As tax attorneys in Houston, we often see investments made by local ethnic communities that are focused on investing overseas or raising money from overseas. This often involves those who immigrate to the U.S. from foreign countries, and do well in the U.S. financially.
The investments are often made based on direct knowledge of opportunities abroad. This may include opportunities to source equipment from the U.S. or other countries, to use the U.S. banking or financial system, or to protect cash from tumultuous foreign affairs.
The investments are often made in smaller denominations, a few thousand dollars from each investor, or larger one-time investments from overseas. The result is the same, cash deposits into U.S. bank accounts held by one or more entities controlled by a U.S. resident individual and then large transfers out.
The IRS often spots these transfers and audits these tax returns for the U.S. resident. On audit by the IRS, the IRS uses the bank deposit method for identifying taxable income and imposes income tax on the transfers.
We have covered the IRS’s bank deposit analysis previously, but we haven’t addressed the intermediary conduit defense. The recent Warfa v. Commissioner, Docket No. 7562-19 (2023) case provides an opportunity to do so.
Contents
Facts & Procedural History
Faysal Warfa formed a U.S. entity called Rayan Investments to collect funds from investors in his ethnic and religious community to finance Kaah Real Estate, a real estate development company in Ethiopia.
Rayan Investments facilitated the purchase and shipment of heavy machinery from China to Ethiopia and transferred funds to Kaah Real Estate through Kaah Express, which is owned by Mr. Warfa. The funds were either withdrawn in cash to pay for expenses or directly deposited into the Ethiopian bank account of Kaah Real Estate. It’s worth noting that no sales took place between Kaah Real Estate and Rayan Investments.
The IRS did a bank deposit analysis for 2015 and 2016 for accounts controlled by Mr. Warfa. It issued notices of deficiencies for $41,268 in 2015 and $220,333 in 2016. Mr. Warfa filed a tax court petition to challenge the determination.
Methods for Identifying Underreported Income
The IRS uses two methods to uncover unreported income. This includes the direct method and indirect methods.
The direct method involves reviewing the taxpayer’s financial records and comparing their transactions to what was reported on their tax return(s). This method is the most accurate but can be time-consuming for the IRS, especially when a large number of records need to be reviewed. The direct method requires access to the taxpayer’s financial records and is usually used when the records are available and complete.
The indirect methods are often used when records are missing or incomplete. These methods are used to estimate income. The indirect methods the IRS uses for identifying underreported income involve gathering evidence and estimating the amount of unreported income. The most common indirect methods the IRS uses include the following:
- Bank Deposit Method (Indirect)
- Net worth method (Indirect)
- Expenditures method (Indirect)
- Cash method (Direct)
- Percentage markup method (Direct)
Indirect methods for identifying income are not defined by any statutory provision or regulation. The authority is primarily based on court cases that recognize estimation as an acceptable way of identifying income. Each method has its own challenges and limitations.
The Bank Deposit Method
The bank deposit method involves the analysis of a taxpayer’s bank deposits to discover unreported or underreported income.
Under the bank deposit method, all bank deposits are assumed to be taxable income unless proven otherwise. From this starting point deposits that are known to be non-taxable (such as gifts, transfers between accounts, etc.) are subtracted.
The bank deposit method of proving income is not defined by any statutory provision or regulation. The authority to use this technique is primarily based on a Supreme Court decision that recognized the bank deposit method as an acceptable way of proving income. Despite its widespread use, there is no specific authorization for the IRS to use this method, and it remains an interpretive tool in the determination of unreported or underreported income.
The Gleckman v. United States, 80 F. 2d 394 (8th Cir. 1935), case is an example of how the courts have applied the bank deposit method. Gleckman is a criminal case that arose out of an IRS audit. The taxpayer filed income tax returns once he learned that illegal alcohol sales were taxable. The IRS audited the tax returns. The IRS auditor and in-house accountant examined the taxpayer’s bank records and agreed on the amount of taxable deposits that were not reported on the taxpayer’s income tax returns. A new IRS agent was assigned to the case and discovered additional deposits. This led to the criminal case. In the criminal case, the government put on evidence that $156,822.06 of deposits were made into the taxpayer’s bank accounts and the auditor was able to trace and eliminate $63,915.48 as nontaxable loans, stock and bond transactions, and rents and salary items. This left a balance of untraceable cash and unexplained deposits of $92,906.58. The trial also showed that the taxpayer owned an interest in various distilleries that manufactured whisky and that he should be one of them. The court summed up its reasoning as follows:
Undoubtedly, the burden was upon the government to prove that an income tax was due from Mr. Gleckman for the years in question over and above the amount returned he could not be guilty of attempting to evade or defeat a tax unless some tax was due. O’Brien v. United States (C.C.A.) 51 F.(2d) 193. It may be conceded also that the bare fact, standing alone, that a man has deposited a sum of money in a bank would not prove that he owed income tax on the amount; nor would the bare fact that he received and cashed a check for a large amount, in and of itself, suffice to establish that income tax was due on account of it.
On the other hand, if it be shown that a man has a business or calling of a lucrative nature and is constantly, day by day and month by month, receiving moneys and depositing them to his account and checking against them for his own uses, there is most potent testimony that he has income, and, if the amount exceeds exemptions and deductions, that the income is taxable.
The court found that the bank deposits and large items of receipts by Mr. Gleckman were identified with a business carried on by him and so were sufficiently shown to be of a taxable nature.
The accuracy of this method is highly dependent on the thoroughness of the IRS’s investigation, whether they identify all of the bank accounts, and the method used to exclude non-taxable deposits.
