                               T.C. Memo. 2017-124


                         UNITED STATES TAX COURT



                RICHARD A. CANATELLA, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 19375-13.                           Filed June 26, 2017.



      Richard A. Canatella, for himself.

      L. Katrine Shelton, Brenn C. Bouwhuis, and Charles B. Burnett, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      MORRISON, Judge: The respondent (referred to here as the “IRS”) issued

a notice of deficiency to the petitioner, Richard A. Canatella, for the taxable years

2008, 2009, and 2010. The IRS determined tax deficiencies of $248,262 for 2008,

$92,758 for 2009, and $128,167 for 2010, and accuracy-related penalties under
                                          -2-

[*2] section 6662(a) of $49,652 for 2008, $18,552 for 2009, and $25,633 for

2010.1 Canatella timely filed a petition under section 6213(a) for redetermination

of the deficiencies.2 We have jurisdiction under section 6214. In this opinion we

hold:

        1.    The Court did not err in allowing the revenue agent to remain in the

courtroom after Canatella’s request to exclude fact witnesses from the courtroom

at the beginning of trial. See infra part 1.

        2.    The counsel for the IRS did not engage in misconduct due to the

mislabeling of exhibits. See infra part 2.

        3.    The IRS’s bank-deposits analysis is not erroneous as a whole.

However, $124,000 in deposits were improperly characterized as income to

Canatella for 2008. See infra part 3.

                                FINDINGS OF FACT

        Some of the facts have been stipulated and are so found.


        1
       Unless otherwise indicated, all section references are to sections of the
Internal Revenue Code as in effect for the years at issue, 2008-2010, and all Rule
references are to the Tax Court Rules of Practice and Procedure. All dollar
amounts are rounded to the nearest dollar.
        2
       Canatella was a resident of California when he filed the petition.
Therefore, an appeal of our decision in this case would go to the U.S. Court of
Appeals for the Ninth Circuit, see sec. 7482(b)(1), unless the parties designate the
Court of Appeals for another circuit, see id. para. (2).
                                            -3-

[*3] I.         Background

          In 2008-10, Canatella operated a law firm doing business as Cotter & Del

Carlo. He was the only lawyer in the firm, which operated as a sole

proprietorship. Before its winding up of business in 2010, the firm had been in

existence over 40 years and specialized in probate matters.

          As a result of litigation or settlements, Canatella often received funds

payable to his clients and was obligated to hold the funds in trust until

distributions were warranted. From 2008 to 2010, Canatella maintained 20 bank

accounts at six financial institutions.

II.       Tax Reporting; Notice of Deficiency

          Canatella filed late Forms 1040, “U.S. Individual Income Tax Return”, for

2008, 2009, and 2010. Canatella filed both his 2008 and 2009 returns on June 10,

2011, and his 2010 return on November 4, 2011.

          During each of the three years, Canatella filed under the status of married-

filing-separately. An accountant prepared each of the returns. On his returns for

2008, 2009, and 2010, Canatella did not report any income other than the business

income that he reported on his Schedules C, “Profit or Loss From Business”. The

Schedules C reported the following business income, expenses (broken down into

various categories), and gain/loss from the operation of Cotter & Del Carlo:
                                         -4-

           [*4]                           2008        2009          2010
           Gross receipts               $509,486    $382,372     $170,654
           Expenses                      436,096      311,130     210,851
           Net profit/loss                73,390       71,242      (40,197)

      Even though Canatella reported only business income on his tax returns, the

IRS received information returns from payors showing that they paid Canatella

interest and Social Security income. The IRS initiated an audit of the 2008, 2009,

and 2010 returns on account of both his failure to timely file these returns and his

failure to report on the late-filed returns his interest and Social Security income.

The IRS, through its revenue agent, requested documents from Canatella regarding

his business income, interest income, and Social Security income. In response,

Canatella provided (1) a QuickBooks ledger and (2) canceled checks that had been

deposited into his main business checking account, No. 9667. The documents

neither referenced the other bank accounts receiving interest income nor

accounted for discrepancies in interest and Social Security income.

      The IRS issued summonses to all the banks where Canatella had accounts

open during the three-year period. Using the summoned account information, a

bank-deposits analysis reconstructed Canatella’s income. In conducting the bank-

deposits analysis, the IRS: (1) totaled all deposits into all Canatella’s bank

accounts, (2) subtracted out all deposits (or portions of deposits) determined to be
                                        -5-

[*5] nontaxable, including interaccount transfers and refunds, and deposits from

nontaxable sources, (3) subtracted the amounts of income that Canatella had

reported on his tax returns, and (4) determined that the resulting amount for each

year was Canatella’s unreported Schedule C gross receipts. In its bank-deposits

analysis the IRS did not determine that any deposits into account No. 9193 were

taxable because it determined that account No. 9193 was an IOLTA account. An

IOLTA account is an account for client funds that are in small amounts or held for

short periods.

