The opinion
T.C. Memo. 1997-248
UNITED STATES TAX COURT
BIG HONG NG, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
STRONG HOPE, LTD., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 20814-93, 21277-93. Filed June 2, 1997.
Albert C. Lum, for petitioners.
Debra K. Estrem and James P. Thurston, for respondent.
MEMORANDUM OPINION
JACOBS, Judge: In docket No. 20814-93, petitioner Big Hong Ng
(Ms. Ng) seeks a redetermination of the following revised tax
determinations made by respondent:
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Additions to Tax
Sec. Sec. Sec. Sec. Sec. Sec. Sec.
Year Deficiency 6651(a)(1) 6653(a)(1)(A) 6653(a)(1) 6653(a)(1)(B) 6654 6661 6662
1
1986 $1,327,802 $331,951 $66,390 --- --- $331,951 ---
1
1987 830,395 207,850 41,570 --- --- 207,850 ---
1988 878,617 219,654 --- $43,930 --- --- 219,654 ---
1989 1,431,742 357,936 --- --- --- --- --- $286,348
1990 256,186 64,047 --- --- --- $16,869 --- ---
1
50 percent of the interest on the portion of the underpayment attributable to negligence.
A substantial portion of the deficiencies and additions to tax was
asserted in respondent's amended answer.
In docket No. 21277-93, petitioner Strong Hope, Ltd. (Strong
Hope), a Hong Kong corporation wholly owned by Ms. Ng, seeks a
redetermination of the following deficiency and additions to tax:
Additions to Tax
Year Deficiency Sec. 6651(a)(1) Sec. 6662
1989 $262,298 $52,460 $52,460
The aforementioned docketed cases have been consolidated for
trial, briefing, and opinion.
Following concessions by the parties, the issues remaining for
decision are: (1) Whether Ms. Ng had unreported income in the
amounts determined by respondent; (2) whether Ms. Ng is entitled to
claimed pass-through losses from her S corporation, Hong Kong
Restaurant, Inc.; (3) whether Ms. Ng is entitled to defer the gain
from the sale of certain real estate pursuant to section 1031; (4)
whether Ms. Ng received a liquidating distribution from Strong Hope
when that corporation transferred its interest in real estate to
her; (5) whether Ms. Ng is entitled to the entire investment
interest deduction claimed; (6) whether Ms. Ng is entitled to a
claimed net operating loss carryover; (7) whether Ms. Ng is liable
for an accuracy-related penalty and for additions to tax for
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negligence, substantial understatement, failure to file timely
returns, and failure to pay estimated tax; (8) whether Strong Hope
had discharge of indebtedness income; (9) whether Strong Hope's
basis in certain real estate that it transferred should be adjusted
as determined by respondent; (10) whether respondent properly
disallowed a net operating loss carryover to Strong Hope; and (11)
whether Strong Hope is liable for an accuracy-related penalty and
for an addition to tax for failure to file a timely return.
All section references are to the Internal Revenue Code for
the years under consideration. All Rule references are to the Tax
Court Rules of Practice and Procedure.
Some of the facts have been stipulated and are so found. The
stipulations of facts and the attached exhibits are incorporated
herein by this reference.
Background
Ms. Ng, also known as Don Hong Ng, Bik Hung Ng Leong, and
other names, resided in San Francisco, California, at the time she
filed her petition. Ms. Ng's tax returns for all years under
consideration were untimely filed.
Ms. Ng was born in 1935 and came to the United States from
Hong Kong in approximately 1958. She studied English and music in
the United States, and became a resident alien shortly after her
marriage in 1962 to Sik Chong Leong in Reno, Nevada. They were
divorced in 1968 and had no children. Ms. Ng acquired her U.S.
citizenship in 1966. Ms. Ng has a son, Timothy Lee, who was born
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in 1957.
Strong Hope was incorporated in Hong Kong in 1981. It owned
a 50-percent undivided interest in a rental property at 850
Stockton Street in San Francisco during part of 1989. Ms. Ng owned
the other half interest. In its petition, Strong Hope states its
principal place of business to be c/o Poon and Company, CPAs, 43-59
Queens Road East, Hong Kong. Strong Hope's 1989 tax return was
untimely filed.
Ms. Ng owned or controlled the following bank accounts during
the years under consideration:
Account Title Bank
United States:
Strong Hope Union Bank
Strong Hope Limited (Calif.) Bank of America
Permanent Union Limited Bank of the Orient
Strong Hope Limited Sumitomo Bank
Ms. Ng Bank of America
Hong Kong:
Ms. Ng Hang Seng Bank
J.B. Wings Wing Lung Bank
Strong Hope Wing Lung Bank
Permanent Union Ltd. (HK) Wing Lung Bank
Don Hong Ng Wing Lung Bank
Don Hong Ng Wing Lung Bank
Ms. Ng and Sik Yuen Ng Wing Lung Bank
Ms. Ng owned interests in the following entities during the
years under consideration:
San Francisco:
Golden Dragon Restaurant 50% ownership
Permanent Union Ltd. 100%
Strong Hope Limited (Calif.) 100%
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Ocean City Restaurant 5%
Seattle:
Hong Kong Inv. Ltd. 100%
Hong Kong Restaurant, Inc. 100%
Ocean City Restaurant 8%
Ocean City Investments unknown
Hong Kong:
Permanent Union Limited 100%
Ocean City Restaurant
and Night Club Limited at least 4.5%
Strong Hope 100%
Bik Hung Investment Limited 100%
J.B. Wings 50%
Ms. Ng directly or indirectly owned interests in the following
properties during the years under consideration:
Property Owner
San Francisco:
1610 Lombard Ms. Ng
1733 Larkin Ms. Ng
850 Stockton Ms. Ng and Strong Hope
857 Clay Strong Hope Limited (Calif.)
1835 Franklin Ms. Ng
Seattle:
507 Maynard Hong Kong Investments
609 South Weller Ocean City Investments
Hong Kong:
Flat 1, 41A Stubbs Road Ms. Ng
Flat 2, 41A Stubbs Road Ms. Ng
Ms. Ng contends that she has difficulty understanding English,
which is not her native language, and that accounts for
discrepancies in statements she made during respondent's
investigation. Although Ms. Ng's trial testimony was given largely
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through an interpreter, we found that when using English to
testify, she did not have any difficulty.
