Appeal from a decision of the United States Tax Court, 74 T.C. 260 (1980), upholding as revised a deficiency in petitioner's income taxes for the taxable year ending December 31, 1974. Reversed in part, affirmed in part, and remanded .
Before Friendly, Mansfield and Kearse, Circuit Judges.
Raul Llorente, a taxpayer, appeals from a decision of the United States Tax Court filed May 13, 1980, upholding with modifications a statutory Notice of Deficiency issued by the Commissioner of Internal Revenue (Commissioner) pursuant to §§ 6212, 6651(a), 6653(a) and 6654(a), Internal Revenue Code of 1954, which, using the expenditures method to reconstruct Llorente's income for the year 1974, claimed that he had unreported income based on alleged expenditures for (1) cocaine, (2) living expenses, and (3) the purchase of a bar and grill. Llorente claims that the Commissioner's assessment was arbitrary and without rational foundation. We reverse the decision insofar as it upheld the assessment based on an alleged illegal expenditure for cocaine. In all other respects the Tax Court's decision is affirmed.
In September, 1976, the Commissioner sent Llorente a Notice of Deficiency determining that he owed $29,403.76 in income tax, along with penalties and fines totaling another $9,762.06, for unreported income allegedly received during 1974. The largest item in the reconstructed income statement was an entry for $54,000 which, according to the Commissioner, had been "expended (by Llorente) for the purchase of cocaine." Llorente filed a petition with the Tax Court contesting the Notice of Deficiency, and a hearing on the matter was held before Judge Sterrett. At that hearing, Llorente testified that he had never purchased any cocaine and had not entered into any dealings with others to purchase cocaine.
The Commissioner's chief witness, a New York City undercover police agent named John Hernandez, testified that he had seen or overheard known cocaine dealers speaking with Llorente about future shipments of cocaine. Based on this evidence and on the additional fact that as a result of Hernandez' investigation Llorente had been indicted for conspiring to criminally possess and sell a controlled substance and had pled guilty to the crime of attempted conspiracy to criminally possess a controlled substance, the Tax Court, in a six-to-five decision, determined that the Notice of Deficiency had not been prepared arbitrarily. Nevertheless, the Court reduced the cocaine expenditure item from $54,000 to $18,000 on the theory that, although an informant had told Agent Hernandez that Llorente had on one occasion been seen inspecting cocaine costing $54,000, Llorente was only one of three potential buyers present at the time and therefore should not be presumed to have purchased more than one-third of the cocaine.
The stipulated facts reveal that Llorente immigrated to the United States from Colombia in 1965, bringing $1,500 cash with him. By 1972 he and his wife had saved $11,000, $10,000 of which they used that year to make a down payment on a home. In 1973 he and his wife filed a joint tax return showing gross income of $13,020, of which $565 represented interest income. In January, 1974, Llorente purchased the La Paz Bar and Grill for $9,000 cash.
Soon after the bar reopened under Llorente's ownership, New York City police officers began investigating some of its customers for their possible participation in a Colombian cocaine network. On March 8, 1975, as a result of this investigation, Llorente was arrested and later indicted by a New York state grand jury on charges of conspiring to criminally possess and sell a controlled substance. On May 24, 1977, Llorente, after remaining in jail for over two years because of his inability to post $300,000 bail, entered a plea of guilty in the New York State Supreme Court to the crime of attempted conspiracy to criminally possess a controlled substance; on September 6, 1977, he was sentenced to time served and released.
Llorente did not file an income tax return for 1974.*fn1 The Commissioner was advised by John Hernandez, the undercover agent who had led the investigation of the La Paz Bar and Grill, that Llorente had been seen by an informant inspecting six kilos of cocaine worth at least $54,000. Using the expenditures method of income reconstruction, the Commissioner computed Llorente's gross income by adding $54,000, representing the purported cocaine purchase, to estimates of Llorente's living costs ($7,800) and mortgage payments ($3,156). After allowing Llorente certain itemized deductions, the Commissioner determined that Llorente owed income tax amounting to $29,403.76 for the year 1974, plus $9,762.06 in penalties pursuant to I.R.C. §§ 6651(a), 6653(a), and 6654(a). A Notice of Deficiency was sent to Llorente in September, 1976, while he was still incarcerated. Llorente filed a petition with the Tax Court contesting the deficiency calculations, and a hearing was held before Judge Sterrett.
