Gaskins v. Internal Revenue

UNPUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
 MARK D. PRIDGEN; DEWEY R.
GASKINS,
Petitioners-Appellants,
and
KAY D. PRIDGEN; FRANCINE P. No. 99-2313 GASKINS,
Petitioners,
v.
INTERNAL REVENUE,
Respondent-Appellee. 
Appeal from the United States Tax Court.
(T. Ct. Nos. 97-2048, 97-2075)
Argued: September 27, 2000
Decided: January 22, 2001
Before WILLIAMS and KING, Circuit Judges, and
HAMILTON, Senior Circuit Judge.
Affirmed by unpublished per curiam opinion.
COUNSEL
ARGUED: Trawick Hamilton Stubbs, Jr., STUBBS & PERDUE,
P.A., New Bern, North Carolina, for Appellants. Charles Foster Mar-
shall, III, Tax Division, UNITED STATES DEPARTMENT OF JUS-

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TICE, Washington, D.C., for Appellee. ON BRIEF: Paula M.
Junghans, Acting Assistant Attorney General, Ann B. Durney, Tax
Division, UNITED STATES DEPARTMENT OF JUSTICE, Wash-
ington, D.C., for Appellee.
Unpublished opinions are not binding precedent in this circuit. See
Local Rule 36(c).
OPINION
PER CURIAM:
In 1987, Mark D. Pridgen and Dewey R. Gaskins ("the taxpayers"),
along with Harry Lee Roberts,1 formed Beaufort Leaf Tobacco Com-
pany, a North Carolina general partnership, for the principal purpose
of buying and selling tobacco; they continued in business until 1992.
In this appeal, we are called upon to decide whether the United States
Tax Court erred in finding the taxpayers liable for deficiencies, inter-
est, and penalties due on their 1990 and 1991 federal income tax
returns because Beaufort Leaf failed to report all of its income from
sales of tobacco and failed to substantiate alleged tobacco purchases
claimed as cost of goods sold. We hold that the tax court did not err
in finding that the unreported sales of excess and nonexistent quota
tobacco fell within the scope of the partnership business under North
Carolina law and that the tax court did not err in disallowing unsub-
stantiated tobacco purchases claimed as cost of goods sold. Finally,
we hold that the tax court’s finding that the taxpayers are liable for
accuracy-related penalties under I.R.C. § 6662 is not clearly errone-
ous. Accordingly, we affirm the decision of the tax court.
I.
On November 1, 1996, the Commissioner of the Internal Revenue
Service issued notices of deficiency to Mark D. and Kay D. Pridgen
1Roberts was deceased at the time of the hearing before the tax court.
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and to Dewey R. and Francine P. Gaskins for the taxable years 1990
and 1991. In addition to the deficiencies, the Commissioner assessed
penalties for the taxable years in question.2 On February 3, 1997, the
Pridgens and the Gaskinses filed petitions for redetermination of the
deficiencies and penalties. The United States Tax Court had jurisdic-
tion over the petitions pursuant to I.R.C. §§ 6213(a) and 7442. The
tax court consolidated the cases for trial, briefing, and opinion. In a
Stipulation of Facts filed on March 3, 1998, the parties agreed that
Kay D. Pridgen and Francine P. Gaskins were entitled to innocent
spouse relief for the taxable years in question under I.R.C. § 6013(e).
On July 13, 1999, the tax court entered decisions sustaining the Com-
missioner’s determinations against the taxpayers. On September 27,
1999, the taxpayers filed a timely notice of appeal.
In the Stipulation of Facts, the parties agreed that
[u]nder Beaufort Leaf’s oral partnership agreement, each
partner held a one-third distributive share of all partnership
income, gain, loss, deduction, or credit (computed after tak-
ing into account guaranteed payment of $30,000 to Mr.
Roberts for each taxable year). Mr. Roberts caused Beaufort
Leaf to file a U.S. Partnership Return of Income (Form
1065) for each of the taxable years 1990 and 1991.
(J.A. at 22.) Roberts was responsible for the day-to-day operations
and management of Beaufort Leaf, while the taxpayers financed the
partnership operations by co-signing a note for $300,000.