Court Cases That Apply the Bank Deposit Method
There have been a number of court cases that apply and explain the bank deposit method. Here are a few examples:
- United States v. Johnson, 319 U.S. 503 (1943):
Facts: The defendant, Johnson, was charged with tax evasion. The government used the Bank Deposit Method to estimate Johnson’s taxable income by analyzing his bank deposits. Johnson argued that some of the deposits were gifts or loans and therefore not taxable income.
Holding: The Supreme Court clarified that the Bank Deposit Method cannot be used to estimate income in cases where the deposits were shown to be nontaxable, such as gifts or loans. Therefore, the government’s estimate of Johnson’s taxable income was inaccurate and the case was sent back for further proceedings.
- United States v. Calderon, 348 U.S. 160 (1954):
Facts: The defendant, Calderon, was charged with tax evasion. The government used the Bank Deposit Method to estimate Calderon’s taxable income by analyzing his bank deposits. Calderon argued that the government’s estimate was inaccurate and that the Bank Deposit Method was unconstitutional.
Holding: The Supreme Court upheld the Bank Deposit Method as a legitimate means for estimating unreported income, as long as it was used in a fair and accurate manner. The court ruled that the method was reasonable and not arbitrary, and that it could be used as long as it was implemented fairly and accurately.
- United States v. Giampa, 904 F.2d 119 (2d Cir. 1990):
Facts: The defendant, Giampa, was charged with tax evasion. The government used the Bank Deposit Method to estimate Giampa’s taxable income by analyzing his bank deposits. Giampa argued that the government had not proved that the deposits were taxable income.
Holding: The Second Circuit Court of Appeals held that the government must first prove that the deposits in question were taxable income before using the Bank Deposit Method to estimate unreported income. Therefore, the government’s estimate of Giampa’s taxable income was inaccurate and the case was sent back for further proceedings.
Funds Received as an Intermediary Conduit
The bank deposit method has since become a widely accepted tool for the government to estimate unreported income on audit by the IRS. However, it is important to note that the method has its limitations and can be challenged by taxpayers.
For example, a taxpayer may argue that a deposit was a loan or a gift and not income. As relevant here, funds received as an intermediary conduit are also not subject to income tax for the taxpayer.
The court summarized the law for intermediaries as follows:
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.
Based on this intermediary conduit premise and the facts presented, the court found that most of the deposits were not income to the taxpayers.
It should be noted that this is slightly different than the situation where the taxpayer is a business that is paid money that it is to put to use and earn a profit for himself. The profit aspect can be problematic.
Evidence Showing Intermediary Conduit Investments
The evidence, in this case, was mixed. While the records were not perfect, the testimony was credible. This shows what evidence is needed to support an intermediary conduit investment defense.
The court made this observation about the records presented:
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.
The taxpayer also presented the testimony of numerous investors who the court believed. The court agreed with the taxpayer for all amounts other than the amount identified by one investor whom the court did not find credible.
While not trotted out in the opinion, the fact that the U.S. entity had no other functions also helped. Other “conduit” cases have found there to be a conduit when the entity was not transacting business and had no “real economic function” other than passing funds. See, e.g., P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084 (9th Cir. 1987).
The court opinion also notes that the taxpayer was not extracting significant personal income and implied that he wasn’t living an extravagant lifestyle. This was noted by the court in passing by noting the amount he was paid from the businesses and that he drove a modest vehicle.
Documenting the Intermediary Conduit Defense
This case highlights several of the ways investors can document their intermediary conduit defense to avoid an adjustment on audit by the IRS.
First, naturally, taxpayers can keep clear and complete documentation of the investments, including receipts, invoices, and other financial records. Investors should also be issued shares for their investment if it is a C corporation or partnership or LLC units if otherwise, and separate deposit slips should be prepared for each investment to avoid confusion.
Second, taxpayers can keep written evidence of the participation of investors. This may include meeting minutes and other communications. Even board presentations and other materials that are commonly provided to investors can help.
Third, for any distributions to the taxpayers under audit, documentation that the amounts were not excessive, was reasonable under the circumstances and were not used for extravagant lifestyle-type expenses can help.
Other Considerations
The intermediate conduit defense may help the taxpayer with the IRS’s deposit analysis, but it may also result in the entity being subject to tax as a partnership.
A “conduit” is exactly what a partnership is. A partnership is treated as a conduit through which income passes to its partners, who are responsible for reporting their pro rata share of tax on their individual income tax returns. As a partnership, the entity would be required to file a partnership tax return and distribute items of income and expense to the partners.
This can be problematic if the entity is profitable. The profits would be distributed to the individual partners, which could result in the IRS opting to audit the individual partners and proposing adjustments to their income tax returns.
Losses at the entity level may also be problematic. It may also result in losses or expenses taken by the taxpayer-owner of the entity being reduced, as losses and expenses may also be reallocated to the partners.
IRS penalties for the partnership return can also be at issue. The IRS may impose penalties on the partnership for failure to file the partnership tax return and for failure to issue Schedule K-1’s to the partners. These penalties can add up fast.
The newer BBA partnership rules make it easier for the IRS to make adjustments to partnership returns, which makes these types of adjustments more probable.
The Takeaway
As tax attorneys in Houston have seen, investments made by local ethnic communities often involve investing overseas, which can trigger IRS audits. This court case provides insights into how taxpayers can defend themselves against an IRS audit. Taxpayers can defend themselves by showing that funds received were strictly as an intermediary conduit for transactions and they received no material benefit from the funds. To do so, taxpayers need clear and complete documentation of investments, evidence of the participation of investors, and documentation showing that any distributions were reasonable and not used for extravagant expenses.
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