At the hearing Llorente took the stand on his own behalf and denied ever purchasing cocaine or having been involved with any cocaine transactions. He estimated that his 1974 living expenses ran to between $900 and $1,000 per month. He admitted that he had spent $9,000 during 1974 to purchase the bar, but claimed that the sum had come from accumulated family savings: "I had that money saved up, and as proof of that, I have my bank books here my savings banks." He did not, however, offer the bank books in evidence.
Llorente's principal argument at the hearing was that the Commissioner's Notice of Deficiency was arbitrary and excessive, and that therefore the burden of proof should shift to the Commissioner. In responding to this contention, the Commissioner relied principally on the testimony of undercover Agent Hernandez. Hernandez testified that he had purchased cocaine on several occasions at Llorente's bar during 1974, but had never made a purchase from Llorente himself. Llorente did figure directly, however, in two incidents observed by Hernandez. In the first Hernandez asked Louis Irving Taylor, a La Paz Bar patron from whom he had purchased drugs in the past, whether the shipment he was waiting for had arrived. Taylor got up from the table where he had been sitting with Hernandez and spoke to Llorente out of Hernandez' hearing. When Taylor returned to the table, he informed Hernandez that the shipment had not yet arrived. In the second incident, Hernandez arrived at the bar to purchase cocaine from Alvaro Doronzoro, another drug contact at the La Paz Bar. After Hernandez asked Doronzoro for his cocaine, Doronzoro spoke with Llorente, and Hernandez overheard Llorente respond that the shipment had not arrived.
Hernandez also testified to a third incident involving Llorente which had been recounted to him by an unnamed informant.*fn2 According to Hernandez, his informant had told him that a shipment of six kilos of cocaine had been received in Queens; that Llorente and Doronzoro had gone with the informant to the house where the cocaine was located to inspect it; and that Llorente's opinion had been sought because the cocaine was damp.*fn3 Hernandez later relayed an account of this third incident to revenue agents from the Manhattan District Director's office, and told them that the cost of cocaine at the time was between $9,000 and $14,000 per kilo. It was on the basis of this information from Hernandez that the Notice of Deficiency was prepared.
By a six-to-five vote the Tax Court, upon reviewing the record of the hearing before Judge Sterrett, upheld the Commissioner's Notice of Deficiency. 74 T.C. at 266. The majority*fn4 concluded that the evidence of Llorente's knowledge of pending drug shipments, his inspection of six kilos of cocaine, his indictment on a drug-related conspiracy count, and his plea of guilty to a lesser charge demonstrated that the Commissioner had not "arbitrarily placed petitioner in the drug business, a business not noted for its nonprofit purpose." Id. The Court then decided that, although the Commissioner was correct in inferring that Llorente was connected "in some manner" with cocaine dealings, the $54,000 expenditure for cocaine, which the Commissioner had attributed to Llorente, should be reduced and that since Doronzoro and the unnamed informant were both present with Llorente at the time when the six kilos of cocaine were inspected Llorente should not be presumed to have purchased more than one-third of the six kilos. The Court accordingly reduced the cocaine expenditure item in the deficiency notice to $18,000. To this it added the $9,000 which Llorente had admitted spending for purchase of the bar in 1974, as well as an adjusted $10,800 estimate for living expenses, based on Llorente's testimony that his family was spending between $900 and $1,000 per month in 1974.*fn5
In responding to Llorente's argument that the Tax Court's recent decision in Jackson v. Commissioner, 73 T.C. 394 (1979), and the Ninth Circuit's decision in Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), rev'g, 67 T.C. 672 (1977), were on point and required the Tax Court to find that the Commissioner's Notice of Deficiency was arbitrary and excessive, Judge Sterrett suggested that Jackson and Weimerskirch were best read as holding that a Notice of Deficiency ceases to be arbitrary when the taxpayer is shown to have been connected in some fashion with the business in which the unreported income was allegedly generated:
"The deficiency in Jackson was premised on respondent's conclusion that the taxpayer was in the drug business. Yet, there was no firsthand testimony introduced at the trial by respondent to support such a conclusion, and he was compelled to admit that the deficiency was based upon what an informant, who did not testify, had told his agent. Thus, there was no evidence to put Jackson in the drug business, much less any evidence relevant to drug income. Similarly, the facts in Weimerskirch are inapposite. There, there was a notice of deficiency based upon statements of unidentified informers and ...