2For taxable year 1990, Pridgen was assessed a deficiency of $129,169
and a penalty under I.R.C. § 6662(a) of $25,834; for taxable year 1991,
Pridgen was assessed a deficiency of $232,416 and a penalty under
§ 6662(a) of $46,483. For taxable year 1990, Gaskins was assessed a
deficiency of $131,723 and a penalty under § 6662(a) of $26,345; for
taxable year 1991, Gaskins was assessed a deficiency of $240,086 and
a penalty under § 6662(a) of $48,017. An addition to tax pursuant to
I.R.C § 6651(a)(1) of $12,004 was also assessed against Gaskins for the
1991 taxable year. The deficiencies were determined based upon adjust-
ments to each taxpayer’s distributive share of Beaufort Leaf’s net income
for each taxable year.
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The marketing of tobacco is regulated by the United States Depart-
ment of Agriculture ("USDA"), which uses a quota system to control
the amount of tobacco bought and sold. See generally 7 U.S.C.A.
§§ 1311-1316 (1999 & Supp. 2000) (providing overview of statutory
quota system); Cole v. USDA, 33 F.3d 1263, 1265-66 (11th Cir. 1994)
(providing an overview of the statutory and regulatory framework).
"The amount of tobacco marketed is controlled by a quota system that
establishes an allotment to each tobacco-producing farm." Cole, 33
F.3d at 1265. A penalty is specified in 7 U.S.C.A. § 1314(a) for the
marketing of tobacco in excess of a producer’s allotment. Dealers
who resell excess-quota tobacco also are subject to a penalty. See 7
C.F.R. § 723.410(g) (1993).
The USDA monitors the marketing of excess-quota tobacco
through a record-keeping system designed to account for all tobacco
sales and purchases. As an integral part of this record-keeping system,
dealers, like Beaufort Leaf, are required to keep a Dealer’s Record on
form MQ-79 issued by the USDA. Cole, 33 F.3d at 1265. The form
MQ-79 is a comprehensive record filed weekly with the Agricultural
Stabilization and Conservation Service ("ASCS") that reports the date
and amount of each purchase or resale of tobacco, the identity of the
seller or purchaser, the pounds purchased, the price, and a running
balance of the amount of tobacco on hand after each transaction. See
7 C.F.R. § 723.404 (1983). When purchases or resales are made at
auction, the dealer’s MQ-79 lists the warehouse at which the purchase
or sale is made and is signed by a warehouse representative.
As explained by the Eleventh Circuit in Cole,
The [USDA] issues a marketing card to each producer. A
marketing card shows the producer’s total allotment or
quota; every time the producer sells tobacco, the quantity of
the sale is noted on the card. Purchasers from a producer
should, and as a practical matter do, look at the producer’s
card at the time of each purchase; and thus, it is readily
apparent to any purchaser when the producer has sold his
quota of tobacco. In addition, parties who purchase tobacco
(including dealers) are required to report the amount of each
purchase to the USDA. Similarly, each purchaser is required
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to report each resale. Thus there is a reported accounting
each time the ownership of a pound of tobacco changes.
Cole, 33 F.3d at 1265-66.
Roberts personally performed all buying and selling of tobacco for
Beaufort Leaf during the taxable years 1990 and 1991. According to
documents entered into evidence and to witness testimony, all of Rob-
erts’s tobacco sales were made in Beaufort Leaf’s name, and all
checks were made payable to Beaufort Leaf. Many of Roberts’s sales,
however, were not deposited in the partnership bank account or
recorded on the partnership books. Beaufort Leaf’s Forms 1065
reported gross receipts from tobacco sales of $1,264,700 in 1990 and
$2,849,451 in 1991.3 According to the Stipulation of Facts, the gross
receipts reported on Beaufort Leaf’s Forms 1065 were computed by
their accountant solely based upon the deposits made into Beaufort
Leaf’s bank accounts and were reduced by deposits identified by Rob-
erts as borrowed funds.
For both 1990 and 1991, the unreported gross receipts, as deter-
mined by the Commissioner, represent proceeds from sales of tobacco
that were not deposited into Beaufort Leaf’s bank account and were
not otherwise reflected in the partnership’s books or records. In 1990,
Beaufort Leaf’s MQ-79s, along with three receipts documenting the
sale of tobacco by Beaufort Leaf to one E.D. Peagram, showed total
tobacco sales of $2,153,228. Of this amount, Beaufort Leaf reported
only $1,264,700 of these sales on its return. Thus, the Commissioner
determined that in 1990 Beaufort Leaf failed to report $888,528 of
Roberts’s sales as partnership income.
