When New Mexico audits an individual's income tax by treating unexplained bank deposits as unreported business income, which deposits count — and which are excluded as loans, transfers, or income already reported?

Plain-English summary

When the Department reconstructed a construction contractor's income from bank deposits and treated the gap between his federal and New Mexico "gross receipts" figures as unreported income, the hearing officer went deposit by deposit — excluding loans, transfers, refunds, and already-reported gains, but keeping unexplained deposits. Protest GRANTED IN PART and DENIED IN PART.

Don Hetter owned Storm Construction Company. After a 1995 gross-receipts audit (resolved in an earlier decision), the Department used the same bank-deposit information in 1999 to audit his personal income tax. Because he had no books, the auditor added up deposits into his business account, compared the total to the gross receipts he reported on his federal Schedule C, and treated the difference — about $84,413 for 1995 — as unreported income, which it used to bump up his federal adjusted gross income and assess more New Mexico tax. (A separate 1996 assessment was abated in full after Hetter provided information.)

The Department's method was conceptually flawed

New Mexico income tax is built on federal adjusted gross income (Section 7-2-2(B), tying "base income" to adjusted gross income under IRC § 62). The hearing officer pointed out that a mismatch between a taxpayer's gross receipts on federal Schedule C and his gross receipts reported for New Mexico gross receipts tax does not prove income was omitted from federal AGI. The two figures often do not correlate — a multistate business, or the many exemptions and deductions in the Gross Receipts and Compensating Tax Act, can make them diverge — so the discrepancy is not reliable proof of unreported income. Still, because an assessment is presumed correct (Section 7-1-17(C)), Hetter had to prove, deposit by deposit, that each amount was not additional income.

Deposits excluded from income (Hetter met his burden)

• $42,273.97 — proceeds from selling property on which he had affixed a mobile home. He showed he had already reported this sale as a long-term capital gain on his federal Schedule D, so it was already in his federal AGI and could not be added again.
• $10,212.89 and $7,500 — proceeds of two Western Bank loans (one corroborated by loan documents, the other adequately explained through his account records). Loan proceeds are not income.
• $50 and $100 — refunds of deposits he had paid an architectural/engineering firm to borrow plans for preparing bids. Returned deposits are not income.
• $2,000 — a transfer from his own payroll account to his business account, corroborated by his records. Moving your own money between accounts is not income.

Deposits kept in income (Hetter failed his burden)

• $1,250 and $500 — real-estate-contract payments from a buyer. His testimony was credible, but he could not show where he had reported this income on his 1995 federal return, and he gave no breakdown to separate any nontaxable return of basis.
• $18,410.32 — he claimed this was a loan from the Village of Columbus, but he could not explain why a town would lend him money, and his own records labeled it (and related deposits) draws from the "Columbus Project" — i.e., construction receipts.
• $3,700 — he said this was another payroll-to-business transfer, but produced no records to corroborate it.

Result: protest GRANTED IN PART and DENIED IN PART, according to which deposits Hetter proved were not income.

What this means for you

Bank-deposit audits are only a starting point — you can rebut them

If you lack formal books, the Department may reconstruct your income from bank deposits. That total is presumed correct, but you can knock out specific deposits by proving what they really were. The burden is on you, deposit by deposit.

Loans, transfers, refunds, and returned basis are not income

Deposits that are loan proceeds, transfers between your own accounts, or refunds of money you had put up are not taxable income. Keep loan documents, transfer records, and receipts so you can trace each deposit to a non-income source.

Income you already reported cannot be taxed twice

Hetter's biggest win was showing the property-sale proceeds were already in his federal adjusted gross income as a reported capital gain. Because New Mexico tax starts from federal AGI, income already captured there cannot be added again through a gross-receipts discrepancy.

