Appeal from the United States Tax Court. No. 11486-01-Joel Gerber, Judge.
The opinion of the court was delivered by: Rovner, Circuit Judge.
Before MANION, ROVNER and SYKES, Circuit Judges.
The Internal Revenue Service audited the 1997 tax return of Nick and Helen Kikalos and found that they underreported their income and thus owed more tax than they had paid. The IRS also assessed an accuracy-related penalty against the pair in the amount equal to twenty percent of the underpayment. The couple petitioned the United States Tax Court for a redetermination of the deficiency and after a two-day hearing, the court sustained both the deficiency and the penalty. Nick and Helen Kikalos appeal and we affirm.
In 1997, the tax year at issue, Nick and Helen Kikalos owned four liquor stores in Hammond, Indiana. The stores, operating under the name "Nick's Liquor Mart," sold beer, wine, liquor and cigarettes, among other things.*fn1 These family-run ventures were sole proprietorships, with daughter Elizabeth managing one of the stores. Elizabeth and her brother, Nick Jr., together owned a fifth store called "Nick's Cigarette City." At the time of this audit, Nick and Helen Kikalos (we will call them the taxpayers for shorthand) were no strangers to the IRS, having been audited every year from 1986 through 1993. A recurring theme in these audits had been the IRS's displeasure with the taxpayers' record-keeping. In 1995, at the conclusion of the audits for tax years 1990, 1991 and 1992, the IRS and the taxpayers executed an "Agreement to Maintain Adequate Books and Records," which specified certain records for the taxpayers to keep in the future. The agreed-upon records included daily cash register tapes and daily cash reconciliations. The daily cash reconciliations were to include the amount of cash which was withdrawn from the business for whatever purpose, the amount of cash available for bank deposits, and a record of the amount, date and type of draw being withdrawn from the business. The 1997 audit was triggered in part when the Mercantile National Bank contacted the IRS to report unusual financial activity by Nick Kikalos.*fn2 Kikalos had purchased thirty-one cashier's checks from the Mercantile National Bank in 1997 in an amount totaling $809,734.51. Kikalos used cash and third-party checks to purchase the checks.
The audit ultimately focused on the cigarette aspect of the taxpayers' stores. Nick's Liquor participated in cigarette company programs called "buydowns." A buydown is a discount a cigarette manufacturer provides to a retail outlet for each pack or carton of cigarettes sold during a certain time period. The manufacturers give the discount directly to the retailer with the expectation that the retailer will then pass on the savings to the ultimate consumer. There are no coupons involved in buydown programs. Rather, the cashier at the point of sale must be aware of the buydown programs for particular brands of cigarettes and ring up the sale accordingly. At Nick's Liquor, the store managers were responsible for informing the cashiers about the cigarette brands on buydown at any particular time. Some cigarette companies attempted to verify that retailers were passing the discounts on to their customers by checking the prices displayed in the retailers' windows. Manufacturers also asked retailers to take inventory at the beginning and end of a buydown period to verify the amount of buydown reimbursement a retailer should receive. Nick's Liquor conducted its own inventories that were not audited or verified by the cigarette companies.
After the close of a buydown period, Nick's Liquor would submit a request for reimbursement to the manufacturer sponsoring the program, and the manufacturer would then issue a check based on the number of cartons purchased during the buydown period multiplied by the discount per carton. The delay between the request for reimbursement and issuance of a check would sometimes be as long as two months. Because of this delay, some checks received in early 1997 were due to sales made in 1996 and some payments for 1997 buydown sales were not received until early 1998. In addition to buydowns, Nick's Liquor honored manufacturers' paper coupons. Cigarette companies reimbursed Nick's Liquor for the face value of submitted coupons plus postage costs. For the sake of simplicity, we will use the term "buydown" to include both buydown and coupon income, unless otherwise indicated.
According to the IRS, Nick's Liquor received substantial payments from cigarette companies in 1997 that were not deposited to the stores' business bank accounts, were not reported to the stores' accountant and consequently were not disclosed on the couple's 1997 tax return. Instead of recording this income through normal channels, Kikalos took more than $500,000 worth of buydown reimbursement checks, combined them with other third party checks and used them to purchase more than $800,000 worth of cashier's checks from the Mercantile National Bank. After the bank contacted the IRS, a revenue agent commenced an audit and attempted to determine whether these cashier's checks represented unreported income. The taxpayers and their accountant provided a number of records to the revenue agent, including spreadsheets that purported to document cigarette buydown income. The spreadsheets contained many different and conflicting numbers for this type of income so the revenue agent selected the largest figure given in any spreadsheet, $777,848, and used that as the baseline figure for buy-down income. The taxpayers had reported $653,164 of buydown income on their 1997 return, leading the revenue agent to conclude that the taxpayers had underreported their income by $124,684. The agent issued a deficiency notice for the amount of tax due on this additional income, and also imposed an accuracy-related penalty equal to twenty percent of the underpayment pursuant to 26 U.S.C. § 6662(a).