Similarly, the Commissioner determined that tobacco sales in 1991
totaled $3,904,027 instead of the $2,849,451 shown on Beaufort
Leaf’s returns. As a result, the Commissioner increased Beaufort
Leaf’s income by $1,054,576 for 1991. The unreported sales are doc-
umented by a list of 247 checks from warehouse auction sales that
were made payable to Beaufort Leaf but not deposited into its
account. This list of undeposited checks also reports the amount and
3These figures are rounded to nearest whole dollar.
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date of each sale and the name of the warehouse where the sale took
place. Of these unreported sales, seventy-five took place in Big Dixie
Warehouse, which taxpayer Gaskins purchased in 1990, and six took
place in Bob Clark’s Warehouse, in which taxpayer Pridgen had an
ownership interest.
The Commissioner sent the taxpayers notices of deficiency for
1990 and 1991, determining that the unreported tobacco sales consti-
tuted income to Beaufort Leaf and that the taxpayers were liable for
the tax on their distributive shares of this income. The Commissioner
also disallowed $429,421 of Beaufort Leaf’s cost of goods sold for
1990 and $1,173,203 of its cost of goods sold for 1991 because those
amounts did not represent ordinary and necessary business expenses.
The Commissioner also assessed the taxpayers accuracy-related pen-
alties under I.R.C. § 6662 because they substantially understated their
tax liability, or, in the alternative, because their understatement was
due to negligence. The taxpayers challenged the Commissioner’s
findings and the case proceded to trial before the tax court.
The parties agree that Roberts was engaged in a scheme during
1990 and 1991 to fraudulently use Beaufort Leaf’s MQ-79s. Pursuant
to this scheme, Roberts and other tobacco dealers defrauded the
USDA by selling excess quota or nonexistent quota tobacco. These
dealers conspired together to create nonexistent quota tobacco by
entering false tobacco purchases on bogus dealers’ MQ-79s. The par-
ticipants in this scheme then bought tobacco inventory in cash trans-
actions directly from farmers who had produced excess farm quota
tobacco. With excess quota tobacco purchased directly from the farm-
ers in hand and MQ-79s falsified to make the purchases look legiti-
mate, various bogus and legitimate dealers were able to sell excess
quota tobacco at warehouse auction and make a profit.
The record indicates that this scheme to buy and sell excess-quota
tobacco was masterminded by James V. Wells. At trial, the taxpayers
introduced an examination report of Wells’s tax returns for 1988-
1991 ("the Wells report"), which describes the scheme in detail.
According to the Wells report, Wells used individuals and corporate
entities as nominees and/or alter egos. When the tobacco was sold at
a warehouse, the check was written to the dealer who was the owner
of record. The dealer endorsed the check and handed it over to Wells
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or one of his nominees/alter egos who handled Wells’s money. Often
the endorsed check was cashed and the money was turned over to
Wells or one of his moneymen. Alternatively, the check was depos-
ited into a nominee/alter ego business account, endorsed over to a co-
conspirator, or used directly to purchase an asset. No one in the
scheme reported the receipts.
Roberts was identified by the Wells report as one of the individuals
involved in the scheme. The Wells report also noted that "other indi-
viduals and their controlled corporations were used to launder money
and/or hold assets." Pridgen v. Comm’r, 77 T.C.M. (CCH) 2117
(1999). Among these were Roberts and Beaufort Leaf. Despite Rob-
erts’s involvement with Wells, the tax court found evidence that only
$288,560 of Beaufort Leaf’s unreported sales for 1991 were deposited
into accounts controlled by Wells.
Beaufort Leaf’s Forms 1065 reported that Beaufort Leaf’s cost of
goods sold included tobacco purchases totaling $1,057,163 for 1990
and $2,713,562 for 1991. The tobacco purchases reported on the
Forms 1065 were based primarily upon cancelled checks, plus some
accounting adjustments and entries. One such entry stated that for
1991, Beaufort Leaf had an account payable of $350,000 for tobacco
purchased from Okay Leaf. The tax court found that the cancelled
checks disallowed by the Commissioner are payable to persons identi-
fied in the Wells report "as persons associated with Mr. Wells." Id.
"The same is true of the account payable to Okay Leaf, a company
identified in the [Wells] report as controlled by Mr. Wells." Id. The
taxpayers did not call any of the check payees to testify as to the
nature of the payments made.
