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February 26, 1985


On Appeal from the Decision of the United States Tax Court. (Tax Ct. No. 6583-77)

Author: Katz

Before GIBBONS, BECKER, Circuit Judges, and KATZ, District Judge*fn*


KATZ, District Judge

Unreported income from illegal gambling is a frustrating problem for the tax collector. Estimates show that such income is substantial.*fn1 The Internal Revenue Service has sometimes overreacted by imposing arbitrary assessments.*fn2 The presumption of correctness which attaches to the Commissioner's assessment of a tax deficiency is, however, an important tool for recovering taxes on unreported income.*fn3

In unreported income cases, the presumption of correctness imposes on the taxpayer the difficult burden of proving a negative, that he did not earn the income the government claims he earned. The burden usually arises, however, from the taxpayer's own failure to keep business records of transactions known only to him.*fn4 Nevertheless, the taxpayer's record keeping failures do not justify "a naked assessment without any foundation whatsoever." United States v. Janis, 428 U.S. 433, 441, 49 L. Ed. 2d 1046, 96 S. Ct. 3021 (1976).*fn5

In United States v. Gerardo, 552 F.2d 549 (3d Cir. 1977), this Court struck a balance between the tax collector's legitimate interest in assessing tax on illegal gambling income and the taxpayer's right to be free from oppressive and arbitrary assessments. Gerardo requires that the Commissioner's reliance on the presumption of correctness rest on "some evidence . . . which would support an inference of the taxpayer's involvement in gambling activity during the period covered by the assessment. Without that evidentiary foundation, minimal though it may be, an assessment may not be supported even where the taxpayer is silent. " United States v. Gerardo, 552 F.2d at 554. In DeCavalacante v. Commissioner of Internal Revenue, 620 F.2d 23, 27 (3d Cir. 1980), this Court reiterated that "the 'Commissioner [must] provide some predicate evidence connecting the taxpayer to the charged activity.'"*fn6


Appellant L. Jay Walker appeals from a decision of the Tax Court upholding the Commissioner's assessment of tax deficiencies for the years 1973 and 1974. The Tax Court found that Walker derived illegal income of $192,448 in 1973 and $123,880 in 1974 from his involvement in an illegal "numbers" operation. The tax deficiency assessed against him for 1973 was $122,708 and for 1974 was $73,598.*fn7 The Tax Court's factual findings are binding upon us unless clearly erroneous. DeCavalcante v. Commissioner, 620 F.2d at 26.

During the summer of 1974, the Pennsylvania State police conducted an undercover investigation of an illegal numbers operation in Harrisburg, Pennsylvania.*fn8 Part of the investigation focused on two Harrisburg cafes, the Blue Note and the Lounge. The taxpayer was the titleholder of the Lounge. An undercover policeman assigned to the investigation occasionally placed bets with the owner of the Blue Note Cafe. On several occasions, a numbers runner from the Harrisburg area visited the Blue Note bar, learned what bets had been placed at the bar that day and then used the telephone to report this information. August 7, 1974, the undercover policeman watched the numbers runner dial the telephone. Observing from fifteen to twenty feet away, the investigator believed that the runner dialed the number "233-4477." Appellant Walker's number at the time was "234-4473."

On September 19, 1974, the Pennsylvania State Police executed a number of search warrants relating to their investigation. Records were seized from the taxpayer's home and from the home of John L. Barbee, who admitted at the Tax Court hearing that he was the "processor" for a numbers game.*fn9 Mr. Barbee was a meticulous record keeper.

The Commissioner's comparison between the records seized from Barbee and those seized from Appellant Walker is the foundation for the deficiency assessment in this case. Two types of records seized in the raid on Barbee's home were introduced into evidence at the Tax Court proceeding: calendars summarizing daily income and "tally sheets" showing the daily transactions of seventeen numbers runners. Walker's records showed the same information as Barbee's "tally sheets" for four of these seventeen runners on September 17 and 18, 1974.

The government introduced Barbee's calendars for the years 1972 through 1974. Each Monday through Saturday on the calendars from January, 1972 through September 17, 1974 was marked with three figures: the total amount of bets collected by all runners less the runner's twenty-five percent commission; the winning number for the day; and the amount of winnings paid out for that day.

