GOLDBERG, Circuit Judge:
This is an appeal by the government from an adverse ruling on taxpayers' suit to harvest a refund of taxes paid under protest. Using "net worth statements" to demonstrate an unexplained flowering of taxpayers' wealth, the government sought to show that the luxuriating of financial seedlings into larger plants was attributable to the receipt of unreported monetary nutrients.
Taxpayers, Kenneth Poy Lee and his wife, Chow Joy Lee, are American citizens of Chinese ancestry. During the taxable years in question, 1962 through 1964, they operated a grocery store that Mr. Lee owned, the Acme Food Mart in Greenwood, Mississippi. They conducted the business as a partnership, with Mr. Lee acting as business manager.
Mr. Lee personally maintained all business records, basically utilizing a cash receipts and disbursements method of accounting and reporting income. He recorded sales and expenses by a single-entry bookkeeping method. When customers made cash purchases, the total was computed on an adding machine and then punched into a cash register. Credit transactions were treated as cash sales at the time of collection. At the end of each day, the cash register total would be recorded in the taxpayers' books, typically without further verification. Annual inventories were made by estimating the amount of goods on hand after January 1 of each year.
Taxpayers were not familiar with the preparation of federal income tax returns although Mr. Lee regularly prepared state sales tax returns. Each year Mr. Lee took his records to a certified public accountant, who prepared his individual and partnership federal tax returns for him.
On January 1, 1966, William J. Sykes, an agent of the Internal Revenue Service, visited taxpayers in the hope of obtaining their consent to extending the three-year statute of limitations for taxable year 1962.
On February 1, 1966, Sykes and Eugene Fortenberry, a special agent of the IRS, began an extensive examination of taxpayers' records and returns for the taxable years in issue. Fortenberry was later replaced by special agent Donald L. Mann, who completed the investigation of taxpayers' returns. In May, 1966 Mann prepared a "net worth statement" for the taxable years in issue and submitted it to taxpayers for their inspection. Taxpayers registered no objections to the net worth statement at that time, and on January 15, 1970, the District Director of the IRS assessed additional income taxes, penalties, and interest for the taxable years 1962, 1963, and
Because the three-year statute of limitations had already run for each of the taxable years in question, the government's case depended upon proof by clear and convincing evidence that the returns were fraudulent with the intent to evade tax. See Jenkins v. United States, 5 Cir.1963, 313 F.2d 624. Whenever such fraud is shown, there is no limitations period, id; 26 U.S.C.A. § 6501(c)(1), but the government's burden is heavy indeed.
The proof of fraud offered in the instant case consisted of government computations revealing that the taxpayers' "net worth" during the three years in question increased by $71,637.45 while taxpayers only reported adjusted gross income for the same period approximately totalling $8,000. Based upon the evidence adduced at trial, the district judge made findings of fact that there were several inaccuracies in the government's computations. The following errors were thought to be particularly prejudicial
The court below recognized that the government may sometimes use unreported and unexplained growth in net worth figures to infer fraud. See, e. g., Sasser v. United States, 5 Cir.1953, 208 F.2d 535. But the trial judge also held that countervailing circumstances may be sufficiently strong to offset the "badge of fraud" inferable from unreported growth in net worth. The district judge cited the following factors as here outweighing any inference of fraud: the government's inaccuracies in computing taxpayers' net worth growth; taxpayers' limited educational backgrounds;
We agree that all the surrounding circumstances must be considered when fraud is sought to be proved by use of net worth statements. See, e. g., Webb v. Commissioner, 5 Cir.1968, 394 F.2d 366, 379 (lack of education); Anderson v. Commissioner, 5 Cir.1957, 250 F.2d 242, 250 (attitude of taxpayer). Additionally, we are aware that the conclusion that the government failed to sustain its burden of proving fraud is a finding of fact that ordinarily will not be disturbed on appeal.
Rewis v. United States, 5 Cir.1971, 445 F.2d 1303, 1304. Nevertheless, on the instant record we are convinced that in reaching his decision the able district judge misconceived the effect of some of the evidence and that a remand for reconsideration and for expanded fact findings is needed in order to "avoid any chance of an unjust result." Gibbs v. Tomlinson, 5 Cir.1966, 362 F.2d 394,
Confusion when using the "net worth statements" technique to show the existence of unreported income is perhaps to be expected.
It appears from the instant record that in applying this method the trial judge was led astray by the three evidentiary inaccuracies of the government's computations. We set out in a footnote the specific misconceptions of evidence that we believe were made,
The general misapprehension of evidence we have here discerned was the giving of almost controlling weight to the discovery of errors in the government's computations. The presence of accounting or mathematical errors
Kalil v. Commissioner, 5 Cir., 271 F.2d 550, 551 (emphasis original).
Although the government's burden is a heavy one, it is not a millstone of impossible carriage. The extent of the understatement of income may be a mystery, but this is not synonymous with insolvability. We believe the trial court donned the robes of a mathematician and operated under a mistaken theory that he had to find computerized certainty in the understatement before he could conclude fraud. While he must discern a plot, he need not reconstruct every line of the scenario.
On remand the learned trial judge should not expect the government to weigh with exactitude every stone in the lode or account for every penny in the hoard. Substantiality, albeit imprecise, in the understatement of income is sufficient to carry the day. We remand this case to allow the court below to reconsider the evidence in the light of the directions herein contained.
Reversed and remanded with directions.
Adjusted Gross Tax Paid Adjusted Gross Additional Income on Income Income Tax Penalties Interest Year Reported Reported Alleged by IRS Assessed Assessed Assessed1962 $2,767.67 $ 93.43 $30,616.49 $7,506.29 $3,753.15 $3,075.83 1963 (-477.48) 0.00 20,213.44 4,142.43 2,071.22 1,444.12 1964 5,589.94 206.85 20,807.52 3,703.55 1,851.78 1,073.17 TOTAL ADDITIONAL ASSESSMENT: $28,621.54
Webb v. Commissioner, 5 Cir.1968, 394 F.2d 366, 377-378.
(2) Overstating the inventory figures for each taxable year: Because taxpayers' inventory estimates were apparently based upon retail resale value, rather than cost (here approximately equal to retail minus 20%), the trial judge concluded that the amounts were overstated. Logically, however, a 20% reduction for each year's inventory estimates would likely produce little net effect. Also, the next step should again have been to calculate the correct amounts.
(3) Failure of the government to show taxable character of income sources: The trial judge concluded that lack of government evidence as to the sources of the income inferred weighed against any inference of fraud in failing to report income. But the government does not bear the burden of negativing such an inference. It is up to the taxpayer at least to raise the issue of the exempt character of income that is shown to have been received after the opening of the net worth computation period. Cf. Holland v. United States, 1954, 348 U.S. 121, 75 S.Ct. 127, 99 L.Ed. 150.