Opinion
Civil Action No. 02-699, USBC Adv. No. 00-02262, USBC Dkt. No. 00-20773
December 9, 2002
U.S. Dept. Justice, Attn. Gerald A. Role, Esq., Washington, DC, for Appellant's
Calaiaro Corbett, Attn. J. Craig Brungo, Esq., Pittsburgh, PA, for Apellee's
OPINION and ORDER OF COURT
The United States Department of the Treasury, Internal Revenue Service ("Appellant" or "IRS"), appeals from an order of January 28, 2002, by U.S. Bankruptcy Judge Bernard Markovitz, finding that Manuel J. Xenakis ("Appellee") owes the IRS a pre-petition debt of $1,360 in unpaid excise taxes, penalties in the amount of $340, and interest to be calculated by the parties. For the reasons set forth in the opinion which follows, the order of the Bankruptcy Court is affirmed.
I. INTRODUCTION
A. Factual History
The underlying facts of this case are set out in detail in an earlier opinion In re: Xenakis v. United States. Dep't of the Treasury, IRS, 281 B.R. 585 (W.D. Pa. 2001). Briefly stated, Appellee served sixteen months in prison in 1994-1995 as a result of his participation in a numbers racket from December 1989 through July 1991. When he was released, the IRS informed him that he owed wagering excise tax arising from unreported illegal income. Mr. Xenakis refused to pay, claiming that he had merely been a middleman who had received a flat fee for his services rather than a percentage of the profits; he further claimed that the fees had been reported as "miscellaneous income" on his federal income tax returns each year.
In August 1995, the IRS issued assessments totaling $700,066.25, including $371,065.00 for unpaid taxes, $236,235.75 for accrued interest and $92,765.50 for penalties. Appellee filed for voluntary bankruptcy under 11 U.S.C. § 701 et seq. on February 4, 2000, claiming assets of $58,275.11, and debts of $993,249.33, which included $873,455.77 owed to the IRS. Mr. xenakis filed suit against the IRS in Bankruptcy Court in the Western District of Pennsylvania on June 22, 2000, seeking, inter alia, a determination that the tax on his wagering activities (including principal, interest and penalties) was dischargeable under § 523(a)(7) of the Bankruptcy Code.
Prior to trial, the government admitted that it had apparently misplaced the file containing the information on which the tax assessments were based. Mr. Xenakis claimed that failure to produce these records damaged his case in that he would be unable to carry his burden at trial to produce evidence to rebut the assessments. After an expedited hearing held on January 30, 2001, the Bankruptcy Court ordered that because the IRS was unable to produce its file on Mr. Xenakis, the IRS would be prohibited from entering into evidence any material from that file. However, the court simultaneously ruled that "this Order is without prejudice to the Plaintiff's request that the Internal Revenue Service be prohibited from entering its assessment(s) into evidence at trial. That issue will by decided by the Trial Judge."
At a trial held on February 7, 2001, Mr. Xenakis testified that he did not receive a percentage of the bets but only a flat payment of $250 each week and that the weekly winnings, if any, from his activities in the Pittsburgh area were delivered intact to the organizer of the numbers game. The IRS offered only a single witness, a bankruptcy specialist charged with the task of responding to Mr. Xenakis' complaint. In order to compile the necessary facts for the response, she had reviewed IRS computer records known as "the literal transcripts." She testified that she did not prepare the information in the literal transcripts; did not know if there were clerical or arithmetic errors in the calculation of the assessment or entry errors in the process of recording data into the computer; had no records in court to substantiate the assessment; and had no personal knowledge of how it was made. Finally, she testified that she could not determine from the literal transcripts the extent of the assessment (i.e., whether it was based only on Mr. Xenakis' activities in Pittsburgh or in many areas) or who did the assessment. The IRS did not present any records to support the assessment either at trial or with its post-trial brief.
Over Appellee's objections at trial, the Bankruptcy Judge accepted the assessment of liability prepared by the IRS. Xenakis v. United States, 262 B.R. 339 Bankr. W.D. Pa. 2001). He found that under 11 U.S.C. § 523 (a)(1)(B)(i), the wagering excise tax and the interest thereon were not dischargeable because Mr. Xenakis had failed to comply with IRS regulations regarding monthly reports of wagering income. However, the penalty on the unpaid assessment was dischargeable under § 523(a)(7)(B) inasmuch as it was imposed on unpaid taxes for a period more than three years prior to filing for bankruptcy. Xenakis, 262 B.R. at 345-346.
