SC Administrative Law Court Decisions

Anonymous Taxpayer (Taxpayer) challenges a proposed assessment of income taxes made by the South Carolina Department of Revenue (DOR) for tax year 1997. The proposed assessment is for income taxes of $3,649 and for a penalty for filing a frivolous return of $500. Taxpayer opposes both the assessment and the penalty.

After reviewing the arguments and evidence, the taxpayer is liable for additional income taxes of $3,649 and a penalty of $500 for filing a frivolous return.

1. Is the taxpayer liable for a proposed assessment of $3,649 of income taxes for tax year 1997?

2. Is the taxpayer liable for a $500 penalty for filing a frivolous return for tax year 1997?

1. Positions of Parties

The taxpayer argues that he had no taxable income for 1997 since he received no income from sources listed in section 861 of the Internal Revenue Code. DOR asserts that the taxpayer earned wages from employment in South Carolina during 1997 and that section 861 of the Internal Revenue Code is irrelevant to the taxpayer's circumstances.

2. Findings of Fact

I find by a preponderance of the evidence the following facts:

During 1997, the taxpayer resided in South Carolina and worked for Southeastern Alarm Systems (Southeastern). The taxpayer provided labor to Southeastern as an employee and in return for that labor Southeastern paid money to the taxpayer. Southeastern provided funds to the taxpayer in the gross amount of $63,662, but delivered at least $3,961.92 of that amount to DOR as "South Carolina Income Tax Withheld" for the taxpayer. (See SC1040 line 15 of taxpayer's filed return).

On April 14, 1998, the taxpayer filed a South Carolina income tax return with DOR for the 1997 tax year. In answer to the form's question of "income subject to tax," the taxpayer inserted a zero in the space given. In addition to the SC1040 form, pursuant to the instructions on the SC1040, the taxpayer attached the W-2 form given to him by Southeastern. Further, on line 15 of SC1040, the taxpayer stated that the amount of "South Carolina income tax withheld" was $3,961. Thus, since the taxpayer reported a taxable income of zero and a withholding of $3,961, the return showed $3,961 as the "amount to be refunded." In due course, DOR issued a refund for $3,961.

During June 1999, DOR determined that the taxpayer had incorrectly computed his taxable income. Taxpayer claims he does not know how much he was paid by Southeastern during 1997. Thus, to arrive at the taxpayer's taxable income, DOR consulted withholding records filed by Southeastern with DOR and consulted information filed by Southeastern with the South Carolina Employment Security Commission. Those records confirmed wages paid to the taxpayer for 1997 of $63,662. To arrive at taxable income, DOR subtracted a standard deduction of $4,150 and a personal exemption of $2,650 to arrive at a taxable income of $56,862.

3. Conclusions of Law

a. Taxable or Non-taxable

Before addressing the substantive issue of whether Taxpayer received taxable income, a procedural matter must be decided. Taxpayer argues that he should not have been compelled at the hearing to answer questions about his income for the 1997 tax year once having claimed his right against self-incrimination embodied within the Fifth Amendment. Under the facts of this case, the Fifth Amendment was not properly claimed by Taxpayer.

No doubt exists that the Fifth Amendment protects against self-incrimination not only at a criminal trial but in any other proceeding in which the answers to official questions might tend to incriminate the witness in future criminal proceedings. Minnesota v. Murphy, 465 U.S. 420, 426, (1984). However, even though broadly available, the privilege can be used only to ward off a real danger of criminal prosecution as opposed to a speculative possibility. Brown v. Walker, 161 U.S. 591 (1896); Mason v. United States, 244 U.S. 362 (1917) (a danger of "imaginary and unsubstantial character" will not suffice); Hoffman v. United States, 341 U.S. 479 (1951) (the privilege's protection extends only to witnesses who have "reasonable cause to apprehend danger from a direct answer."). In deciding if a real danger exists, the trial court and not the witness determines whether the privilege has been properly asserted. Ohio v. Reiner, 121 S.Ct. 1252 (2001). If the trial court finds the privilege is not properly invoked due to the witness being mistaken about the danger of incrimination, the trial court may order the witness to answer the question. Hoffman v. United States, 341 U.S. 479, 486 (1951); Bank One v. Abbe, 916 F.2d 1067, 1077 (6th Cir.1990) ("It is for the court to decide whether a witness' silence is justified and to require him to answer if it clearly appears to the court that the witness asserting the privilege is mistaken as to its validity.").

