Opinion
7562-19
05-04-2023
FAYSAL WARFA & AISHA IBRAHIM, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is
ORDERED that the Clerk of the Court shall transmit with this order to petitioner and respondent a copy of the pages of the transcript of the trial in this case before Judge Ronald L. Buch at St. Paul, Minnesota, containing his oral findings of fact and opinion rendered at the trial session at which the case was heard. In accordance with the oral findings of fact and opinion, a decision will be entered under Rule 155.
Ronald L. Buch, Judge.
Bench Opinion by Judge Ronald L. Buch
March 30, 2023
Faysal Warfa & Aisha Ibrahim v. Commissioner of Internal Revenue
Docket No. 7562-19
THE COURT: The following represents the Court's oral findings of fact and opinion in this case. The oral findings of fact and opinion may not be relied upon as precedent in any other case. These oral findings of fact and opinion are made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code and Tax Court Rule 152. Rule references in this opinion are to the Tax Court Rules of Practice and Procedure, and section references are to the Internal Revenue Code, in effect at all relevant times.Faysal Warfa gathered funds from people in his ethnic and religious community for the purpose of funding Kaah Real Estate, a real estate development company in Ethiopia. Mr. Warfa created a U.S. entity, Rayan Investments, to receive and disburse the funds from investors. Seeing significant bank deposits into accounts controlled by Mr. Warfa, the Commissioner determined deficiencies for 2015 and 2016, the years in issue.
Rayan Investments spent funds on behalf of, or remitted funds to, Kaah Real Estate in various ways.
Sometimes Rayan Investments bought heavy machinery and had it shipped directly to Kaah Real Estate. On other occasions, Rayan Investments transferred cash to Ethiopia to pay expenses of Kaah Real Estate. And on yet other occasions, Rayan Investments transferred funds to the Ethiopian bank account of Kaah Real Estate.
Mr. Warfa's business practices didn't align with traditional U.S. corporate business practices. In Ethiopia, he dealt in cash. He allowed others to make deposits into his accounts. And he didn't maintain a clear set of books showing the movement of funds. But his underlying bank records, his receipts for major purchases, his testimony, and a parade of witnesses consistently support the notion that Rayan Investments was merely a conduit for investing in Kaah Real Estate. A portion of the deposits are not taxable to Petitioners.
FINDINGS OF FACT
Faysal Warfa moved to the United States in 1996. He has a high school level education from Somalia and has taken some English as a second language courses.
Mr. Warfa has a vast range of job experience. When he first moved to the United States he worked at a meat processing plant. Later, he moved to Minneapolis to work for an electronics company. He also started various businesses. During 2015 and 2016, he owned and operated Kaah Express, Kaah Coffee, Kaah Income Tax, Kaah Travel Agents, Seward Market, Kaah Real Estate, and Rayan Investments. Despite his many businesses, Mr. Warfa lives a modest lifestyle. He makes roughly $4,500 a month, and rents a house in Minnesota for himself and a house in Kenya for his family; he drives a 2011 GMC truck. Construction Project in Ethiopia
Kaah Real Estate is an Ethiopian real estate development company that was incorporated on August 15, 2015. It was formed to oversee the construction of homes in Ethiopia. Because of political unrest in Ethiopia, Kaah Real Estate has halted its operations. However, when it was operating, Mr. Warfa spent most of his time in Ethiopia managing the company's day to day operations as the owner and general manager. Kaah Real Estate had many employees, all of which were in Ethiopia. These employees included engineers, managers, accountants, and drivers amongst others. All of Kaah Real Estate's operations were funded by money received from investors. Mr. Warfa found these investors through his Somalian community here in the United States. They are mostly people that frequent his businesses or attend his mosque.