Based upon the evidence presented at trial, the tax court sustained
the Commissioner’s determinations of deficiencies and penalties. See
id. First, the tax court found that the unreported tobacco sales consti-
tuted additional income to Beaufort Leaf. The tax court rejected the
taxpayers’ argument that the unreported sales were outside the scope
of the partnership, finding that, at most, only $288,560 of the unre-
ported income for 1991 was related to the Wells scheme. The tax
court discredited the taxpayers’ testimony that they did not know or
approve of Beaufort Leaf’s participation in the Wells scheme, noting
that the taxpayers had financial interests in tobacco warehouses where
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sales in the scheme took place and that the taxpayers were knowl-
edgeable members of a relatively small tobacco community.
Next, the tax court found that the taxpayers were not entitled to
deduct tobacco purchases of $429,421 in 1990 and $1,173,203 in
1991 as cost of goods sold. Although the taxpayers presented evi-
dence of cancelled checks "issued to individuals or entities that were
known tobacco vendors" to substantiate the purchases in question, the
tax court found that the taxpayers failed to verify that the checks were
for actual purchases of tobacco by calling any of the payees to testify.
Id. The tax court further found that the taxpayers’ own evidence
regarding Wells’s scheme suggested that Roberts had issued checks
to the tobacco companies to transmit proceeds from the sale of excess
quota tobacco, after falsifying tobacco purchases on the MQ-79s. Id.
In support of this finding, the tax court noted that the checks disal-
lowed by the Commissioner were written to persons identified in the
Wells report as associates of Wells. Id.
Last, the tax court found that the taxpayers were liable for
accuracy-related penalties under I.R.C. § 6662 for substantially
understating the amount of income tax that they owed. The tax court
ruled that the taxpayers were not entitled to an exception from the
penalties for "reasonable cause" or "good faith," see I.R.C. § 6664(c),
because the tax court previously had found that the taxpayers knew
or approved of Beaufort Leaf’s participation in the Wells scheme.
The taxpayers raise several issues on appeal related to the tax
court’s ruling. The taxpayers argue that the tax court erred by finding,
first, that under North Carolina partnership jurisprudence the sales of
excess and nonexistent quota tobacco fell within the scope of Beau-
fort Leaf’s business and, second, that the taxpayers failed to substanti-
ate tobacco purchases claimed as cost of goods sold. Finally, the
taxpayers assert that the tax court erred by finding them liable for
accuracy-related penalties under I.R.C. § 6662. We address each
argument in turn.
II.
We note at the outset that "[i]t is well established that as a general
matter, the Commissioner’s determination of deficiency is presumed
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correct, and the taxpayer bears ‘the burden of proving it wrong’"
before the tax court. Cebollero v. Comm’r, 967 F.2d 986, 990 (4th
Cir. 1992) (quoting Welch v. Helvering, 290 U.S. 111, 115 (1933));
see also Helvering v. Taylor, 293 U.S. 507, 515 (1935) (noting that
the burden of proof is on the taxpayer to invalidate the Commission-
er’s determination). When the taxpayer appeals a decision of the tax
court, the tax court’s factual findings must be affirmed unless they are
clearly erroneous. Hendricks v. Comm’r, 32 F.3d 94, 97 (4th Cir.
1994). "The tax court’s decision is clearly erroneous only where
‘although there is evidence to support it, on the entire evidence the
reviewing court is left with the definite and firm conviction that a
mistake has been committed.’" Id. (quoting Faulconer v. Comm’r,
748 F.2d 890, 895 (4th Cir. 1984)). However, mixed questions of law
and fact are reviewed de novo when the reviewing court must con-
sider legal concepts and exercise judgment about the values underly-
ing those legal principles. This is particularly true when the tax court
interprets state law and draws conclusions about federal tax liability
based upon characterization of state legal principles. Walters v. Com-
missioner, 48 F.3d 838, 842 (4th Cir. 1995).
We hold that the tax court did not err in finding that, under North
Carolina law, the unreported sales of excess and nonexistent quota
tobacco fell within the scope of Beaufort Leaf’s partnership business.
The North Carolina Uniform Partnership Act states, in relevant part,
(a) Every partner is an agent of the partnership for the pur-
pose of its business, and the act of every partner, including
the execution in the partnership name of any instrument, for
apparently carrying on in the usual way the business of the
partnership of which he is a member binds the partnership,
unless the partner so acting has in fact no authority to act for
the partnership in the particular matter, and the person with
whom he is dealing has knowledge of the fact that he has
no such authority.
N.C. Gen. Stat. Ann. § 59-39(a) (Lexis 1999).
In this case, Roberts was authorized to sell tobacco on behalf of
Beaufort Leaf. According to the Stipulation of Facts, "Roberts person-
ally performed all buying and selling of tobacco for Beaufort Leaf
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during the taxable years 1990 and 1991." (JA 24.) As a general part-
ner of Beaufort Leaf, Roberts was a general agent. Investors Title Ins.