B. The Initial Appeal
Mr. Xenakis filed a timely appeal with this Court on May 23, 2001, pursuant to 28 U.S.C. § 158 (a)(1) and 11 U.S.C. Bankr. Rule 8001, as an appeal from a final order of a Bankruptcy Court Judge in the United States Bankruptcy Court for the Western District of Pennsylvania. in an opinion dated November 16, 2001, I concluded that the Bankruptcy Court had properly applied the law in determining that the wagering excise tax and accrued interest which the IRS assessed was not dischargeable in bankruptcy under 11 U.S.C. § 523 (A)(7). Xenakis, 285 B.R. at 590. However, I also held that although the IRS had established the connection between Mr. Xenakis and the numbers racket during the period in question, thus linking him to the illegal tax generating activity, the amount of the assessment could not be determined because the records on which it had been presumably based were excluded by the Bankruptcy Court after the IRS admitted that the administrative file had been lost. Thus, despite the "presumption of correctness" which generally applies to the government's calculations of tax owed, the amount of tax could only be described as arbitrary because there was no evidence from which it could be calculated. I therefore remanded the case to the Bankruptcy Court for further proceedings to determine the correct amount of taxes and interest owed. In all other regards, the opinion of the Bankruptcy Court was affirmed.
C. The Bankruptcy Court proceedings on Remand
On remand, the Bankruptcy Court held a hearing on this matter on January 28, 2002. (Transcript of Hearing, Bankruptcy Record Item 50, "Transcript.") There, counsel for the IRS stated that "we have no evidence beyond the initial assessments which we put into evidence at the first proceeding here." (Transcript at 2.) Mr. Xenakis did not testify or offer other evidence. The IRS proposed that
a possible way to proceed would be for us to come up with a figure . . . based on the testimony that Judge Ambrose looked at, calculate the percentage. We will stipulate to that as being what the amount would be under the District Court's formulation, you know, without conceding that we believe that's valid. And, then take it from there. The Court could enter an order in that amount.
(Transcript at 5.)
The Bankruptcy Judge stated, "I'm not going to compute the taxes, . . . I wouldn't know how to start." (Transcript at 6.) Mr. Xenakis then offered his calculation that based on gambling receipts of $4,000 a month for 17 months, the tax due totaled $1,360 plus penalties and interest. (Id. at 10.)
The Bankruptcy Court then entered an Order of Court, noting that
although we are not confident that debtor's self-serving numbers are true and correct, we are constrained by the memorandum opinion and order of the District Court and the failure of IRS to offer any evidence to the contrary. Accordingly, we find that debtor's numbers reflect the amount of his debt to IRS.
(Order of Court dated January 28, 2000, "Order of Court," at 2.)
The Court therefore concluded that the amount owed by Mr. Xenakis to the IRS was $1,360 plus unpaid penalties in the amount of $340 and interest to be calculated by the parties. (Order of Court at 3)
The IRS filed a Notice of Appeal on February 7, 2002. After a stay of several months requested by the Appellant for purposes of achieving a negotiated settlement (Docket Nos. 2 and 3), Appellant filed a brief in which it argued that the Bankruptcy Court had not erred in its first analysis, i.e., affording the tax assessment a presumption of correctness and finding that Mr. Xenakis had failed to meet his burden to rebut that presumption. ("Appellant's Brief," Docket No. 4, at 4.)
II. JURISDICTION AND STANDARD OF REVIEW
This Court has jurisdiction over the appeal pursuant to 28 U.S.C. § 158 (a)(1) and 11 U.S.C. Bankr. Rule 8001, as an appeal from a final order of a Bankruptcy Court Judge in the United States Bankruptcy Court for the Western District of Pennsylvania. A district court may affirm, modify or reverse a bankruptcy judge's judgment, order or decree, or remand with instructions for further proceedings. 11 U.S.C. Bankr. Rule 8013.
III. LEGAL ANALYSIS
In its Statement of Issues to be Presented on Appeal, the IRS outlines the following:
Whether debtor lacked standing to challenge his tax liability in this proceeding?
Whether the bankruptcy court was required to abstain from considering debtor's challenge to his tax liability?
Whether the assessments made against debtor were entitled to a presumption of correctness?
Whether debtor presented evidence sufficient to rebut the presumption of correctness?
Whether debtor presented legally sufficient evidence to establish his tax liability?
(Bankruptcy Record, Item NO. 47, dated February 15, 2002.)
The standing and abstention issues are not addressed in Appellant's Brief and therefore will not be addressed in this Opinion. Nor will I reiterate the reasoning by which I concluded that the tax liability as originally determined by the IRS was based on a naked assessment," since it is clear from the January 28, 2002 hearing transcript that although both the IRS and the Bankruptcy Judge disagreed with my conclusion, there was no confusion about the concept. Moreover, Appellant's arguments about the reasoning or analysis of the November 2001 opinion should have been more properly raised in a motion for reconsideration.
