American Valmar International Ltd., Inc. & Valeri Markovski v. Commissioner of Internal Revenue

Citations: 229 F.3d 98; 86 A.F.T.R.2d (RIA) 6362; 2000 U.S. App. LEXIS 24856Docket: 4171

Court: Court of Appeals for the Second Circuit; October 4, 2000; Federal Appellate Court

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In the case of American Valmar International Ltd. Inc. v. Commissioner of Internal Revenue, the United States Court of Appeals for the Second Circuit addressed an appeal concerning federal income tax deficiencies and penalties assessed against Valmar and its sole shareholder, Valeri Markovski, for the tax years 1991 through 1993. The Tax Court had previously ruled that customer deposits made to Valmar for purchasing goods were taxable income, which Valmar contested, arguing these deposits should not be taxed because they were not freely available for use. The Court of Appeals agreed with Valmar, concluding that only commissions earned and portions of deposits that Valmar was not obligated to refund should be considered taxable income. Additionally, the appeal challenged the Tax Court's findings regarding constructive dividends, disallowed deductions, and penalties imposed on Valmar and Markovski. The appellate court affirmed the Tax Court’s decisions in all respects except for the classification of genuine customer deposits as income, remanding the case for further findings on this issue. Markovski's claims regarding constructive dividends and penalties were also addressed but were largely affirmed. The case illustrates the complexities surrounding income classification and tax liabilities for commission brokers.

Valmar maintained a customer account during the tax years in question, which recorded wire transfers and was claimed to consist solely of customer funds designated for purchasing goods. These funds were held in interest-bearing accounts or used to buy U.S. Treasury bills, with Valmar retaining all earned interest. At year-end, the account displayed debits for purchases and commissions, but Valmar reported only its commissions as income, totaling $1,426,653, $1,507,440, and $32,335 for 1991, 1992, and 1993, respectively. The Commissioner argued that all funds in the account were taxable income, asserting they were not exclusively for customer benefit, a position upheld by the Tax Court.

The Tax Court did not categorize the funds as disguised income but recognized Valmar as a commission broker, noting that some funds were indeed intended for customer purchases. However, it inferred from two specific transactions that the year-end balances were entirely income. In the first instance, Valmar debited $57,137 for condominium improvements, which was claimed to be for a customer but was found to benefit Markovski instead, thus constituting a constructive dividend. In the second case, a $24,500 debit was purportedly a customer instruction, but the funds were traced to Markovski's step-daughter, leading the court to conclude they should also be included in gross income. Ultimately, the Tax Court determined that due to these transactions, it could not be certain Valmar managed the customer account solely for customer benefit, warranting the inclusion of year-end balances in taxable income.

Markovski received substantial wire transfers totaling $2,346,340 across 1991 and 1992, which he claims were not income but rather a 'ruble hoard' from his time in the former Soviet Union. He contends these funds were labeled as business transactions to circumvent currency controls. The Tax Court acknowledged Markovski's significant wealth prior to emigration but determined that six deposits from 1991 were related to Valmar's business operations, thus including them in Valmar's income and treating them as a constructive dividend to Markovski. The seventh transfer in 1992 was recognized as part of the ruble hoard.

The Commissioner assessed accuracy-related penalties against both Valmar and Markovski for substantial understatements of income, as per I.R.C. § 6662, and imposed a delinquency penalty on Valmar due to late returns under I.R.C. § 6651. The Tax Court upheld these penalties, adjusting them based on recalculated deficiencies.

In their appeal, the appellants argued that the Tax Court incorrectly classified year-end customer deposits for Valmar as taxable income. The dispute centered on whether these deposits were available for Valmar's use or if they were held for customers. The Tax Court found insufficient evidence to refute the existence of customer obligations despite poor record-keeping and ultimately included all year-end balances, adding $2,966,428 to Valmar's taxable income. The appellants contended that only a small percentage of the deposits were implicated in disputed transactions, questioning the justification for including the entire balance as income.

Customer deposits that do not grant the recipient 'complete dominion' are not taxable as income upon receipt. The Supreme Court's decision in *Commissioner v. Indianapolis Power & Light Co.* established that deposits, such as those taken by a utility company from customers with poor credit, should not be included in taxable income if they are subject to an obligation to repay. The court emphasized that economic benefit derived from deposits does not determine taxability; rather, the key factor is whether the recipient has the obligation to return the funds. 

In this context, Valmar's customer deposits were similarly assessed. The Tax Court found that Valmar had obligations to its customers regarding the funds, as the deposits were not commitments to purchase specific goods. Valmar's ability to use the excess funds depended on customer requests for additional goods or refunds, paralleling the situation in *Indianapolis Power*. The Court reiterated that possession of funds does not equate to complete dominion if there is an obligation to the customer. 

