Williams v. C.I.R.

• Decision Date: 14 July 1993
• Docket Number: No. 92-2385,92-2385
• Citation: 999 F.2d 760
• Parties: -5501, 93-2 USTC P 50,404 Melvin WILLIAMS; Mary Williams, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 760

999 F.2d 760

72 A.F.T.R.2d 93-5501, 93-2 USTC P 50,404

Melvin WILLIAMS; Mary Williams, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 92-2385.

United States Court of Appeals Fourth Circuit.

Argued May 4, 1993.

Decided July 14, 1993.

Joseph L. Gibson, Jr., Silver Spring, MD, argued, for petitioners-appellants.

John A. Nolet, Tax Div., U.S. Dept. of Justice, Washington, DC, argued (James A. Bruton, Acting Asst. Atty. Gen., Gary R. Allen, Kenneth L. Greene, on brief), for respondent-appellee.

Before MURNAGHAN and WILLIAMS, Circuit Judges, and BUTZNER, Senior Circuit Judge.

OPINION

MURNAGHAN, Circuit Judge:

Taxpayers Melvin and Mary Williams have appealed the United States Tax Court's assessments of tax deficiencies against them. The Internal Revenue Service (IRS), using documents, cash and valuable items seized from the Taxpayers' residence in connection with a grand jury investigation of possible criminal violations of federal narcotics laws--an investigation that never yielded an indictment--applied the "source and application of funds method" to determine tax deficiencies for the years 1980 through 1984. The Taxpayers as Appellants have challenged the Notices of Deficiency as arbitrary and erroneous, claiming that the Commissioner of Internal Revenue failed to produce predicate evidence to connect them to the drug related activities that the IRS claimed generated the unreported illegal income. The Appellants also have claimed that the Notices of Deficiency disguised a criminal charge of drug distribution for which they had never been indicted by a grand jury. Consequently, they have contended, the determination of deficiency denied them due process of law.

I.

Melvin Williams has a history of illegal drug activities which includes an arrest in 1963, a conviction in 1974 for conspiracy to distribute narcotics (resulting in a 15 year prison sentence), and a conviction in 1985 for attempting to possess cocaine with the intent to distribute in violation of 21 U.S.C. § 841(a)(1) and 18 U.S.C. § 2.

Evidence admitted at the criminal proceeding for his 1985 conviction established that in 1984 he had attempted to purchase four kilos of cocaine for $100,000 from an undercover agent. A witness who had turned state's evidence, Walter Robinson, testified at that trial that he began purchasing cocaine from the Taxpayer for commercial distribution in 1983, and that the Taxpayer employed the use of a beeper service to facilitate his drug distribution activities.

In 1984, in connection with another grand jury investigation of possible additional criminal violations of federal narcotics and tax laws, the IRS, agents of the Drug Enforcement Agency (DEA), and the Baltimore City Police seized various documents, cash, and valuable items from the Taxpayers' residence. Although there was no grand jury indictment, the IRS began to determine unreported income with respect to the 1980 through 1984 tax years. (Mary Williams had filed joint tax returns with Melvin Williams for 1981, 1982 and 1983, and was assessed deficiencies only for those years.) The IRS used the "source and application of funds method," which involved a computation of the Appellants' known sources of funds, and a calculation of their outlays of cash for major purchases, personal living expenses, investments, and bank deposits. Where the applications of funds exceeded known sources of funds, the difference was determined to be unreported income.

Notices of Deficiency were issued to the Taxpayers. The Notices included deficiencies in reported income as well as additions to tax consisting of fines for fraud and additions for substantial understatement of income. The Taxpayers timely petitioned for a redetermination. In an amended answer the Commissioner of Internal Revenue sought increased deficiencies.

At trial, the Tax Court heard evidence on the methodology used by the IRS to derive individual entries in their source and application of funds analysis. The Tax Court also admitted into evidence a transcript of testimony by Walter Robinson in response to questioning on direct examination at Melvin Williams' 1985 criminal trial. The testimony, admitted over hearsay objections, was intended to connect Melvin Williams to involvement in illegal drug activities in the early 1980's. The IRS could not produce Robinson himself as a witness, since he had been placed in the Federal Witness Protection Program as a result of his earlier testimony.

At the end of the testimony, the Appellants again objected to the introduction of the Robinson testimony, arguing that they had had no opportunity to cross-examine Robinson and that the exhibit offered by the Commissioner failed to include Robinson's cross-examination testimony at the 1985 trial. The parties then agreed to submit a joint exhibit that would include the trial transcript pages that contained Robinson's testimony both on direct and on cross-examination.