For convenience and clarity, we have combined additional
findings of fact and opinion with respect to each issue.
Issue 1. Unreported Income
The largest adjustments to Ms. Ng's income are based on
respondent's determination that Ms. Ng failed to report substantial
amounts of income. Specifically, respondent determined that Ms. Ng
failed to report: (a) Self-employment income which was deposited
into bank accounts she controlled in the amounts of $54,849 in
1986, $50,444 in 1987, $563,513 in 1988, and $346,993 in 1989; (b)
income consisting of deposits from Hong Kong into bank accounts she
controlled, rental and interest income, and forgiveness of debt
income, not subject to self-employment tax in the amounts of
$168,300 in 1986, $247,761 in 1987, $170,545 in 1988, $212,459 in
1989, and $93,208 in 1990; and (c) income which was deposited into
the tip account, discussed infra, as well as other Hong Kong bank
accounts, in the amounts of $1,643,928 in 1986, $242,098 in 1987,
$245,355 in 1988, $719,163 in 1989, and $159,153 in 1990.
In the amended answer, respondent asserted additional
unreported income, totaling $3,271,690 for the 5 years under
consideration, from unexplained deposits to bank accounts in
foreign banks. Of this amount, at least $2,577,089 arises from
deposits to the tip account, discussed in detail, infra.
Respondent bears the burden of proof with respect to the increase
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in the asserted deficiencies and additions to tax made in the
amended answer. Ms. Ng bears the burden of proof with respect to
the deficiencies and additions to tax determined by respondent in
the notice of deficiency. Rule 142(a).
Ms. Ng claims that respondent's deficiency determination was
arbitrarily derived, and as a result, the presumption of
correctness generally attributed to the notice of deficiency should
disappear. In this regard, the United States Court of Appeals for
the Ninth Circuit (where an appeal in Ms. Ng's case would lie) has
held that in order for the presumption of correctness to attach to
the notice of deficiency in unreported income cases, the
Commissioner must come forward with substantive evidence
establishing "some evidentiary foundation" linking the taxpayer to
the income-producing activity, Weimerskrirch v. Commissioner, 596
F.2d 358, 361-362 (9th Cir. 1979), revg. 67 T.C. 672 (1977), or
"demonstrating that the taxpayer received unreported income."
Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir. 1982), affg.
an Order of this Court; see also Rapp v. Commissioner, 774 F.2d
932, 935 (9th Cir. 1985), affg. an Order of this Court. We
therefore must examine the record to determine whether there is a
minimal evidentiary foundation supporting respondent's
determination of unreported income.
In the instant case, we find the record contains substantive
evidence to support respondent's determination of unreported
income. See Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir.
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1993), affg. T.C. Memo. 1991-636; Erickson v. Commissioner, 937
F.2d 1548, 1551 (10th Cir. 1991), affg. T.C. Memo. 1989-552. We do
not find that respondent's determinations were arbitrary and thus
do not agree with Ms. Ng's assertion that the burden of proof
should shift to respondent.
Ms. Ng transacted business using large amounts of cash. She
commingled her personal funds with funds of entities she owned or
controlled in her U.S. and Hong Kong bank accounts, and she
commingled the funds of one entity with those of another.
Moreover, she disregarded the legal ownership of the accounts when
writing checks. For example, she deposited into Strong Hope's
checking account rents from property located at 857 Clay Street,
which was owned by Strong Hope Limited (Calif.) and wrote checks
from Strong Hope's checking account to pay expenses of property
located at 1610 Lombard Street which she wholly owned. Ms. Ng
claims she "commingled funds and used cash and cashier's checks on
many occasions out of fear that the respondent or other creditors
would seize her accounts."
Revenue Agent Theresa Martin (the revenue agent) reconstructed
Ms. Ng's income for the years under consideration by analyzing Ms.
Ng's bank deposits and cash expenditures. Use of the bank deposits
and cash expenditures method to reconstruct income is well
established. DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), affd.
959 F.2d 16 (2d Cir. 1992); Parks v. Commissioner, 94 T.C. 654, 658
(1990); Nicholas v. Commissioner, 70 T.C. 1057, 1064 (1978); Estate
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of Mason v. Commissioner, 64 T.C. 651, 656 (1975), affd. 566 F.2d
2 (6th Cir. 1977). Bank deposits are prima facie evidence of
income. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). In a cash
expenditures analysis, the amount by which a taxpayer's cash
expenditures exceeds his known sources of income is assumed to be
taxable income, unless the taxpayer can show the expenditures were
made from a nontaxable source. DeVenney v. Commissioner, 85 T.C.
927, 930 (1985).
In analyzing the bank deposits, the revenue agent separated
cash, checks, cashier's checks, and wire transfers. She examined
the source of each deposit. She separated those items subject to
self-employment tax, such as presumed receipts from the
restaurants, from those items not subject to self-employment tax,
such as rental income. These appeared as separate adjustments in
the notice of deficiency with respect to Ms. Ng.
To the extent possible the revenue agent eliminated those
items that had been reported or came from nontaxable sources, such
as transfers and refinancing proceeds. The revenue agent also
subtracted from unidentified cash deposits the maximum amount of
reported rents that could have been paid in cash or by check;
moreover, she subtracted substantiated partnership draws paid
directly to Ms. Ng by Golden Dragon Restaurant. We are satisfied
that the revenue agent gave Ms. Ng credit for every nontaxable
source of income that could be identified. Moreover, before the
trial, respondent conceded certain nontaxable items that became
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apparent from records and documents summonsed from Hong Kong after
the notice of deficiency was issued and certain other items
ultimately substantiated by Ms. Ng.