Co. v. Herzig, 360 S.E.2d 786, 789 (N.C. 1987). There is no evidence
to suggest that those with whom Roberts dealt would have had any
reason to know that Roberts was not authorized to sell tobacco to
them. For example, a witness who had purchased tobacco from Rob-
erts testified at trial that because Roberts made all tobacco sales in the
same manner, excess-quota sales would have been indistinguishable
from authorized within-quota tobacco sales. Moreover, the purchasers
made all checks payable to Beaufort Leaf, demonstrating that they
believed they were buying the tobacco from the partnership rather
than from Roberts individually. Although there are circumstances
when a person dealing with an agent bears the responsibility of know-
ing the extent of the agent’s authority, this is not true when dealing
with one who is a general agent. Herzig, 360 S.E.2d at 788. "In such
case the burden is on the principal to show that the other party had
notice of a restriction upon the power of the general agent." Id.; N.C.
Gen. Stat. Ann. § 59-39(a).
Further, the tax court did not find credible the taxpayers’ testimony
that they did not "know of or approve Beaufort Leaf’s participation
in" Roberts’s illegal activities. Pridgen v. Comm’r, 77 T.C.M. (CCH)
2117 (1999). The tax court noted
Both petitioners owned or had a financial interest in tobacco
warehouses and were actively engaged in the tobacco busi-
ness. They are knowledgeable and sophisticated members of
the relatively small community of persons who engage in
that business. We do not believe that Mr. Roberts’ activities
in furtherance of the scheme that petitioners describe as
widespread, could have escaped the attention of both peti-
tioners. Indeed, we note that some of the unreported sales
were made at the warehouses in which petitioners had an
interest. Furthermore, we do not accept the testimony of
each petitioner that he agreed to finance the operation of
Beaufort Leaf by cosigning a note for $300,000 and he took
no action to supervise those operations by reviewing the
partnership’s Forms MQ-79 or taking any other action.
Id. The tax court continued by explicitly rejecting the taxpayers’
assertion that neither they nor Beaufort Leaf realized any proceeds or
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economic benefit from Beaufort Leaf’s participation in the scheme.
The tax court noted that the taxpayers’ testimony left open the possi-
bility that "moneys or economic benefit was received by other per-
sons or entities related to them. It also leaves open the possibility that
moneys or economic benefit was received from someone other than
Beaufort Leaf." Id. Such credibility and factual determinations are
properly within the discretion of the trial court, and, in this case, tax-
payers have not shown that those findings were clearly erroneous.
Given the findings of the trial court, the taxpayers were properly
taxed on their distributive shares of partnership income. Partnerships
are not taxed at the entity level. See I.R.C. § 701. Instead, the individ-
ual partners are taxed on their distributive shares of the partnership
income on their federal income tax returns. See I.R.C. §§ 701-704.
This holds true even if the partner does not actually receive his share
of the income. See, e.g., Treas. Reg. § 1.702-1(a) (stating that "[e]ach
partner is required to take into account separately in his return his dis-
tributive share, whether or not distributed, of each class or item of
partnership income, gain, loss, deduction, or credit" (emphasis
added)). An individual partner also is taxed on his distributive share
even if he is not aware of the income received. See Brooks v. Comm’r,
70 T.C.M. (CCH) 458 (1995) (holding that "[a] partner is taxable on
her distributive share of partnership income regardless of whether she
receives it or is even aware of its existence."). A partner also is taxed
on his distributive share of partnership income when "another partner
has embezzled it without his knowledge." Stern v. Comm’r, 48
T.C.M. (CCH) 605 (1984) (noting that "we have held that the fact that
a partner is somehow defrauded by another partner does not relieve
the deceived partner from tax liability with respect to his or her dis-
tributive share of partnership income"). The Supreme Court pointedly
has noted that "[f]ew principles of partnership taxation are more
firmly established than that no matter the reason for nondistribution
each partner must pay taxes on his distributive share." United States
v. Basye, 410 U.S. 441, 454 (1973).4 The facts, reflected in the record
4The seeming harshness of this rule is mitigated by the theft loss
deduction allowed under I.R.C. § 165(c)(3). "[A]ny loss arising from
theft shall be treated as sustained during the taxable year in which the
taxpayer discovers such loss." I.R.C. § 165(e). In this case, the taxpayers
did not seek such relief.
