Cole v. Comm'r of Internal Revenue, 10–2194.

• Decision Date: 28 March 2011
• Docket Number: No. 10–2194.,10–2194.
• Parties: Scott C. COLE and Jennifer A. Cole, Petitioners–Appellants,v.COMMISSIONER of INTERNAL REVENUE, Respondent–Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

637 F.3d 767

107 A.F.T.R.2d 2011-1493

2011-1 USTC P 50,301

Scott C. COLE and Jennifer A. Cole, Petitioners–Appellants,

v.COMMISSIONER of INTERNAL REVENUE, Respondent–Appellee.

No. 10–2194.

United States Court of Appeals, Seventh Circuit.

Argued Oct. 22, 2010.Decided March 28, 2011.

Scott C. Cole (argued), Brownsburg, IN, pro se.Jennifer A. Cole, Brownsburg, IN, pro se.Bruce R. Ellisen, Damon Taaffe (argued), Attorneys, Department of Justice, William J. Wilkins, Attorney, Internal Revenue Service, Washington, DC, for Respondent–Appellee.Before KANNE, TINDER, and HAMILTON, Circuit Judges.TINDER, Circuit Judge.

Appellants Scott C. and Jennifer A. Cole (a married couple from Brownsburg, Indiana) ran into trouble with the Internal Revenue Service (IRS) in 2003, when a revenue agent began auditing their 2001 joint tax return. Through this audit, the agent discovered a web of corporate and partnership entities serving dubious purposes, undocumented financial transactions, and inconsistent reports regarding the Coles' income. Incongruously, although Scott engineered much of the financial and legal tangle that landed him and Jennifer in hot water with the IRS, Scott is a licensed Indiana attorney with a practice focused on business planning and tax matters. We outline the confusing maze of entities and financial dealings below, but be forewarned that much of it makes little business or legal sense as the Coles fail to dispel the perception underlying the Tax Court's finding that the perplexing arrangements served as nothing but after-the-fact attempts to avoid taxation on the substantial income Scott earned in 2001.

Background

Scott and his brother Darren T. Cole formed a partnership called the Bentley Group on February 2, 1998. Under the partnership agreement, each was entitled to an “equal share of the net profits and losses ... unless all partners agree to a different proportion.” The Cole brothers, as licensed Indiana attorneys, did business as Cole Law Offices. Scott incorporated Scott C. Cole, P.C. (SCC) on October 28, 1997, as an Indiana professional corporation. Scott filed SCC's first and only tax return for tax year 2000 on March 25, 2005. SCC was declared the 99% owner of the Bentley Group (with Darren the remaining 1% owner) in the Bentley Group's 2001 tax return, filed November 10, 2004. Scott does not explain why he purportedly divested his interest in the group (or why his brother divested all but 1% of his interest), but the only documentary evidence of the transfer is that Bentley Group 2001 tax return filed in 2004. The Indiana Secretary of State administratively dissolved SCC on September 5, 2001, for failing to file mandated business entity reports. Scott also created JAC Investments, LLC. Scott reported on JAC's 2001 tax return that Jennifer Cole owned 50% of JAC and her family trust owned another 49%. Scott reported owning the remaining 1%, yet he generated all of JAC's income from legal services he performed independent of the Bentley Group.

The Bentley Group's operations appeared to hum modestly along prior to 2001. Darren managed the practice; his wife Lisa worked as a paralegal. As noted above, Scott's practice involved business planning and taxation. He created limited liability companies, prepared corporate and individual tax returns, and represented clients before the IRS. The trio had signature authority over the group's checking account. Scott and Darren agreed to deem withdrawals beyond amounts earned as borrowed money. In 1999, the group reported total income at $46,121 and deductions of $46,609 (including rent, repairs, and maintenance and other business-related deductions) for an ordinary income loss of $488. In 2000, the group reported $69,698 in total income and $68,393 in deductions for an ordinary income gain of $1,305. This unexceptional pattern of business changed drastically in 2001.