The government also introduced Mr. Barbee's "tally sheets" for September 17 and 18. From these slips of paper, Barbee derived the figures to enter on his calendar. These tally sheets contained codes identifying the seventeen numbers runners. Next to the codes, Barbee entered the amount collected by each runner less his twenty-five percent commission.*fn10 The tally sheets also contained the winning numbers for each day,*fn11 as well as the amount of each winning bet and how much the bet paid off.*fn12

The State Police also seized several papers from Walker's residence. Comparing these papers with those taken from Barbee shows that Walker was involved with four of the seventeen coded runners reflected in Barbee's records for September 17 and September 18, 1974. On one handwritten slip, the number "594" was written across the top. Barbee's tally sheets and calendar show that this was the winning number for September 17. Below the winning number, four other numbers were written. These numbers correspond with the amounts Barbee recorded as collected by four numbers runners on September 17.*fn13 On another handwritten slip seized at Walker's home, the winning number for September 18 was written. Walker's records for September 18 also tally with Barbee's records for that date in showing the collections of four of the seventeen numbers runners, as well as their payoffs to winners.*fn14 Comparing Walker's with Barbee's records makes clear that Walker was involved with the same four numbers runners on both September 17 and September 18.

Thus, both sets of records show a connection for two days in September between Walker and four of the seventeen numbers writers of whom Barbee kept track. The two sets of records tie Walker to Barbee's calendar only for September 17 and September 18, 1974. The records show no evidence of participation by Walker in the gambling activities for any period except these two days. The Tax Court, however, upheld the Commissioner's assessment against Walker for the total income reflected in Barbee's calendars from the beginning of 1973 through the time of the search in September, 1974.*fn15


Although there is sufficient evidence that Walker was involved to some extent in the numbers operation on September 17 and September 18, 1974,*fn16 the Commissioner has failed to make a minimal evidentiary showing of Walker's involvement before those two days. Under Gerardo and DeCavalcante, the Commissioner is not entitled to the presumption of the correctness of the assessment for the period beginning January 1, 1973 and ending September 16, 1974.

This Court's holding in Gerardo controls. In that case, the Internal Revenue Service conducted an undercover investigation of an illegal lottery between August 5, 1966 and February 3, 1967. The investigation culminated in raids in early February, 1967 in which daily tally sheets were seized. Gerardo was subsequently convicted in New Jersey state court for conspiracy to operate a lottery between August, 1966 and February, 1967.*fn17 The Commissioner assessed deficiencies based on Gerardo's unreported income from April 4, 1966, four months before the commencement of the investigation, through February 3, 1967. There was only one reference in the Tax Court record to support the assessment from April 4 to August 5. On April 4, 1966 New Jersey prosecutors raided a residence in the Newark area and a large volume of betting slips were seized. Most of the codes on the slips taken in the April 4 raid matched those taken in the raids in February, 1967. In addition, several individuals arrested as a result of the April 4 search were observed to be part of the IRS investigation which resulted in Gerardo's conviction. The Court held that, although the August 4, 1966 to February 3, 1967 assessment was supported by sufficient evidence, the Commissioner had failed to produce the minimal predicate evidence necessary to raise the presumption of correctness as to the assessment before August 5, 1966. The Court determined that the identity of codes on the two sets of gambling records was insufficient evidence to link Gerardo to an illegal gambling enterprise before August 5, 1966:

The raid conducted by the prosecutor's office of Essex County on April 4, 1966 disclosed no link to Gerardo nor did it reveal his participation in the lottery. Gerardo was not observed at that time, and no other investigation which implicated Gerardo took place between April 4 and August 5. The codes on the April 4 betting slips, even though identical to those on the February 3 betting slips, do not, without more, identify Gerardo's involvement. . . . . Even if we were to accept the Commissioner's assertion that the lottery observed by the IRS in August, 1966 was the same lottery as that being conducted in April, 1966, the evidence in the Tax Court of Gerardo's gambling operations, was limited to the period from August 5, 1966 through February 3, 1967. We are obliged to conclude therefore that, absent proof in the record that Gerardo was involved in gambling activities from April 4, 1966 through August 5, 1966, no court could properly draw an inference of such involvement.