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and as found by the tax court, require the legal conclusion that each
taxpayer is liable for the tax on his one-third distributive share of the
proceeds from Beaufort Leaf’s unreported tobacco sales.
III.
Taxpayers next argue that the tax court erred in finding that they
failed to substantiate tobacco purchases claimed as cost of goods sold.
The taxpayers bear the "burden of proving the amount of the deduct-
ible expenses since deductions are a matter of statutory privilege and
must be shown by substantial evidence." Nowland v. Comm’r, 244
F.2d 450, 453 (4th Cir. 1957); see also Cummings v. Comm’r, 410
F.2d 675, 679 (5th Cir. 1969) (observing that "the burden is upon the
taxpayer to establish a statutory right to specific deductions and to
substantiate his eligibility therefor"). "Whether the taxpayer has pro-
duced sufficient evidence to support a deduction is a question of fact
which [is reviewed] for clear error." United States v. Wisconsin
Power & Light Co., 38 F.3d 329, 337 (7th Cir. 1994); see also Norg-
aard v. Comm’r, 939 F.2d 874, 877 (9th. Cir. 1991) (same).
In this case, Beaufort Leaf claimed tobacco purchases as cost of
goods sold totaling $1,057,163 for 1990 and $2,713,562 for 1991.
The tax court found that the taxpayers did not substantiate the
amounts disallowed by the Commissioner as purchases of tobacco.
Specifically, the tax court found that the taxpayers’ own evidence
suggested that Beaufort Leaf filed falsified MQ-79s to document pur-
chases of tobacco that Beaufort Leaf never made. The tax court noted
that an audit report indicated that many of the disallowed checks were
issued to persons related to Wells in order to transmit to Wells pro-
ceeds of the scheme. In fact, one of the checks was made payable to
Wells himself. Moreover, the taxpayers’ failure to present any of the
check payees as witnesses raises an "inference drawn from other facts
in the case" that such testimony would have been adverse to the tax-
payers. See, e.g., Wichita Terminal Elevator Co. v. Comm’r, 162 F.2d
513, 515-16 (10th Cir. 1947) ("[A]n inference of fact drawn by [the
tax court] is not to be overturned on review if it is reasonable and has
substantial support in the evidence."); Comm’r v. Scottish American
Inv. Co., 323 U.S. 119, 124 (1944) ("And when the Tax Court’s fac-
tual inferences and conclusions are determinative of compliance with
statutory requirements, the appellate courts are limited to a determina-
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tion of whether they have any substantial basis in the evidence."); see
also Mammoth Oil Co. v. United States, 275 U.S. 13, 52 (1927)
("While [defendant corporation’s agent’s] failure to testify cannot
properly be held to supply any fact not reasonably supported by the
substantive evidence in the case, it justly may be inferred that he was
not in position to combat or explain away any fact or circumstance
so supported by evidence . . . ." (citations omitted)). Furthermore, the
taxpayers did not claim that the checks were issued for any purpose
other than to purchase tobacco or that they were deductible in connec-
tion with an activity other than Beaufort Leaf’s business of purchas-
ing and selling tobacco.
In light of the evidence that Roberts and the payees on the checks
were involved in the Wells scheme, the tax court reasonably did not
unquestioningly accept the checks as evidence of tobacco purchases.
See, e.g., Young v. Comm’r, 57 T.C.M. (CCH) 436 (1989) (refusing
to accept checks at face value as substantiation of rental expenses or
to "place any reliance on the ‘memo references’ appearing on the face
of the checks"); Bailey v. Comm’r, 49 T.C.M. (CCH) 141 (1984)
(finding that checks were not sufficient to support the purchase of ath-
letic equipment as a business expense).
In an attempt to buttress their argument that the tax court erred in
holding that the taxpayers failed to substantiate the disallowed pur-
chases as purchases of tobacco, the taxpayers offer a statistical expec-
tation of income that they argue reflects the evidence and common
tobacco industry expectations. They rely upon evidence provided at
trial, specifically the 1990 and 1991 tax returns for Beaufort Leaf, that
they claim demonstrates that the partnership incurred a net profit
equal to 10-15% of gross sales for the years in question. The taxpay-
ers further argue that these amounts are consistent with cost or profit
margin percentages provided by witnesses for the taxpayers. Beaufort
Leaf’s accountant testified that "if you look at the overall picture,
when it wind [sic] up in the end of the year, I’m thinking 10 to 15
percent would be a pretty good profit." (J.A. at 212.) Another witness
testified that he considered "somewhere around 6 to 7 percent" a nor-
mal gross profit margin for tobacco sales of this kind. (J.A. at 258.)
