 $ 25.00 $ 25.00 Cash deposited: Bettendorf Bank & Trust 28.55 54.13 208.93 Oscar Mayer Credit Union 180.76 191.66 Real estate: 1906 Grant, Bettendorf 13,500.00 13,500.00 13,500.00 Less depreciation (240.00) 406 W. 8th, Davenport 9,550.00 Real estate contract, 406 W. 8th 9,550.00 Total 13,734.31 23,320.79 23,043.93 *298 In December 1960 petitioner purchased, at a cost of $ 6,076.50, a 1960 Cadillac automobile, which she used for personal purposes and owned at the close of the calendar years 1960, 1961, and 1962. In 1964 she sold the automobile for*218 $ 1,700. In the net worth increase computation on which the deficiency determination was based, respondent included the automobile as an asset in the amount of $ 6,076.50 at the end of each year 1960, 1961, and 1962, without any adjustment for depreciation or other decrease in value. At the close of 1960, 1961, and 1962 petitioner's liabilities included the following: Item Dec. 31, 1960 Dec. 31, 1961 Dec. 31, 1962 Real estate contract, 1906 Grant $ 5,937.76 Bettendorf Bank & Trust: Note dated 12/5/60 1,595.70 Real estate mortgage dated 8/2/61 $ 9,825.18 $ 7,964.07 Liability ledger -- notes 1,000.00 Davenport Bank & Trust 4,000.00 Real estate contract, 406 W. 8th 5,258.83 Total 7,533.46 15,084.01 12,964.07 In addition to the foregoing liabilities, petitioner executed a promissory note on February 5, 1962, to the Bettendorf Bank & Trust Co. in the amount of $ 2,918.88, payable in 24 equal monthly installments of $ 121.62. This note included the renewal of a prior obligation of $ 2,105, an advance of $ 500, a filing fee of $ 1, and discount (interest) of $ 312.88. Petitioner made monthly payments on the note during the rest of 1962, *219 leaving a balance due of $ 1,702.68 at the end of that year. In computing petitioner's net worth as of December 31, 1962, respondent treated $ 1,516.63 as the amount of the liability on the note, eliminating the portion ($ 186.05) of the discount and filing fee attributable to the period subsequent to that date. Also, in 1962 petitioner borrowed $ 1,000 from Lou White, and the debt remained unpaid at the end of the year. It was repaid in 1963. In computing petitioner's net worth as of December 31, 1962, respondent did not include the $ 1,000 debt among petitioner's liabilities. Respondent's computation of petitioner's increase in net worth and understatement of adjusted gross income was as follows: Item [1962] Net worth -- end of year $ 14,313.28 $ 14,639.73 Net worth -- beginning of year 12,277.35 14,313.28 Net worth increase 2,035.93 326.45 Adjustments to net worth: 1 Add personal expenses paid 4,870.76 3,691.99 Adjusted gross income: As redetermined 6,906.69 4,018.44 Per return 3,900.00 1,536.37 Understatement of adjusted gross income 3,006.69 2,482.07 *299 *220 OPINION The first issue is whether respondent was justified in employing the net worth increase plus nondeductible expenditures method to reconstruct petitioner's taxable income. We think he was. Since petitioner's income included a percentage of the profits of the tavern, and she maintained no adequate personal records, respondent could look beyond the Form W-2 furnished by her employer. See Barry Meneguzzo, 43 T.C. 824, 832 (1965). Her taxable income could be verified only by determining the amount of the tavern's profits paid to her; yet its records were incomplete and inconsistent. See Holland v. United States, 348 U.S. 121, 131-132 (1954); Schwarzkopf v. Commissioner, 246 F. 2d 731 (C.A. 3, 1957), affirming a Memorandum Opinion of this Court. Finally, petitioner had no income from nontaxable sources during the years in question, and a probable taxable source of the unreported income -- the tavern -- existed. See Holland v. United States, supra at 137-138. The net worth method may properly be employed in these circumstances. Bodoglau v. Commissioner, 230 F. 2d 336*221 (C.A. 7, 1956), affirming 22 T.C. 912 (1954); Morris Lipsitz, 21 T.C. 917, 931 (1954), affd. 220 F. 2d 871 (C.A. 4, 1955), certiorari denied 350 U.S. 845 (1955). Turning to the contested items in respondent's computations, there is no merit in petitioner's