United States v. Gerardo, 552 F.2d at 554. (Emphasis added).

In DeCavalcante, the taxpayer pled guilty to conspiracy to operate an illegal gambling enterprise between January 1, 1965 and December 15, 1969. The Commissioner assessed the taxpayer for unreported income from illegal gambling between 1965 and 1969. The Tax Court upheld the assessment for the second half of 1968 and 1969, but refused to find any deficiency between 1965 and the middle of 1968. Both sides appealed. This Court affirmed both aspects of the Tax Court's opinion. The investigation leading to DeCavalcante's conviction had taken place in 1968 and 1969. The Court refused to accept the Commissioner's argument that an inference should arise that the gambling enterprise must have begun before its detection and that this inference should provide the necessary predicate of minimal evidence for an assessment. The Court held:

[I]n support of his pre- 1968 assessment, the Commissioner argues that the gambling operation in which DeCavalcante was involved "manifestly did not arise overnight" . . . . The Commissioner's argument misses the mark, however, by ignoring the fact that a similar inference could have been drawn in Gerardo. The essential point of Gerardo is that no inference is reasonable if it is wholly lacking of even a minimal factual basis.

DeCavalcante v. Commissioner, 602 F.2d at 28 (citations and footnotes omitted).


Under this Court's holdings in Gerardo and DeCavalcante, we must reverse the Tax Court's decision allowing the assessment from January 1, 1973 through September 16, 1974. Gerardo requires minimal predicate evidence linking the taxpayer's involvement in the illegal enterprise to the beginning of the assessment period. In the present case, Barbee's records make clear that the numbers operation was in existence in January, 1973. The evidence of Walker's involvement in the operation for two days in September, 1974, however, does not give rise to an inference that he participated in the operation from its inception. Gerardo was, in fact, a stronger case for upholding the Commissioner's assessment than this one. Gerardo's position as third in command of the wagering operation from August, 1966 to February 1967 did not justify an inference that he was involved in the game from April to August, 1966. The evidence in the present case indicates that Walker was involved not with the entire numbers business reflected in Barbee's records, but with just four of seventeen numbers runners.*fn18


The Tax Court also erred in its determination that the Commissioner was entitled to a presumption that all the proceeds of the lottery inured to Walker. The Tax Court relied on Gerardo for its conclusion. In that case, this Court stated:

Gerardo's final contention that there was an insufficient factual basis upon which to attribute the entire proceeds of the lottery to him, is equally without merit. The record reveals sufficient evidence that, at least from August 5, 1966 through February 3, 1967, Gerardo held a controlling position in the lottery operation. That evidence suffices to give effect to the presumption of correctness of the Commissioner's determination. As the Commissioner points out, Gerardo's argument that he should not be assessed with the entire tax as he was not the "boss" misses the mark. . . . It is not incumbent upon the Commissioner to show that no one except Gerardo received the lottery profits. Rather, it was Gerardo's burden to prove that others and not he alone shared the lottery proceeds. Gerardo, however, failed to sustain this burden.

United States v. Gerardo, 552 F.2d at 556.

The Tax Court's reliance on Gerardo is misplaced. Gerardo stands for the proposition that before the presumption of correctness can attach to the Commissioner's determination that a taxpayer should be charged with all the profits of an illegal business, the Commissioner must supply minimal predicate evidence to establish the proposition. Here the Commissioner has failed to make such a showing. Indeed, comparison of the betting slips seized at Walker's and Barbee's residences indicates that Walker was connected with only four of the enterprise's seventeen numbers runners. While Barbee's records reflect a net take of $2565.27 for September 17 and 18, 1974, Walker's records reveal a net take of only $556.54.*fn19 Not only has the Commissioner failed to come forward with any minimal predicate evidence, but the existing evidence shows that Walker did not have a controlling interest in the entire operation.

CODE 9/17/74 9/18/74

B-1 77.32 114.22

16 107.72 98.87

J 111.18 74.01

N 32.25 45.97

328.47 333.07


Having determined that no minimal evidentiary foundation supports the assessments for any period other than September 17 and 18, 1974, and that no minimal evidentiary foundation supports a finding that all of the profits of the operation inured to Walker, we reverse and remand for further proceedings consistent with this opinion.

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