      The IRS provided Canatella with a copy of the bank-deposits analysis and

gave him an opportunity to contest it. Canatella did not furnish any additional

documents to contest the bank-deposits analysis.

      The IRS mailed a notice of deficiency to Canatella for 2008, 2009, and 2010

on May 31, 2013. Reflecting the bank-deposits analysis, the notice determined

Canatella under-reported his Schedule C income by $285,725 for 2008, ($36,391)

for 2009,3 and $232,827 for 2010. The notice disallowed certain business-expense

deductions Canatella claimed on his Schedules C. These disallowed deductions

totaled $336,478 for 2008, $250,320 for 2009, and $144,227 for 2010. The notice


      3
      For 2009 the IRS determined Canatella over-reported his Schedule C
income by $36,391.
                                         -6-

[*6] determined that Canatella had failed to report interest and Social Security

income. The notice determined tax deficiencies of $248,262 for 2008, $92,758 for

2009, and $128,167 for 2010 and section 6662(a) penalties of $49,652 for 2008,

$18,552 for 2009, and $25,633 for 2010.

III.   Stipulation of Settled Issues; Concessions

       After the issuance of the notice of deficiency, the parties executed a

stipulation of settled issues. They agreed that Canatella was entitled to business-

expense deductions of $105,384 for 2008, $76,016 for 2009, and $80,753 for 2010

for categories in which he had claimed deductions on his Schedules C. The parties

also agreed that Canatella was entitled to business-expense deductions of

$108,462 for 2008, $68,360 for 2009, and $24,936 for 2010 for categories in

which he had not claimed deductions on his Schedules C.4 The parties agreed on

the amounts of unreported interest income and Social Security income for each

       4
        In the categories of business-expenses for which Canatella had not claimed
any deductions on his Schedules C, the stipulation of settled issues states that
Canatella is entitled to deductions of “at least” $90,417 for 2008 and $54,112 for
2009 for “case costs and payments to clients”. Thus, the stipulation of settled
issues preserved Canatella’s right to prove his entitlement to deductions for “case
costs and payments to clients” above these dollar thresholds for both years. But in
his brief, Canatella disputes only whether deposits are properly includable in his
income, not whether he is entitled to deductions for the payment of the deposited
funds to his clients. He has therefore waived any argument regarding these
deductions. See Rule 151; Nicklaus v. Commissioner, 117 T.C. 117, 120 n.4
(2001).
                                         -7-

[*7] year. (These amounts totaled $70,975 of interest income and $39,154 in

Social Security income for all three years.). They agreed that Canatella is liable

for the negligence penalty under section 6662(a) for 2008, 2009, and 2010.5 The

parties did not agree on the amounts of Canatella’s Schedule C gross receipts.

      In its brief the IRS conceded that account No. 3427 is an IOLTA account

and that none of the deposits into the account that it determined to be taxable as

part of its bank-deposits analysis are includable in Canatella’s income. Remaining

at issue is the validity of the bank-deposits analysis as a whole and, alternatively,

the taxability of four deposits that Canatella specifically challenges.

                                      OPINION

1.    Designated Representative

      At the beginning of trial, Canatella requested that all witnesses be excluded

from the courtroom under Rule 145. The Court ordered all witnesses excluded

from the courtroom, but made an exception for the revenue agent. The revenue

agent was designated the IRS’s representative by the trial attorneys from the IRS

Office of Chief Counsel. Therefore the revenue agent was properly permitted to

remain in the courtroom under the exception in Rule 145(a) for “an officer or


      5
       On brief Canatella disputes his liability for the sec. 6662(a) penalties, but
he is bound by the stipulation of settled issues. See Rule 91(e).
                                         -8-

[*8] employee of a party which is not a natural person designated as its

representative by its attorney.” Canatella contends in his brief that the designated

representative of the IRS was the trial attorney’s supervising attorney (who also

was in the courtroom) and that therefore the revenue agent could not also be the

designated representative. However, the supervising attorney was not the IRS’s

designated representative under Rule 145(a).

2.    Alleged Misconduct by IRS Trial Attorney

      On brief, Canatella claims the IRS’s trial attorney violated Rules 1-

102(a)(4) and 1-102(a)(5) of the 1969 American Bar Association Model Code of

Professional Responsibility (“Model Code”) by fraudulently stating that Canatella

had been given the latest version of the stipulated exhibits before trial.

