UNITED STATES TAX COURT
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T.C. Memo. 2006-78
UNITED STATES TAX COURT
SID PAUL RUCKRIEGEL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
AL A. RUCKRIEGEL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 21675-03, 21676-03.
Filed April 18, 2006.
Ps were each 50-percent shareholders in an S
corporation that incurred ordinary losses before and
during the years in question (1999 and 2000). They
were also 50-percent partners in a partnership that
advanced funds, both directly and indirectly (through
Ps) to the S corporation in 1997-2000. The issue for
decision is whether all or a portion of those advances
resulted in loans from the partnership to Ps and from
Ps to the S corporation, thereby providing Ps with
sufficient bases in the S corporation, under sec.
1366(d)(1)(B), I.R.C., to permit each P to deduct his
50-percent share of that corporation’s ordinary losses
for the years in question.
Held: Only the partnership advances through Ps
resulted in loans from the partnership to Ps and from
Ps to the S corporation, and those advances provided Ps
with sufficient bases in the S corporation to deduct
- 2 only a small portion of that corporation’s 1999
ordinary loss and none of its 2000 ordinary loss.
Scott W. Dolson and Robert C. Webb, for petitioners.
Denise A. Diloreto and Mark D. Eblen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge:
These consolidated cases involve the
following determinations by respondent of deficiencies in
petitioners’ Federal income tax:
Year
Al A. Ruckriegel
Sid Paul Ruckriegel
1999
$110,544
$107,064
2000
122,272
124,130
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
All dollar amounts have been rounded to the nearest
dollar.
The issue for decision is whether petitioners had sufficient
bases in their S corporation,1 Sidal Inc. (Sidal), during 1999
and 2000 (the audit years), under section 1366(d)(1)(B), to
1
The term “S corporation” is defined in sec. 1361(a)(1).
In general, an S corporation has no Federal income tax liability,
and its items of income, deduction, credit, and such are passed
through to (i.e., taken into account by) its shareholders. See
secs. 1363(a), 1366(a).
- 3 permit each of them to deduct his pro rata share of Sidal’s
ordinary losses, to the extent of $329,7972 for 1999 and $492,588
for 2000 (sometimes, the basis issue).3
The notices of deficiency contain certain other adjustments
that are purely computational.
Their resolution solely depends
upon our resolution of the basis issue.
2
The parties stipulate that Sid Paul Ruckriegel’s (Sid’s)
1999 deduction for Sidal’s 1999 losses was $324,750, but Sid’s
1999 return confirms that he reported a 1999 loss of $329,797
from Sidal. That is also the amount of the Sidal loss respondent
disallowed in the notice of deficiency issued to Sid. Erroneous
stipulations are not binding on this Court. See Gulf Oil Corp.
v. Commissioner, 87 T.C. 135, 159-160 n.4 (1986), affd. 914 F.2d
396 (3d Cir. 1990). Therefore, we find that Sid’s 1999 reported
loss from Sidal is $329,797.
3
In his notices of deficiency, respondent also made
adjustments, pursuant to sec. 267(a)(2), increasing each
petitioner’s “passthrough” income from Sidal by $12,407 for 1999
and $37,233 for 2000 attributable to Sidal’s disallowed
deductions for interest owed to a related party. Respondent
characterizes the adjustments, both on brief and in his notices
of deficiency, as increases in each petitioner’s interest income
from Sidal. Although petitioners assign error to those
adjustments in their petitions, they make no argument either in
their trial memoranda or on brief concerning the adjustments.
Consequently, we consider the adjustments to have been conceded
by petitioners. See Nicklaus v. Commissioner, 117 T.C. 117, 120
n.4 (2001); Rybak v. Commissioner, 91 T.C. 524, 566 n.19 (1988);
Zimmerman v. Commissioner, 67 T.C. 94, 104 n.7 (1976).
- 4 FINDINGS OF FACT4
Some facts have been stipulated and are so found.
The
stipulation of facts, with attached exhibits, is incorporated by
this reference.