A federal "gross receipts" gap does not automatically mean unreported income

The mismatch between Schedule C gross receipts and New Mexico gross receipts is not reliable proof that income was left out of federal AGI — the two measures are defined differently. But you still have to come forward with evidence tracing each disputed deposit; unexplained or mislabeled deposits (like the "Columbus Project" draws) will stay in.

Common questions

Q: How did the Department calculate the extra income?
A: It reconstructed the business's receipts from bank deposits, compared them to the gross receipts reported on the federal Schedule C, and treated the difference as unreported income, then recalculated federal adjusted gross income to assess more New Mexico tax.

Q: Why did the hearing officer call that method flawed?
A: Because New Mexico income tax starts from federal adjusted gross income, and a gap between federal and New Mexico gross receipts does not prove income was omitted from AGI. The two gross-receipts measures are defined differently and often do not match.

Q: Why was the $42,273.97 excluded?
A: Hetter showed he had already reported that property sale as a capital gain on his federal return, so it was already included in his federal adjusted gross income and could not be counted again.

Q: Why did some deposits stay in income even though his testimony was credible?
A: For those deposits he could not corroborate his explanation or show the income was reported — for example, the "Columbus Project" draw his own records showed was a construction receipt, and the uncorroborated $3,700 transfer. Credible testimony alone did not carry his burden.

Citations and references

Statutes and regulations:

• NMSA 1978, § 7-1-17(C) — a Department assessment is presumed correct; the taxpayer must rebut it
• NMSA 1978, § 7-2-3 — income tax imposed on the net income of New Mexico residents
• NMSA 1978, § 7-2-2(N) — "net income" means base income with adjustments
• NMSA 1978, § 7-2-2(B) — "base income" means federal adjusted gross income under IRC § 62, plus adjustments
• NMSA 1978, § 7-9-53 — deduction for receipts from selling real property, with an exception for improvements built by a seller in the construction business
• NMSA 1978, § 7-1-24 — protest of an assessment
• Internal Revenue Code § 62 — definition of adjusted gross income

Cases cited:

• Archuleta v. O'Cheskey, 84 N.M. 428, 504 P.2d 638 (Ct. App. 1972)

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Don R. Hetter
• Decision PDF: D&O 01-24

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
DON R. HETTER, NO. 01-24
PROTEST TO ASSESSMENT NOS. 398465 AND 398466

DECISION AND ORDER

This matter came on for formal hearing on January 13, 2000 before Gerald B.

Richardson, Hearing Officer. Don Hetter, hereinafter, “Taxpayer”, represented himself at the

hearing. The Taxation and Revenue Department, hereinafter, “Department”, was represented by

Mónica M. Ontiveros, Special Assistant Attorney General. At the close of the hearing, the

record was left open for an additional 30 days, or until February 14, 2000, for the Taxpayer to

submit additional documentation in support of his case and some additional information was

submitted. Based upon the evidence and the arguments presented, IT IS DECIDED AND

ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. The Taxpayer was the owner of a construction company, Storm Construction

Company, which was audited by the Department in 1995, resulting in the issuance of

assessments for underreporting of gross receipts taxes.

2. The Taxpayer protested those assessments and those protests were resolved after a

formal hearing and the issuance of Decision and Order No. 99-12.

3. In 1999, the Department audited the Taxpayer for personal income taxes, using

information about the Taxpayer’s gross receipts from his construction business obtained during

the 1995 audit.

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4. The 1995 audit was based upon the bank records of the Taxpayer for his business and

personal accounts.

5. As a result of the Department’s audits, on June 2, 1999, the Department issued

Assessment No. 398465, assessing $568 in personal income tax, $56.80 in penalty and $184.60

in interest for the 1996 tax year and Assessment No. 398466, assessing $5,148.60 in personal

income tax, $514.86 in penalty and $2,445.58 in interest for the 1995 tax year.

6. On June 26, 1999, the Taxpayer filed written protests to Assessment Nos. 398465 and

398466.

7. As a result of information provided the Department by the Taxpayer at the formal

hearing and afterwards, the Department has abated Assessment No. 398465, eliminating the

liability for personal income tax, penalty and interest for the 1996 tax year.