Practitioners before this Court are not required to comply with the Model Code.

However, they are required to comply with the American Bar Association Model

Rules of Professional Conduct (“Model Rules”). Rule 201(a). Sections 1-

102(a)(4) and 1-102(a)(5) of the Model Code correspond to Rule 8.4 of the Model

Rules. We are unconvinced that the IRS’s trial attorney engaged in any type of

misconduct. During trial, the trial attorney represented only that: (1) mislabeled

versions of the documents were exchanged before trial and (2) Canatella was not

working from the correct version at trial. After she discovered the discrepancy the
                                         -9-

[*9] trial attorney took the initiative to correct the problem so that Canatella could

properly cross-examine the witness. Accordingly, we find no basis for Canatella’s

allegation of misconduct.

3.    Bank-Deposits Analysis

      The notice of deficiency determined, on the basis of the IRS bank-deposits

analysis, the amounts of Canatella’s total gross receipts and his unreported gross

receipts. On brief the IRS concedes that the deposits into account No. 3427 are

not gross income to Canatella. The relevant amounts are summarized below:

                    Item                       2008        2009          2010
     Total gross receipts according to
      notice of deficiency                $795,211      $345,481      $403,481
     Unreported gross receipts
      according to notice of
      deficiency                            285,725       -36,391      232,827
     Unreported gross receipts after
      concession by IRS in brief
      regarding account No. 3427            260,725       -36,391      141,448

      Gross income generally includes “income from whatever source derived”

unless specifically excluded by statute. Sec. 61(a). Taxpayers are required to

maintain records sufficient to establish the amounts of income, deductions, and

other items which underlie their federal income tax liabilities. Sec. 6001; sec.

1.6001-1(a), (e), Income Tax Regs. If a taxpayer fails to keep adequate books and
                                        - 10 -

[*10] records, the IRS may reconstruct the taxpayer’s income by any method that

is reasonable under the circumstances. Petzoldt v. Commissioner, 92 T.C. 661,

687 (1989). The reconstruction need not be exact, so long as it is reasonable and

substantially correct. Id. at 693; Meneguzzo v. Commissioner, 43 T.C. 824

(1965). The use of bank deposits is recognized as a reasonable method of

reconstructing income. Parks v. Commissioner, 94 T.C. 654, 658 (1990); Tokarski

v. Commissioner, 87 T.C. 74, 77 (1986); Nicholas v. Commissioner, 70 T.C. 1057,

1065 (1978). “The bank deposits method assumes that all money deposited in a

taxpayer’s bank account during a given period constitutes taxable income, but the

Government must take into account any nontaxable source or deductible expense

of which it has knowledge.” Clayton v. Commissioner, 102 T.C. 632, 645-646

(1994) (citing DiLeo v. Commissioner, 96 T.C. 858, 867 (1991)), aff’d, 959 F.2d

16 (2d Cir. 1992). The notice of deficiency issued to Canatella reflected the

conclusions of the IRS bank-deposits analysis in its gross-receipts determinations.

As a general rule, a taxpayer bears the burden of proving the IRS’s determinations

in a notice of deficiency to be in error. Rule 142(a).

      Section 7491(a), which shifts the burden of proof to the IRS under certain

circumstances, does not apply with respect to any factual dispute in this case

because Canatella did not keep adequate books and records. See sec.
                                       - 11 -

[*11] 7491(a)(2)(A) and (B). He claims that he kept his law-practice books on a

computer program called QuickBooks. He gave the printouts from QuickBooks to

the IRS during the examination. However, the revenue agent credibly testified

that the QuickBooks printouts covered only one of Canatella’s business accounts

(Canatella did not introduce the QuickBooks printouts at trial).

      The U.S. Court of Appeals for the Ninth Circuit recognizes another

exception to the general rule where the notice of deficiency determines that the

taxpayer failed to report income. Llorente v. Commissioner, 649 F.2d 152, 156

(2d Cir. 1981), aff’g in part and rev’g in part 74 T.C. 260 (1980); Weimerskirch v.

Commissioner, 596 F.2d 358 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). In such

circumstances, the IRS must come forward with evidence establishing a minimal

foundation, which may consist of evidence linking the taxpayer with an income-

producing activity. Petzoldt v. Commissioner, 92 T.C. at 689. Canatella does not

dispute that he received income from his law practice. However, he contends that

the IRS’s determinations of unreported gross receipts should not be sustained

because the bank records used by the IRS “did not specify the taxable or

nontaxable nature of the deposits”. It is a fundamental principle underlying the

bank-deposits method that all deposits are presumptively taxable. United States v.