At the time the petitions were filed, petitioner Sid Paul
Ruckriegel (Sid) resided in Peoria, Illinois, and petitioner Al
A. Ruckriegel (Al) resided in Terre Haute, Indiana.
Sidal, Inc.
Sidal, an Indiana corporation, elected S corporation status
at the time of its organization in 1993 and retained that status
through December 31, 2000.
During that period, petitioners were
each 50-percent shareholders in Sidal.
Sidal operated
approximately 50 fast food franchise restaurants throughout
Indiana and part of Illinois during the 1997-2000 period.
From
its incorporation in 1993 through 2000, Sidal operated at a loss.
Sid and Al actively managed the Sidal restaurants.
Paulan Properties Partnership
From its formation, in 1993, through December 31, 2000,
petitioners were each 50-percent partners of Paulan Properties
Partnership (Paulan), a general partnership governed by Indiana
4
To the extent that petitioners fail to object to
respondent’s proposed findings of fact, or vice versa, we
conclude that those proposed findings of fact are correct except
to the extent that the nonobjecting party’s proposed findings of
fact are clearly inconsistent therewith. See Jonson v.
Commissioner, 118 T.C. 106, 108 n.4 (2002), affd. 353 F.3d 1181
(10th Cir. 2003).
- 5 law.
Paulan owns real property and leases it to several of the
restaurants operated by Sidal, as well as to other restaurant
operators.
Petitioners managed Paulan’s properties.
From 1997
through 2000, Paulan operated at a profit.
Other Individuals and Entities Related to Paulan and Sidal
Lovella Ruckriegel (Lovella) and Robert Ruckriegel (Robert)
are petitioners’ parents.
Pursuant to the Paulan partnership
agreement, control and management of Paulan were vested in
Lovella.
As a practical matter, however, Lovella’s duties
consisted of receiving, depositing, and recording incoming cash
and writing and recording checks on Paulan’s behalf.
Robert and Lovella own the controlling interest in BR
Associates, Inc., which provides financial advice, bookkeeping,
secretarial, and administrative services to Paulan and Sidal.
Larry Freyberger (Freyberger) works for BR Associates, Inc., with
the title of controller, and he maintains Sidal’s general ledger.
His services on behalf of Paulan consist of receiving the check
register from Lovella and computerizing the transactions recorded
therein, using previously assigned account numbers.
He and his
staff provide general bookkeeping services for Sidal and
provide a trial balance5 to an outside certified public
accountant (C.P.A.) at yearend.
5
A trial balance (or adjusted trial balance) is a record
taken from the books of account. See Cooper & Ijiri, Kohler’s
Dictionary for Accountants 24, 514 (6th ed. 1983).
- 6 Ralph Michel (Michel) was the outside C.P.A., and he
prepared tax returns for Paulan and Sidal for 1997, 1998, and
2000 and for petitioners for 1997-2000.
He has been the
principal tax adviser to petitioners since 1976 and to Paulan and
Sidal since their formation in 1993.
Ernst & Young (EY) prepared
and compiled financial statements for Paulan and Sidal and
prepared tax returns for those entities for 1999.
EY did not
audit the books of either entity.
Prior Audits and Tax Planning Discussions Between Michel and
Petitioners
Respondent audited petitioners’ 1995 and 1996 returns.
A
result of that audit was the denial of petitioners’ deductions of
Sidal’s 1995 and 1996 losses on the ground that petitioners
lacked bases in Sidal.
Petitioners paid the deficiencies
relating to the denial of those deductions.
After that audit,
Michel spoke with the Internal Revenue Service (IRS) agent who
conducted the audit regarding the proper way to structure future
loans to Sidal so as to enable petitioners to achieve bases in
Sidal equal to the loan amounts.
In 1997, after that
conversation, Michel advised petitioners that loans to Sidal
could be structured to obtain tax bases for them in Sidal, and he
advised them regarding that structure.
The 1997-2000 loans to
Sidal were structured in accordance with Michel’s advice.