The Tax Court held that the Commissioner's determinations of unreported income were not arbitrary and that thus the burden was on the Taxpayers to show that the determinations were incorrect. In reference to the additional deficiencies noted in the Commissioner's amended answer, the Tax Court stated that generally the burden would be on the Commissioner to sustain the burden of proof on all "new matters" pleaded. However, it found that the Commissioner was not required in this case to bear the burden of proof under the new matter doctrine because the additional deficiencies noted in the amended answer derived from applications obtained by reexamining the original unreported income theory rather than from a new theory. Thus the amended answer with some additional calculations of deficiencies did not provide a true "new matter."

The Tax Court noted that given the circumstances of the case, the Commissioner was probably not required to produce predicate evidence connecting the Taxpayers to illegal activity in order to retain the presumption of correctness on the original Notice of Deficiency. It went on to find, however, that the Commissioner had introduced such evidence. The Tax Court also found the source and application of funds method used by the Commissioner to be reasonable. It then considered, item by item, the amounts disputed in the Commissioner's source and application of funds analysis, and upheld them in large part. Finally, the Tax Court sustained the additions to tax for fraud and substantial understatement. The Taxpayers' motion for Reconsideration was denied and the Taxpayers have appealed.

II.

On appeal, Appellants have argued that there was an inadequate evidentiary foundation for the Commissioner's determinations of unreported income and that thus the Notices of Deficiency were arbitrary. They also have contended that the determinations were tantamount to a criminal charge brought forth by the Government in the form of a Notice of Deficiency, and therefore violated their Fifth Amendment right to indictment by a grand jury. ^*

A taxpayer is required to keep sufficient records to enable the Commissioner to determine his or her correct tax liability. In the absence of such records, the Commissioner may compute the taxpayer's income by any method that clearly reflects income. Where the taxpayer has failed to report amounts of income, and where available records are not sufficient otherwise to establish income, the Government may employ indirect methods. See Sutherland v. Commissioner, 32 T.C. 862, 866-67, 1959 WL 1050 (1959); Holland v. United States, 348 U.S. 121, 130, 75 S.Ct. 127, 133, 99 L.Ed. 150 (1954); 26 U.S.C. §§ 6001 and 446(b).

The Commissioner reconstructed the Taxpayers' income for the years at issue using the source and application of funds method, which has long been regarded as a reasonable method of determining income. See United States v. Johnson, 319 U.S. 503, 517, 63 S.Ct. 1233, 1240, 87 L.Ed. 1546 (1943); Taglianetti v. United States, 398 F.2d 558, 562 (1st Cir.1968); Meier v. Commissioner, 91 T.C. 273, 295-96, 1988 WL 85980 (1988). The source and application of funds method, sometimes referred to as the cash expenditures method, is based on the assumption that the amount by which a taxpayer's applications of funds exceeds his known sources of assets and income is taxable income, absent some showing by taxpayer of a nontaxable source. The Commissioner's determinations, derived from the application of funds method and announced in the Notice of Deficiency, are presumed correct, and the taxpayer bears the burden of proving that the determinations are arbitrary or erroneous. See Helvering v. Taylor, 293 U.S. 507, 515, 55 S.Ct. 287, 79 L.Ed. 623 (1935); Liddy v. Commissioner, 808 F.2d 312, 314 (4th Cir.1986).

Consistent with the presumption of correctness of the Commissioner's determinations of deficiencies, the Tax Court generally will not look behind the statutory notice of deficiency to examine the evidence used, the propriety of the Commissioner's motive, the administrative policy, or the procedure followed in making the deficiency determination. Anastasato v. Commissioner, 794 F.2d 884, 886-887 (3rd Cir.1986); Dellacroce v. Commissioner, 83 T.C. 269, 280, 1984 WL 15606 (1984). However, some courts have declined to accord a presumption of correctness to the Commissioner's determination of unreported income (legal or illegal) where the Commissioner simply relies on the presumption without introducing any evidence linking the taxpayer to the income generating activity in question. See Anastasato, 794 F.2d at 887; Gerardo v. Commissioner, 552 F.2d 549, 554 (3rd Cir.1977).

"The evidence of record must at least link the taxpayer with some tax-generating acts, such as the purchase or sale of controlled substances." Llorente v. Commissioner, 649 F.2d 152, 156 (2nd Cir.1981).

The Appellants have charged that the Commissioner failed to establish a link between Melvin Williams...