As a result, the taxpayers argue that reducing the allowed cost of
goods sold in the manner suggested by the Commissioner would
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reflect a level of net income that is simply not consistent with the evi-
dence or with common tobacco industry expectations.
Despite the taxpayers’ suggestions to the contrary, however, the tax
court was not required to estimate the net profit earned by the taxpay-
ers in this case in calculating the allowable cost of goods sold. The
taxpayers primarily rely upon Cohan v. Comm’r, 39 F.2d 540 (2d Cir.
1930). In Cohan, the taxpayer estimated that he had expenses of
$55,000 over approximately a two year period. See id. at 543. "The
Board refused to allow him any part of this, on the ground that it was
impossible to tell how much he had in fact spent, in the absence of
any items or details." Id. The Second Circuit held that the Board of
Tax Appeals went too far in denying the taxpayer any of his expenses.
The court noted, "[a]bsolute certainty in such matters is usually
impossible and is not necessary; the Board should make as close an
approximation as it can, bearing heavily if it chooses upon the tax-
payer whose inexactitude is of his own making." Id.; see also Millikin
v. Comm’r, 298 F.2d 830, 834 (4th Cir. 1962) (recognizing the
"Cohan rule"); Arevalo v. Comm’r, 78 T.C.M. (CCH) 634 (1999) (cit-
ing Cohan). "However, there must be sufficient evidence in the record
to permit the Court to conclude that a deductible expense was
incurred in at least the amount allowed." Arevalo, 78 T.C.M. (CCH)
634.5
Cohan is inapplicable to this case. First, this is a case "where the
claimed but unsubstantiated deductions are of a sort for which the tax-
payer could have and should have maintained the necessary records."
Lerch v. Comm’r, 877 F.2d 624, 628 (7th Cir. 1989). Under such cir-
cumstances "[t]he tax court was under no obligation to guess as to the
amount of the . . . expenses." Buelow v. Comm’r, 970 F.2d 412, 415
(7th Cir. 1992); see also Lerch, 877 F.2d at 628 (following the "pres-
ent trend" in refusing to invoke the Cohan rule where the taxpayer
5Even if estimation were applicable in this case, the taxpayers failed
to present sufficient evidence of average profits earned by tobacco deal-
ers in 1990 and 1991. An assessment of profit margin averages in the
tobacco industry is "specialized knowledge" for which expert testimony
is required. See Fed. R. Evid. 702. Neither of the witnesses who testified
about profit margin averages in the tobacco business was qualified as an
expert.
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failed to maintain the proper records); Lutheran Mut. Life Ins. Co. v.
U.S., 816 F.2d 376, 379 (8th Cir. 1987) (observing that "given the
lack of evidentiary support for taxpayer’s claimed deductions, we
cannot say that the trial court erred in declining to uphold at least
some deduction under Cohan"); Bay Sound Transp. Co. v. U.S., 410
F.2d 505, 511 (5th Cir. 1969) ("The record fails to reveal that [tax-
payer] proved even a portion of his expenses to be deductible."). No
records were maintained to substantiate Roberts’s claim that the disal-
lowed checks were for tobacco purchases. Beaufort Leaf’s accountant
testified that he had no independent knowledge of the purpose of the
disallowed checks. Roberts never provided the accountant "with any
receipts or invoices or other documents to show that these checks
were, in fact, for tobacco purchases." (J.A. at 214.) This is true as well
of the $350,000 account payable "owed" by the partnership to Okay
Leaf.
Second, other courts have distinguished the Cohan estimation of
the cost of goods sold on bases that are likewise applicable here. In
Allen v. Comm’r, 26 T.C.M. (CCH) 493 (1967), the tax court held that
where the Commissioner "did not disallow the expenses claimed in
full and, in fact, allowed a substantial portion of them, petitioner
should come forward with persuasive evidence to establish that he is
entitled to a greater allowance." Id. Similarly, the tax court in Schultz
v. Comm’r, 44 B.T.A. 146, 151 (1941), held Cohan inapplicable in a
case where the Commissioner disallowed approximately 75% of
expenses claimed where the taxpayers offered nothing more than a
general statement of how the amounts were spent. In Schultz, the tax
court noted that the Commissioner "recognized that ‘something was
spent’, and . . . made presumably ‘as close an approximation’ as he
could. There is nothing upon which the Board can base a different or
greater approximation." Id. Like Allen and Schulz, this case is inappo-
site to Cohan. In Cohan, the Commissioner estimated that the tax-
payer had expenses of over $55,000 but refused to allow him any
portion of this amount. Cohan, 39 F.2d at 543. Here, the Commis-
sioner had allowed taxpayers all expenses in 1990 and 1991 that
appeared legitimate—$627,472 in 1990 and $1,000,359 in 1991. The
tax court found that the taxpayers offered no "persuasive evidence"
to establish that they were entitled to a greater allowance because the
disallowed checks were payable to associates of the Wells scheme
and therefore were of questionable authenticity. Thus, the taxpayers
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did not adequately substantiate "the amounts disallowed by respon-
dent as purchases of tobacco." Pridgen, 77 T.C.M. (CCH) 2117.