The
IRS agent auditing petitioners’ 1997 and 1998 tax years did not
challenge petitioners’ passthrough deductions of Sidal’s losses
- 7 to the extent of petitioners’ bases in Sidal attributable to (1)
$1 million wire transfers from Paulan to each petitioner and from
each petitioner to Sidal on November 24, 1997 (the wire transfer
payments), and (2) a $200,000 capital contribution by each
petitioner to Sidal on July 11, 1997.
Description of the Loans
On 11 occasions during the 1997-2000 period, Paulan
transferred funds directly or indirectly (via the wire transfer
payments) to Sidal.6
The bank loans that constituted the source
of the funds, the transactions themselves, and the manner in
which they were reflected in the financial statements of Paulan
and Sidal are described as follows.
1997
Paulan Bank Borrowings
July 10 - $3,550,550.00 ($3.6 million less $49,450.00 in
closing costs) from the Merchants Bank of Terre Haute, Indiana
(Merchants Bank) (the $3.6 million Merchants Bank loan).
6
On their individual returns for 1997, petitioners each
claimed a debt basis of $1 million in Sidal attributable to the
wire transfer payments, and they deducted suspended Sidal losses
from prior years. As noted in the text, respondent did not
challenge those deductions. The amounts of basis attributable to
those payments that carried over to 1999 are not certain. A
basis schedule for 1993-99, prepared by Michel, indicates a
remaining 1999 basis from those payments of $5,065 for each
petitioner, but petitioners’ 1999 returns indicate a remaining
basis of $5,064 for Al and $34,554 for Sid. As discussed infra,
respondent denies the existence of any post-1998 carryover basis
under sec. 1366(d)(1)(B) attributable to the wire transfer
payments.
- 8 July 10 - $1 million in the form of a revolving loan line of
credit arrangement with Merchants Bank (the $1 million Merchants
Bank loan).
Both the $3.6 million and the $1 million Merchants Bank
loans were secured by assets of both Paulan and Sidal and
guaranteed by Sidal, Robert, Lovella, and petitioners.
December 8 - $2 million from Merchants Bank (the $2 million
Merchants Bank loan), secured by life insurance policies,
securities, and Paulan real and personal property, and also
guaranteed by Sidal, Robert, Lovella, and petitioners.
Paulan Payments
The July 11 Payment
On July 11, Paulan wrote a check to Sidal for $1.2 million.
The source of that payment was the $3.6 million Merchants Bank
loan.
Sidal’s adjusted trial balances for its taxable years
ending December 31, 1997, 1998, 1999, and 2000, reflect the $1.2
million payment to it as giving rise to a note payable to Paulan.
Correspondingly, Paulan’s adjusted trial balances for its taxable
years ending December 31, 1997 and 1998, reflect the $1.2 million
payment to Sidal as giving rise to a note receivable from Sidal.7
Sidal made principal and interest payments to Paulan on that note
of $74,328 in 1997, $178,388 in 1998, $148,657 in 1999, and
7
Paulan’s adjusted trial balances for its taxable years
ending Dec. 31, 1999 and 2000, are not in evidence.
- 9 $193,253 in 2000.
No adjusting journal entries were made on any
of the above-mentioned Paulan and Sidal trial balances to
recharacterize either Paulan’s July 11 payment to Sidal or any of
the principal and interest payments by Sidal to Paulan as
consistent with, first, loans by Paulan to petitioners and, then,
loans by petitioners to Sidal.
The November 24 Wire Transfer Payments
The source of the wire transfer payments is not clear from
the record.8
All of the Paulan and Sidal adjusted trial balances
in evidence, beginning with the adjusted trial balances for the
taxable year ending December 31, 1997, reflect the wire transfer
payments as $1 million loans from Paulan to each petitioner and
from each petitioner to Sidal.
Sidal made principal and interest
payments directly to Paulan in connection with the wire transfer
payments totaling $276,518 in 1998, $230,431 in 1999, and
$299,561 in 2000.9
8
The parties stipulated that the source of the wire
transfer payments were the $2 million Merchants Bank loan, which
occurred on Dec. 8, 1997, 2 weeks after the wire transfer
payments.