Mr. Warfa used Rayan Investments to funnel funds received from investors to Kaah Real Estate. Rayan Investments is a U.S. entity formed to hold and distribute funds to Kaah Real Estate. Investor funds included cash, checks, and sometimes a combination of both. These funds were deposited into Rayan Investments' bank account. Sometimes investors provided the funds directly to Mr. Warfa, who deposited them into Rayan Investments' bank account. Other times, the funds were deposited directly into Mr. Warfa's personal account and then transferred to Rayan Investments' bank account.
Rayan Investments used the investor funds to finance construction for Kaah Real Estate in various ways. Sometimes Rayan Investments bought equipment and heavy machinery from China and shipped it directly to Ethiopia. And other times, Rayan Investments transferred funds through Kaah Express, a money wiring service owned by Mr. Warfa, either (1) to Ethiopia for a cash withdrawal if needed to pay expenses at that moment, or (2) directly to the Ethiopian bank account of Kaah Real Estate. There were no sales between Kaah Real Estate and Rayan Investments.
Notice of Deficiency, Petition, and Trial
Married taxpayers Mr. Warfa and Aisha Ibrahim timely filed a joint return for each year in issue, reporting income of $43,500 and $48,000, respectively. The income reported was based on wages received from Kaah Express. They also claimed dependents on their returns.
They claimed six dependents for 2015 and seven dependents for 2016.
On February 13, 2019, the Commissioner issued Mr. Warfa and Ms. Ibrahim a Notice of Deficiency for 2015 and 2016, determining deficiencies of $41,268 and $220,333, respectively. Using a bank deposits analysis, the Commissioner determined deficiencies based on unexplained deposits into various accounts associated with Mr. Warfa during the years in issue. This analysis led the Commissioner to adjust petitioner's gross receipts by $133,127 for 2015 and $580,775 for 2016, the amounts of the unexplained deposits.
The Commissioner also determined section 6662(a) penalties for the years in issue. The IRS examiner who made the decision to assert penalties obtained approval on a Civil Penalty Approval Form signed by his group manager on October 16, 2018, before the notice of deficiency was mailed. The primary position taken on the penalty approval form was that the substantial understatement penalty applies; negligence was asserted as an alternative.
While residing in Minnesota, Mr. Warfa and Ms. Ibrahim timely petitioned the Tax Court challenging the determinations. The Court tried this case in St. Paul, Minnesota. Mr. Warfa appeared in person and was accompanied by an interpreter during his testimony. He provided the Court with various documents, such as bank statements, invoices, and receipts to substantiate his claim that the bank deposits were funds received from investors to fund a real estate project and therefore are not taxable income. However, his documentation was far from perfect. Investors were not issued shares for their investment in Kaah Real Estate. Mr. Warfa prepared receipts showing people's investments, but those receipts don't explain all of the deposits and contain errors. Mr. Warfa sometimes aggregated deposits, so he did not have a separate slip for each investment, and some of the deposit slips did not match or add up to the amounts invested. In total, Mr. Warfa supplied receipts showing investments of $570,100 for 2016. Of that amount, the Commissioner already treated $167,000 as not taxable. Mr. Warfa did not supply copies of any receipts for 2015.
Mr. Warfa's version of events was partially supported by his records and also by several witnesses, most of whom were credible. Several of the investors in Kaah Real Estate appeared and testified as to their intent when investing. They expected to receive eventual returns on their investments, but like any investment, they knew they could lose their money. They explained their trust in Mr. Warfa because of his reputation within their ethnic and religious community.
Some of the investors visited the construction site in Ethiopia and have seen the progress that has been made. Each of the witnesses understood that the political unrest that broke out in Ethiopia in 2016 caused the project to halt. All remain hopeful that they will eventually see returns on their investments.