During a July 22, 1991, interview, Ms. Ng told the revenue
agent that she had only one foreign bank account from 1986 through
1989, and that only her salary from Ocean City Restaurant and Night
Club, Limited in Hong Kong (Ocean City HK) was deposited into that
account. In response to a discovery request, Ms. Ng's counsel
informed respondent that Ms. Ng had signature authority over 2
foreign accounts, one account at Hang Seng Bank and one account at
Wing Lung Bank, which belonged to Ocean City HK. Ms. Ng refused to
consent to the release of her foreign bank records until ordered to
do so by the U.S. District Court for the Northern District of
California. The revenue agent ultimately discovered, and obtained
records showing, that Ms. Ng had one account at Hang Seng Bank and
six accounts at Wing Lung Bank. The additional income asserted in
the amended answer involves deposits to Ms. Ng's bank accounts at
Hang Seng Bank and Wing Lung Bank.
The revenue agent also analyzed Ms. Ng's cash expenditures.
Those expenditures that could not be traced to a nontaxable source
or reported income were considered unreported income. For example,
the revenue agent included $45,568.68 as unreported income for
1988, which was the amount Ms. Ng paid in cash for a cashier's
check on July 5, 1988, because the revenue agent could not trace
that cash purchase to a nontaxable source.
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Tip Account
One of the Hong Kong accounts the revenue agent examined was
referred to by the parties as the tip account. The reason for such
nomenclature is because the deposits into this account came from
tips paid to employees of Ocean City HK. Ms. Ng denies ownership
of this account.
Ocean City HK has seating capacity for approximately 5,000
people and is the largest restaurant in Hong Kong. Ms. Ng owned at
least a 4.5-percent interest in Ocean City HK and was employed
there as deputy managing director from 1978 until 1991. Her duties
included supervision of personnel, floor shows, and food
preparation. She signed checks on the restaurant's behalf but was
not involved in accounting.
Ms. Ng and her brother, Sik Yuen Ng, who also was employed at
Ocean City HK, opened the tip account at Wing Lung Bank on March
11, 1981. The account was in their names, and they each had
signature authority.
Deposits to the tip account from 1986 through 1990 were
generally in cash as follows:
Year Amount Deposited Number of Deposits
1986 $1,543,418 156 (6 noncash deposits)
1987 231,541 57 (3 noncash deposits)
1988 228,910 49 (all cash)
1989 567,919 36 (3 noncash deposits)
1990 5,301 1 (cash)
All the withdrawals from the tip account which the revenue
agent could trace were for the benefit of Ms. Ng or a restaurant
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which she partially owned in the United States. The withdrawals
occurring from 1986 through 1989 fall into three general
categories:
* $491,752--transferred directly to Ms. Ng's personal bank
account in the United States or to American Express to pay her
personal American Express bills;
* $535,012--paid for the direct benefit of U.S. restaurants in
which Ms. Ng had an ownership interest; and
* $1,920,158--no information provided.
In February 1991, Ms. Ng resigned from her position at Ocean
City HK and transferred a portion of her stock ownership to her
son. This was apparently done as a result of a controversy
concerning her use of the tip account. The managing director of
the restaurant, Jack Lee, also resigned and transferred ownership
of all of his stock to Ms. Ng's son in February 1991. Ms. Ng and
Mr. Lee had been business partners since 1965.
Sometime in 1990 or early 1991, Ocean City HK was reorganized
and new owners were brought into the business. In May 1991, a
newly constituted board of directors decided to close the tip
account.
The accounting firm of KPMG Peat Marwick (Peat Marwick) was
employed to conduct a financial audit of Ocean City HK for the year
ending March 31, 1991. James Arkoosh, Peat Marwick's Hong Kong
resident partner, testified that the tip account was included as an
asset of Ocean City HK on its balance sheet for the year ended
March 31, 1991. He did not know whether the tip account had been
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treated as an asset of Ocean City HK for any of the years under
consideration, and no persuasive evidence was introduced for us to
conclude that the tip account belonged to the restaurant.
In her posttrial brief, Ms. Ng claims that she did not own the
tip account but rather it was owned by Ocean City HK, that certain
deposits into the account were counted twice by respondent, and
that disbursements to her from the account were loans. The record
in this case belies these claims.
Ms. Ng and her brother had complete control over the tip
account. Although the source of deposits into the account may have
been tips received by Ocean City HK employees, a substantial
portion of the withdrawals from the account went to Ms. Ng or for
her benefit. We therefore find that Ms. Ng controlled the tip
account and treated it as her own.
The parties stipulated that $98,911 of the deposits in the tip
account were not included in respondent's adjustments because that
amount was transferred to Ms. Ng's Bank of America account and
already had been counted in determining her reconstructed income.
Ms. Ng has not shown that other amounts were counted twice.
Further, we are not convinced that the withdrawals from the tip
account were loaned to her, or that she intended to repay any such
alleged loans.
Nonetheless, we believe some disbursements from the tip
account were for the benefit of Ocean City HK shareholders other
than Ms. Ng, who in effect acted as agent for Ocean City HK in the
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United States. The parties stipulated that $530,603 in
disbursements from the tip account between 1986 and 1989 were paid
to Ocean City Restaurant in San Francisco, in which Ms. Ng had a 5-
percent ownership interest, or to its suppliers. Accordingly we
find, and thus hold, that only 5 percent of the $530,603 deposited
into the tip account was income to Ms. Ng.
The parties also agreed that $473,660 was paid directly to Ms.
Ng from the tip account. Ms. Ng claims that some of the $473,660
went to Ocean City Seattle and Ocean City San Francisco, as well as
to the Golden Palace Restaurant in Los Angeles, in which she had no
ownership interest. Other than an exhibit showing that a $50,000
withdrawal from the tip account on November 30, 1987, was recorded
on the books of Ocean City HK as a loan to the Golden Palace, Ms.