In the instant case, the privilege was not properly invoked since no danger of incrimination existed for the Taxpayer. Here, giving Taxpayer the most generous interpretation possible, Taxpayer apparently sought to invoke the privilege on the ground that his answers could lead to criminal tax liability concerning his 1997 tax return. The ALJ inquired as to the possibility of any criminal charge resulting from the taxpayer's answers related to his income tax liability for 1997. In response, counsel for DOR stated that counsel was authorized to declare that the witness was not now nor would he in the future be the target of any criminal prosecution for any 1997 income tax return. Counsel's statements were unambiguous and left no doubt that no criminal actions would result from answers concerning the 1997 tax return. Accordingly, no incrimination was at hand, and Taxpayer was properly directed to answer the question and justify his non-taxability position.

In attempting to justify his position of non-taxability, Taxpayer argues that only income from sources listed in IRC § 861 are taxable. He then asserts that since he received no income from a source listed in IRC § 861, he had no income taxable by South Carolina. The taxpayer's view is patently incorrect.

First, plainly Taxpayer received taxable income during 1997. Here, Taxpayer provided services to Southeastern during 1997 and in return Southeastern compensated Taxpayer by paying funds to him. Compensation paid in return for labor or services is income taxable under the income tax laws. IRC § 61 (gross income includes "[c]ompensation for services . . ."); see also e.g. Commissioner v. Kowalski, 434 U.S. 77, 98 S.Ct. 315, 54 L.Ed.2d 252 (1977); United States v. May, 555 F.Supp. 1008 (E.D.Mich.1983) ("it is clear that wages, salaries, and any other things of value received in exchange for work performed are income within the meaning of the Sixteenth Amendment to the United States Constitution, and the Internal Revenue Code.").

Second, given that Taxpayer received funds in exchange for his labor and that such funds are taxable, Taxpayer must demonstrate how such funds are transformed into non-taxable income. Taxpayer attempts to show the non-taxability of his income by reliance upon IRC § 861. Taxpayer's argument fails.

Taxpayer cannot conclude that he has no South Carolina taxable income by merely relying upon whether the source of the income is listed in IRC § 861 since South Carolina specifically declined to adopt IRC § 861 as a part of South Carolina's tax laws. Thus, IRC § 861 forms no part of South Carolina taxation law and has no relevance to South Carolina taxation. See S.C. Code Ann. § 12-6-50 ("For purposes of this chapter, except as otherwise specifically provided, the following Internal Revenue Code Sections are specifically not adopted by this State: (11) Sections 861 through 908 . . .").

Further, even if IRC § 861 applied in this case, Taxpayer would still be subject to tax. Specifically, IRC § 861(a)(3) explains that "compensation from labor or personal services performed in the United States" is gross income from a source within the United States. Thus, Taxpayer received compensation for labor performed in the United States for Southeastern and therefore received income from a source listed in IRC § 861.

Accordingly, Taxpayer had income taxable by South Carolina for tax year 1997.

b. Amount of Taxable Income

Having found Taxpayer received taxable income, the remaining question is what is the amount of taxable income.

i. Burden of Proof

DOR argues that Taxpayer had taxable compensation during 1997 of $63,662 which resulted in taxable income of $56,862 after DOR subtracted a standard deduction of $4,150 and a personal exemption of $2,650. In presenting his case, Taxpayer argued he did not have the burden of proving that DOR's assessment of income tax was incorrect. Rather, he argued that DOR had the burden of proving its assessment was correct. Taxpayer is mistaken. In administrative matters challenging the correctness of a DOR income tax assessment, the Taxpayer has the burden of proving the DOR assessment is incorrect.

