holding that the Court has discretion not to be bound by the stipulation of facts where clearly contrary evidence is presented at trial
How later courts described this case
- holding that the Court has discretion not to be bound by the stipulation of facts where clearly contrary evidence is presented at trial
- “The crucial test of the existence of a constructive dividend is whether ‘the distribution was primarily for the benefit of the shareholder.’”
Written by the judges who cited it.
The opinion
United States Tax Court
T.C. Memo. 2022-124
ROBERT LEWIS STARER AND MERLE ANN STARER,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 615-13. Filed December 20, 2022.
—————
Douglas E. Kahle, for petitioners.
Timothy B. Heavner and Robert J. Braxton, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: Petitioners Robert Lewis Starer and Merle Ann
Starer are controlling shareholders of the Bayview Corp. (Bayview), an
S corporation that operates agriculture and horse-breeding businesses.
It also serves as a holding company for their family’s primary residence,
a farm, and several unimproved subdivided properties initially marked
for development. From 2006 until 2010, Bayview engaged in a series of
transactions to transfer six of its unimproved subdivided properties to
various third parties. Two of these transfers were effectively made
gratuitously. The other four transfers were made in exchange for cash
plus a repurchase agreement compelling Bayview to repurchase the
property for its original net purchase price upon demand of the
transferees. Bayview reported these four transactions as nontaxable
loans 1 in its books on the grounds that it had obligations under the
1 Hereinafter, any reference to “loans” is for ease of referring to petitioners’
arguments and is not meant as a characterization of the substances of the
transaction(s) by the Court.
Served 12/20/22
2
[*2] repurchase agreements to reacquire the transferred properties and
repay the transferees.
After conducting an examination of Bayview’s tax reporting,
respondent determined Bayview’s repurchase obligations to be illusory,
and that being the case, the four transfers made in exchange for
consideration should have been characterized as sales while the two
effectively gratuitous transfers constituted distributions of appreciated
property. Respondent made adjustments to subject these transactions
to taxation and discovered additional deficiencies through the course of
his examination.
By notice of deficiency dated October 12, 2012, respondent
determined deficiencies in federal income tax of $616,558, $167,086, and
$580,035, and accuracy-related penalties under section 6662(a) 2 of
$123,312, $33,417, and $116,007, for petitioners’ taxable years 2008,
2009, and 2010 (years in issue), respectively.
The issues to be decided are: (1) whether any resulting tax
liabilities from the transactions in issue should pass through to
petitioners’ two grantor trusts as shareholders of record in Bayview or
to petitioners as reported on Bayview’s tax return; (2) whether
respondent’s determination that Bayview’s accounting of four transfers
of property should be treated as sales rather than loans constitutes a
change in petitioners’ method of accounting, and if so, whether
respondent abused his discretion in making the foregoing
determination; (3) whether two transfers of property constitute
constructive distributions of appreciated property from Bayview to
petitioners; (4) whether petitioners’ rent-free use of their home in 2008,
2009, and 2010 constitutes a constructive dividend from Bayview to
petitioners; (5) whether Bayview is entitled to a bad debt deduction for
2008; and (6) whether petitioners are liable for section 6662(a) accuracy-
related penalties for the years in issue.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The
Stipulations of Fact and the attached Exhibits are hereby incorporated
2 Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure. Monetary amounts are rounded to the nearest dollar.
3
[*3] by this reference. Petitioners, husband and wife, resided in Virgina
when they timely filed the Petition.
I. Petitioners’ Businesses
Petitioners are controlling shareholders and corporate officers of
Bayview, a Virginia corporation electing to be taxed as an S corporation
for federal income tax purposes. In addition to Bayview, petitioners held
controlling ownership in and served as corporate directors of two other
closely held corporations, Village Builders, Inc. (Village Builders) and
Historic Arms, Inc. (Historic Arms), at relevant times during the years
in issue. Village Builders, a now-defunct Virginia C corporation
dissolved in 2008, operated a construction business that built modular
homes. Historic Arms, a Delaware C corporation, continues to operate
a firearms training and dealing business. Petitioners and their related
entities operated under the cash method of accounting for all relevant
taxable years.
II. Bayview
Bayview is the owner of several contiguous parcels of real
property (collectively known as Scott’s Farm) in Cape Charles, Virginia.
Scott’s Farm was acquired in 1995 for $795,000 and improved by a
4,688-square-foot residence, a horse barn, an airplane landing strip, and
a swimming pool. In 2006 a portion of Scott’s Farm was subdivided into
eight lots (numbered Lots 1 through 8) totaling 17.81 acres. Bayview’s
basis in each lot is $23,520.
As outlined below, petitioners had several longstanding
relationships with individuals who would eventually become parties to
the transactions in issue. Those transactions consist of six transfers of
its subdivided properties; Lots 3 through 6 were transferred in exchange
for consideration while Lots 1 and 2 were effectively transferred
gratuitously. Lots 7 and 8 remain assets of Bayview.
A. Relationships With Parties to the Transactions
Petitioners first became acquainted with an individual named
Thomas Wilson when he unexpectedly landed his airplane on their
landing strip. Their relationship progressed into engaging in business
transactions, such as Mr. Starer’s drawing upon his banking
relationships to secure financing for Mr. Wilson’s purchase of a plane.
They eventually entered into real estate transactions together after
petitioners learned Mr. Wilson was a significant real estate investor
4
[*4] with an eye towards investing in the county wherein petitioners
lived. Mr. Wilson subsequently passed away in an airplane crash in
2011.
William Messick is a construction manager from Pennsylvania
who received a bachelor of science degree in electrical engineering from
Lafayette College. Mr. Messick owns and operates WLM Management,
Inc. (WLM Management), a company that provides property and
construction management services, as well as several other companies
through which he offers consulting services. Mr. Messick and
petitioners have a long-standing business and personal relationship
stretching over 15 years preceding the date of trial in this case. Their
relationship began when petitioners contracted one of Mr. Messick’s
companies to perform construction services in Pennsylvania. Mr.
Messick thereafter reciprocated by hiring Village Builders to construct
a chain of residences and purchasing an office building owned by
petitioners. Immediately before and during the years in issue, several
transfers of cash were made between entities controlled by Mr. Messick
and petitioners. From 2006 to 2008 Bayview transferred a total of
$1,485,058 to WLM Management while WLM Management transferred
a total of $244,000 to Bayview. By the end of 2008, Mr. Messick was
experiencing significant cashflow problems brought on by the 2008–09
global financial crisis, which led to economic strain on his businesses.
Valerie and William C. Harvey met petitioners through their
relationship with petitioners’ son-in-law, Eric Smith, who worked with
Mr. Harvey at a real estate development company called Armada
Hoffler. Mr. Smith had informed the Harveys of a real estate
investment opportunity offered by petitioners. Although they were not
in the market to invest in real estate at the time, the Harveys viewed
the structure of the deal as an investment akin to that of a high-interest
loan that would result in a balloon payment at the end of a specified
term. The Harveys had no business relationship with petitioners before
the years in issue.
For his part, Mr. Smith serves as the chief investment officer of
Armada Hoffler after having worked as a management consultant for
Booz Allen Hamilton. He received a degree in finance from the
University of Pennsylvania. Mr. Smith had never advised the Harveys
on real estate transactions before informing them of the investment
opportunity offered by petitioners. Mr. Smith had been petitioners’ son-
in-law for approximately 15 years as of the date of trial, and in that time,
they developed a history of engaging in business deals surrounding real
5
[*5] estate. A typical deal involved Mr. Smith’s acquiring financing for
properties whereon petitioners planned to build houses. Once a house
had been built, they would sell the property together and split the profits
therefrom evenly. Throughout the record, petitioners often note the
trust they developed in Mr. Smith following the successful conclusion of
countless comparable deals.