9
As noted, petitioners’ claims of basis in Sidal, under
sec. 1366(d)(1)(B), attributable to the wire transfer payments
were not challenged by respondent in connection with the audit of
petitioners’ 1997 and 1998 returns.
- 10 1998
During 1998, Paulan wrote four checks to Sidal as follows:
Jan. 20
$100,000
Feb. 17
200,000
Aug. 25
18,000
Oct. 27
650,000
Total
968,000
The source of those payments was the $1 million Merchants Bank
loan.
Sidal’s adjusted trial balances for the taxable years ending
December 31, 1998, 1999, and 2000, reflect a note payable to
Paulan in the sum of $928,000,10 and Paulan’s adjusted trial
balance for the taxable year ending December 31, 1998, reflects a
corresponding note receivable from Sidal.
No adjusting entries
were made on those trial balances to recharacterize Paulan’s 1998
payments to Sidal, to the extent of $928,000, as Paulan’s loans
to petitioners and petitioners’ loans to Sidal.11
Handwritten
10
There is no explanation in the record for the
discrepancy between the total amount of the 1998 Paulan checks,
$968,000, and the $928,000 note payable from Sidal to Paulan
reflected on Sidal’s adjusted trial balances.
11
Although (1) a handwritten entry on Sidal’s adjusted
trial balance for its taxable year ending Dec. 31, 1999,
indicates that the $928,000 note payable to Paulan was “reclassed
by AJEs” (adjusting journal entries) and (2) Sidal’s general
ledger for 1999 reflects the elimination, on Oct. 19, 1999, of
$928,000 as an intercompany note to Paulan, Sidal’s adjusted
trial balance for the following year (2000) still reflects the
$928,000 as a note payable to Paulan as of Dec. 31, 2000.
- 11 entries on Sidal’s adjusted trial balance for its taxable year
ending December 31, 2000, show 2000 principal and interest
payments on those loans of $67,213 and $111,175, respectively.
1999
On April 20, 1999, Paulan borrowed $250,000 from Bavaria,
Inc., a C corporation, the stock of which is wholly owned by
Robert and Lovella.
On December 31, 1999, Paulan used the
proceeds of that loan to write a check to Sidal for $250,000.
On November 12, 1999, Paulan borrowed $525,000 from Civitas
Bank.
That loan was secured by certain marketable securities and
guaranteed by Robert and Lovella.
On November 17, 1999, Paulan
used the proceeds of that loan to write a check to Sidal for
$525,000.
Although both Paulan’s and Sidal’s general ledgers for 1999
reflect the two advances as resulting in a $775,000 payable from
Sidal to Paulan, adjusting entries were made on both entities’
adjusted trial balances for the taxable year ending December 31,
1999, to change the $775,000 from a note payable by Sidal to
Paulan to notes for $125,000 and $262,500 payable by Sidal to
each petitioner and receivables by Paulan from each petitioner.
- 12 2000
On May 11, 2000, Paulan borrowed $1,350,000 from Old
National Bank (formerly Merchants Bank).12
The loan was secured,
in part, by Paulan real property and guaranteed by Robert,
Lovella, and petitioners.
The loan was the source of the
following three Paulan checks to Sidal written in 2000:
Jan. 21
$200,000
Mar. 28
500,000
Oct. 5
400,000
Total
1,100,000
Although Sidal’s adjusted trial balance for its taxable year
ending December 31, 2000, originally reflected a note payable to
Paulan for $1.1 million, adjusting entries were made, as of
December 31, 2000, to reflect, instead, notes payable to
petitioners for $550,000 each.
The Promissory Notes
Sometime during the years 1997-2000, petitioners each
executed promissory notes to Paulan, and Sidal executed
promissory notes to each petitioner (collectively, the promissory
12
Paulan applied for, and Old National Bank approved, a
$1,750,000 loan. There is no explanation in the record for the
$400,000 discrepancy between the loan applied for and approved
and the actual amount of the loan.