One witness was not credible. Mowlid Hussein purportedly had the largest investment of any of the witnesses who testified. His testimony and the documents relating to his purported investment are inconsistent and at times implausible. Mr. Hussein is purported to have invested $160,000 in May 2016. Of that $160,000, the Commissioner already treated $41,000 as not taxable. Mr. Hussein testified that he brought the entire $160,000 to Mr. Warfa in cash. He initially testified that he brought it in an envelope, but seemed to realize that this much cash would likely not fit in an envelope. Then he changed his explanation of how he brought the cash. He testified that he brought the entire amount at one time, but the deposit slips that allegedly relate to his investment are spread over several weeks. Also, some of those deposit slips were for cashier's checks, but the remitter lines on those cashier's checks contain the names of people other than Mr. Hussein. Mr. Hussein did not offer any plausible explanation of these various inconsistencies or why the remaining $119,000 that the Commissioner treated as taxable should not be taxable.
OPINION
I. Burden of Proof
Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and taxpayers bear the burden of proving otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
The burden of proof may shift to the Commissioner in certain circumstances. I.R.C. § 7491(a)(1). To shift the burden, taxpayers must have complied with applicable substantiation and record-keeping requirements and have cooperated with the Commissioner's reasonable requests "for witnesses, information, documents, meetings, and interviews." I.R.C. § 7491(a)(2). Mr. Warfa and Ms. Ibrahim do not contend that the burden shifts nor does the record establish that they satisfy the prerequisites for shifting the burden under section 7491.
II. Unreported Income
"[G]ross income means all income from whatever source derived," including compensation for services such as wages and salaries, gross income derived from business, and dividends, among others. I.R.C. § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-31 (1955); see Durland v. Commissioner, T.C. Memo. 2016-133, at *161. Taxpayers must maintain books and records sufficient to establish their income and expenses. I.R.C. § 6001; Treas. Reg. § 1.6001-1(a). If they fail to do so, the Commissioner may reconstruct income through any reasonable method that clearly reflects income. I.R.C. § 446(b); Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989). We have long accepted the bank deposits method for this purpose. Clayton v. Commissioner, 102 T.C. 632, 645-46 (1994). The bank deposits method assumes all deposits are taxable, but the Commissioner must account for any nontaxable source or deductible expense of which he has knowledge. Id. The United States Court of Appeals for the Eighth Circuit, the court to which this case is appealable, requires that the government "initially introduce evidence to show (1) that, during the tax years in question, the taxpayer was engaged in an income producing business or calling; (2) that he made regular deposits of funds into bank accounts; and (3) that an adequate and full investigation of those accounts was conducted in order to distinguish between income and non-income deposits." United States v. Abodeely, 801 F.2d 1020, 1023 (8th Cir. 1986).
Taxpayers bear the burden of proving a nontaxable source for deposits. Barnes v. Commissioner, T.C. Memo. 2016-212 at *32-34, aff'd, 773 Fed.Appx. 205 (5th Cir. 2019). Nontaxable sources include funds attributable to "loans, gifts, inheritances, or assets on hand at the beginning of the taxable period." Burgo v. Commissioner, 69 T.C. 729, 743 n.14 (1978).
Petitioners argue that the deposits have nontaxable sources because they were merely investments made by many investors to fund a real estate project in Ethiopia, and Mr. Warfa and Rayan Investments were mere conduits for transferring the funds. The Commissioner disagrees, arguing that the deposits are taxable because there is no support for nontaxable sources.
It is well settled that the mere receipt of possession of money does not by itself constitute taxable income. Na v. Commissioner, T.C. Memo. 2015-21, at *21. "We accept as sound law the rule that a taxpayer need not treat as income moneys which he did not receive under a claim of right, which were not his to keep, and which he was required to transmit to someone else as a mere conduit." Diamond v. Commissioner, 56 T.C. 530, 541, aff'd, 492 F.2d 826 (7th Cir. 1974). Therefore, if a taxpayer receives and disburses funds strictly as an intermediary for transactions and receives no material benefit from the funds, then the taxpayer need not include the funds in their income. Na, T.C. Memo. 2015-21, at *24.
