Tax Court In Brief | Barrington v. Commissioner | Guilty Plea To Determine Tax Liability And Constructive Divident Versus Compensation

Barrington v. Commissioner, T.C. Memo. 2022-68 | July 6, 2022 | Buch, J.| Dkt. No. 1781-14

Opinion

Summary: From October 2001 to July 2002, John Stewart Jakows served time in prison for a felony conviction for forgery and theft. After his release, he changed his name to John Edward Barrington joined with his wife, Deanna Barrington, in creating real estate development businesses—referred to here as Barrington Corp.— that were, in reality, a fraud. The Barringtons bilked over $6 million from investors and others. The Barringtons ran all their personal expenses through Barrington Corp. and received no salary. The Barringtons failed to file individual income tax returns, and only one of the three corporations filed an income tax return for 2003, reporting no income and no expenses. The FBI investigated the Barringtons and involved the IRS's Criminal Investigation Division (CI). A grand jury indicted the Barringtons on multiple counts. Ultimately, the Barringtons entered separate guilty pleas, but both pleaded guilty of tax evasion. Documents obtained by the government in pursuit of the Barringtons' cases consisted of more than 10,000 pages. In the pleas, the Barringtons each admitted to receiving unreported income totaling over $600,000 for 2003 through 2005. The plea agreements separated, in various amounts, the unreported income into six categories of personal expenses paid by Barrington Corp.: (1) home mortgage, (2) vehicle and boat, (3) household furnishings, (4) cash/check withdrawal, (5) legal fees, and (6) miscellaneous expenses labeled as "general ledger shareholders equity." The FBI's records were destroyed in 2009 in the ordinary course of its operations. The Barringtons had the opportunity to retrieve the records before their destruction but they did not do so. The IRS, in its civil examination, used the information and figures from the plea agreements as the basis for deficiency determinations and additions to tax for all three years. The Barringtons filed a joint petition challenging the IRS's deficiency determinations, mainly focused on the IRS's determinations of compensation from Barrington Corp. and Mrs. Barrington claimed she incurred expenses that offset her 2003 gross receipts. The case was tried to the Tax Court, and this opinion followed.

Key Issues:

• Whether the Barringtons carried their burden and showed that the IRS's determinations of deficiencies were arbitrary or erroneous when they were based primarily on the Barringtons' guilty pleas in their criminal cases?

Primary Holdings:

• The Barringtons failed to carry their burden. Because the Barringtons failed to report any income for 2003 through 2005, the IRS needed only to present evidence linking the Barringtons to an income-producing activity to shift the burden to them. The IRS did so by presenting the Barringtons' plea agreements, and the Barringtons failed to adequately show the determinations were arbitrary or erroneous.

Key Points of Law:

• Burden of Proof and Production. The IRS's determinations in a notice of deficiency are generally presumed correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The IRS's determinations of unreported income are presumptively correct if supported by a minimal evidentiary foundation linking the taxpayer to an income-producing activity. Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir. 1993), aff'gC. Memo. 1991-636. After the Commissioner produces evidence linking the taxpayer to an income-producing activity, the burden shifts to the taxpayer to prove the determinations are arbitrary or erroneous. Id.
• Income—Admissions from Plea Agreement. Gross income includes all income from whatever source derived. I.R.C. § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955). Section 6001 requires taxpayers to maintain records substantiating their income. If a taxpayer fails to do so, the IRS may reconstruct the taxpayer's income using any reasonable method that reflects income. Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989). The IRS's reconstruction "need only be reasonable in light of all surrounding facts and circumstances" and "is given greater latitude . . . where the case involves an illegal enterprise in which the taxpayer has failed to file a return and has kept no records." Id. at 687, 693. A taxpayer's admissions in a plea agreement from a prior criminal proceeding as to the amount of his or her unreported income is strong evidence of that amount. Ephrem v. Commissioner, T.C. Memo. 2014-12, at *6–7.
• Characterization of Income. Whether a corporation's payment of personal expenses of a shareholder who is also an employee is a constructive dividend or compensation is a question of fact. Smith v. Commissioner, T.C. Memo 1995-410, 70 T.C.M. (CCH) 502, 506; Manning v. Commissioner, T.C. Memo. 1993-127, 65 T.C.M. (CCH) 2221, 2237.
• Constructive Dividends. Section 61(a)(7) provides that gross income includes dividends. A dividend is a distribution from a corporation to its shareholders out of earnings and profits. I.R.C. § 316(a). A corporation may formally declare dividends, but a constructive dividend occurs when "a corporation confers an economic benefit on a shareholder without the expectation of repayment." Magnon v. Commissioner, 73 T.C. 980, 993–94 (1980). Corporate payments for personal shareholder expenses that serve no corporate business purpose may be treated as constructive dividends to the shareholder. Strong v. Commissioner, T.C. Memo. 2005-125, 89 T.C.M. (CCH) 1339, 1351.
• Section 61(a)(1) provides that gross income includes "[c]ompensation for services, including fees, commissions, fringe benefits, and similar items." Payments from a corporation to a shareholder warrant close scrutiny to determine whether they are more appropriately construed as compensation for services or dividends. Wienke v. Commissioner, T.C. Memo. 2020-143, at *32. When shareholders were actively involved in business operations but received little to no salary, the payment of personal expenses may be treated as compensation. See In Smith, 70 T.C.M. (CCH) at 506; Ghosn v. Commissioner, T.C. Memo. 1995-192, 69 T.C.M. (CCH) 2508, 2510.
• Business Expenses. Taxpayers bear the burden of proving their entitlement to deductions. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Section 6001 requires taxpayers to maintain records sufficient to establish the amount of each deduction. Failure to present such records counts heavily against a taxpayer's attempted proof. See Rogers v. Commissioner, T.C. Memo. 2014-141, at *17. Section 162(a) generally allows a deduction for ordinary and necessary expenses paid in carrying on a trade or business. See R.C. § 162(a); Rule 142(a). If the taxpayer establishes that an expense is deductible but cannot substantiate the precise amount, the Tax Court may estimate the amount, bearing heavily against the taxpayer. Cohan v. Commissioner, 39 F.2d at 543–44; Mileham v. Commissioner, T.C. Memo. 2017-168, at *36; see Vanicek v. Commissioner, 85 T.C. 731, 742–43 (1985).
• Additions to Tax. The IRS may determine additions to tax for failure to timely file returns under section 6651(a)(1), and the amount may be increased rate on account of fraud pursuant to I.R.C. § 6651(f). Section 6651(a)(2) also allows a determination for additions to tax for failure to timely pay, and section 6654 allows for additions to tax for failure to make estimated tax payments under section 6654 for each year. The supervisory approval requirement of section 6751(b) does not apply to any addition to tax under section 6651 or 6654. See R.C. § 6751(b)(2); see Hendrickson v. Commissioner, T.C. Memo. 2019-10, at *26, aff'd, 125 A.F.T.R.2d 2020-2185 (6th Cir. 2020).

Insights: Guilty pleas in a criminal case can be used by the IRS to determine tax liability. When the Barringtons entered their pleas, voluminous documents, including their own records, were available, yet they failed to retrieve them. Later, they blamed the destruction of the records as a basis to challenge the IRS's determination, and the Tax Court gave them little pity over that circumstance. Their admissions in the plea agreements from the prior criminal proceedings constituted strong evidence of the amounts used by the IRS to determine the Barringtons' tax liability. And, the Barringtons' income from Barrington Corp. constituted compensation because they were made in exchange for their efforts at Barrington Corp., the Barringtons were not mere shareholders, and they never received a salary. The IRS's determination that those payments were compensation and taxable as such was reinforced by the Barringtons' practice of putting personal commissions into the corporate accounts before using them to pay personal expenses. Because commissions are a form of compensation, the practice so engaged by the Barringtons shows consistent funneling of the Barringtons' compensation through Barrington Corp.

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