The taxpayers petitioned the Tax Court for a redetermination of the deficiency. After a two-day hearing, the court determined that the taxpayers had in fact under-reported their income by $242,666, nearly twice the agent's determination. The court therefore upheld the IRS's deficiency notice as well as the penalty. In reaching this result, the court took a different evidentiary path than the revenue agent. The court noted that three of the four spreadsheets provided by the taxpayers reflected $521,695 in buydown income but the fourth indicated $777,848. The court found that, despite requests from the revenue agent, the taxpayers failed to furnish adequate records to substantiate the amount of buydown income recorded by each of the four stores on a daily, monthly or annual basis. Nor did the taxpayers provide records to reconcile cigarette company reimbursement payments with the amounts reported as buydown income. The court noted the unusual purchase of thirty-one cashier's checks, which Kikalos accomplished by using buydown reimbursement checks, other third-party checks, and cash in amounts less than $10,000 to avoid IRS reporting requirements. Kikalos did not tell his accountant about these cashier's checks and he did not record the receipt of the third party checks in the accounting records for Nick's Liquors. All in all, Kikalos converted $531,605 of buydown reimbursement checks into cashier's checks. The court remarked that Kikalos admitted in his testimony that one of his objectives in purchasing the cashier's checks with third-party checks rather than cash was to avoid reporting cash transactions exceeding $10,000 to the IRS. The court found significant the taxpayers' failure to demonstrate that the third-party checks used to purchase the cashier's checks were included in gross business income. Moreover, the accountant for Nick's Liquor testified that she was unaware of the existence of the cashier's checks. The accountant verified that the only entry in the 1997 for cigarette company checks was the $400,746 entry in October. She could not recall what documentation she was given to support this entry but said, "I would imagine it was checks." Tr. at 236. She said the basis for the amount of the entry was "[p]robably a deposit appearing in the bank, but I couldn't say for sure." Id. She then clarified that although she could not recall the documentation exactly, she believed it was a deposit slip. Id. The taxpayers did not produce credible evidence that the cigarette company checks used to purchase the cashier's checks were part of this October 1997 entry.
From these facts, the court concluded that Kikalos had not reported $531,605 in buydown checks that had been used to purchase cashier's checks. The accountant for Nick's Liquor had noted $400,746 in buydown income in the October 1997 records for the stores. The court added those two figures for a total of $932,352. The court then adjusted to exclude 1996 buydown income that was received in 1997 (a $73,392 subtraction), and to include 1997 income that was not received until 1998 (a $100,810 addition). The IRS conceded that it had double-counted $63,940 in "rack and promotional" income from cigarette companies, so the court excluded that amount as well. All in all, the court calculated $895,830 in buydown income. Kikalos and his wife reported $653,164 in buydown income on their 1997 tax return, and the court concluded that unreported buydown income equaled $242,666. Although this figure was nearly double the amount originally claimed by the IRS, the government did not seek an increased deficiency. Because Kikalos did not have adequate records to challenge this calculation, the court upheld the original deficiency. The court also upheld the accuracy-related penalties imposed by the IRS under section 6662. That section allows a 20% penalty on any understatement of tax attributable to negligence or disregard of the rules and regulations, or any substantial understatement of income tax. The court found that Kikalos violated this section when he failed to keep adequate books or records after repeatedly being warned by the IRS to do so. The court again noted Kikalos's testimony that his practice of purchasing cashier's checks was designed in part to conceal large cash transactions from the government. These two factors justified the accuracy-related penalty, according to the court. The taxpayers appeal.
On appeal, Kikalos and his wife raise three issues. First, they assert that the Tax Court impermissibly allowed the IRS to introduce a new theory of unreported income in its post-trial brief. Second, they contend that the Tax Court then clearly erred in accepting that post-trial theory that the couple received $890,055*fn3 in buydown income in 1997. Finally, the taxpayers maintain that the Tax Court clearly erred in imposing a negligence penalty against them. In reviewing decisions of the Tax Court, we assess questions of law de novo, and review factual determinations for clear error. Estate of Kunze v. Commissioner, 233 F.3d 948, 950 (7th Cir. 2000); Kikalos v. Commissioner, 190 F.3d 791, 793 (7th Cir. 1999). Moreover, we review applications of law to the facts for clear error. Kunze, 233 F.3d at 948; Kikalos, 190 F.3d at 793; Pittman v. Commissioner, 100 F.3d 1308, ...