From one perspective, 2001 was the group's banner year financially. Yet the Coles' bungled management of their revenue bonanza turned their partnership's good fortunes into a fiscal calamity. A substantial portion of the 2001 revenue—a whopping $1.2 million—came from the group's biggest client: the co-trustees of the George Sandefur Living Trust. Trustees Constance J. Gestner and Terri L. Haynes made four payments of $300,000 between June 18, 2001, and July 5, 2001, for Scott's legal services for the trust. The trustees made the first check payable to “Scott Cole and Associates” and the other three checks payable to “Cole Law Office.” All four checks were deposited into the Bentley Group's account. Gestner signed an affidavit on April 12, 2005, stating that the trustees “retained Scott Cole as the Attorney to represent the Trust and to help us with any and all Trust and Estate matters.” The affidavit states that she was “fully advised by Scott Cole that his Attorney's fee would exceed the usual and ordinary maximum fee for legal services of an unsupervised administration of an estate of ten percent (10%),” that she consented to Scott's $1.2 million fee, and that she was “very satisfied with the legal representation of Scott Cole.” For tax year 2001, the Bentley Group reported $1,583,900 in gross receipts and ordinary income with no deductions. Despite Scott's financial windfall in 2001, he filed for bankruptcy in 2002, but in that proceeding failed to disclose any interest in the Bentley Group, Cole Law Offices, or any other law practice. As noted above, tax year 2001 was the year the Cole brothers maintained to the IRS that they transferred 99% of their ownership interest in the Bentley Group to Scott's professional corporation SCC (which also became defunct in 2001). But don't forget that the Bentley Group's 2001 return wasn't filed until near the end of 2004, well after the Coles learned that an audit was underway. The timing of this financial sleight of hand did not go unnoticed by the IRS or by the Tax Court judge.

The IRS began auditing the Coles' 2001 joint return in 2003. After meeting with Scott fairly early in the audit process, the IRS learned of the brothers' involvement with the Bentley Group and the investigation expanded to include Darren and Lisa's 2001 joint tax return. The IRS was not favorably impressed with the Bentley Group's belated 2001 tax return. Although the 2001 return reported Darren with a 1% interest and SCC with a 99% interest in the Bentley Group, the return also reported no “distribution of property or a transfer ... of a partnership interest during the tax year.” The Bentley Group's 2000 return declared each Cole brother as a 50% owner of the group. The Cole brothers did not file employment tax returns or report the purported divestment of their Bentley Group interest on their respective joint tax returns filed with their spouses. Although the Bentley Group's 2001 return was not filed until November 2004, SCC did not exist as of September 5, 2001, and never filed a 2001 return.

Scott and Jennifer's 2001 joint tax return reported $100,358 in total income and $100,276 in adjusted gross income. Through various deductions, exemptions, and credits, they took their reported taxable income down to $18,265 with a tax liability of $505. Both Scott and Jennifer signed the self-prepared return on April 11, 2002. Yet in 2001, Scott withdrew $1,173,263 from the Bentley Group's bank account. Darren and Lisa withdrew $198,308. Despite the lack of documentation, Scott and Jennifer argue that Scott's withdrawals were “investment loans” from the Bentley Group. For example, Scott made or authorized transfers of $340,000 and $300,000 to J & D Investments, LLC. Scott also “invested” $150,000 in Larkin Investments, LP. Testimony at trial indicated that both companies were managed by Scott's friends. Scott also loaned $10,000 to his brother Mark Cole for Mark's roofing company. Scott also loaned $125,865.50 to MR Parts, LLC (operated by Scott's church colleagues) and $10,400 to Houses Restored to Homes, LLC (managed by Scott's father). Scott also gave his mother $50,000 from the Bentley account to invest in MR Parts. Scott loaned his father $40,000 from the Bentley account and told his father to pay him back by giving $40,000 to Scott's church in Scott's name. Scott and Jennifer claimed a $40,000 charitable deduction yet did not report any of that money as taxable wages or self-employment income.

The IRS auditors discovered separate from the Bentley Group that JAC had total deposits of $95,446 in 2001. Nearly all of the deposits were checks made out to Scott, not JAC. The IRS determined that only $15,794 was nontaxable, but the Coles only reported self-employment tax on $1,162 of JAC's income. Scott also deposited $79,294 into Jennifer's checking account in 2001, of which $59,264 was from Scott's legal practice. This money paid for school tuition, music lessons, and residential landscaping. None of these deposits were reported as income.

Because the Coles did not maintain adequate books and records, IRS auditors reconstructed their 2001 earnings by employing two well-established indirect methods of identifying a person's income. The first was the “specific items” method, which examines evidence of specific amounts of a taxpayer's unreported taxable income, such as the Coles' withdrawals from the Bentley Group's bank account and other sources. See United States v. Medel, 592 F.2d 1305, 1314 n. 8 (5th Cir.1979); 35A Am.Jur.2d Federal Tax Enforcement § 1208. Second, the IRS performed a “bank deposits” analysis of the Coles' income from other sources. This method assumes that all money deposited in a taxpayer's account in a certain period constitutes income, taking into account known nontaxable sources and deductible expenses. See Clayton v. Comm'r, 102 T.C. 632, 645 (1994) (citing DiLeo v. Comm'r, 96 T.C. 858, 867 (1991), aff'd 959 F.2d 16 (2d Cir.1992)); Estate of Mason v. Comm'r, 64 T.C. 651, 656 (1975) (citing e.g., Boyett v. Comm'r, 204 F.2d 205 (5th Cir.1953)...