Ng presented no evidence that any specific disbursement went to any
of these restaurants. The funds were wired directly to Ms. Ng, and
there is no evidence that she transmitted the money to the Golden
Palace. Accordingly, we find, and thus hold, that all of the
$473,660 paid directly to Ms. Ng from the tip account is income to
her.
The parties agreed that $4,409 was paid from the tip account
to Golden Dragon Restaurant or its suppliers. Ms. Ng is a 50-
percent owner of the Golden Dragon, and we find, and thus hold,
that half of this $4,409 is income to her.
The parties stipulated that $18,092 was disbursed from the tip
account to pay Ms. Ng's personal credit card bills. We find, and
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thus hold, that the entire amount of those deposits is income to
Ms. Ng.
To summarize, except for the amounts that we found are not
income to Ms. Ng, we find, and thus hold, that all of the tip
account deposits are income to Ms. Ng.
Other Accounts
The revenue agent used unexplained cash deposits to other bank
accounts Ms. Ng owned or controlled as the basis to reconstruct Ms.
Ng's income.
Ms. Ng's personal checking account in the United States was at
the Bank of America in San Francisco. The deposits to the Bank of
America account, after reduction for reported and nontaxable rents
and partnership draws, determined to be unreported income,
included:
Number of Rent, Draw Unreported Income
Year Cash Deposits Deposits Reduction Adjustment
1986 $ 68,866 58 ($14,017) $ 54,849
1987 80,798 30 ( 30,354) 50,444
1
1988 121,760 56 ( 34,925) 101,911
1989 61,210 37 -0- 61,210
1 No explanation was given for the mathematical discrepancy.
Ms. Ng controlled an account at Union Bank in San Francisco
that she opened in the name of Strong Hope, as well as an account
at Bank of the Orient in San Francisco in the name of Permanent
Union Ltd. Both companies were wholly owned by Ms. Ng. The
revenue agent analyzed the deposits to these accounts and
determined that the following unexplained cash deposits made to
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each account (after reduction for the maximum reported rents that
could have been received in cash) represented unreported income of
Ms. Ng:
1988 Cash Deposits
Union Bank (39 deposits) $59,157
Bank of the Orient (53 deposits) 67,545
Rent reduction (48,541)
Adjustment $78,161
Ms. Ng also made deposits of checks from her restaurants and
other identified and unidentified sources. She made wire transfers
of unidentified funds to Sumitomo Bank. She used cash from
unidentified sources to purchase cashier's checks. She made
contributions to capital and loans to her restaurants with
unidentified funds. Ms. Ng made numerous check and cash deposits
into her accounts at Hang Seng Bank and Wing Lung Bank in Hong
Kong, and numerous wire deposits from the Hong Kong banks to her
Bank of America account in San Francisco.
Cash and check deposits into Ms. Ng's account at Hang Seng
Bank were as follows:
Year Total Deposits
1986 $170,910
1987 228,512
1988 42,835
1989 60,686
1990 21,350
The revenue agent reduced these deposits by $30,000 to account for
two transfers ($15,000 in 1986 and $15,000 in 1987), and the
revenue agent determined the remaining amounts to be unreported
income.
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Deposits into one of Ms. Ng's accounts at Wing Lung Bank were
as follows:
Year Total Deposits
1986 $260,442
1987 1,558
1988 11,141
1989 167,515
1990 34,754
Wire transfers from Wing Lung Bank and Hang Seng Bank into Ms.
Ng's Bank of America account in San Francisco were as follows:
Year Total Deposits
1986 $163,300
1987 291,980
1988 168,549
1989 296,895
The revenue agent reduced the above amounts by $225,000 to account
for several nontaxable transactions that could be traced.
Ms. Ng contends that partnership draws in cash from the Golden
Dragon Restaurant were improperly added to Ms. Ng's income by the
revenue agent. In her bank deposits analysis, the revenue agent
subtracted substantiated partnership draws paid directly to Ms. Ng
from Golden Dragon Restaurant for 1987. The revenue agent
requested documents that would substantiate draws from the
restaurant for other years, but Ms. Ng did not provide them. Under
the circumstances, we find that it was appropriate for the revenue
agent to subtract from her calculation of Ms. Ng's unreported
income only those partnership draws that were substantiated.
Ms. Ng also contends that the revenue agent improperly treated
as income to Ms. Ng amounts that were deposited into accounts
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belonging to separate entities Ms. Ng owned. However, Ms. Ng
treated accounts belonging to entities she owned as though they
were her personal accounts. As stated previously, she disregarded
the legal ownership of the accounts and commingled personal funds
with funds of the entities she controlled. She also disregarded
legal ownership of the accounts when writing checks. We find that
it was reasonable for respondent to treat the accounts as belonging
to Ms. Ng, as she herself had done.
Upon review of all of respondent's adjustments and supporting
documentation, we conclude that with the exception of certain
amounts deposited into the tip account that we found should be
excluded from Ms. Ng's reconstructed income, and $32,559 of
cancellation of indebtedness income for 1989,1 Ms. Ng had
1
Respondent determined that amounts deposited into
Strong Hope's account at Union Bank were the income of Ms. Ng.
On the books of Strong Hope the deposits were treated as loans to
Ms. Ng. To avoid being whipsawed, respondent increased the
amount Ms. Ng owed to Strong Hope to reflect that the amounts
deposited into Strong Hope's account at Union Bank and used for
her benefit were amounts Strong Hope loaned to Ms. Ng.
Respondent also adjusted the loan balance shown on the books of
Strong Hope as due from Ms. Ng to include expense items that had
been booked as loans from Ms. Ng to Strong Hope but which were
never substantiated by Ms. Ng. The net amount left owing to
Strong Hope by Ms. Ng was $32,559, and respondent took the
position that this debt was forgiven and/or canceled on May 9,
1989, when Strong Hope distributed its one-half interest in 850
Stockton Street to Ms. Ng.