Mr. Warfa credibly established nontaxable sources for a portion of the funds he received. While the documents Mr. Warfa provided were not perfect, they showed that Mr. Warfa and Rayan Investments received funds from investors that were subsequently transferred to Kaah Real Estate or used in furtherance of the Kaah Real Estate construction project. This conclusion is further supported by Mr. Warfa's testimony and the testimony of several credible witnesses who testified to being investors in the real estate project, with some even visiting the construction project in person. It is immaterial that Mr. Warfa owned both Rayan Investments and Kaah Real Estate. Mr. Warfa and Rayan Investments were mere conduits of the funds.
But Mr. Warfa only established that a portion of the funds came from nontaxable sources. Mr. Warfa offered no evidence of a nontaxable source for the unexplained deposits in 2015. As for 2016, Mr. Warfa offered evidence showing that deposits totaling $570,100 came from investors. But the Commissioner had already treated $167,000 of those deposits referenced in the receipts and the corresponding testimony as not taxable. And because of the implausible testimony and contradictory documents as to $119,000 of the investment purportedly received from Mr. Hussein, Mr. Warfa failed to establish a nontaxable source for that amount. Thus, in addition to the amounts the Commissioner already determined were not taxable, Mr. Warfa established that bank deposits totaling $284,100 in 2016 were derived from nontaxable sources. III. Penalties
Section 6662(a) provides that a taxpayer may be liable for a penalty of 20% of the portion of an underpayment of tax required to be reported on a return that is attributable to, among other things, negligence or disregard of the rules or regulations or a substantial understatement of income tax. See I.R.C. § 6662(b)(1) and (2). Only one section 6662 accuracy-related penalty may be imposed with respect to a given portion of an underpayment. Treas. Reg. § 1.6662-2(c); see also Mileham v. Commissioner, T.C. Memo. 2017-168, at *46.
Under section 7491(c), the Commissioner bears the burden of production with respect to penalties and must produce evidence that any penalty is appropriate. See Higbee, 116 T.C. at 446. For section 6662 penalties, which require managerial approval pursuant to section 6751(b), the Commissioner must establish compliance with section 6751(b). Walquist v. Commissioner, 152 T.C. 61, 68 (2019). Once the Commissioner meets his burden, petitioners must come forward with persuasive evidence that the Commissioner's determination is incorrect or that an exception applies. Higbee, 116 T.C. at 446-47; see I.R.C. § 6664(c)(1) (reasonable cause and good faith exception).
The Commissioner met his burden of production with respect to section 6751(b). The Civil Penalty Approval Form shows that the IRS examiner obtained approval for the penalties on October 16, 2018, before the Commissioner issued the notice of deficiency on February 13, 2019, or otherwise formally communicated the decision to determine penalties.
The Commissioner determined the penalties based on a substantial understatement of income tax, or in the alternative, negligence. Section 6662(d)(1)(A) defines a substantial understatement of income tax as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. Petitioners' understatements may be substantial for 2015 and 2016 if they exceed $5,000 and are greater than 10% of the amount required to be shown on their returns.
Regardless, the negligence penalty applies. "'Negligence' . . . includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly." Treas. Reg. § 1.6662-3(b)(1). The record shows that Petitioners were negligent because they failed to keep adequate books and records to substantiate the bank deposits.
Although the Commissioner met his burden of production as to penalties, Petitioners may nonetheless demonstrate that the reasonable cause and good faith exception of section 6664(c)(1) applies. However, they failed to provide any evidence to support this exception. Accordingly, the section 6662 accuracy-related penalty applies for the years in issue.
IV. Conclusion
The Commissioner determined that Petitioners omitted income. He made this determination based on unexplained bank deposits. Mr. Warfa was able to establish nontaxable sources for some of those deposits beyond those that the Commissioner already identified as nontaxable. But Petitioners offered no defense as to the penalties.
Because the amount of any resulting liability will need to be calculated, Decision will be entered under Rule 155.
This concludes the Court's oral findings of fact and opinion in this case.
(Whereupon, at 10:45 a.m., the above-entitled matter was concluded.)