Based on the facts and the legal analysis above, we find the Cohan
estimation of cost of goods sold inapplicable.
After considering and rejecting all of the taxpayers’ arguments on
this issue, we conclude that the tax court did not err in finding that
the taxpayers failed to substantiate all of the tobacco purchases
claimed as cost of goods sold.
IV.
Finally, the taxpayers argue that the tax court erred in finding that
the taxpayers were liable for accuracy-related penalties in addition to
the tax determined in the notices of deficiency. We review the tax
court’s finding that the taxpayers are liable for penalties "under the
clearly erroneous standard unless ‘there has been an erroneous inter-
pretation of the applicable legal standard.’" Antonides v. Comm’r, 893
F.2d 656, 659 (4th Cir. 1990) (quoting Faulconer v. Comm’r, 748
F.2d 890, 895 (4th Cir. 1984)).
Internal Revenue Code § 6662(a), in conjunction with § 6662(b)(1)
and (2), imposes a penalty equal to 20% of the underpayment of tax
attributable to "[n]egligence or disregard of rules or regulations" or
"any substantial understatement of income tax." I.R.C. § 6662(b)(1),
(2). "[T]here is a substantial understatement of income tax for any
taxable year if the amount of the understatement for the taxable year
exceeds the greater of — (i) 10 percent of the tax required to be
shown on the return for the taxable year, or (ii) $5,000." I.R.C.
§ 6662(d)(1)(A)(i), (ii). The taxpayers in this case qualify for the pen-
alties based on a substantial understatement of their income tax.
Section 6664(c), however, provides a "reasonable cause exception
to penalties imposed under § 6662." Under § 6664(c), "[n]o penalty
shall be imposed under this part with respect to any portion of an
underpayment if it is shown that there was a reasonable cause for such
portion and that the taxpayer acted in good faith with respect to such
portion." I.R.C. § 6664(c)(1). Here, the tax court found that
"[p]etitioners have not shown that there was reasonable cause for the
underpayment in this case or that they have acted in good faith." Prid-
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gen v. Comm’r, 77 T.C.M. (CCH) 2117 (1999). The tax court pointed
to its finding that it "did not accept petitioners’ testimony that they
did not know of or approve Beaufort Leaf’s participation in the
scheme." Id. The taxpayers’ only counter to this finding is that the tax
court continued to use its disregard of the taxpayers’ testimony as its
only theme for upholding the Commissioner’s determination in its
entirety. The tax court, however, was entitled to do so. The tax court
heard all the evidence in this case. It was uniquely situated to make
findings of fact and to judge the credibility of the witnesses. "Where
there are two permissible views of the evidence, the factfinder’s
choice between them cannot be clearly erroneous." Anderson v. City
of Bessemer, 470 U.S. 564, 574 (1985). "The tax court’s assessment
of the credibility of witnesses and its findings of fact are entitled to
substantial deference and are not subject to reversal unless clearly
erroneous." Cebollero v. Comm’r, 967 F.2d 987, 992 (4th Cir. 1992)
(internal quotations omitted). We are unable to hold that the tax
court’s findings on this issue are clearly erroneous.
V.
In conclusion, the tax court did not err in finding that the unre-
ported sales of excess and nonexistent quota tobacco fell within the
scope of Beaufort Leaf’s business under North Carolina law and in
finding that the taxpayers failed to substantiate tobacco purchases
claimed as cost of goods sold. We also affirm the tax court’s determi-
nation that the taxpayers are liable for accuracy-related penalties
under I.R.C. § 6662, as well as deficiencies and interest due on their
1990 and 1991 returns. Accordingly, the decision of the tax court is
affirmed.
AFFIRMED
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