contention that the value of the Cadillac automobile acquired in 1960, used exclusively for nonbusiness purposes, should be reduced each year for depreciation. This argument misconceives the theory of the net worth method as a tax-measuring device. The term "net worth" in this context does not mean the economic affluence of the taxpayer, but instead means the difference, as of the end of the taxable year, between the value of his assets in terms of actual expenditures therefor and his liabilities. The reference is to the tax basis of an asset, not to its fluctuating market value. See 10 Mertens, Law of Federal Income Taxation, sec. 55.19, p. 116 (1964 ed.); Balter, Tax Fraud and Evasion 10.52-10.53 (3d ed. 1963). Thus, items such as depreciation -- which affect value but entail no current outlay -- are taken into*222 account only if they are deductible; otherwise the "net worth increase" for each year, which is one of the components of adjusted gross income as computed by the method, would be reduced by an amount which could not be deducted in computing taxable income. 1 *300 Consequently, the decrease in value during 1961 and 1962 of the automobile, for which a depreciation deduction was not allowable, has no relevance in determining petitioner's taxable income. See 30 J. Taxation 378, 379 (1969). While petitioner's "net worth" from an economic standpoint was no doubt affected by deterioration of the automobile, this was not so for purposes of a net worth computation. See Holland v. United States, supra at 125;*223 Schultz v. Commissioner, 278 F. 2d 926, 932 (C.A. 5, 1960), remanding on other grounds 30 T.C. 256 (1958). Lenske v. United States, 383 F. 2d 20 (C.A. 9, 1967), on which petitioner relies, is distinguishable in that the property there involved was depreciable for tax purposes. The next issue involves petitioner's claim that her note payable to Bettendorf Bank & Trust Co. should be shown as a liability as of December 31, 1962, in the amount of $ 1,702.68 rather than $ 1,516.63. As disclosed by our findings, the difference in these two sums represents the unpaid part of the discount and filing fee originally included in the principal amount of the note. Here, again, the theory of the net worth method must be borne in mind. The loan made available to petitioner only the net amount of the principal sum, not including the add-on obligations. Only such net amount was reflected in newly acquired assets. Repayments on the note will absorb an equal amount of assets, and included in the repayments will be a proportionate amount of deductible interest. See John Randolph Hopkins, 15 T.C. 160, 181 (1950);*224 cf. Bayou Verret Land Co., 52 T.C. 971, 985-986 (1969). But until the discount or other add-on obligation is actually paid or otherwise becomes deductible, it may not be taken into account in computing petitioner's net worth. See 30 J. Taxation 378, 380 (1969). There remains the question concerning the $ 1,000 debt owed to Lou White at the close of 1962. The record relating to this item is not as complete as it might be, but we have found as a fact that petitioner borrowed the money and had not repaid it by the end of the year. Petitioner so testified, and there is no evidence to the contrary. While petitioner's testimony as to the manner in which the debt was repaid in 1963 is not consistent with the revenue agent's understanding of a May 1968 conversation with petitioner, we believe this inconsistency was due to petitioner's nervousness and lack of ability to articulate. There is no inconsistency as to the truly relevant fact -- the existence of the debt as of December 31, 1962 -- or the fact that it was ultimately repaid. Decision will be entered under Rule 50. Footnotes 1. Petitioner received no income from nontaxable sources during 1961 and 1962.↩ 1. Alternatively, were the decline in value of a nondepreciable asset reflected in the computation of the assets, that same amount would have to be added to the "net worth increase" as a "nondeductible expenditure." The result would be the same as disregarding such diminution in value in initially computing the assets.↩