B. Transfers Made in Exchange for Consideration
1. Lots 3 and 5
On December 27, 2006, Bayview sold Lots 3 and 5 to Mr. Wilson
for $795,000 each. Mr. Wilson used the lots as collateral to obtain two
loans totaling $1 million from PNC Bank in order to finance the
purchases. Simultaneously with the transfers of title to Lots 3 and 5,
the transacting parties executed two nonassignable repurchase
agreements whereby Mr. Wilson acquired the right to compel Bayview
to repurchase the lots for the net proceeds of the original sales. Bayview
reported the sales to Mr. Wilson as loans in its books and as “repurchase
obligations” that increased its liabilities on its Form 1120S, U.S. Income
Tax Return of an S Corporation, for tax year 2006. Mr. Wilson never
exercised either repurchase agreement; instead, on February 11, 2010,
he conveyed both Lots 3 and 5 to PNC Mortgage in foreclosure. PNC
Bank, as the highest and last bidder of the properties, paid the County
of Northampton, as trustee of the properties, $108,000 and $117,000 at
a public foreclosure sale in consideration for the titles to Lots 3 and 5,
respectively.
2. Lot 4
On January 19, 2007, Bayview sold Lot 4 to Mr. Messick for
$800,000. Mr. Messick used Lot 4 as collateral to borrow $640,000 from
National City Mortgage in order to finance the purchase. He purchased
Lot 4 intending to develop the property and build a house but
accomplished neither. As in the sales of Lots 3 and 5, the transacting
parties executed a repurchase agreement coinciding with the
transaction whereby Mr. Messick acquired the right to compel Bayview
to repurchase the lot for the net proceeds of the original sale. Bayview
reported the sale to Mr. Messick as a loan in its books and accordingly
increased its liabilities under the “repurchase obligations” label on its
Form 1120S for tax year 2007. As with Mr. Wilson, instead of invoking
his right under the repurchase agreement to compel Bayview to
repurchase the property for the net proceeds of the original sale,
6
[*6] $729,028, Mr. Messick conveyed Lot 4 to National City Mortgage in
foreclosure in August 2009. National City Mortgage, as the highest and
last bidder on the property, paid the County of Northampton, as trustee
of the property, $225,000 at a public foreclosure sale in consideration for
the title to Lot 4.
3. Lot 6
On September 14, 2007, Bayview sold Lot 6 to the Harveys for full
consideration of $788,096 despite recording a purchase price of
$925,000. The transacting parties also executed a repurchase
agreement. The terms therein and the subsequent invocation thereof
varied from those of the previous two transactions. This repurchase
agreement included a ground lease whereby the Harveys agreed to lease
Lot 6 to WLM Management in exchange for payments of rent, and, if
WLM Management defaulted on its rental payments, the Harveys had
the right per an acceleration clause to compel Bayview to repurchase the
property for the net proceeds of the original sale. The repurchase
agreement also entitled the Harveys to receive unreimbursed out-of-
pocket expenses incurred in connection with owning Lot 6 and an
additional $75,000 added to the original purchase price upon the
exercise of their right to compel Bayview to repurchase the property.
Bayview reported the sale to the Harveys as a loan in its books and
accordingly increased its liabilities under the “repurchase obligations”
label on its Form 1120S for tax year 2007.
The Harveys planned to use the proceeds from WLM
Management’s rental payments to pay the mortgage they acquired to
finance their purchase of Lot 6. The amount of the rental payments due
under the ground lease coincided with the amounts due on their
mortgage. Shortly after the conclusion of the transaction, WLM
Management stopped making rental payments and defaulted on its
obligation under the ground lease. In October 2009 and March 2010,
the Harveys made demands through an attorney to require Bayview to
repurchase Lot 6 in accordance with the acceleration clause of the
repurchase agreement. Bayview declined to honor its obligation under
the repurchase agreement and thereby refused to repurchase Lot 6 from
the Harveys. Despite hiring an attorney to make formal demands on
their behalf, the Harveys declined to pursue litigation against Bayview
for breach of contract. In June 2010 the Harveys conveyed Lot 6 to
Eastern Shore Lot, LLC, which was wholly owned by Hampton
University.
7
[*7] C. Gratuitous Transfers
1. Lot 1
On June 24, 2008, Bayview conveyed the title to Lot 1 to Mr.
Messick. The deed was recorded by the Clerk’s Office of Northampton
County and a grantor’s tax based on a stated value of $895,000 was paid.
A sale agreement executed for Lot 1 obligated Mr. Messick to make three
payments to Bayview totaling $895,000 in exchange for the title to the
lot. A repurchase agreement was not included with this transaction.
Mr. Messick did not make any of the payments to Bayview and thereby
defaulted on his obligation under the sale agreement. However,
Bayview declined to pursue litigation against Mr. Messick as a means
to recover the payments.
Mr. Messick did not attempt to develop or sell Lot 1. Instead, he
used the lot as collateral to obtain a loan from First Security Bank and
deposited the loan proceeds into WLM Management’s bank accounts to
finance his other business ventures. He later defaulted on his loan
obligation to First Security Bank. On January 12, 2010, in full
satisfaction of the loan, Mr. Messick conveyed Lot 1 to First Security
Bank in a deed in lieu of foreclosure.
2. Lot 2
On September 17, 2008, Bayview conveyed the title to Lot 2 by
general warranty deed to Ravenna Holdings, LLC (Ravenna). The deed
was recorded by the Clerk’s Office of Northampton County and a
grantor’s tax was paid based on a stated value of $895,000. However,
Ravenna did not in fact pay any consideration in exchange for the
conveyance of Lot 2 from Bayview. The deed to Lot 2 shows that
Bayview did not retain any rights to the lot following its conveyance to
Ravenna. There is no evidence of a written record documenting any
other terms or restrictions with respect to the conveyance.
At the time of the conveyance, Mr. Smith, petitioner’s son-in-law,
was the sole member of Ravenna. He formed Ravenna for the exclusive
purpose of holding and selling land to be received from Bayview. At all
relevant times, Ravenna’s sole asset was the deed to Lot 2. Ravenna
neither developed nor sold Lot 2 after receiving the deed. On August 31,
2012, Mr. Smith assigned the entirety of his interest in Ravenna to
Bayview, effectively conveying Lot 2 back to Bayview. Bayview did not
pay Mr. Smith anything in exchange for the assignment.
8
[*8] D. Petitioners’ Rent-Free Use of Personal Residence
For all relevant taxable years, Bayview owned the title to
petitioners’ personal residence. Petitioners lived in the residence
without paying rent to Bayview. A separate portion of the residence was
used for the business operations of Historic Arms pursuant to a rental
agreement whereby it paid rent to Bayview for the use of the portions it
occupied. Bayview did not have any employment agreements with
petitioners specifying whether they were required to live in the
residence, nor were petitioners required to live there by state law or
regulation. The value of petitioners’ rent-free use of the residence was
stipulated to be $24,000 per year.
E. Intercompany Transfers
In 2008 Bayview transferred a total of $252,920 to Village
Builders while Village Builders transferred a total of $25,920 to
Bayview. Bayview classified the transfer of funds to Village Builders as
a loan. The corporations did not execute a promissory note nor any other
written agreement to establish a record of indebtedness or terms of
repayment, interest, or maturity.