Stone, 770 F.2d 840, 844 (1985). If Canatella is correct that the bank-deposits
                                        - 12 -

[*12] method can be used only when the bank records show whether the deposits

are taxable (i.e. includable in gross income for tax purposes), then the bank-

deposits method could never be used. The bank records relied on by the IRS need

not specify the taxable or nontaxable nature of the deposits.

      Next, Canatella contends that the IRS has incorrectly concluded that some

bank deposits were income and that therefore all of the results of its bank-deposits

analysis should be rejected. It is true that the IRS has incorrectly concluded that

some bank deposits were income. This is illustrated by its concession on brief that

it incorrectly determined that deposits into account No. 3427 were income. And,

as we explain later in this opinion, we hold that one deposit (and portions of two

other deposits) were incorrectly determined by the IRS to be income. However,

courts recognize that some errors are unavoidable when an indirect method is used

to reconstruct income, especially where the taxpayer has failed to maintain

adequate records. United States v. Stonehill, 702 F.2d 1288, 1296 (9th Cir. 1983).

In this case, the IRS made an effort to determine which deposits were attributable

to nontaxable sources (and indeed, it determined that some deposits were

attributable to nontaxable sources). Cf. Westby v. Commissioner, T.C. Memo.

2004-179 (bank-deposits analysis invalid where IRS did not make adjustments for
                                         - 13 -

[*13] nontaxable items). We will not reject the IRS’s bank-deposits analysis in its

entirety merely because of these few incorrect determinations.

      Next, Canatella contends that the bank-deposits method is unnecessary

because he kept records of his income through QuickBooks. But as already

explained, he apparently used QuickBooks to track only one of his business

accounts. Further, he did not produce the QuickBooks records at trial. Therefore

we are unable to conclude that the IRS was unreasonable in engaging in its own

method of determining Canatella’s income. We therefore reject Canatella’s

argument that the results of the bank-deposits analysis should be categorically

dismissed.

      Canatella is still entitled to prove that a particular deposit is not taxable.

See Clayton v. Commissioner, 102 T.C. at 645-646. Canatella takes up this

challenge with respect to four specific deposits made in 2008.

      The first deposit was a $61,487 deposit into account No. 2293 on February

12, 2008. This deposit was a transfer from the account that the parties agree was

an IOLTA account, IOLTA No. 9193. Three days before this interaccount

transfer, Canatella had deposited into IOLTA No. 9193 a check in the exact

amount of the transfer. The check was from Residential Mortgage Capital and

was written to Deborah Dolch as conservator for Elizabeth Zut. On the same day
                                        - 14 -

[*14] as the $61,487 interaccount transfer from IOLTA No. 9193 to account No.

2293, Canatella wrote a $20,000 check to Elizabeth Zut drawing on account No.

2293. Canatella asserts the $61,487 deposit is not taxable to him because account

No. 2293 is a client-trust account. He refers to account No. 2293 in his brief as

the “Zut conservatorship distribution account”.

      As a general rule, funds that a taxpayer receives in trust for another person

are not includable in the taxpayer’s gross income. Ford Dealers Advert. Fund, Inc.

v. Commissioner, 55 T.C. 761, 771 (1971), aff’d, 456 F.2d 255 (5th Cir. 1972).

Under this general rule, if a lawyer receives funds that professional regulations

require to be segregated from other funds and accounted for separately, the funds

are not includable in the income of the lawyer. Miele v. Commissioner, 72 T.C.

284, 290 (1979). Under the California Rules of Professional Conduct, Canatella

was required to hold all client funds in bank accounts that were labeled “Trust

Account”, “Client’s Fund Account”, or something similar. Cal. R. Prof. Conduct

4-100(A). He was prohibited from commingling client funds with his own funds.