In her posttrial brief, respondent states that if we hold
that "the amounts deposited into Strong Hope's Union Bank account
are the income of Ms. Ng", then respondent concedes that the
forgiveness of income issue should be resolved in favor of Ms.
Ng.
We find that the amounts deposited into Strong Hope's Union
(continued...)
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unreported income in the amounts determined by respondent.
A final note with respect to the unreported income issue. In
her posttrial brief, Ms. Ng asserts that "the nature of this case
cries out for a net worth analysis" and requests the Court to
"direct the parties to cooperate in an effort to do a net worth
analysis to reach a more accurate and just result." We will not
accede to Ms. Ng's request. Whatever Ms. Ng's net worth, it is not
relevant to whether the bank deposits and other income traced to
her during the years under consideration constitute income to her.
What happened to this income after Ms. Ng received it does not
change its character as income. Moreover, there is "no requirement
that the Commissioner use the net worth method for computing
income." Estate of Mason v. Commissioner, 64 T.C. at 662.
Issue 2. Hong Kong Restaurant Losses
We now turn our attention to whether Ms. Ng is entitled to
claimed pass-through losses from her solely owned S corporation,
Hong Kong Restaurant, Inc. This, in turn, depends upon whether Ms.
Ng had sufficient basis in that corporation to claim the losses.
Pursuant to section 1366, S corporation income, losses,
deductions, and credits are passed through pro rata to
shareholders. The amount that can be claimed is limited to the sum
of a shareholder's adjusted basis in the corporate stock, and his
1
(...continued)
Bank account are the income of Ms. Ng.
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adjusted basis in any indebtedness that the corporation owes to the
shareholder. Sec. 1366(d).
Ms. Ng deducted losses from Hong Kong Restaurant, Inc., on her
individual tax returns as follows:
Year Deduction
1986 $173,228
1987 149,993
1988 284,778
1989 129,328
Ms. Ng established that she purchased 3,675 shares of stock in
Hong Kong Restaurant, Inc., a State of Washington corporation, for
$36,750 when that company was incorporated in 1983. Sixteen other
investors also purchased stock at that time, and the company's
initial capitalization was $500,000. Ms. Ng contends that she
later purchased all of the stock owned by the other investors and
invested at least $700,000 in the company. There is no credible
evidence to support her claim. Minutes of an August 3, 1984, board
of directors' meeting show Ms. Ng as the sole shareholder, but
there is no evidence as to how she acquired the additional shares
or how much she might have paid for them.
Ms. Ng claims that a lack of evidence as to how the stock was
acquired "is not important for purposes of determining her initial
basis * * * for Federal income tax purposes." Ms. Ng also contends
that preparation of tax returns by a reputable accounting firm
"supports an inference that the capital stock and loans from
shareholders reflected on the balance sheets would have been
reviewed and are correct." We disagree. See Sperl v.
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Commissioner, T.C. Memo. 1993-515.
Ms. Ng has the burden of proving her basis in an investment.
With the exception of the initial $36,750 stock purchase, she has
presented no evidence that would permit us to make such a
determination. Furthermore, prior to 1986, she claimed at least
$94,218 in accumulated losses which would result in a decrease in
her basis in the stock of (or loans to) Hong Kong Restaurant, Inc.
See secs. 1.1367-1(c)(2) and 1.1367-2(b)(1), Income Tax Regs.
The record reveals that Hong Kong Restaurant, Inc., purchased
its restaurant assets from Fong & Fong Co., Inc., in November of
1983 for $700,000. Ms. Ng claims that she borrowed $500,000 to
permit the company to purchase the assets. The record, however,
does not support this claim. Rather, the record reveals that Ms.
Ng borrowed $500,000 from Wing Lung Bank on February 4, 1985, which
was 15 months after the purchase of the assets, and according to
bank records that $500,000 loan was to be used for the remodeling
of Ocean City Restaurant in San Francisco.
Ms. Ng's wholly owned corporation, Hong Kong Investments
Limited, obtained another $500,000 loan from Wing Lung Bank on
September 18, 1984. However, we do not believe those funds were
loaned to Ms. Ng to invest in Hong Kong Restaurant, Inc., as she
contends. Rather, we believe the proceeds of the additional
$500,000 loan were used to purchase the building that Hong Kong
Restaurant had been leasing from another party.
Ms. Ng claims she further borrowed $100,000 from Hong Kong
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Investments, Limited to pay for Hong Kong Restaurant, Inc. The
evidence does not support this claim.
To summarize, Ms. Ng proved an initial basis of $36,750 in the
stock of Hong Kong Restaurant, Inc. which was totally absorbed by
pass-through losses she claimed prior to 1986. She did not prove
any additional contributions to capital or shareholder loans.
Accordingly, we hold that the deductions claimed during the years
under consideration were properly disallowed.
Issue 3. Section 1031 Exchange
Ms. Ng deferred gain from the sale of her Larkin and Lombard
Street properties in San Francisco pursuant to section 1031. The
deferred gain from the sale of her Larkin Street property in 1988
was $393,177, and the deferred gain from the sale of her Lombard
Street property in 1989 was $516,633. Ms. Ng's sale of her Larkin
and Lombard Street properties was followed by Strong Hope's
conveyance of its one-half interest in an apartment building at 850
Stockton Street in San Francisco to Ms. Ng. Ms. Ng owned the other
half interest in the Stockton Street property. Respondent
determined that Ms. Ng was not entitled to the deferred gain on the
sale of these 2 properties on the ground that Ms. Ng did not intend
to exchange the properties for like-kind property, as required to
obtain deferral of gain under section 1031. The underlying facts
support respondent's assertions.
In July of 1988, Wing Lung Bank demanded that Ms. Ng satisfy
her delinquent bank loans. Ms. Ng advised the bank that she would
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raise the cash needed to pay off her loans by selling the Larkin
Street and Lombard Street properties in an exchange transaction.