Bayview claimed a bad debt deduction of $227,420 on its 2008
Form 1120S in connection with the funds transferred to Village
Builders. Village Builders entered debt forgiveness income of $227,420
in its adjusting journal entries for 2008; however, it did not report any
cancellation of debt income on its 2008 tax return as required under the
2008 Instructions for Form 1120, U.S. Corporation Income Tax Return.
F. Ownership of Bayview
In August 2003 petitioners conveyed a separate 47% interest
comprising nonvoting shares in Bayview to two grantor trusts, Old
Plantation Trust and Family Plantation Trust, respectively. The
remaining six percent interest comprised voting shares they retained as
joint tenants. Bayview did not make allocations or distributions to
either trust during any relevant year in issue. On its Forms 1120S from
2006 to 2010, Bayview reported petitioners as each owning 50% of its
stock and allocated tax items and distributions accordingly.
9
[*9] III. Notice of Deficiency
Respondent conducted an examination of Bayview’s tax returns
for taxable years 2008 through 2010, which led to adjustments of
petitioners’ individual income tax for the same years.
In the notice issued to petitioners, respondent determined the
following deficiencies and accuracy-related penalties pursuant to section
6662(a) for the years in issue:
Year Deficiency I.R.C. § 6662 Penalty
2008 $616,558 $123,312
2009 167,086 33,417
2010 580,035 116,007
The deficiency for 2008 is based on the following adjustments:
Adjustments for 2008 Amount
Ordinary income from Bayview: flowthrough adjustment for $46,294
disallowance of bad debt deduction of $227,420 claimed on Bayview’s
2008 Form 1120S
– original loss of $96,103
– corrected loss of $49,809
– resulting in adjustment of $46,294
Compensation — fair market rental value of petitioners’ home 24,000
Social Security RRB (computational) 11,864
Capital gain/loss from sale of property 4,027,926
(partially section 481 and partially sales during 2008)
Exemptions (computational) 2,334
Alternative minimum tax (computational) 12,319
Section 481(b) credit (computational) (9,560)
Earned income credit (computational) 109
10
[*10] The 2008 adjustment for capital gain/loss from the sale of
property comprises the following items:
Description Amount
Section 481 adjustment of repurchase loans reported on Bayview’s $2,387,585
return concerning transfers of Lots 3, 4, 5, and 6
Receipt of appreciated property from Bayview through transfer of 895,000
Lot 1 in 2008
Receipt of appreciated property from Bayview through transfer of 895,000
Lot 2 in 2008
Less basis in Lots 3, 4, 5, and 6 (94,080)
Less basis in Lots 1 and 2 (47,040)
Capital loss allowed (8,539)
Total Capital Gain $4,027,926
The deficiency for 2009 is based on the following adjustments:
Adjustments for 2009 Amount
Debt cancellation 3 $545,487
Compensation — fair market rental value of petitioners’ home 24,000
Social Security RRB (computational) 12,540
Exemptions (computational) 2,434
3 The debt cancellation adjustment is an alternative position, presented in the
event we found against respondent on the section 481 adjustment. Because we hold
for respondent on the section 481 adjustment, we do not uphold the debt cancellation
adjustments. We direct the parties to clearly reflect the determination in their Rule
155 computations.
11
[*11] The deficiency for 2010 is based on the following adjustments:
Adjustments for 2010 Amount
Debt cancellation 4 $1,721,357
Compensation — fair market rental value of petitioners’ home 24,000
Social Security RRB (computational) 20,368
Petitioners timely petitioned this Court for redetermination.
OPINION
I. Burden of Proof
The Commissioner’s determinations in a notice of deficiency are
generally presumed correct, and taxpayers bear the burden of proving
them incorrect. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111,
115 (1933). Petitioners have not shown that the threshold requirements
of section 7491(a) have been met as required to shift the burden of proof
to respondent. 5 As a result, the burden remains on petitioners to prove
that respondent’s determinations are in error with respect to all issues.
4 See supra note 3.
5 At trial petitioners conceded that they carry the burden of proof on all issues.
Yet in their posttrial briefs, petitioners attempt to raise a new issue that they neither
pleaded in their Petition nor argued at trial: They contend respondent’s
determinations are arbitrary, preclude the attachment of the presumption of
correctness to respondent’s determinations, and shift the burden of proof to
respondent. In their briefs petitioners maintain that respondent issued a “naked”
notice of deficiency void of any supporting evidence, and therefore, the adjustments in
the notice are erroneous. They cite several cases that stand for the proposition that
respondent must offer foundational support for a deficiency determination to reap the
benefit of the presumption of correctness. We will not consider this untimely
argument. In certain circumstances an issue not raised by the pleadings may be “tried
by express or implied consent of the parties . . . [and] treated in all respects as if they
had been raised in the pleadings.” Rule 41(b)(1). However, we have held that when a
party is not aware of an issue at trial, he cannot be held to have expressly or impliedly
consented to the trial of that issue, as required for application of Rule 41(b). See
Markwardt v. Commissioner, 64 T.C. 989, 998 (1975). This Court has held on multiple
occasions that we will not consider issues raised for the first time at trial (or on brief)
on account of the lack of notice and consequent prejudice to the opposing party. See,
e.g., Estate of Mandels v. Commissioner, 64 T.C. 61, 73 (1975); Genecure, L.L.C. v.
12
[*12] II. Shareholders of Bayview
As a preliminary matter, petitioners take the position that any
tax liabilities resulting from this deficiency proceeding should pass
through to the two grantor trusts established in 2003 on the grounds
that they transferred to each trust 47% of Bayview’s outstanding shares
before the years in issue. Respondent on the other hand contends that
any resulting tax liabilities should flow through to petitioners
proportionately as reported on Bayview’s Form 1120S for each year in
issue.
In general, a corporation electing to be taxed as an S corporation
does not pay tax at the corporate level. I.R.C. § 1363(a). Rather, an
S corporation shareholder reports a pro rata share of the S corporation’s
income, loss, and credit items on a per-share, per-day basis for the
shareholder’s taxable year in which the S corporation’s taxable year
ends. I.R.C. § 1366(a). An S corporation shareholder is required to
recognize his or her percentage share of the S corporation’s items of
income for any taxable year even if the shareholder does not receive a
distribution from the S corporation for that year. Treas. Reg. § 1.1366-
1(a)(1); see also Jones v. Commissioner, T.C. Memo. 2010-112, 2010 WL
2011013, at *3.
Certain trusts may be eligible shareholders of an S corporation
under section 1361(c)(2). As relevant here, a grantor trust may be
treated as a shareholder of an S corporation under section
1361(c)(2)(A)(i). 6 Under section 671, the deemed owners of a grantor
trust are taxable on the trust’s income attributable to them. See, e.g.,
Madorin v. Commissioner, 84 T.C. 667, 675 (1985). A trust may also be
eligible to be a shareholder of an S corporation under section
1361(c)(2)(A)(v) (electing small business trust or ESBT), which would
Commissioner, T.C. Memo. 2022-52; Friedman v. Commissioner, T.C. Memo. 1992-588,
aff’d without published opinion, 48 F.3d 535 (11th Cir. 1995). Moreover, even if we
were to entertain the argument, it would fail in the light of the fact that the record is
replete with evidence demonstrating the foundation for respondent’s determinations
including, but not limited to, petitioners’ individual tax returns, Bayview’s tax returns,
deeds of sale, purchase/sale agreements, repurchase agreements, bank statements,
and foreclosure statements.
6 Section 1361(c)(2)(A)(i) describes one permissible S corporation shareholder
as “[a] trust all of which is treated (under subpart E of part I of subchapter J of this
chapter) as owned by an individual who is a citizen or resident of the United States.”
See also Treas. Reg. § 1.1361-1(h)(1)(i) and (ii). Treasury Regulation § 1.1361-1 refers
to a grantor trust as a “qualified subpart E trust.”
