Clinco v. Commissioner

Judge Holmes Reprimands Lawyer for AI 'Hallucinations' in $2.2M Case

The Tax Court recently addressed a $2.2 million tax deficiency case involving a now-deceased attorney and his wife, with the IRS prevailing on most issues. But the decision took an unexpected turn when Judge Holmes publicly rebuked the taxpayers' counsel for submitting legal arguments containing fabricated case citations generated by artificial intelligence. The Court's warning underscores the growing concerns surrounding the use of AI in legal practice and the potential for inaccurate or misleading information to undermine the integrity of the judicial process.

The Business: Cash Skimming at MedCafe

Following the rebuke of the taxpayer's counsel for AI-generated legal fallacies, the Tax Court turned its attention to the financial specifics of MedCafe, the restaurant and bar at the heart of the $2.2 million tax dispute.

MedCafe Westwood LLC was a family affair. The now-deceased Clinco owned 66.6% of the business, while his brother Michael held the remaining 33.4% through 2014. Another brother, David, served as the manager and bookkeeper. Clinco oversaw vendor relations, lease agreements, and the restaurant's day-to-day operations, dedicating approximately 25-30 hours per week to the business. In 2015, he converted MedCafe into a single-member LLC.

The restaurant operated with approximately 60 employees, many working short, three-to-four-hour shifts. Critically, MedCafe did not meticulously record cash tips received by its employees, nor did it claim a tip deduction on its tax filings. Employees were responsible for self-reporting their tips, which included cash payments from customers that were not deposited into the restaurant's bank accounts. Clinco estimated that roughly 90% of MedCafe's income stemmed from credit card transactions, with the remaining 10% arriving in cash. Some sales were processed through Grubhub.

The IRS's scrutiny began with Revenue Agent (RA) Yi Liu in 2019. Due to Clinco's declining health, his accountant handled most of the communications with the RA. During a meeting with Clinco, he admitted that approximately 10% of the restaurant's revenues were received in cash. This admission, coupled with a discrepancy between the reported gross receipts and the income suggested by the credit card-to-cash ratio, prompted the RA to conduct a bank-deposits analysis.

The RA examined several bank accounts associated with MedCafe, identifying deposits from UCLA, Grubhub, and other payors as potential sources of business income. Specifically, the RA's analysis of Chase accounts ending in 0436, 8203, 9631, and 0670, as well as City National Bank accounts ending in 5081, 1208, 1194, and 3446, revealed cash deposits and other transactions that appeared to represent unreported income. The RA also used third-party information return processing (IRP) data, specifically Forms 1099, to uncover payments to MedCafe from UCLA, First Data Reporting, American Express, and Grubhub. By reconciling the bank deposit analysis with the third-party IRP data and Clinco’s admission of 10% cash receipts, the IRS reconstructed MedCafe’s gross receipts.

Legal Analysis: Electronic Signatures and Fabricated Law

...l Bank accounts ending in 5081, 1208, 1194, and 3446, revealed cash deposits and other transactions that appeared to represent unreported income. The RA also used third-party information return processing (IRP) data, specifically Forms 1099, to uncover payments to MedCafe from UCLA, First Data Reporting, American Express, and Grubhub. By reconciling the bank deposit analysis with the third-party IRP data and Clinco’s admission of 10% cash receipts, the IRS reconstructed MedCafe’s gross receipts.

Clinco's counsel, however, raised two legal objections to the IRS's determination, first challenging the legitimacy of the Notice of Deficiency and second, questioning the validity of the IRS's evidence.

Clinco argued that the Notice of Deficiency was invalid because it lacked a "wet" signature, asserting that an IRS employee with delegated authority was required to sign the notice in ink for it to be valid, thus conferring jurisdiction on the Tax Court. He pointed to Form 4549-A, Report of Income Tax Examination Changes, arguing that it was unsigned, violating Internal Revenue Manual (IRM) 4.8.9.11.1 (Jan. 10, 2023), which provides internal guidance for IRS employees on operating and administering tax law.

The Tax Court rejected this argument on multiple grounds. First, the court clarified that Letter 531, not Form 4549-A, constituted the actual Notice of Deficiency. This letter was signed by David H. Okuda, the technical services territory manager, with initials indicating the signature was imprinted by a delegated signing official. The court cited IRM sections 4.8.9.11.1, 4.10.1.4.4 (Aug. 28, 2025), and 10.10.1.3.1.1 (Oct. 17, 2023), which provide ample methods for signing notices, including delegation, a typed name, and an electronic image. More fundamentally, the court noted that even an unsigned notice of deficiency can be valid, citing Tavano v. Commissioner, 986 F.2d 1389, 1390 (11th Cir. 1993), and Urban v. Commissioner, 964 F.2d 888, 889 (9th Cir. 1992).