Precedents confirm that control over deposits, unrestricted use, and lack of interest payment do not negate the obligation to repay or imply complete dominion. Other cases, such as *Houston Indus. Inc. v. United States* and *Oak Indus. Inc. v. Commissioner*, support the stance that such deposits are not taxable income because they are effectively refundable or can be used to offset future services, similar to loan proceeds that carry a repayment obligation.

The reversal of the Tax Court's findings is limited, specifically regarding the connection of condominium improvements and a wire transfer to Panarey to Valmar's business. The Tax Court previously determined that Valmar had legitimate customers and obligations, indicating that some or all funds in the customer account were actual deposits owed to those customers, which undermines the inference that these funds were fully available for Valmar's use. The transactions involving the condominium and Panarey do not negate this conclusion, as it's typical for commission brokers to receive customer funds as compensation, suggesting these might be disguised commissions. Even if customer funds were misappropriated, it does not make all deposits taxable income. The Tax Court's findings of just two minor transactions over three years do not align with the established existence of Valmar's real customer obligations. The Tax Court did not adequately explore whether other year-end balances were under Valmar's complete control and thus taxable. The case is remanded for the Tax Court to assess what portion of the $2,966,428 is taxable.

Valmar also disputes the Tax Court's rejection of additional claimed deductions of $291,293, $104,894, and $38,828 for the years 1991, 1992, and 1993, arguing these had been conceded by the Commissioner. The Tax Court ruled that Valmar failed to substantiate these deductions and that the burden of proof lies with the taxpayer. Since the Tax Court's conclusions are well-supported by evidence, Valmar has not met its burden. The deduction issues would be moot if the year-end balances are not taxable.

Regarding the ruble hoard, the Tax Court's factual findings on wire transfers to Markovski were based on credibility assessments and are upheld. The Tax Court determined that six 1991 deposits were income to Valmar and a constructive dividend to Markovski. This affirms that diverted amounts taxed as constructive dividends are also taxable to the corporation. Additionally, the $57,137 spent on condominium improvements is deemed a constructive dividend to Markovski.

The appellants contended that the Tax Court incorrectly upheld the imposition of a delinquency penalty on Valmar and understatement penalties on both Valmar and Markovski. According to Section 6651 of the Tax Code, a five-percent monthly penalty (up to 25% total) applies for failure to file a tax return unless the taxpayer demonstrates reasonable cause and lack of willful neglect. Reasonable causes include unavoidable postal delays, serious illness, or reliance on incorrect advice from a tax advisor. The taxpayer carries the burden of proving timely filing. The Tax Court determined that Valmar's returns were late based on conflicting testimony from the appellants' accountant and the Commissioner's evidence, including postmarks, concluding the accountant's testimony was unreliable, thus affirming the delinquency penalty against Valmar.

Section 6662 of the Tax Code imposes a 20% penalty on underpayments attributable to substantial understatements of income tax, defined as exceeding either 10% of the required tax or $5,000 (or $10,000 for corporations). No penalty applies if the taxpayer had substantial authority for their treatment of the item. The court reversed accuracy-related penalties concerning year-end customer account balances, instructing the Tax Court to reassess this on remand. The accuracy-related penalty against Markovski was upheld due to his failure to report amounts deemed constructive dividends by the Commissioner, supported by insufficient documentation from him.

In conclusion, the Tax Court's decisions regarding the constructive dividends and penalties on Markovski, the delinquency penalty on Valmar, and the non-business nature of certain transactions were affirmed. However, further findings were required on Valmar's taxable income related to year-end customer account balances, and the appropriateness of a related accuracy penalty will be reconsidered post-remand.

The Honorable Charles L. Brieant, a United States District Judge for the Southern District of New York, noted that the Commissioner erroneously adjusted the appellants' income by omitting two transfers, resulting in a total adjustment of $613,410 instead of $746,340. Appellants disputed the inclusion of an additional $337,000 in Valmar's gross income, which Valmar claimed was transferred to a customer's bank account at the customer's request. The Tax Court sided with Valmar and did not uphold the deficiency concerning these funds. Appellants argued for a shift in the burden of proof to the Commissioner regarding the ruble hoard, referencing the case Gold Emporium, Inc. v. Commissioner, which stated that the presumption of correctness does not apply when an assessment lacks a rational foundation. However, it was concluded that demonstrating the lack of merit in the assessment would negate the need to argue for a shift in the burden. As the Tax Court's ruling on the ruble hoard transfers was not reversed and the potential exclusion of deposits from Valmar’s taxable income remains undetermined, this matter is left for future proceedings without further comment.