13
[*13] treat current beneficiaries as the shareholders of the S corporation
for tax purposes, or if no current beneficiaries, then the trust as the
shareholder of the S corporation under section 1361(c)(2)(B)(v). In order
to qualify as an ESBT, the trust must elect to be taxed as such. This
requires the filing of an ESBT election and an ESBT statement in
accordance with the provisions of Treasury Regulation
§ 1.1361-1(m)(2)(i) and (ii)(A).
Petitioners argue that, because of the grantor trust status of each
trust, Bayview properly issued Schedules K–1, Shareholder’s Share of
Income, Deductions, Credits, etc., solely to petitioners in accordance
with section 671. They claim never to have filed a Form 1041, U.S.
Income Tax Return for Estates and Trusts, for either trust because
neither trust received reportable distributions of income from Bayview
during the years in issue. Notwithstanding that claim, petitioners
maintain that even if there was reportable income to either trust, the S
corporation election enables them as individuals to be liable for 100% of
such income. We understand this as a contention that petitioners made
a proper ESBT election for both trusts; however, there is no evidence in
the record demonstrating that petitioners filed the required election or
election statement as required by Treasury Regulation § 1.1361-
1(m)(2)(i) and (ii)(A). The lack of this evidence would result in
unintended consequences but for the parties’ agreement that the trusts
in issue qualify as grantor trusts. 7
Neither the evidence nor petitioners’ contentions lend credence to
their position that any resulting tax liabilities from the transactions in
issue should pass through to the trusts. If we were to accept petitioners’
contention that the trusts own the S corporation shares and are grantor
trusts or valid ESBTs for income tax purposes, petitioners would
continue to be taxed on their individual income tax returns for any
allocations of tax items made to the trusts. See I.R.C. § 1361(c)(2)(B)(i),
(v). Similarly, the shareholder information reported on Bayview’s tax
returns shows petitioners as each owning 50% of Bayview, and tax items
were allocated accordingly. We find that petitioners failed to
demonstrate that any resulting tax liabilities from the transactions in
issue should flow through to the trusts. Consequently, any resulting
liabilities shall pass through to petitioners individually in accordance
7 If the trusts did not qualify as grantor trusts and failed to make valid ESBT
elections, the transfer of Bayview’s stock to the trusts would result in the termination
of Bayview’s status as an S corporation for ceasing to be a small business corporation
as defined by section 1361(b). See I.R.C. § 1362(d)(2); Treas. Reg. § 1.1362-2(b)(1).
14
[*14] with their pro rata share of Bayview’s tax items as reported on
Bayview’s Forms 1120S for the relevant year.
III. Section 481 Change in Method of Accounting Adjustment to
Clearly Reflect Income
Section 446(a) sets forth the general rule that “[t]axable income
shall be computed under the method of accounting on the basis of which
the taxpayer regularly computes his income in keeping his books.” If a
taxpayer’s method of accounting does not clearly reflect income, the
Commissioner is authorized to impose a change on the taxpayer’s
method of accounting that, in his opinion, does clearly reflect income.
See I.R.C. § 446(b); Treas. Reg. § 1.446-1(b)(1). The Commissioner has
broad discretion in determining whether a taxpayer’s method of
accounting clearly reflects income. See Thor Power Tool Co. v.
Commissioner, 439 U.S. 522 (1979); RCA Corp. v. United States, 664
F.2d 881 (2d Cir. 1981). Once he determines that a taxpayer’s method
of accounting does not clearly reflect income and thereafter uses his
authority to select a method of accounting that he believes does clearly
reflect income, the Commissioner’s selection may be challenged
successfully only upon a demonstration of an abuse of discretion. See
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 353 n.3 (1st Cir.
1970), aff’g T.C. Memo. 1969-79; Standard Paving Co. v. Commissioner,
190 F.2d 330, 332 (10th Cir. 1951), aff’g 13 T.C. 425 (1949); Drazen v.
Commissioner, 34 T.C. 1070, 1076 (1960).
One of the mechanisms by which the Commissioner effects his
discretionary authority under section 446(b) is through operation of
section 481. If there has been a change in a taxpayer’s method of
accounting for any taxable year (year of change) which is different from
the method used for the preceding taxable year, section 481(a)
authorizes the Commissioner to adjust the taxpayer’s taxable income for
the year of change to account for those adjustments determined to be
necessary solely by reason of the change in order to prevent amounts
from being duplicated or omitted. See Primo Pants Co. v. Commissioner,
78 T.C. 705, 720 (1982). It is well established that, when applicable,
section 481 may affect closed years (i.e., years barred by the statute of
limitations) and permits the Commissioner to adjust a taxpayer’s
income for the year of change for income earned but unreported for
otherwise closed years under the taxpayer’s previous method of
accounting. See Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th
Cir. 1965); see also Suzy’s Zoo v. Commissioner, 114 T.C. 1, 13 (2000),
15
[*15] aff’d, 273 F.3d 875 (9th Cir. 2001); Superior Coach of Fla., Inc. v.
Commissioner, 80 T.C. 895, 912 (1983).
A “method of accounting” includes not only the taxpayer’s overall
plan of accounting for gross income or deductions but also the taxpayer’s
accounting treatment for any “material item” within the overall plan.
Treas. Reg. §§ 1.481-1(a)(1), 1.446-1(e)(2)(ii). A material item is any
item that involves the proper time for the inclusion of the item in income
or the taking of a deduction. Treas. Reg. § 1.446-1(e)(2)(ii)(a). If a
change leaves a taxpayer’s lifetime taxable income constant but affects
when it is recognized, the change concerns an “item that involves the
proper time for the inclusion of [an] item in income or the taking of a
deduction” and implicates a change in method of accounting. See id.
The Court has applied these concepts in the context of section 481
adjustments by focusing on whether a taxpayer’s accounting practice
permanently distorts the taxpayer’s lifetime income. Where a
taxpayer’s accounting practice permanently avoids reporting of income
and accordingly distorts its lifetime income, the practice is not a method
of accounting and section 481(a) is inapplicable to a change of the
accounting practice. Schuster’s Express, Inc. v. Commissioner, 66 T.C.
588 (1976), aff’d without published opinion, 562 F.2d 39 (2d Cir. 1977).
On the other hand, when an accounting practice merely postpones the
reporting of income, rather than permanently avoiding the reporting of
income over the taxpayer’s lifetime, it involves the proper time for
reporting income. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500,
510 (1989); Copy Data, Inc. v. Commissioner, 91 T.C. 26, 30 (1988);
Primo Pants Co., 78 T.C. at 723; Schuster’s Express, Inc., 66 T.C. at 597.
Respondent did not require Bayview to change its overall plan of
accounting for gross income or deductions but merely required it to
change the treatment of reporting its transfers of property from loans to
sales. Petitioners concede that the transactions should be
recharacterized as sales, and we agree. Petitioners dispute, however,
that the change in the treatment of Bayview’s accounting for its
transfers of Lots 3, 4, 5, and 6 from loans to sales constitutes a change
in method of accounting for purposes of section 481. “[A] change in
method of accounting does not include adjustment of any item of income
or deduction that does not involve the proper time for the inclusion of
the item of income or the taking of a deduction.” Treas. Reg. § 1.446-
1(e)(2)(ii)(b).
16
[*16] Petitioners contend that the accounting practice at issue here is
a direct parallel to a practice the Court analyzed in Saline Sewer Co. v.
Commissioner, T.C. Memo. 1992-236, 1992 Tax Ct. Memo LEXIS 245.