I make only two points. First, the IRS appears to misconstrue the shifting burden of proof and persuasion in a case such as this even though the process has been clearly set out by the Third Circuit Court of Appeals as follows:
The government meets its initial burden of proof in an action to collect tax merely by introducing its deficiency determination. The presumption of correctness establishes a prima fade case, but it arises only if supported by foundational evidence connecting the taxpayer with the tax-generating activity. The presumption shifts the burden of proof to the taxpayer. If the taxpayer rebuts the presumption by showing that it is arbitrary and erroneous, the presumption disappears. . . . If the taxpayer rebuts the presumption with credible and relevant evidence sufficient to establish that the determination was erroneous, the procedural burden of going forward with the evidence shifts to the Commissioner. we further held, however, that the ultimate burden of proof or persuasion remains with the taxpayer. If the taxpayer offers evidence that the determination was Incorrect, and the Commissioner offers no evidence to support the assessment, the taxpayer will have met his ultimate burden unless such evidence is specifically rejected as improbable, unreasonable or questionable.Anastasato v. Comm'r, 794 F.2d 884, 887 (3d Cir. 1986) (internal citations and quotations omitted).
Here, the IRS introduced its assessment and evidence that tied Mr. Xenakis to the tax-generating activity, i.e., his own testimony that he had participated in the Sabatini numbers racket. The Bankruptcy Court properly determined the assessment was thus entitled initially to the presumption of correctness, and shifted the burden of proof to Mr. Xenakis to show that the assessment was arbitrary and erroneous. what failed to occur was a recognition that Mr. Xenakis successfully carried that burden by showing that the assessment could only be arbitrary because the evidence on which it was based had been excluded through a prior ruling of the Bankruptcy Court. Thus, according to Anastasato, the burden of going forward with additional evidence to support the assessment shifted to the IRS. Even if no such evidence was offered, Mr. Xenakis could still have lost the battle if the Bankruptcy Court determined that any evidence he presented was "improbable, unreasonable or questionable."
My decision that the IRS had presented a naked assessment was based on the fact that the Bankruptcy Court had expressly excluded any documentary evidence allegedly in the lost administrative file. AS supreme Court stated in United States v. Janis, "if what was seized . . . cannot be used in the formulation of the assessment. . . . the determination of tax then may be one without rational foundation and excessive and not properly subject to the usual rule with respect to the burden of proof in tax cases. . . . Certainly, proof that an assessment is utterly without foundation is proof that it is arbitrary and erroneous." 428 U.S. 433, 441-42 (1976). I agree with the conclusion reached in Coleman v. United States, 704 F.2d 326, 329 (6th Cir. 1983), that "it is difficult to conceive more direct evidence of a naked assessment without any foundation whatsoever than the government's own concessions that it is without any reports, work papers and other documents to support its conclusions." (Emphasis added.) Thus, this case falls into the category of exceptions to the presumption of correctness discussed in United States v. Schroeder, 900 F.2d 1144, 1149 (7th Cir. 1990), that is, "where records supporting an assessment are excluded from evidence or are non-existent so that the basis upon which an assessment is calculated is beyond the knowledge of the court, the assessment is arbitrary and erroneous." (Emphasis added.) The burden of proof thus shifted to the IRS to offer alternative evidence to support the assessments.
The cases cited by Appellant as basis for its argument that an assessment may be given preclusive effect "if supported by foundational evidence connecting the tax-payer with the tax-generating activity" are not persuasive because the issue in each of those cases was precisely whether that connection existed, not whether there was evidence of the volume of illegal activity. The courts in those cases were confronted with situations where there was sufficient, often irrefutable, documentary evidence, e.g., betting slips or record books, that the tax-payer received a certain volume of illegal income. Therefore, the only question before the court was whether that level of income could be extrapolated to a period for which there was no clear evidence of participation See e.g., Carson v. United States, 560 F.2d 693 (5th Cir. 1977) where the Court accepted a "reverse projection" of gambling activity for the periods January 1971 and August 1971 through January 1972, based on the amount of gambling revenue reflected in betting slips for a one-week period, seized on January 15, 1972. Here, although there was a minor dispute about whether Mr. Xenakis was involved for seventeen rather than twenty months, the question was not involvement, but volume. To determine an assessment which is not arbitrary, the court must have both.
