Funds Deposited to Taxpayer's Account Were Held in Trust for Her Boss, Amounts Generally Not Taxable to Her

The credibility of a taxpayer when testifying can often make or break a case at the Tax Court.  That is especially true when the taxpayer is claiming certain defenses—such as the claim that funds the taxpayer deposited into her bank account were not truly her income, but that of her employer.

In the case of Na v. Commissioner, TC Memo 2015-21 the taxpayer’s testimony was found to be credible.

Ms. Na worked for Artnouveau City USA, Inc., a company owned and operated by Doo Young Choi.  Mr. Choi also owned and operated another company (Artmonde, LLC) and he established the working hours for Ms. Na and she worked on the premises of Artnoveau.

Artnoveau reported income paid to Ms. Na on Form 1099MISC and she reported such income on her tax return on Schedule C, reporting a principal business activity of “offices of real estate agents and brokers.”  She normally reported income of less than $100,000, as established by the testimony of the CPA that had been preparing her returns for more than 10 years. 

The only exception to that was in 2008 when she reported gambling winnings of $1,421,385 along with her other income.  On Schedule A she reported gambling losses that offset those winnings which had been reported to her Forms W-2G. 

The return was selected by the IRS for examination.  When the IRS looked at Ms. Na’s bank accounts they found substantial deposits being made into the accounts.  Based on a bank deposits analysis the IRS determined that over $1,000,000 of additional income should be reported by Ms. Na based on deposits for which a nontaxable source was not identified.

Ms. Na did not claim that these deposits represented transfers from other accounts she had or gifts—rather, she claimed she received these funds on behalf of her boss, Mr. Choi and transferred them to his accounts, holding the funds in trust and acting as a mere conduit for Mr. Choi.

The gambling was also the income of Mr. Choi. Ms. Na herself did not like gambling, but her boss had her accompany him to casinos and obtain player’s cards in her name that he would use.  When Mr. Choi won, the winnings ended up being reported to Ms. Choi on the Forms W-2G.

She also would make payments for various luxury items for Mr. Choi out of her account, using the funds that were directed into the account by Mr. Choi.  That included paying for Mr. Choi’s Mercedes.

The Tax Court points out that, generally, the bank deposits analysis method is a valid technique to establish a presumption that amounts represent income.  The burden is not on the IRS to establish where that income originated from—rather, the burden is on the taxpayer to explain why the deposits did not represent income.  That is due to the general broad income rule of IRC §61 that requires inclusion of all income from whatever source derived.

In this case there was no question the funds went into Ms. Na’s account, an account over which she had sole signature authority.  However, the Court points out that, despite this fact, the amount may not be income if Ms. Na lacks accession to the wealth because of the fact she is holding the funds as a mere conduit.

The Court, citing the case of James v. United States, 366 U.S. 213 (1961), noted that to establish this fact the taxpayer must show that she received the funds:

·      Subject to a consensual recognition (either express or implied) of an obligation to repay the funds or

·      Subject to restrictions on the disposition of the funds

The opinion notes that the Tax Court (and the Ninth Circuit Court of Appeals where an appeal of the opinion would be heard) have generally found against the taxpayer on such issues where the only testimony is that of the taxpayer and the testimony is vague and improbable or other evidence does not exist to corroborate the taxpayer’s claims. However, if the Court finds the taxpayer’s testimony credible the mere fact that there may not exist detailed corroborative evidence will not be fatal to the taxpayer’s claims.

In this case the Court generally found Ms. Na’s testimony to be credible.  As the opinion notes:

We found Ms. Na’s testimony remarkable, but not incredible. And crucially, other evidence in the record corroborates it: Mr. Chyun credibly testified to Ms. Na’s history of reporting no more than $100,000 of income. He also testified to a conversation with Ms. Na, occurring at the time of the events concerned, in which she provided the same explanation for her gambling winnings as the one she offered at trial.

And, more importantly, what other evidence existed was wholly consistent with her story.  For that reason the Court generally accepted her claim that most of the income was not hers.

However the Court did note that she had not offered an explanation for just under $80,000 of the deposits in question.  For those amounts the Court did find that Ms. Na was required to pay tax (including self-employment tax) on that income.

The case provides a clear example of the simple rule that taxpayers must be able to explain amounts that they receive during the year but claim are not income—the burden is not on the IRS to show it’s income once the IRS can show the taxpayer received it.  As well, if a taxpayer is claiming that, for whatever reason, amounts deposited into the account are not income, it is very important that evidence aside from the taxpayer’s own statements be consistent with the story the taxpayer is telling.