In Saline Sewer we held that “the failure to report customer connection
fees as income, and instead treat them as contributions to capital
pursuant to section 118, is clearly not a timing issue.” See id at *9. We
found that the mischaracterization caused a permanent distortion of the
taxpayer’s taxable income, and accordingly, the Commissioner’s
recharacterization of these receipts as taxable income did not give rise
to section 481 adjustments. See id at *9–10. Petitioners contend that
Bayview’s practice of reporting the transfer proceeds as liabilities did
not merely defer the recognition of income; it served to permanently
avoid reporting as income the net gain from what petitioners have since
stipulated were sales of Bayview’s property. Petitioners concede that
Bayview’s accounting method was improper because these transfers
were in fact sales.
Petitioners overstate their case. We agree that the transactions
in issue were sales because Bayview never intended to fulfill its
repurchase obligations. 8 Bayview improperly deferred gains realized in
8 As noted in the Court’s Order denying petitioner’s Motion for Partial
Summary Judgment dated February 21, 2014, for a payment to constitute a
nontaxable loan at the time the payments are received, the recipient must intend to
repay the amounts and the transferor must intend to enforce payment. See Haag v.
Commissioner, 88 T.C. 604, 615–16 (1987), aff’d without published opinion, 855 F.2d
855 (8th Cir. 1988); Beaver v. Commissioner, 55 T.C. 85, 91 (1970). Further, the
obligation to repay must be unconditional and not contingent on a future event. United
States v. Henderson, 375 F.2d 36, 39 (5th Cir. 1967); Haag, 88 T.C. at 616. We also
noted that the proceeds from a loan “do not constitute income because whatever
temporary economic benefit the borrower derives from the use of the funds is offset by
the corresponding obligation to repay them.” Moore v. United States, 412 F.2d 974,
978 (5th Cir. 1969).
Even without petitioners’ concession, the record provides an abundance of
evidence that Bayview’s obligations under the repurchase agreements were too
contingent upon future events to evince an unconditional obligation to repay the
amounts received from the transfers, and that the transactions were not true loans
and were never intended to be true loans. At trial, Mr. Messick, who purchased Lot 4,
testified to being friends with and a longtime business associate of petitioners. When
asked why he did not invoke his right to repayment under the repurchase agreement
rather than allow the lot to be foreclosed upon (which would have netted him a higher
overall return), Mr. Messick explained he did not consider it to be an option because of
the ongoing financial crisis. This explanation is difficult to reconcile with the fact that
Mr. Messick had been experiencing cashflow problems at the time and presumably
would have been looking for efficient ways to raise capital. Petitioners claimed that
17
[*17] 2006 and 2007 by incorrectly reporting its transfers of property as
loans rather than sales. Consequently, the proceeds resulting from the
transfers would have inevitably been reportable as cancellation of debt
income for later years. 9 The change in accounting method results in
Bayview’s having no outstanding debt to cancel, and therefore to
recognize as income, for 2008. Section 481 was designed to cure the
distortions of taxable income resulting from changes in the taxpayer’s
method of accounting. Grogan v. United States, 475 F.2d 15 (5th Cir.
1973); Graff Chevrolet Co., 343 F.2d at 572. Section 481 assures that
the taxpayer’s income is reported correctly for the year of change and
that the distortion is taken into account in accordance with that section.
If section 481 were not applicable, the amount Bayview received for its
transfer of property would be omitted from income as a result of the
change in accounting method in 2008 recharacterizing the transactions
from loans to sales.
In the light of the foregoing, we find that petitioners failed to
demonstrate that Bayview’s accounting practice permanently distorted
its lifetime income. Because respondent’s adjustments affect the timing
of the inclusion of income deferred by Bayview, we find that the change
affects a material item and therefore constitutes a change in method of
accounting. See Treas. Reg. §§ 1.481-1(a)(1), 1.446-1(e)(2)(ii). To assure
petitioners’ income is reported correctly as a result of this change in
method of accounting, section 481 requires that the income received
from the transfers be recognized for 2008. See Superior Coach of Fla.,
Inc., 80 T.C. at 912 (holding that there is no conflict between section 481
and the statute of limitations because the statute of limitations is
directed towards stale claims, and, until the year of change, the
Mr. Wilson, who purchased Lots 3 and 5, became known to them when he
serendipitously landed his airplane on their airstrip one day. He likewise neglected to
invoke the repurchase agreements accompanying his transactions with Bayview before
his death in 2011. The Harveys, who purchased Lot 6, were the only transferees to
invoke their right under the repurchase agreement to compel Bayview to repurchase
the lot. Most importantly, Bayview rebuffed the Harveys’ claim and declined to
repurchase the property. Despite Bayview’s default on its obligation, the Harveys did
not file a lawsuit to enforce their rights under the repurchase agreement even though
Mr. Harvey testified that they had fulfilled their obligation thereunder by providing
full consideration for Lot 6.
9 The only way Bayview’s accounting practice would have permanently
distorted its lifetime income would have been if it had intended from the start to
mischaracterize the sales as loans and purposefully fail to report cancellation of debt
income. Neither party contends this to have been the case, and at this time we decline
to find it was so.
18
[*18] Commissioner has no claim against the taxpayer for amounts
which the taxpayer should have reported for prior years).
Finally, petitioners do not contend that respondent abused his
discretion in making the changes to Bayview’s method of accounting and
thereupon have conceded the issue. See Leahy v. Commissioner, 87 T.C.
56, 73–74 (1986). Consequently, we sustain respondent’s section 481
adjustments.
IV. Constructive Transfers
Generally, unless otherwise provided, gross income under section
61 includes all accessions to wealth from whatever source derived.
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
Moreover, “gain . . . constitutes taxable income when its recipient has
such control over it that, as a practical matter, he derives readily
realizable economic value from it. That occurs when [property] . . . is
delivered by its owner to the taxpayer in a manner which allows the
recipient freedom to dispose of it at will . . . .” Rogers v. Commissioner,
T.C. Memo. 2011-277, 2011 WL 5885083, at *2 (quoting Rutkin v. United
States, 343 U.S. 130, 137 (1952)), aff’d, 728 F.3d 673 (7th Cir. 2013);
see also United States v. Rochelle, 384 F.2d 748, 751 (5th Cir. 1967);
McSpadden v. Commissioner, 50 T.C. 478, 490 (1968). The economic
benefit accruing to the taxpayer is the controlling factor in determining
whether gain is income. Rutkin, 343 U.S. at 137; Rochelle, 384 F.2d
at 751.
When a corporation confers an economic benefit upon a
shareholder without expectation of reimbursement, that economic
benefit becomes a constructive distribution10 and is taxable as such. See
Loftin & Woodward, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir.
1978). A distribution need not be formally declared or even intended by
a corporation but can be constructive. Noble v. Commissioner, 368 F.2d
439, 442–43 (9th Cir. 1966), aff’g T.C. Memo. 1965-84. Whether a
distribution is a constructive distribution depends on whether it was
made primarily for the benefit of the shareholder. See Hood v.
Commissioner, 115 T.C. 172, 179–80 (2000). The determination of
10 The Court uses the term “constructive distribution” to describe what our
caselaw has sometimes referred to as a “constructive dividend.” See, e.g., Key Carpets,
Inc. v. Commissioner, T.C. Memo. 2016-30, at *19 n.12. We use the two terms
interchangeably here, or simply refer to them as “constructive transfers” because of
Bayview’s S corporation status and the differing tax treatment thereof as described in
section 1368.
19
[*19] whether the shareholder or the corporation primarily benefits is a
question of fact. Id. at 180. To avoid having a distribution treated as a
constructive distribution, the taxpayer must show that the corporation
primarily benefited from the distribution. See id. at 181. The crucial
concept in a finding that there is a constructive distribution is that the
corporation has conferred a benefit on the shareholder to distribute
available earnings and profits without the expectation of repayment.