Ms. Ng entered into a contract to sell the Larkin Street
property to David Mandel for $565,000 on September 2, 1988. She
subsequently transferred the property to Independent Exchange
Services, Inc. (IES), which in turn transferred the property to Mr.
Mandel on November 10, 1988. The net cash due Ms. Ng was
$85,317.57 after all existing loans and taxes were paid.
Ms. Ng entered into a contract to sell the Lombard Street
property to JSM & Inter Realty Corporation for $990,000 on January
5, 1989. She subsequently transferred the property to IES, which
in turn transferred the property to JSM & Inter Realty Corporation
on February 6, 1989. The net proceeds from this sale to Ms. Ng
($304,178.26) were placed in an escrow account with Founders Title
Company (Founders).
On January 11, 1989, Ms. Ng agreed to pay $1.1 million to
Strong Hope for the purchase of Strong Hope's 50-percent interest
in the Stockton Street property. Also on January 11, Ms. Ng and
Strong Hope agreed to an addendum to the sale contract providing
that IES would be substituted for Ms. Ng as buyer, and that once
Strong Hope conveyed the property to IES, the property then would
be transferred from IES to Ms. Ng.
Ms. Ng was required to pay $100,000 to the Internal Revenue
Service (IRS) on May 9, 1989, apparently to satisfy a tax lien, in
order to open her restaurant in San Francisco. She also had to
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receive the exchange property by that time as required under
section 1031(a)(3)(B). IES, Strong Hope, and Ms. Ng entered into
an agreement on that date providing that IES would purchase the
Stockton Street property from Strong Hope for $1.1 million, and
that Strong Hope would deed the property directly to Ms. Ng. The
purchase price was to be paid as follows:
$ 400,088.33 Assumption of deed of trust
389,343.80 Cash in escrow
310,000.00 Promissory note from Ms. Ng to IES, assigned to
seller
567.87 Paid by Ms. Ng
$1,100,000.00
Ms. Ng, as agent of Strong Hope, deeded Strong Hope's 50-
percent interest to herself on May 9, 1989. Ms. Ng wanted the
escrowed funds to be released on that date. Founders refused to
pay the escrowed funds directly to Strong Hope because Founders
previously had been instructed to release the money only to IES.
On May 11, 1989, the escrow was canceled pursuant to instructions
from IES, and on May 16, 1989, Founders issued a check to IES for
$309,056.94, representing the proceeds from the sale of Ms. Ng's
Lombard Street property.
The proceeds from the sale of the Larkin Street and Lombard
Street properties, ostensibly used to acquire the Stockton Street
property from Strong Hope in a section 1031 exchange, actually were
used by Ms. Ng for her own purposes as follows:
* January 12, 1989--IES issued a $85,165.54 check to Strong
Hope, representing net proceeds from the sale of the Larkin Street
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property.
* January 13, 1989--IES check deposited into Strong Hope's
Union Bank account, purportedly as a deposit toward the purchase
price of the Stockton Street property. Ms. Ng purchased a money
order for $85,165.54 with funds from Strong Hope's Union Bank
account. She used the money order to make a mortgage payment on
the Stockton Street property, one-half of which she owned outright.
One-half of the payment ($42,583.27)--benefiting the other 50-
percent interest in the Stockton Street property Strong Hope owned
--was recorded as a loan to Strong Hope from Ms. Ng.
* May 16, 1989--Founders issued check to IES for
$309,056.94.
* May 23, 1989--IES issued check to Strong Hope for
$157,161.59, representing net proceeds after tax withholding from
sale of the Lombard Street property. Of the $303,828.26 disbursed,
IES withheld $110,000 for the IRS and $36,666.67 for the California
Franchise Tax Board.
* May 25, 1989--IES check for $157,161.59 deposited into
Strong Hope's Union Bank account, where the balance was $1,469
immediately prior to the deposit. Ms. Ng purchased 3 cashier's
checks on May 25 with the deposited funds: $100,000 payable to
Strong Hope Limited, a California corporation (Strong Hope
Limited), which is not the same entity as petitioner Strong Hope,
Ltd., a Hong Kong corporation and purported seller of the Stockton
Street property; $25,000 payable to Strong Hope Limited; and
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$25,000 payable to Ms. Ng. The 3 cashier's checks were treated as
follows:
$100,000--booked by Strong Hope Limited as a loan
from Ms. Ng.
$25,000--deposited into Strong Hope Limited's
account at Bank of America on May 25, 1989.
$25,000--deposited into Ms. Ng's personal account at
Bank of America on May 25, 1989.
* June 23, 1989--Check for $22,000 drawn on Strong Hope
Limited's account at Bank of America and deposited into Ms. Ng's
personal account at Bank of America.
Section 1001(c) requires recognition of gain or loss on the
sale or exchange of property. However, under section 1031(a),
nonrecognition is permitted if property held for productive use in
a trade or business or for investment is exchanged solely for like-
kind property also held for business or investment purposes.
Section 1031(a) assumes that the new property is substantially
a continuation of the old investment. See Commissioner v. P.G.
Lake, Inc., 356 U.S. 260, 268 (1958). A taxpayer must satisfy the
specific requirements and underlying purpose of section 1031(a) to
qualify for deferral of gain. Bolker v. Commissioner, 760 F.2d
1039, 1044 (9th Cir. 1985), affg. 81 T.C. 782 (1983). A
transaction will not be treated as an exchange if the taxpayer had
control over the sale proceeds. Coupe v. Commissioner, 52 T.C.
394, 409 (1969); see also Klein v. Commissioner, T.C. Memo. 1993-
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491. A transaction also will not qualify under section 1031 if the
person with whom the taxpayer made the exchange was acting as the
taxpayer's agent. Coupe, 52 T.C. at 406.