- 13 notes), bearing the following dates of execution and in the
following amounts:13
Date
Sid to
Paulan
Sidal
to Sid
Al to
Paulan
Paulan
to Sid
6/30/97
$600,000
$600,000
$600,000
$600,000
12/18/97
1,000,000
1,000,000
1,000,000
1,000,000
10/31/98
464,000
464,000
464,000
464,000
4/20/99
125,000
125,000
125,000
125,000
11/12/99
262,500
262,500
262,500
262,500
1/31/00
100,000
100,000
100,000
100,000
3/31/00
250,000
250,000
250,000
250,000
10/31/00
200,000
200,000
200,000
200,000
The June 30, 1997, promissory notes predate the transaction
to which they relate; i.e., Paulan’s July 11, 1997, check to
Sidal for $1.2 million.
Similarly, the April 20 and November 12,
1999, promissory notes predate the transactions to which they
relate; i.e., Paulan’s December 31 and November 17, 1999, checks
to Sidal for $250,000 and $525,000 respectively.14
13
Thus, for each alleged effective date, there were four
promissory notes (one each by Sid and Al to Paulan, and two by
Sidal, one each to Sid and Al) in matching amounts. With the
exception of the notes dated Dec. 18, 1997, which correspond to
the $1 million wire transfer payments, and the notes dated Oct.
31, 1998, each promissory note represents one-half of the amount
of a check from Paulan to Sidal. The notes dated Oct. 31, 1998,
each represent one-half of $928,000.
14
The Apr. 20 and Nov. 12, 1999, promissory notes bear
effective dates and amounts corresponding to Paulan’s borrowings
(continued...)
- 14 Directors and Partners’ Minutes
Sidal
For each Sidal promissory note, petitioners, in their
capacities as the directors of Sidal, executed minutes of a
“Special Meeting of the Board of Directors of Sidal, Inc.”, which
purported to be the minutes of a board of directors meeting to
authorize (1) the borrowing from each petitioner and (2) the
promissory note to each petitioner.
In each case, the specified
date of the board of directors meeting was the effective date
appearing on the corresponding promissory notes.
Paulan
Petitioners, in their capacities as the sole general
partners of Paulan, executed “Minutes of the Special Meeting of
the Partners of Paulan Properties” specifically authorizing the
following loans: (1) the wire transfer payments reflected in the
promissory notes of $1 million from each petitioner to Paulan,
dated December 18, 1997, (2) the $250,000 check to Sidal, dated
December 31, 1999, reflected in the promissory notes of $125,000
from each petitioner to Paulan, dated April 20, 1999, and (3) the
$525,000 check to Sidal, dated November 17, 1999, reflected in
the promissory notes of $262,500 from each petitioner dated
November 12, 1999.
14
The partners’ minutes authorizing those three
(...continued)
of $250,000 on Apr. 20, 1999, and $525,000 on Nov. 12, 1999.
- 15 loans to petitioners reflect meeting dates of December 18, 1997,
April 20, 1999, and November 12, 1999, the dates of petitioners’
promissory notes.
Petitioners also executed partners minutes reflecting an
April 1, 1997, meeting of the Paulan partners (a date prior to
any of the Paulan bank borrowings or advances to Sidal or
petitioners).
Those minutes, in effect, provide advance
authorization for any future Paulan loans to petitioners for the
purpose of enabling them to relend the funds to Sidal and for
those loans to take the form of direct payments to Sidal.
None of the Sidal or Paulan minutes described herein
(collectively, the minutes) were drafted and executed earlier
than June 2000, and the minutes describing an October 31, 2000,
Sidal board of directors meeting were drafted and executed
sometime after October 31, 2000.
Stock Basis
Petitioners’ adjusted tax bases in their Sidal stock were
zero as of January 1, 1999, 2000, and 2001.
OPINION
I.