CTM Constr., Inc. v. Commissioner, T.C. Memo. 1988-590, 1988 Tax Ct.
Memo LEXIS 619, at *11 (“Generally, a constructive distribution occurs
when corporate assets are diverted to or for the benefit of a shareholder
without adequate consideration for the diversion.” (citing Sammons v.
Commissioner, 472 F.2d 449 (5th Cir. 1972), aff’g in part, rev’g in part
T.C. Memo. 1971-145)); see also Magnon v. Commissioner, 73 T.C. 980,
994 (1980) (“The crucial test of the existence of a constructive dividend
is whether ‘the distribution was primarily for the benefit of the
shareholder.’”).
A. Constructive Distributions of Appreciated Property
In 2008 Bayview transferred Lot 1 to Mr. Messick and Lot 2 to
Ravenna without receiving any consideration in return. 11 Respondent
determined that the transfers constituted constructive distributions of
appreciated property to petitioners as shareholders of Bayview followed
by gifts or compensatory transfers to Mr. Messick, as their friend and
business associate, and Mr. Smith, as their son-in-law and the sole
member of Ravenna. 12 He subsequently adjusted petitioners’ income to
reflect their pro rata share of built-in capital gains deriving from the
11 At trial petitioners moved to submit evidence of respondent’s examination of
their tax returns along with a deposition from the examining agent (later identified as
respondent’s Rule 81(c) designee) arguing it was relevant in demonstrating that
petitioners received no consideration in exchange for Bayview’s property transfers to
Mr. Messick and Ravenna. Respondent did not dispute and in fact agreed that no
consideration had been exchanged. Respondent filed a Motion in Limine to preclude
the evidence on grounds of relevance by contending that this fact is not in dispute. We
agree with respondent and will therefore grant his Motion.
12 On brief, petitioners argue for the first time that respondent’s
determinations relating to Bayview’s constructive distributions of appreciated
properties were not reflected in the notice of deficiency. Again, we need not consider
an argument raised for the first time on brief. Estate of Mandels, 64 T.C. at 73. We
nevertheless observe that the Stipulations of Fact reflect amounts received for
appreciated property from Bayview in the 2008 capital gain adjustment.
20
[*20] constructive distributions of the properties. 13 Noting that
petitioners contend and therefore bear the burden of proving that
Bayview, rather than petitioners, benefited from the transfers of Lots 1
and 2, we turn to the parties’ contentions.
1. Lot 1
Respondent contends that petitioners primarily benefited from
Bayview’s transfer of Lot 1 because the transfer was designed to assist
their friend and business partner Mr. Messick when he needed cash to
finance his floundering businesses. Respondent’s argument rests on the
suggestion that petitioners permitted Mr. Messick to use Lot 1 as
collateral for a mortgage so that he could use the proceeds therefrom to
finance his own companies’ business operations. To support this
position, he highlights several allegedly unrelated business dealings
between petitioners and Mr. Messick, which included construction work,
consulting projects, and prior exchanges of property. Respondent posits
that when considering the relationship between Mr. Messick and
petitioners as well as the numerous transactions between Bayview and
WLM Management, it should be of no consequence that Bayview would
transfer a parcel of real property directly to Mr. Messick to serve as
compensation for a previous transaction or service or to assist him
financially during a time of need.
Petitioners maintain that Bayview’s transfer of Lot 1 to Mr.
Messick was intended as a seller-financed installment sale whereon Mr.
Messick failed to make agreed-upon payments. They contend that
neither they nor Bayview received any benefit from the transfer because
of the lack of consideration. According to them, Lot 1 was deeded to Mr.
Messick pursuant to a formal sale agreement whereby Mr. Messick
promised to make three payments totaling $895,000 within four months
of receiving title to the property. They explain that the original plan
was for Mr. Messick to borrow against the property and thereafter pass
the necessary proceeds along to Bayview to cover the purchase price.
They profess to have been comfortable with this arrangement because
Mr. Messick had proven himself trustworthy throughout their 15-year
relationship. However, this trust was ostensibly misplaced because
after he obtained title to the property Mr. Messick used it for his
personal benefit and failed to make any of the scheduled payments to
Bayview. Petitioners claim to have considered causing Bayview to
13 This adjustment reflects the proper computation when an S corporation has
no accumulated earnings or profits. See I.R.C. § 1368(b).
21
[*21] pursue Mr. Messick in litigation but ultimately decided against it.
They believed litigation was unlikely to yield any recovery and “would
be just throwing good money after bad” on account of Mr. Messick’s
financial situation.
In view of the amount involved it is simply unreasonable for
prudent businesspersons, as we assume petitioners and Bayview to be,
to enter an agreement to sell a high-value asset and thereafter decline
to pursue the $895,000 compensation to which they are entitled. It is
far more likely that this transfer served as compensation to Mr. Messick
with respect to some act which petitioners have placed an $895,000
value on or as a gift based on their personal relationship to assist him
through his financial woes. Be that as it may, petitioners have not
demonstrated what benefit Bayview received in return for its effectively
gratuitous transfer of Lot 1 to Mr. Messick. Bayview’s decision not to
enforce the $895,000 obligation Mr. Messick purportedly was required
but failed to pay weighs heavily against petitioners in this regard. In
addition, any potential benefit to Bayview was precluded following Mr.
Messick’s acquisition of a loan using Lot 1 as collateral, his failure to
make payments thereon, and the lender’s subsequent foreclosure on the
lot. Mr. Messick effectively sold Lot 1 to a third party without having to
pay Bayview anything in exchange. On the basis of these
considerations, we find that petitioners failed to demonstrate that
Bayview’s transfer of Lot 1 to Mr. Messick was made primarily for the
benefit of Bayview rather than themselves. Consequently, we hold that
the transfer constituted a constructive distribution of appreciated
property from Bayview to petitioners.
2. Lot 2
Respondent maintains that petitioners primarily benefited from
Bayview’s transfer of Lot 2 to Ravenna because their son-in-law (and by
extension, their daughter) received full ownership of Lot 2 without
providing any consideration in return. He asserts that petitioners’ claim
of an oral agreement between Bayview and Ravenna to form a joint
venture for purposes of selling Lot 2 has no merit because the
arrangement lacked any attributes of a true joint venture. Since
Bayview did not become a member of Ravenna along with Mr. Smith,
respondent argues that Bayview relinquished any and all rights it had
in Lot 2, which both weighs against a finding of a true joint venture and
precludes a nontaxable contribution of property under section 721(a).
Respondent further supports his position by pointing to the absence of a
written agreement showing (1) what Bayview risked if Ravenna lost
22
[*22] Lot 2 through foreclosure or forced sale by a creditor; (2) that
Bayview had any authority to prevent Ravenna from selling,
mortgaging, or conducting any other activity with respect to Lot 2; and
(3) what Ravenna contributed to the joint venture. Respondent’s
alternative position centers on the notion that although Bayview
received no consideration in exchange for Lot 2, the deed of sale recorded
a purchase price of $895,000 and that such a figure was not merely
registered for “ceremonial deed purposes” as petitioners insist. By
recording this purchase price on the “ceremonial” deed of sale,
respondent alternatively contends that the transfer primarily benefited
petitioners because it enabled them to artificially inflate the value of the
property and the values of surrounding property owned by Bayview.