8. The 1995 personal income tax assessment was based upon the Department’s

determination that the Taxpayer had underreported $84,412.62 in gross receipts as reflected in

bank deposits made into the Taxpayer’s construction business account during that year, thus

affecting the amount of income the Taxpayer reported on Schedule C of his federal income tax

return and the Taxpayer’s federal adjusted gross income, upon which the Taxpayer’s New

Mexico income taxes are based.

9. On November 7, 1995 the Taxpayer deposited $42,273.97 in his bank account. This

amount represents the Taxpayer’s net proceeds from the sale of property in a subdivision on

Miller Road, on which the Taxpayer had moved and affixed a mobile home. The Taxpayer did

not provide a breakdown of the amount as to what portion of the amount represented the

recovery of the cost of the real property and what portion of the amount represented the value of

the improvements and the mobile home that the Taxpayer had affixed to the property. The

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Taxpayer, however, established that he had reported the income made from the sale of the

property on Schedule D of his 1995 federal personal income tax return, reporting $5,843.26 as

long-term capital gain income. The capital gain income was reported on line 13 of the

Taxpayer’s 1995 form 1040 and was taken into consideration in determining the Taxpayer’s

federal adjusted gross income for 1995.

10. On March 6, 1995 and July 11, 1995, the Taxpayer deposited payments received from

Debra Gray in the amounts of $1,250 and $500, respectively. These were payments made under

a real estate contract for real property the Taxpayer sold to Ms. Gray.

11. On March 20, 1995, the Taxpayer deposited $10,212.89 into his account. This

amount was directly deposited in the Taxpayer’s account as loan proceeds. The Taxpayer had

borrowed $18,000 from Western Bank. The $10,212.89 represented the proceeds from that loan

after $7,500 in principal and $287.11 in interest was applied from the loan to pay off an earlier

loan the Taxpayer had received from Western Bank.

12. On October 25, 1995, the Taxpayer deposited $7,500 into his account. The Taxpayer

provided testimony and corroborating loan documents establishing that this amount represented

loan proceeds from a loan from Western Bank.

13. On February 27, 1995 and July 5, 1995 the Taxpayer deposited $50 and $100,

respectively, into his account. These amounts represented refunds from Molzen & Corbin, an

architectural and engineering firm, of deposits which had been made to borrow copies of plans of

projects upon which the Taxpayer desired to make bids.

14. On October 4, 1995 the Taxpayer deposited $18,410.32 into his account from the

Village of Columbus, New Mexico. This amount represented a draw from a construction project

the Taxpayer was performing for the Village of Columbus.

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15. On August 29, 1995, the Taxpayer deposited $2,000 into his account. This amount

represents a voice transfer of monies from the Taxpayer’s payroll account to his general business

account.

16. On October 24, 1995, the Taxpayer deposited $3,700 into his account.

DISCUSSION

The issues in this protest essentially came down to whether the Taxpayer met his burden

of proof with respect to the items the Department considered to be gross receipts of the

Taxpayer’s business for purposes of calculating the Taxpayer’s income from his business which

would be included in the Taxpayer’s personal income for tax year 1995. Section 7-1-17(C)

NMSA 1978 provides that there is a presumption of correctness which attaches to an assessment

of tax issued by the Department. This means that the burden is on a taxpayer contesting the

assessment to present evidence or arguments to overcome the presumption of correctness.

Archuleta v. O’Cheskey, 84 N.M. 428, 504 P.2d 638 (Ct. App. 1972).

The Department’s auditor used the Taxpayer’s bank deposits in order to try to reconstruct

the Taxpayer’s gross receipts from his construction business, because the Taxpayer did not have

books of account which could be audited. The bank deposits were then compared to the gross

receipts from a business or profession as reported on the Taxpayer’s Schedule C of his Federal

personal income tax return. The discrepancy was treated as unreported gross receipts and the

Taxpayer’s federal adjusted gross income was recalculated and used as a basis to determine the

amount of personal income tax which the Department assessed for tax years 1995 and 1996.