Generally, the burden of proof is on the party asserting the affirmative in an adjudicatory administrative proceeding. 2 Am.Jur.2d Administrative Law § 360 (1994). In the present case, DOR notified Taxpayer that an additional income tax was due. Taxpayer then notified DOR that the DOR's assessment of his income tax liability was incorrect. When DOR declined to change its assessment, Taxpayer requested and obtained this contested case hearing in order to show that DOR's assessment was incorrect. Therefore, Taxpayer asserts the affirmative on this issue and he must carry the burden of proving that DOR's assessment is incorrect. Id.; cf. Cloyd v. Mabry, 295 S.C. 86, 367 S.E.2d 171 (S.C. App. 1988) ("A taxpayer contesting an assessment has the burden of showing that the valuation of the taxing authority is incorrect. . . . Ordinarily, this will be done by proving the actual value of the property. . . . The taxpayer may, however, show by other evidence that the assessing authority's valuation is incorrect. If he does so, the presumption of correctness is then removed and the taxpayer is entitled to appropriate relief.") (citations omitted). Other jurisdictions have reached the same conclusion. See, e.g., In re Broce Const. Co., Inc., 27 Kan.App.2d 967, 980, 9 P.3d 1281, 1290 (Kan. App. 2000) ("[O]ur Supreme Court has long held that 'the tax found by the tax commission to be due is presumed to be valid [and] the taxpayer has the burden of showing its invalidity.'"). (citations omitted).

Here, Taxpayer failed to offer any evidence challenging the amount of the income tax assessment. Rather, Taxpayer specifically stated he did not know what amount he was paid by Southeastern during 1997 for services he rendered to the company. Thus, Taxpayer failed to disprove the amount of DOR's assessment and thus failed to prove his case.

ii. Evidence of Compensation Paid

Moreover, regardless of who bore the burden of proof, DOR established that during 1997 Southeastern paid Taxpayer $63,662 for services rendered as an employee.

Initially, DOR sought to introduce into evidence a W-2 issued by Southeastern to Taxpayer. DOR argued that the W-2 should not be excluded as hearsay since Taxpayer adopted the entire contents of the W-2 as an admission when Taxpayer attached the W-2 to his filed return. As authority, DOR cites SCRE Rule 801(d)(2)(B) which provides that a statement is not hearsay (and therefore is not excluded by the hearsay rules) if it is one in which a party "has manifested an adoption or belief in its truth." The request was properly denied since the document was hearsay and was not a document for which Taxpayer manifested an adoption or belief in its truth.

Before a purported adoptive admission of a party is admitted into evidence, it "must appear that [the party] understood and unambiguously assented to the statements." 2A Wright & Miller, Federal Practice and Procedure Crim.3d s 413 (2000) (emphasis added); see also People v. Kennedy, 164 N.Y. 449, 58 N.E. 652 (1900) (purported adoptive admissions "should not be admitted unless the evidence clearly brings them within the rule.") (emphasis added). For example, New Jersey in Corcoran v. Sears Roebuck and Company, 711 A.2d 371 (N.J. Super. Ct. App. Div. 1998) interpreted a rule on adoptive admissions virtually identical to South Carolina's rule. There, the court found that a party's attachment of a report to a response to interrogatories, without more, did not constitute an adoptive admission since the interrogatory merely contained a request for a copy of the report. Merely attaching a report in compliance with a request does not constitute an adoptive admission and further, the failure to include a disclaimer in the response to interrogatories does not automatically convert the attached report to an adoptive admission. Id. ⁽¹⁾

Likewise, in the instant case, Taxpayer merely attached the W-2 to his tax return in response to DOR's directive that the tax return must be accompanied by the W-2 form. Further, at the time of the filing of the return, Taxpayer indicated a lack of adoption of the W-2 since he placed a zero on the lines of the return which required an indication of the amount of income received despite the W-2 plainly showing income from wages. In addition, even after filing, Taxpayer continued to assert that he had no wages. Thus, both at the time of filing and subsequent to filing, the actions of Taxpayer do not allow a conclusion that Taxpayer clearly adopted the W-2. ⁽²⁾ Accordingly, the W-2 is not a statement in which the Taxpayer "has manifested an adoption or belief in its truth."

In any event, the W-2 was merely cumulative to other information establishing compensation paid. DOR confirmed compensation paid to the taxpayer for 1997 by consulting withholding records filed by Southeastern with DOR and by consulting information filed by Southeastern with the South Carolina Employment Security Commission. ⁽³⁾ Such records established compensation paid to Taxpayer in the amount of $63,662. Thus, after a standard deduction of $4,150 and a personal exemption of $2,650, Taxpayer had taxable income of $56,862.