DiMauro v. United States, 706 F.2d 882 (8th Cir. 1983); Gerardo Comm'r., 552 F.2d 549 (3d Cir. 1977); and Anastasato. (Appellant's Brief at 6.) Palmer v. IRS, 116 F.3d 1309 (9th Cir. 1997) is inapposite because the initial issue there was whether the government's method of reconstructing unreported income was reasonable inasmuch as it was based only on cost-of-living statistics for taxpayers' region and minimal reported income. However, the court concluded that the Palmers had waived this argument because it had only been raised in an untimely motion. Id. at 1312. While the court did not specifically accept that method of reconstruction, it did conclude that it was not irrational to extend the unreported income thus calculated to each of the four tax years in question. Id. at 1313.
In Carson, Texas state law enforcement officers seized betting slips and other documents the taxpayer used to record wagers. Working solely from those records, the IRS agents made three excise tax assessments based on the volume of bookmaking activity that occurred during the week of the search. For two of those periods, there was evidence that Carson had rented a duplex where he conducted his bookmaking activities, had extra telephone lines installed, and borrowed money purportedly to pay off bets. Carson v. United States, 560 F.2d 693, 694 (5th Cir. 1977). The court accepted this as a reasonable basis on which to uphold a reverse projection of comparable income based on the records seized during the search. Id. at 698-99. However, for a third period, there was no evidence of involvement in any gambling activity other than one $10 notebook entry for May 1969 and a "cryptic statement" in an IRS report that a review of the records seized "revealed that taxpayer received wagers in both August and November of 1970." Id. at 697-98. On appeal, the IRS simply stated, "With respect to (the 1970-71) assessments, then, the Government relies entirely on the presumption of correctness." In dismissing that assessment, the court stated that the government's "bald reliance" on the presumption of correctness, if accepted, "would support the most arbitrary of assessments so long as the taxpayer found himself unable to prove a negative, frequently difficult in quite innocent circumstances. (This) does not become the government's agents, and we readily reject it." Id. at 698.
By way of example, suppose the penalty imposed by the government for illegal wagering were a flat fine of $10,000.00 for each month in which it could be proven the bookmaker was in operation, regardless of whether he accepted bets of one dollar or one million dollars during that month. Then, the only question here would be whether Mr. Xenakis owed the IRS $170,000 or $200,000 for his admitted Participation in the Sabatini gambling ring. But since the penalty is a 2% excise tax on the amount of wagers placed with the taxpayer, it is essential that the government be able to show — or at least project — on a rational basis, the dollar amount of that activity, otherwise the basis of the 2% calculation is necessarily arbitrary.
Contrary to Appellant's argument that Mr. Xenakis knew what the base amount was because he stated in his pretrial stipulation in the Bankruptcy Court that he had been assessed gambling tax on "an estimate of the entire gambling operation of several states" (Appellant's Brief at 7-8), this argument must also fail. The Third Circuit has made it clear that an estimate of the entire proceeds of a numbers racket which involves more than one person cannot be assessed to only one of them in the absence of evidence that he did not receive the total proceeds of the activity. Walker v. Comm'r, 757 F.2d 36, 42 (3d Cir. 1985) (where government failed to provide "minimal Predicate evidence" to establish that taxpayer had controlling interest in the gambling ring, but was only associated with four of seventeen numbers runners, the presumption of correctness did not attach to the projection of total illegal income). Moreover, to the extent Mr. Xenakis reported those numbers in his pretrial stipulation, they do no more than reflect amounts which Appellee has consistently rejected as being attributable to his activities alone; thus, there is no self-incriminating testimony as to volume of wagers as there is with regard to the period of participation.
As to the second point, as stated in the earlier opinion, it was clear from his own testimony that Mr. xenakis had some, albeit as yet undetermined, tax liability for illegal income. Xenakis, 281 B.R. at 599; see also Schroeder, 900 F.2d at 1149, refusing to void the debtor's tax liability entirely because there were alternative means to "calculate the correct amount of tax due the government." Anastasato intention in remanding the case to the Bankruptcy Court was for the Anastasato analysis to continue and allow the IRS "one final foray for truth in order to provide the court with some indicia that the taxpayer received unreported income." Portillo v. Comm'r, 932 F.2d 1128, 1133 (5th Cir. 1991). As the Court of Appeals stated in Portillo, "the commissioner would merely need to attempt to substantiate the charge of unreported income by . . . showing the taxpayer's net worth, bank deposits, cash expenditures or source and application of funds [to establish] that the taxpayer received a certain amount of unreported income for the tax period in question." id. at 1133-34.