Id. at 4-100(A)(2). Canatella was also required to keep detailed records of client

funds, including a ledger for each client showing all funds he received on behalf

of the client and all disbursements he made on behalf of the client. Id. at

4-100(B)(3); Board of Governors of the State Bar of California, Trust Account
                                       - 15 -

[*15] Record Keeping Standards (1992), http://www.calbar.ca.gov/Attorneys/

Conduct-Discipline/Rules/Rules-of-Professional-Conduct/Current-Rules/Rule-4-1

00. Account No. 2293 was not labeled a client trust account. Canatella routinely

used the account to deposit his legal fees, to pay his business expenses, and to pay

his personal expenses. He did not introduce as evidence any of the ledgers

required for client trust accounts. Nor did he show that he had such ledgers for

account No. 2293. Thus, Canatella did not follow the labeling, anticommingling,

and record-keeping requirements for maintaining account No. 2293 as a client

trust account. Nonetheless, we conclude that Canatella treated $20,000 of the

$61,467 deposit as the funds of his client Elizabeth Zut. Canatella paid $20,000 to

Zut immediately after the transfer of the $61,467 deposit. Under the

circumstances, $20,000 of the $61,467 was not “treated” by Canatella as

“belonging to him.” See Healy v. Commissioner, 345 U.S. 278, 282 (1953). It is

not includable in his income.

      The second deposit is a $40,960 interaccount transfer on April 4, 2008. The

transfer moved money from IOLTA No. 9193 to account No. 2293, the account

that allegedly was the Zut conservatorship distribution account. The day before

this transfer, Canatella deposited a $150,000 check into IOLTA No. 9193. The

$150,000 check was written by the Allstate Insurance Co. to “Cotter & Del Carlo
                                        - 16 -

[*16] Trust Account”. Canatella claims that he transferred $40,960 from IOLTA

No. 9193 to account No. 2293 in order to keep the $40,960 in trust for LaRell

Franklin, one of several heirs entitled to the proceeds of the $150,000 check.

However, at the same time he transferred $40,960 to account No. 2293, Canatella

made a $28,970 distribution directly to Franklin (as well as distributions to four

other heirs). Canatella argues on brief that he had the authority to hold the

$40,960 in trust while Franklin was incarcerated. But there is no evidence that

Franklin gave this authority to Canatella, that Franklin was incarcerated, or that

Canatella distributed the $40,960 to Franklin after his release. Furthermore,

Franklin received $28,970 immediately after Allstate paid the $150,000

settlement. As a result, we are not convinced that the $40,960 transfer from

IOLTA No. 9193 to account No. 2293 was of funds held in trust for Franklin.

      The third deposit is a $150,000 check from Fidelity National Title Insurance

Co. to “Joan Roback and Cotter & Del Carlo, her attorneys”. The check was

deposited into account No. 1629 on May 29, 2008. Canatella argues that this

account is a non-IOLTA client trust account. But the account was not labeled a

client trust account. The account contained commingled funds. There is no

evidence a client ledger was kept. Thus, Canatella did not follow the California

Rules of Professional Conduct for client trust accounts as to account No. 1629.
                                        - 17 -

[*17] But it is also significant that three days after he deposited the $150,000

check into account No. 1629, Canatella wrote an $80,000 check drawing on

account No. 1629 to Joan Roback with the word “Settlement” on the memorandum

line. Simultaneously with that $80,000 deposit he transferred $32,000 from

account No. 1629 to his main operating account, No. 9667. Canatella argues that

he left $38,000 of the $150,000 in account No. 1629 to pay “future litigation

costs”. He claims he is not taxable on the $150,000 to the extent of (1) the

$80,000 transferred to Roback and (2) the $38,000 remaining in account No. 1629.

His claim that $38,000 was used to pay “future litigation costs” is not supported

by the record. Of the $150,000 deposit, only $80,000 was client funds of Roback

and was not includable in Canatella’s income.

      The fourth disputed deposit is a $24,000 deposit of a check from Canatella’s

son. The deposit was made into account No. 2293, the account that Canatella

claims is the Zut conservatorship distribution account, on April 23, 2008.

Canatella testified that this $24,000 check was a repayment of money he had lent

his son. See, e.g., Commissioner v. Tufts, 461 U.S. 300, 307 (1983). But there is

no loan document in the record. Nor did Canatella report that he earned any

interest on the loan for the last three years. Thus, we are reluctant to conclude that

the $24,000 deposit was a loan repayment. However, we observe that the $24,000
                                        - 18 -

[*18] deposit is also nontaxable if it is a gift. Sec. 102(a). There is no evidence

that Canatella was performing legal services for his son. We believe it is more

likely than not that the $24,000 deposit was either a gift or a repayment of a loan.

Therefore we hold that it is nontaxable.

      In conclusion, we hold that the amount of deposits determined by the IRS to

be includable in Canatella’s income for the tax year 2008 should be reduced by

$80,000 + $20,000 + $24,000 = $124,000.

      We have considered all of the arguments the parties have made, and to the

extent that we have not discussed them, we find them to be irrelevant, moot, or

without merit.

      To reflect the foregoing,


                                                 Decision will be entered under

                                       Rule 155.