As mentioned above, petitioners contend that the transfer of Lot 2
to Ravenna was made pursuant to a valid oral agreement to form a joint
venture whereby Mr. Smith, as the sole owner of Ravenna, agreed to
contribute his services by attempting to sell the property; if the property
sold, 80% of the profits were to be distributed to Bayview with the other
20% distributed to Ravenna, but if it did not sell, Ravenna was to
transfer the property back to Bayview. Because a joint venture was
formed, petitioners assert that Bayview’s transfer of the lot to Ravenna
constituted a nontaxable contribution of property under section 721(a).
In support of this position petitioners cite several cases for the
proposition that, under Virginia state law, joint ventures involving the
purchase and sale of real estate may be formed by oral agreement.
Petitioners assert that Mr. Smith was unable to sell Lot 2 because of the
declining real estate market in 2008, and in 2012 he conveyed his
interest in Ravenna to Bayview, which effectively returned Lot 2 to
Bayview and ended their joint venture. Petitioners maintain that they
never received any ownership interest in Lot 2 in their individual names
and therefore they did not receive any personal benefit or accession to
wealth or derive any readily realizable economic value as a consequence
of Bayview’s transfer of Lot 2 to Ravenna.
Joint ventures are the equivalent to partnerships for federal tax
purposes. See I.R.C. § 7701(a)(2). “A partnership is generally said to be
created when persons join together their money, goods, labor, or skill for
the purpose of carrying on a trade, profession, or business and when
there is community of interest in the profits and losses.” Commissioner
v. Tower, 327 U.S. 280, 286 (1946). “A partnership is, in other words, an
organization for the production of income to which each partner
contributes one or both of the ingredients of income—capital or
services.” Commissioner v. Culbertson, 337 U.S. 733, 740 (1949). To
23
[*23] decide whether a partnership exists, a court must also analyze the
relevant facts to determine whether “the parties in good faith and acting
with a business purpose intended to join together in the present conduct
of the enterprise.” Id. at 742. We evaluate a joint venture “by reference
to the same principles that govern the question of whether persons have
formed a partnership which is to be accorded recognition for tax
purposes.” Luna v. Commissioner, 42 T.C. 1067, 1077 (1964). These
principles require us to consider a number of factors, none of which is
conclusive, that include: the contributions, if any, made by both parties
to the venture; the parties’ control over capital and income and the right
of each party to make withdrawals; whether each party shared a mutual
proprietary interest in the net profits and had an obligation to share
losses, or whether one party was the agent or employee of the other,
receiving for his services contingent compensation in the form of a
percentage of income; and whether the parties exercised mutual control
and assumed mutual responsibilities of the venture. See id. at 1077–78.
Applying these factors to the facts and circumstances before us,
we find that the arrangement between Bayview and Ravenna to sell
Lot 2 did not qualify as a joint venture for tax purposes. Firstly, while
Ravenna’s plan to contribute services may have amounted to a requisite
contribution to form a joint venture, see, e.g., Carnegie Prods., Inc. v.
Commissioner, 59 T.C. 642, 652 (1973), the fact that Bayview’s sole role
in the venture was to contribute property weighs against a finding
favorable to petitioners, see Ewing v. Commissioner, 20 T.C. 216, 231–32
(1953), aff’d, 213 F.2d 438 (2d Cir. 1954). Secondly, and most
significantly, Bayview did not retain any legal rights in Lot 2, the sole
underlying asset of the alleged joint venture, after transferring it to
Ravenna. Bayview may have retained some of its legal rights in Lot 2
by contributing it to Ravenna in exchange for an interest in Ravenna
but that is not what occurred here. Instead, Bayview transferred fee
simple title of the lot to Ravenna, which means that Ravenna received
the full bundle of rights that attach to property ownership
unencumbered by any legitimate restriction or detriment and was free
to do with the lot as it wished. Following the transfer, Ravenna had the
sole right to possession, could sue third parties for nuisance or trespass,
could develop or erect improvements on the land, was responsible for
property taxes, and could have mortgaged the property without the
consent of a third party. See, e.g., Musgrave v. Commissioner, T.C.
Memo. 2000-285, 2000 WL 1258400, at *5. In effect, the transfer gave
Ravenna sole control over capital and income in the property, sole
responsibility for the sale of the property, and sole interest in the net
profits of the sale, if it so chose. This type of arrangement does not rise
24
[*24] to the valid formation of a joint venture for federal income tax
purposes. For this reason, we find that Bayview’s gratuitous transfer of
Lot 2 to Ravenna does not constitute a nontaxable contribution of
property under section 721(a).
Bayview itself received no benefit at the time it transferred Lot 2
to Ravenna. The fact that the lot was returned to Bayview in 2012 does
not retroactively erase the fact that Bayview relinquished its rights in
the lot in favor of Ravenna in 2008. With respect to respondent’s
alternative argument, petitioners conceded that the $895,000
consideration recorded on the deed was used as a benchmark for
potential purchasers to take into account before negotiating a future
purchase price for the property. Therefore, at minimum, it is plausible
that petitioners received a personal benefit by artificially inflating the
value of the property to assist Ravenna (and their son-in-law by
attribution) in retrieving a higher price for Lot 2. In the light of the
foregoing, we find that petitioners failed to demonstrate that Bayview’s
gratuitous transfer of Lot 2 to Ravenna was made primarily for the
benefit of Bayview. Accordingly, we hold that this transfer also
constitutes a constructive distribution of appreciated property from
Bayview to petitioners.
B. Constructive Dividend from Petitioners’ Rent-Free Use of
Home Owned by Bayview
Respondent determined that petitioners’ rent-free use of the
home owned by Bayview during the years in issue constituted a
constructive dividend from Bayview to petitioners equal to the $24,000
per year fair rental value of the property. It is well settled that a
shareholder’s use of corporate property can result in a constructive
dividend to him measured by the fair market rental value of the
property. Nicholls, North, Buse Co. v. Commissioner, 56 T.C. 1225,
1240–42 (1971). Petitioners concede to residing in the home during that
time without paying rent to Bayview and do not argue against the
determination that their residence there constitutes a constructive
dividend. Instead, they argue that an 87% reduction should be applied
to the stipulated value of the constructive dividend on the basis of their
self-serving testimony that they lived in only 13% of the home. We do
not find this argument persuasive, and we have no obligation to accept
uncorroborated self-serving testimony. Tokarski v. Commissioner, 87
T.C. 74, 77 (1986). In addition, petitioners have stipulated the amount
of the constructive dividend and Rule 91(e) requires that we bind them
25
[*25] to this stipulation absent clearly contrary evidence. 14 See
Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976) (holding that the
Court has discretion not to be bound by the stipulation of facts where
clearly contrary evidence is presented at trial). Consequently, we
conclude petitioners’ rent-free use of the home constitutes a constructive
dividend from Bayview to petitioners in the amount stipulated by the
parties.
V. Bad Debt Deduction
Respondent disallowed Bayview’s bad debt deduction of $227,420
after determining the debt was not valid. 15 It arose from a worthless
loan Bayview claimed to have made to Village Builders. This
adjustment flowed through to petitioners’ individual tax returns.
Section 166(a)(1) allows a deduction for any debt that becomes wholly
worthless within a taxable year. To deduct a business bad debt, the
taxpayer must show that the debt was created or acquired in connection
with a trade or business and must also establish the amount of the debt,
the worthlessness of the debt, and the year that the debt became
worthless. Davis v. Commissioner, 88 T.C. 122, 142 (1987), aff’d, 866
F.2d 852 (6th Cir. 1989). An intent to establish a debtor-creditor
relationship exists if, when the transfers were made, the debtor
intended to repay the funds and the creditor intended to enforce
repayment. See, e.g., Beaver, 55 T.C. at 91; Fisher v. Commissioner, 54
T.C. 905, 909–10 (1970). This is a question of fact to be determined upon
consideration of all pertinent facts. Haber v. Commissioner, 52 T.C. 255,
266 (1969), aff’d, 422 F.2d 198 (5th Cir. 1970).