In other words, the IRS was not without alternatives to the literal transcripts presented at the first trial. "it has long been held that the Commissioner may estimate assessments by "any reasonable method," and such estimates will be accorded the full presumption of correctness."Coleman, 704 F.2d at 329, citing Delorenzo v. United States, 555 F.2d 27 (2d Cir. 1977); see also Day v. Comm'r, 975 F.2d 534, 538 (8th Cir. 1992); Zuhone v. Comm'r, 883 F.2d 1317, 1326 (7th Cir. 1989); Goodmon v. Comm'r, 761 F.2d 1522, 1524 (11th Cir. 1985); Cummings v. Comm'r, 410 F.2d 675, 678 (5th Cir. 1969. These methods include presenting evidence to explain IRS destruction procedures if, indeed, the file was destroyed rather than lost) or to explain efforts undertaken to locate the file, see United States v. Tarlow, 94-CV-4854 (JLC), 1998 U.S. Dist. LEXIS 8176, *9 (E.D.N.Y. May 14, 1998), upholding government tax calculation even though revenue officer with pertinent information could not be located and parts of administrative file had been lost because government provided the documents that were available and court presumed IRS would offer at trial a certificate of destruction or an affidavit from the IRS explaining procedures that had been taken to locate the file. The government could have presented alternative evidence in the form of investigative history sheets, affidavits of the revenue officers involved and taxpayer records. See, Curley v. United States, 791 F. Supp. 52, 56 (E.D.N.Y. 1992), where court upheld assessment as having a rational foundation even though most documentation had been destroyed; Greenhouse v. United States, 780 F. supp. 136, 142, n. 14 (S.D.N.Y. 1991), upholding assessment based on certified copies of the Certificate of Assessments and other records, along with declaration of tax officers. The IRS could have attempted to reconstruct Mr. Xenakis' income and thus, by inference, his illegal gambling proceeds, by analyzing his bank deposits, annual expenditures or determining his net worth. See, Bacon v. Comm'r, NO. 00-3665, 2001 U.S. App. LEXIS 21882, *6-*7 (3d Cir. Sept. 25, 2001), noting that the "bank deposit method" (i.e., deposits for one year are totaled, certain deductions made, and the excess between the balance and reported income considered additional taxable income), is a reasonable method of reconstruction; Llorente v. Comm'r, 649 F.2d 152, 157 (2d Cir. 1981), upholding in part a notice of deficiency reconstructing annual income based on expenditures, e.g., living expenses and the purchase of a bar and grill; Weimerskirch v. Comm'r, 596 F.2d 358, 361-62 (9th Cir. 1979), approving reconstruction of income from illegal drug sales by estimating total sales less cost of heroin for the period in question, but rejecting the analysis because no records were introduced to substantiate the IRS computations and failure to substantiate the estimated income by alternative means such as showing taxpayer's net worth, bank deposits, cash expenditures, or source and application of funds; United States v. Stonehill, 702 F.2d 1288, 1294 (9th Cir. 1983), upholding tax assessment because "overwhelming" networth evidence showed that taxpayers had acquired real property and securities worth $4,000,000 while reporting total income of only $200,000 for the period in question.
On remand, the IRS presented no alternative evidence to supplement the assessments and testimony at the first trial, but instead merely expressed its disagreement with this court's earlier opinion. Moreover, although stating its reservations about the assessment proffered by Mr. Xenakis, the Bankruptcy Court did accept that assessment and adopt it as part of its own opinion. The IRS, in its brief on appeal, offers only a single sentence addressing the January 28, 2002, Order, arguing that the Bankruptcy Court's current determination on remand cannot be allowed to stand because it was based only on debtor's own self-serving testimony. (Appellant's Brief at 9.)
In the absence of persuasive argument why I should reject Mr. Xenakis' own assessment, as accepted by the Bankruptcy Court, I will affirm that conclusion with one minor modification. As Judge Markovitz properly ruled in his earlier opinion, the penalty assessed is dischargeable inasmuch as it was imposed on unpaid taxes accrued more than three years prior to the taxpayer filing for bankruptcy. Xenakis, 262 B.R. at 345-46, citing § 523(a)(7)(B). The same should hold true for the penalty determined by the Bankruptcy Court on remand.
ORDER OF COURT
And now, this_ 9th day of December, 2002, after careful consideration and for the reasons set forth in the Opinion accompanying this Order, the Order of January 28, 2002, by U.S. Bankruptcy Judge Bernard Markovitz in the matter of Xenakis v. United States, Bankruptcy No. 00-207730BM, Adversary No. 00-2262-BM, is affirmed, with the modification that the penalties in the amount of $340.00 are dischargeable.