Ms. Ng's transactions did not meet the specific requirements
or the underlying purpose of section 1031. She appropriated the
proceeds from the sale of the Larkin Street and Lombard Street
properties for her own use immediately after the money was
deposited into Strong Hope's bank account, which Ms. Ng treated as
her own. We do not believe she ever intended to pay the $310,000
promissory note she gave as part of the purchase price. Strong
Hope acted as Ms. Ng's agent when it deeded the Stockton Street
property directly to Ms. Ng, contrary to the original agreement of
the parties. Furthermore, Ms. Ng never intended to exchange her
Larkin Street and Lombard Street properties for property of like
kind. She sold those properties because she needed the proceeds to
satisfy her delinquent loans with Wing Lung Bank.
We conclude that Ms. Ng did not satisfy the requirements or
underlying purpose of section 1031 and accordingly hold that she is
liable for gain on the sale of the Larkin Street and Lombard Street
properties.
Issue 4. Strong Hope Liquidation
The next issue we consider relates to the tax consequences of
Strong Hope's transfer of its interest in the Stockton Street
property to Ms. Ng. Respondent determined that Strong Hope made a
liquidating distribution to Ms. Ng when it transferred the Stockton
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Street property to her. Ms. Ng contends that because Strong Hope
sold its interest in the Stockton Street property to her, after the
sale, it had an asset, namely, the $110,000 that IES paid to the
IRS on Strong Hope's behalf and which Strong Hope claims should be
refunded to it.
We previously determined that Ms. Ng did not acquire an
interest in the Stockton Street property from Strong Hope in a
section 1031 exchange transaction. In our opinion, the correct
characterization of the transfer of Strong Hope's interest in the
Stockton Street property to Ms. Ng is a distribution of property,
not a sale.
A liquidating distribution of property by a corporation to a
shareholder is taxable to the shareholder as gain from the sale or
exchange of property to the extent the distribution exceeds the
shareholder's basis in his stock. Any distribution that is part of
a series of distributions under a plan to redeem all outstanding
stock is treated as a liquidating distribution. Sec. 346(a).
Liquidating distributions are treated as full payment for a
shareholder's stock. Sec. 331(a). To find a corporate
liquidation, there must be a manifest intention to liquidate and a
continuing purpose to terminate corporate affairs, and the
corporation's activities must be directed to such termination.
Estate of Maguire v. Commissioner, 50 T.C. 130, 142 (1968).
The parties stipulated that Strong Hope's sole U.S. business
activity was the rental of its individual one-half interest in the
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Stockton Street property. There is nothing in the record to
suggest that Strong Hope had business activities outside the U.S.
Upon the purported sale of its one-half interest in the
Stockton Street property to Ms. Ng, Strong Hope filed a final tax
return for 1989 and reported no tax liability for that year.
Emerald Lee, the accountant who prepared Strong Hope's return,
testified that she was informed that Strong Hope was going to be
liquidated. Additionally, Ms. Ng stated in a 1990 Form 5471,
"Information Return of U.S. Persons With Respect To Certain Foreign
Corporations," that:
Strong Hope has distributed all of its assets in early
1990. The company has remained dormant for the remainder
of calendar year 1990[,] * * * no longer conducts
business of any kind and has no assets.
The fair market value of Strong Hope's interest in the
Stockton Street property was $1.1 million. Ms. Ng assumed a
$400,088 mortgage and had a $2 basis in her Strong Hope stock. The
liquidation of Strong Hope results in a gain of $699,910.
Accordingly, we hold that Ms. Ng realized a gain of $699,910 from
the liquidation of Strong Hope.
Issue 5. Investment Interest Deduction
Respondent determined that Ms. Ng had $120 of interest income
in 1989, and that her investment interest deduction was limited
(pursuant to section 163(d)) to $2,000, plus the amount of net
investment income, or a total of $2,120. Respondent thus
disallowed $59,992 of claimed interest expense. Ms. Ng did not
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contest this issue either at trial or in her posttrial brief.
Accordingly, we sustain respondent's determination in this regard.
Issue 6. Net Operating Loss Deduction
Ms. Ng claimed a $13,182 net operating loss deduction in 1986
attributable to a loss carried over from 1985. Respondent
disallowed this deduction. Ms. Ng has presented no evidence to
substantiate the loss. Because Ms. Ng did not meet her burden of
proof, the deduction was properly disallowed.
Issue 7. Ms. Ng's Additions to Tax
Respondent determined that Ms. Ng is liable for an accuracy-
related penalty and for additions to tax for negligence,
substantial understatement, failure to file timely returns, and
failure to pay estimated tax.
For 1986 and 1987, section 6653(a)(1)(A) imposes an addition
to tax of 5 percent of the amount of any underpayment due to
negligence or disregard of rules or regulations, and section
6653(a)(1)(B) provides for an addition of 50 percent of the
interest payable under section 6601 on the portion of the
underpayment attributable to negligence. For 1988, a 5-percent
addition to tax for negligence or disregard of rules or regulations
applies pursuant to section 6653(a)(1). For 1989, section 6662(a)
and (b)(1) and (2) imposes a penalty equal to 20 percent of the
portion of the underpayment that is attributable to negligence or
disregard of rules or regulations, or to substantial understatement
of tax.
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Negligence is defined as the failure to exercise the due care
that a reasonable, prudent person would exercise under similar
circumstances. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th
Cir. 1984), affg. 79 T.C. 714 (1982); Neely v. Commissioner, 85
T.C. 934, 947 (1985). A taxpayer has the burden of proving that
respondent's determination is in error. Luman v. Commissioner, 79
T.C. 846, 860-861 (1982).
We are satisfied, and thus find, that the entire underpayment
is due to Ms. Ng's negligence and intentional disregard of the
Federal income tax rules and regulations. Ms. Ng failed to
maintain adequate records. She commingled her personal funds with
funds of entities she controlled. She misrepresented material
facts to the revenue agent on more than one occasion. She
concealed large amounts of taxable income on which she did not pay
tax. She concealed ownership of property. We therefore hold that
Ms. Ng is liable for the additions to tax for negligence on the
entire underpayment for each of the years 1986 through 1988, and
for the accuracy-related penalty on the entire underpayment for
1989, excluding the amount by which any of the underpayments is to
be reduced in accordance with our findings herein.