The individual transactions which were treated as gross receipts will now be discussed.

The largest item in dispute is $42,273.97, which the Taxpayer testified represented his proceeds

from the sale of property upon which the Taxpayer had moved and affixed a mobile home.

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Section 7-9-53 NMSA 1978 provides a deduction from gross receipts for receipts from the sale

or lease of real property. The statute provides an exception from the deduction, however, for the

portion of the receipts from the sale of real property which is attributable to improvements

constructed on the real property by the seller in the ordinary course of his construction business.

Because the Taxpayer is in the construction business, the Department took the position that it

would allow a deduction for the value of the real property involved in the transaction, but it

argued that since the Taxpayer did not provide such documentation, that the full amount of the

deposit must be included in the Taxpayer’s gross receipts used to calculate his income from his

business for personal income tax purposes.

The Taxpayer demonstrated that he had reported the income from this transaction as a

long term capital gain on Schedule D of his 1995 federal personal income tax return, and that the

capital gain was included in his calculation of his federal adjusted gross income for that year.

This evidence points out the fundamental flaw in the Department’s approach to assessing

personal income tax based upon a discrepancy in the gross receipts as reported on a taxpayer’s

federal Schedule C and gross receipts as reported to the Department under the Gross Receipts

and Compensating Tax Act. Although I can imagine many instances in which a taxpayer’s

“gross receipts” as reported for federal income tax purposes on a federal Schedule C would be

equivalent to taxable gross receipts under the Gross Receipts and Compensating Tax Act, I can

also imagine many instances in which they would not correlate. The gross receipts of a business

operating in multiple states would be quite different than the gross receipts of that same business

for purposes of calculating gross receipts for New Mexico tax purposes. Indeed, given the

number of exemptions and deductions which are contained in the Gross Receipts and

Compensating Tax Act which have been enacted by the legislature and are subject to

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amendment, repeal or modification in any given legislative session, it would appear highly

unlikely that the two can be always be sufficiently correlated to ensure that New Mexico

personal income taxes are assessed correctly based upon federal Schedule C gross receipts. In

this case, the Department assumed that because of the discrepancy in the Taxpayer’s gross

receipts as reported to the Department and the Taxpayer’s gross receipts as reported on Schedule

C, that the income had not been included in the calculation of the Taxpayer’s federal adjusted

gross income, which is the starting point for calculating New Mexico personal income taxes.1

Obviously, that assumption was not correct in this case. The Taxpayer has met his burden of

proving that the $42,273.97 cannot be used to adjust the Taxpayer’s income as reported on

federal Schedule C or for modifying the Taxpayer’s federal adjusted gross income for purposes

of assessing New Mexico personal income tax.

Next, we have the two deposits, in the total amount of $1,750 which the Taxpayer

testified represented payments he had received on a real estate contract from Debra Gray. While

I find the Taxpayer’s testimony as to the source of these payments to be credible and the

Department’s audit procedure, using Schedule C gross receipts for purposes of assessing

personal income tax to be conceptually flawed, nonetheless, the Taxpayer has failed to

demonstrate where any of the income2 he received from his real estate transaction with Ms. Gray

was reported on his 1995 federal income tax return. In the absence of such evidence the amount

will not be excluded for purposes of calculating the Taxpayer’s personal income tax liability for

1995.

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Section 7-2-3 imposes income tax on the “net income” of New Mexico residents and others who derive income
from property or employment in this state. “Net income” is defined as “base income” subject to certain adjustments.
Section 7-2-2(N) NMSA 1978. “Base income” is defined as “adjusted gross income” as defined in Section 62 of the
Internal Revenue Code, plus certain adjustments. Section 7-2-2(B) NMSA 1978.
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Arguably, that portion of the real estate contract payments which represented a return of the Taxpayer’s basis in
the property would not be income subject to tax. The Taxpayer failed to provide any breakdown, however, of the
payments received so that the basis portion could be excluded from consideration as income.