Caselaw has established objective factors to consider when
answering the question of whether a bona fide debtor-creditor
The parties have also stipulated the resulting tax consequences if the Court
14
determined petitioners’ rent-free use of the home constitutes a constructive dividend.
15 Petitioners contend on brief that the notice of deficiency adjusted their 2008
income to include $227,420 in “loan forgiveness” rather than disallow a bad debt
deduction and as a result this determination was made contrary to the evidence.
However, the parties stipulated that the notice contained an adjustment for the
disallowance of a bad debt deduction claimed by Bayview. We find this stipulation
clarified the “loan forgiveness” phrase in the notice, because of the identical amount.
We also note that Statement 1 on Bayview’s 2008 Form 1120S characterized the bad
debt deduction as “loan forgiveness,” and the adjustment in the notice merely offset
the deduction. In any event, we will again bind petitioners to the stipulation because
the evidence presented at trial did not clearly contradict it. See Jasionowski, 66 T.C.
at 318.
26
[*26] relationship exists. Those factors include (1) whether the promise
to repay is evidenced by a note or other instrument that evidences
indebtedness; (2) whether interest was charged or paid; (3) whether a
fixed schedule for repayment and a fixed maturity date were
established; (4) whether collateral was given to secure payment;
(5) whether repayments were made; (6) what the source of any payments
was; (7) whether the borrower had a reasonable prospect of repaying the
loan and whether the lender had sufficient funds to advance the loan;
and (8) whether the parties conducted themselves as if the transaction
was a loan. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980);
see also Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000),
aff’g T.C. Memo. 1998-121; Estate of Mixon v. United States, 464 F.2d
394, 402 (5th Cir. 1972); Knutsen-Rowell, Inc. v. Commissioner, T.C.
Memo. 2011-65.
Respondent argues the arrangement between Bayview and
Village Builders lacked the objective formalities required of a bona fide
debt—there was no written agreement, payment schedule, nor interest
paid—and, since the transfer was not a bona fide debt, it is impossible
to determine whether the debt became worthless. Furthermore,
respondent adds that Village Builders failed to include cancellation of
debt income on Line 10, Other Income, of its 2008 Form 1120 as the 2008
Instructions for Form 1120 require. On the other hand, petitioners
maintain that the debt between the two corporations was a valid debt
because (1) Village Builders had repaid “hundreds of thousands of
dollars” of funds lent to it by Bayview; (2) there was a reasonable
prospect of loan repayment due to Village Builders’ history of repaying
loans from Bayview; and (3) the parties conducted themselves as if the
loan was a valid debt as shown by Village Builders’ reporting of the
forgiven debt as income. Petitioners contend that Village Builders
reported $263,053 of taxable income for 2008 and that $227,420 of that
income accounted for cancellation of debt income. They point to Village
Builders’ balance sheet and adjusted journal entries for tax year 2008
as additional evidence that Village Builders reported the forgiven debt
as cancellation of debt income.
We find that several of the factors above weigh against a
conclusion that petitioners’ corporations maintained a bona fide debtor-
creditor relationship. Nothing in the record shows that the corporations
kept a written agreement evidencing the debt, interest to be paid, a
repayment schedule, or a maturity date. Nor is there any indication
that the corporations conducted themselves as if the transaction was a
loan. According to petitioners, Village Builders never formally
27
[*27] requested a loan from Bayview. Instead, Mr. Starer described how
Village Builders would request a loan from Bayview by testifying that
“Bob Starer, CEO of Village Builders, would say to Bob Starer as CEO
of Bayview Corporation, ‘let me have some money.’” Petitioners cannot
create a deduction simply by deciding to record an intercompany debt
without formalities and then canceling it. See, e.g., Kelly v.
Commissioner, T.C. Memo. 2021-76, at *61. Moreover, a review of
Village Builders’ 2008 Form 1120 shows no income reported on Line 10
as required by instructions to report cancellation of debt income. Thus,
notwithstanding the failure to comply with loan formalities, Village
Builders failed to correspondingly recognize cancellation of debt income
on its own tax return, an omission sufficient for us to disallow Bayview’s
bad debt deduction considering that these are two related closely held
corporations. Accordingly, we find that petitioners have failed to show
that there was a bona fide debtor-creditor relationship between Bayview
and Village Builders. On the basis of the foregoing, we sustain
respondent’s disallowance of Bayview’s bad debt deduction.
VI. Penalties
Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any
portion of an underpayment of tax required to be shown on a return that
is attributable to negligence or disregard of rules or regulations or a
substantial understatement of income tax. “Negligence” includes any
failure to make a reasonable attempt to comply with the internal
revenue laws or to exercise reasonable care in the preparation of a tax
return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). “Disregard”
includes any careless, reckless, or intentional disregard of the Code,
regulations, or certain IRS administrative guidance. I.R.C. § 6662(c);
Treas. Reg. § 1.6662-3(b)(2). An understatement of income tax is
substantial if it exceeds the greater of 10% of the tax required to be
shown on the return for the taxable year or $5,000. I.R.C.
§ 6662(d)(1)(A).
Under section 7491(c), the Commissioner bears the burden of
production regarding penalties and must come forward with sufficient
evidence indicating that it is appropriate to impose penalties. Higbee v.
Commissioner, 116 T.C. 438, 446–47 (2001). Respondent will have met
his burden of production with regard to section 6662 by showing that
the deficiencies exceed the greater of 10% of the tax required to be shown
on the return or at least $5,000 for each year the penalty has been
determined following a Rule 155 computation. However, part of
28
[*28] respondent’s burden of production in this setting includes
demonstrating compliance with section 6751(b).
Section 6751(b)(1) provides that “[n]o penalty . . . shall be assessed
unless the initial determination of such assessment is personally
approved (in writing) by the immediate supervisor of the individual
making such determination or such higher level official as the Secretary
may designate.” This case was tried and the record was closed before
the issuance of our opinion in Graev v. Commissioner, 149 T.C. 485
(2017), supplementing and overruling in part 147 T.C. 460 (2016). Graev
sets forth the history of our interpretation of section 6751(b). After
having earlier taken a contrary position, in Graev we held that the
Commissioner’s burden of production under section 7491(c) includes
establishing compliance with the written supervisory approval
requirement of section 6751(b). Following that decision, various Circuit
Courts of Appeals have split over when such approval is required to be
made, a discussion of which is unnecessary for the reasons set forth
below. Compare Kroner v. Commissioner, 48 F.4th 1272 (11th Cir.
2022), rev’g in part T.C. Memo. 2020-73, and Laidlaw’s Harley Davidson
Sales, Inc. v. Commissioner, 29 F.4th 1066 (9th Cir. 2022), rev’g and
remanding 154 T.C. 68 (2020), with Chai v. Commissioner, 851 F.3d 190
(2d Cir. 2017), aff’g in part, rev’g in part, and remanding T.C. Memo.
2015-42.
In the instant case, respondent did not file a motion to
supplement the record addressing the effect of section 6751(b) on this
case. Neither did he direct the Court on brief or otherwise to any
evidence of section 6751(b) supervisory approval in the record.
Consequently, respondent has failed to satisfy his burden of production
to establish compliance with section 6751(b); therefore, petitioners are
not liable for accuracy-related penalties under section 6662.
The Court has considered all of the arguments made by the
parties, and to the extent they are not addressed herein they are
considered unnecessary, moot, irrelevant, or otherwise without merit.
To reflect the foregoing,
An appropriate order will be issued granting respondent’s Motion
in Limine, and decision will be entered under Rule 155.