Section 6651(a)(1) provides for a 5-percent addition to tax
for each month a return is not filed, unless due to reasonable
cause, with a maximum addition to tax of 25 percent. Because Ms.
Ng did not timely file her returns, section 6651(a)(1) applies to
each of the years under consideration.
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Section 6654 provides for an addition to tax for failure to
pay estimated income tax. Because Ms. Ng failed to pay estimated
tax for 1990, section 6654 applies.
Finally, respondent determined an addition to tax under
section 6661 for 1986, 1987, and 1988. Section 6661 provides for a
25-percent addition to tax for substantial understatement. We
sustain respondent's determination.
Issue 8. Discharge of Indebtedness
Respondent determined that Strong Hope had $516,903 in
discharge of indebtedness income in 1989. This discharge of
indebtedness income relates to debts Strong Hope owed to Strong
Hope Limited (the California corporation) and to Permanent Union
Limited, both of which were wholly owned by Ms. Ng. As of 1989,
Strong Hope owed $434,012 to Strong Hope Limited, and $82,891 to
Permanent Union Limited. Respondent contends that these debts were
discharged when Ms. Ng caused Strong Hope to distribute to her its
sole asset (i.e., the Stockton Street property) and thus liquidate.
Strong Hope argues that it was insolvent prior to the distribution,
that it did not liquidate in 1989, and that any discharge of
indebtedness was not U.S. source or business income.
Gross income includes income from discharge of indebtedness.
Sec. 61(a)(12). However, section 108(a) provides an exclusion if
the discharge of indebtedness occurs when the taxpayer is
insolvent. Strong Hope contends that it comes within the
insolvency exclusion of section 108. We do not agree.
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Strong Hope had assets of $1,173,122 and liabilities of
$916,991 prior to its distribution of the Stockton Street property.
The Stockton Street property was valued at $1.1 million, and
according to Strong Hope's books it had other assets totaling
$73,122. The company had a mortgage of $400,088 and owed $516,903
to Strong Hope Limited and Permanent Union Limited. Based on these
facts, Strong Hope was not insolvent immediately prior to the
discharge of indebtedness.
Strong Hope also contends that it did not liquidate in 1989,
and thus could not have discharge of indebtedness income. We
disagree. Following Strong Hope's distribution of its 50-percent
interest in the Stockton Street property to Ms. Ng on May 9, 1989,
it effectively ceased doing business and the amounts it owed to
Strong Hope Limited and Permanent Union Limited were effectively
discharged. Whether a company actually liquidates is not the test
for determining whether there is income from discharge of
indebtedness. A debt is discharged when it becomes apparent that
the debt will never have to be repaid. Brountas v. Commissioner,
74 T.C. 1062, 1074 (1980), vacated and remanded 692 F.2d 152 (1st
Cir. 1982).
Finally, Strong Hope contends that any discharge of
indebtedness would not be U.S. source income under section 881(a)
or income effectively connected with the conduct of a trade or
business within the United States under section 882(a). Again, we
do not accept this assertion.
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The record clearly reveals that Strong Hope's only business
activity was the rental of the Stockton Street property in San
Francisco, and that the indebtedness to Strong Hope Limited and
Permanent Union Limited was related to that activity. We
accordingly find that Strong Hope's indebtedness was connected with
its business in the United States.
To conclude, we hold that Strong Hope realized discharge of
indebtedness income of $516,903 in 1989.
Issue 9. Stockton Property Basis
For purposes of calculating the amount of gain realized by
Strong Hope under section 336(a) on the distribution of the
Stockton Street property to Ms. Ng, respondent reduced Strong
Hope's adjusted basis in the Stockton Street property. In this
regard, respondent contends that Strong Hope understated the
accumulated depreciation by $45,820 when it reported the sale of
its interest in the property, and second, that a roofing expense of
$10,729 which Strong Hope added to basis was not substantiated.
Strong Hope does not contest respondent's depreciation adjustment.
However, with respect to the roofing expense, Strong Hope asserts
that respondent knows that this expense was incurred. The evidence
is not sufficient to substantiate the claimed roofing expense.
Accordingly, we sustain respondent's adjustments to Strong Hope's
basis in the Stockton Street property.
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Issue 10. Other Adjustments
Respondent contends that Strong Hope could not substantiate
$41,194 of a claimed net operating loss carryover from 1988.
Strong Hope did not contest this determination. We therefore
sustain respondent's determination to the extent the adjustment may
affect Strong Hope's 1989 tax year.
Respondent also claims that Strong Hope should be taxed on
rental income of $2,977 that it received from Celadon Restaurant in
1988. We do not have jurisdiction over Strong Hope's 1988 tax
year. Accordingly, we do not sustain this adjustment.
Issue 11. Strong Hope's Additions to Tax
Respondent determined an addition to tax under section
6651(a)(1) and a penalty under section 6662 against Strong Hope for
1989.
Section 6651(a)(1) imposes an addition to tax for failure to
timely file a return. Strong Hope did not timely file its 1989
corporate tax return; thus, it is liable for the addition to tax
under section 6651(a)(1).
Pursuant to section 6662, a penalty is imposed on that portion
of the underpayment that is attributable to negligence or disregard
of rules and regulations or to substantial understatement. Like
Ms. Ng, Strong Hope was uncooperative during the audit, did not
provide adequate records, and misrepresented facts to respondent's
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agent. We find that Strong Hope was negligent and disregarded rules
and regulations, and substantially understated its tax; thus, it is
liable for the penalty under section 6662.
To reflect the foregoing and concessions,
Decisions will be entered
under Rule 155.