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There were two deposits which the Taxpayer testified represented loan proceeds from

Western Bank. A review of the Taxpayer’s checking account records, Taxpayer’s exhibits 3, 4,

5, 6 and 7, reveal a number of deposits and transactions involving Western Bank, with whom the

Taxpayer apparently had either a line of credit or other financing arrangements for his business.

With respect to the October 25, 1995 deposit in the amount of $7,500, the Taxpayer was able to

present corroborating loan documents after the hearing and the Department agreed that the

amount should be excluded from consideration for purposes of calculating the Taxpayer’s 1995

personal income tax liability. Although the Taxpayer failed to provide similar corroborating loan

documentation from the bank with respect to the March 20, 1995 deposit, I find that the

Taxpayer sufficiently explained the entries in his checking account records with respect to that

deposit to establish that the deposit represented loan proceeds as well.

The Taxpayer testified that two deposits, in the amounts of $100, and $50, represented a

return of monies he had deposited with Molzen & Corbin, an architectural and engineering firm,

when he borrowed plans needed to prepare bids on projects. I found the Taxpayer’s testimony to

be credible and such refunded deposits should not be considered income for purposes of

calculating income taxes.

On October 4, 1995, the Taxpayer deposited $18,410.32 into his account from the Village

of Columbus, New Mexico. Although the Taxpayer testified that this amount represented a loan

from the Village of Columbus, the Taxpayer failed to explain why a municipal government

would be making his business a loan. The Taxpayer’s testimony was further put into question by

his own entries in his checking account records which reflect that that deposit, as well as two

others received during October and November of 1995, were draws from “Columbus Project”.

This indicates that the deposit was a draw from a construction project rather than a loan. As

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such, it would be treated as gross receipts under the Gross Receipts and Compensating Tax Act

and presumably, would also constitute gross receipts from the Taxpayer’s business for purposes

of reporting business gross receipts on the Taxpayer’s Schedule C. Accordingly, this amount

was properly included in the calculation of the Taxpayer’s business income for purposes of the

assessment at issue herein.

Finally, there were two deposits which the Taxpayer testified were voice transfers of

monies from the Taxpayer’s payroll account to his business account. The Taxpayer’s testimony

was corroborated by an entry in his checking account records tendered as Exhibit 3, with respect

to the August 29, 1995 deposit in the amount of $2,000, but the Taxpayer failed to tender any

checking account records to corroborate his testimony with respect to the October 24, 1995

deposit in the amount of $3,700. Accordingly, only the $2,000 will be excluded from the

calculation of the Taxpayer’s business income for purposes of the assessment at issue herein.

CONCLUSIONS OF LAW

1. The Taxpayer filed a timely written protest to Assessment Nos. 3984666 and 398465

pursuant to Section 7-1-24 NMSA 1978 and jurisdiction lies over both the parties and the subject

matter of this protest.

2. The Taxpayer sufficiently established that the following deposits should not have

been included in the calculation of the Taxpayer’s federal adjusted gross income:

November 7, 1995 $42,273.97
March 20, 1995 $10,212.89
October 25, 1995 $ 7,500.00
February 27, 1995 $ 50.00
July 5, 1995 $ 100.00
August 29,1995 $ 2,000.00

3. The Taxpayer failed to sufficiently establish that the following deposits should not

have been included in the calculation of the Taxpayer’s federal adjusted gross income:

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March 6, 1995 $ 1,250.00
July 11, 1995 $ 500.00
October 4, 1995 $18,410.32
October 24, 1995 $ 3,700.00

For the foregoing reasons, the Taxpayer’s protest IS HEREBY GRANTED IN PART

AND DENIED IN PART.

DONE, this 21st day of September, 2001.

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