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Tax Court Allows Estimated Cost of Goods Sold Expense; Upholds Accuracy Related Penalty

(Parker Tax Publishing January 2024)

The Tax Court held that a taxpayer, a fencing contractor who made cash withdrawals when he received checks as payment for his work which he used to pay material and labor costs as well as personal expenses but did not specify what proportion of the withdrawals went to business needs versus personal expenses, was allowed 50 percent of the cash withdrawals as cost of goods sold offsetting his gross income. The court also found the taxpayer was liable for penalties under Code Sec. 6662(a) after rejecting his explanation that he failed to report gross receipts from customers that did not send him Forms 1099-MISC because he did not know how to report that income. Villa v. Comm'r, T.C. Memo. 2023-155.


David Villa was born in Mexico and moved to the United States in 1998 with his father. He completed elementary school in Mexico and attended (but did not complete) high school in the Unites States. David went into the fence-building business with his father after they immigrated. Villa now runs the business as a sole proprietorship.

During 2016 and 2017 (the years at issue), David worked as a subcontractor for All-Texas Fence (All-Texas), and as a direct contractor for various customers. All-Texas supplied David with the wood for his subcontractor projects, but he was responsible for all other costs (including tools, labor, and transportation). For his direct contracting work, David had to pay out of pocket for both the materials and his other costs.

All-Texas paid David nonemployee compensation of $26,022 in 2016 and $28,314 in 2017, and it reported those amounts to David and the IRS on Forms 1099-MISC, Miscellaneous Income. For his direct contracting work, David received payments totaling about $20,817 in 2016 and $40,630 in 2017. When David received a check as payment for his work, he often would deposit the check but immediately withdraw a portion in cash. He would use that cash to pay both (1) his business costs and expenses and (2) personal expenses. These immediate withdrawals, marked "less cash" on the bank deposit slips, totaled $8,996 in 2016 and $16,480 in 2017. David used both cash and debit cards to pay his business costs and expenses; he kept some but not all receipts related to those items.

David asked his cousin to prepare his and his wife's joint income tax returns for each year at issue. David's cousin was then teaching physical education classes and had taken some accounting classes but was not a licensed accountant. David was aware of these facts but relied on his cousin, in part because the cousin previously had helped David's father and brothers prepare their tax returns. David supplied his cousin with various relevant documents, and his cousin prepared the returns for free as a favor to David.

On the returns for the years at issue, the only gross income that the Villas reported was the payments from All-Texas. They did not report any of the payments for David's direct contracting work, and none of the direct contracting customers had reported their payments to him on an information return such as a Form 1099-MISC. On the attached Schedules C, Profit or Loss From Business, the Villas deducted contract labor expenses of $8,750 for 2016 and $10,501 for 2017 and "other" expenses of $11,690 for 2016 and $12,096 for 2017.

After selecting the Villas' returns for examination, the IRS conducted a bank deposits analysis and, in a notice of deficiency, determined that the Villas' gross income for both years at issue should be increased by the payments Villa received for his direct contracting work. The IRS also adjusted the expenses reported on the Schedules C based on the receipts and other documents David produced to substantiate those expenses. The notice of deficiency also determined an accuracy-related penalty under Code Sec. 6662(a) for each year at issue. The IRS determined that the Villas' underpayment of tax for each year was attributable to negligence or disregard of rules or regulations under Code Sec. 6662(b)(1), and/or a substantial understatement of income tax under Code Sec. 6662(b)(2).

The Villas took their case to the Tax Court. They argued that David's Schedule C net profit should be reduced by costs of goods sold of $8,996 for 2016 and $16,480 for 2017, on the basis of his "less cash" withdrawals. David testified that he used his "less cash" withdrawals to pay for both business needs (including fencing materials and contract labor) and personal expenses. He did not specify what proportion of the withdrawals went towards business needs versus personal expenses. He provided a small amount of evidence indicating that he made modest cash payments to a fencing supply distribution company and large cash payments toward business-related accounts he held at Lowe's and Home Depot.

David also testified about the details of recent work he performed on one of his direct contracting jobs: He built an 81-foot fence using $1,584 of materials and $166 of contract labor, and the customer paid $2,400. The Villas asked the court to use this sample job as a basis for estimating total cost of goods sold. They suggested that the job's 73 percent ratio between cost of goods sold and gross receipts could be used to fairly estimate David's total cost of goods sold for both years at issue. However, because David did not pay for the materials used in his subcontracting work for All-Texas, the Villas agreed that the court should apply the 73 percent ratio only to the gross receipts from David's direct contracting work.

On the issue of the Villas' liability for penalties, the only explanation David offered for failing to report any gross receipts from his direct contracting work is that those customers did not send him Forms 1099-MISC or any other information returns, and he therefore "didn't know how to" report that income.


The Tax Court allowed 50 percent of David's "less cash" withdrawals as cost of goods sold by applying the "Cohan rule." Under Cohan v. Comm'r, 39 F.2d 540 (2d Cir. 1930), if a taxpayer clearly shows that he incurred a deductible expense but cannot substantiate the exact amount, a court may estimate the amount of the expense, provided there is a reasonable basis for making such an estimate. In making an estimate under the Cohan rule, the court "bear[s] heavily if it chooses upon the taxpayer whose inexactitude is of his own making."

The court found David's sample job testimony to be credible and likely representative of the direct contracting work that he completed during the years at issue. However, the court found that the sample job analysis did not apply to the indeterminate portion of the "less cash" withdrawals that the Villas admitted David used for personal expenses. In addition, the court said it was unclear whether some portion of the estimated cost of goods sold for David's direct contracting work might already have been included in the contract labor or "other" expenses - and the court held such inexactitude against the Villas under the Cohan rule. Neither the Villas nor the IRS explained the composition of the Schedule C "other" expenses and it was unclear to the court what extent those amounts included materials David used in his direct contracting work. It was clear to the court, however, that a substantial portion of the "less cash" withdrawals represented material and labor costs. Accordingly, the court allowed 50 percent of the "less cash" withdrawals as cost of goods sold.

Next, the court concluded that the Villas were liable for penalties under Code Sec. 6662(a) on the deficiencies for both years at issue. In the court's view, the Villas' failure to report any of David's gross receipts from his direct contracting work was a clear instance of reckless (if not intentional) disregard for the rule of Code Sec. 61 that gross income includes income from whatever source derived absent a clear exclusion provided by law. The court also found that the understatements of tax in this case were clearly substantial under Code Sec. 6662(b)(2) and (d).

The court determined that the Villas did not qualify for the reasonable cause exception under Code Sec. 6664(c)(1). Even assuming that David honestly believed he owed tax only on amounts reported to him via information returns, the court said that such an honest misunderstanding would not have been reasonable. In the court's view, any reasonable person in David's position - with his same education and experience - would have suspected that an exclusion for the income from his direct contracting work would be "too good to be true" and would have inquired into whether such an exclusion really exists (and would have ascertained that it does not). Likewise, the court found that David's reliance on his cousin to prepare the Villas' tax returns was unreasonable under the circumstances. The court found that if the cousin knew of David's gross receipts and told David that they were not taxable, then David was unreasonable in relying on such advice; it would have been incredible on its face and would have warranted further investigation on David's part - all the more so because his cousin was not a professional tax advisor or accountant. On the other hand, if the cousin was not aware of the gross receipts, the court found that David could not have trusted his cousin to prepare an accurate return.

For a discussion of the Cohan rule for estimating deductions, see Parker Tax ¶250,163. For a discussion of accuracy-related penalties on underpayments of tax, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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