The court then turned to what it deemed "fabricated case citations" used to support Clinco's argument. Clinco's attorney, Mr. Wagner, cited three cases that appeared to be generated by an AI large language model: "Cacchillo v. Commissioner, 130 T.C. 132 (2008)," "Miller v. Commissioner, 57 T.C. 440 (1971)," and "Tefel v. Commissioner, 118 T.C. 324 (2002)." The court found that none of these cases existed as cited. "Cacchillo v. Commissioner" was nonexistent, with the cited page belonging to Porter v. Commissioner, 130 T.C. 115 (2008), discussing Section 6015(f) relief claims, completely unrelated to the case. "Miller v. Commissioner" was mis-cited; the correct citation, T.C. Memo. 1984-448, only mentioned a notice of deficiency in passing. The court found that page 440 in volume 57 of the Tax Court Reports is within Winfield Manufacturing Co. v. Renegotiation Board, 57 T.C. 439 (1971)—a case in which there is no mention of a notice of deficiency whatsoever. Finally, no case named "Tefel v. Commissioner" existed, and page 324 of volume 118 of the Tax Court Reports was a paragraph in Hillman v. Commissioner, 118 T.C. 323 (2002), concerning the tax treatment of management fees in an S corporation.

Judge Holmes sharply criticized this practice, stating that the "bouillabaisse of case names, reporter citations, and legal propositions suggests something cooked up by AI" and deemed such submissions "unacceptable." He then reiterated Chief Justice Roberts’s advice to lawyers who write briefs with citations of nonexistent cases: “Always a bad idea.” The court warned that submitting briefs with fictitious caselaw is a "recipe for sanctions" and a clear violation of Rule 11(b) of the Federal Rules of Civil Procedure (FRCP). Although the Tax Court Rules of Practice and Procedure mirror the FRCP, the court could also impose penalties under Section 6673(a)(2), which allows the court to require counsel to personally pay excess costs and attorney fees if they "multiplied the proceedings... unreasonably and vexatiously," or under Section 6673(a)(1), which authorizes a penalty of up to $25,000 for maintaining a frivolous or groundless position.

The Tax Ruling: Bank Deposits vs. Explanations

Following the AI debacle, the Tax Court turned to the substantive tax issues, beginning with the IRS's determination that Clinco underreported his 2015 Schedule C gross receipts by roughly $2.2 million. The IRS, under Section 446(b), which allows the IRS to reconstruct a taxpayer's income if their accounting method doesn't clearly reflect income, reconstructed Clinco's income based on Form 1099 data and estimated cash receipts. The IRS identified three sources of unreported gross receipts: a Form 1099-MISC, Forms 1099-K, and estimated cash receipts.

Clinco challenged the income reconstruction, but the court found his arguments unpersuasive. He argued the IRS did not sufficiently substantiate the sources of unreported income, improperly classified capital contributions as income, and that MedCafe was never profitable. The court noted that once the IRS's reconstruction is determined in a notice of deficiency, the Commissioner is presumed correct, and the taxpayer bears the burden of proving otherwise.

Clinco argued that the IRS failed to adequately identify the sources of income. However, the court found the IRS identified the Forms 1099 through IRP data and the estimated cash receipts through an interview with Clinco. His objections that the IRS might have confused MedCafe with another UCLA restaurant or that IRS records might contain errors were dismissed as speculative. Thus, the court concluded the IRS correctly identified the income from Forms 1099-MISC, Forms 1099-K, and the estimated receipts.

Clinco also contended that he deposited over $385,000 of personal funds into MedCafe's bank accounts, which the IRS incorrectly classified as income. He claimed these were capital contributions. He had sent the Revenue Agent (RA) an email detailing these contributions, leading the RA to agree that $82,242.18 constituted capital contributions, which reduced Clinco’s deficiency accordingly. However, Clinco provided no further evidence of additional contributions. The court, citing Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir. 1997), emphasized that Clinco bore the burden of showing the Commissioner's bank-deposits analysis was inaccurate. An email alone was insufficient to demonstrate that the remaining deposits were nontaxable.

Finally, Clinco argued that MedCafe "never made a profit and had in fact been in bankruptcy." The court curtly dismissed this, noting that even money-losing businesses can have unreported income.

The court then addressed the Schedule E depreciation. For 2015, Clinco claimed $56,798 in Schedule E depreciation for two rental properties he purportedly placed in service that year. Section 167(a) allows a deduction for the depreciation of property used in a trade or business. While Clinco filed Forms 4562 for both properties, reporting a basis of $1,799,100 for an apartment building and $700,000 for a single-family home, he failed to provide any substantiation for these bases or evidence of when the properties were placed in service, as required by Section 6001. The court denied the depreciation deduction due to this lack of substantiation.

Conclusion: A Warning to the Tax Bar

The Tax Court sustained the IRS's determination that Clinco underreported gross receipts by approximately $2.2 million and denied the claimed depreciation deduction, resulting in a Rule 155 entry where the exact deficiency will be calculated. However, beyond the specific dollar amounts, this case serves as a potent reminder of the stringent standards expected of practitioners before the court. The Court's explicit condemnation of fabricated case law, potentially generated by AI, underscores the absolute necessity of verifying all citations. Federal Rule of Civil Procedure 11(b) outlines the duty of attorneys to ensure that their legal contentions are warranted by existing law. While the Tax Court operates under its own Rule 33(b), modeled after FRCP 11, lawyers appearing before it are held to similar ethical standards under the Model Rules of Professional Conduct. The Court's sharp words on AI "hallucinations" in legal briefs is a clear warning: The Tax Court will not tolerate the submission of briefs containing fictitious caselaw, and practitioners must rigorously verify the accuracy of their citations to avoid potential sanctions.