Introduction
Respondent disallowed each petitioner’s deduction of his 50-
percent share of Sidal’s ordinary losses for 1999 and 2000 on the
ground that petitioners had zero bases for their respective
investments in Sidal.
Each petitioner’s basis in Sidal depends
- 16 on the characterization properly attaching to certain payments
originating with Paulan, a partnership, and ultimately received
by Sidal, an S corporation.
Those payments were made on various
dates beginning in 1997 and ending in 2000 (the 1997-2000
payments).
In all but one instance, the 1997-2000 payments were
made directly by Paulan to Sidal (the Paulan direct payments).
In that one instance (the wire transfer payments), payment by
Paulan was made indirectly, through petitioners to Sidal.
The
Paulan direct payments totaled $4,043,000, and the wire transfer
payments totaled $2 million.
We must determine the extent, if
any, to which the 1997-2000 payments provided petitioners with
bases in Sidal.
II.
Burden of Proof
A.
Section 7491
In general, the taxpayer bears the burden of proving that
the Commissioner’s determinations in the deficiency notice are in
error.
See Rule 142(a)(1).
Section 7491(a)(1) provides,
however, that “[i]f * * * a taxpayer introduces credible evidence
with respect to any factual issue relevant to ascertaining * * *
[the taxpayer’s proper tax liability]”, the burden of proof with
respect to that issue shall be on the Commissioner.
Rule 142(a)(2).
See also
Credible evidence is evidence the Court would
find sufficient upon which to base a decision on the issue in
favor of the taxpayer if no contrary evidence were submitted.
- 17 See Higbee v. Commissioner, 116 T.C. 438, 442 (2001); Bernardo v.
Commissioner, T.C. Memo. 2004-199 n.6.
Section 7491(a)(1)
applies only if the taxpayer complies with any substantiation
requirements imposed by the Internal Revenue Code, maintains all
required records, and cooperates with the Commissioner for
witnesses, information, documents, meetings, and interviews.
Sec. 7491(a)(2)(A) and (B).
The taxpayer bears the burden of
proving compliance with the conditions of section 7491(a)(2)(A)
and (B).
H. Conf. Rept. 105-599, at 240 (1998), 1998-3 C.B. 747,
994.
B.
Arguments of the Parties
Petitioners argue that the burden of proof with respect to
the basis issue shifts to respondent because they complied with
all of the conditions of section 7491(a)(2) and presented
credible evidence of sufficient bases in Sidal to sustain their
passthrough deductions for the audit years. Although respondent
concedes that petitioners complied with the record maintenance
and cooperation requirements of section 7491(a)(2)(B), he argues
that petitioners did not comply with the substantiation
requirement of section 7491(a)(2)(A), and that, therefore, the
burden of proof on the basis issue remains with petitioners.
Respondent also argues that petitioners failed to introduce
credible evidence of their bases in Sidal during the audit years.
- 18 C.
Analysis
1.
The Paulan Direct Payments
For reasons discussed infra, we agree with respondent that
petitioners have failed to introduce credible evidence that the
Paulan direct payments provided them with bases in Sidal during
the audit years.
Therefore, it is unnecessary to address the
issue of petitioners’ compliance with the requirement of section
7491(a)(2)(A) “to substantiate any item” as it may apply to those
payments.
Because we find that petitioners have failed to introduce
credible evidence that the Paulan direct payments provided
petitioners with basis in Sidal, we decide the basis issue as it
relates to those payments in respondent’s favor; i.e., the
absence of credible evidence that petitioners acquired bases in
Sidal by virtue of the Paulan direct payments necessarily means
that petitioners cannot sustain their resulting burden of proof
with respect to those payments.
See Bernardo v. Commissioner,
supra n.7.
2.
The Wire Transfer Payments
Because we base our decision (discussed infra) regarding
petitioners’ bases in Sidal attributable to the wire transfer
payments upon a preponderance of the evidence, assignment of the
burden of proof under section 7491 is unnecessary.
See FRGC
Inv., LLC v. Commissioner, T.C. Memo. 2002-276, affd. on this
- 19 issue 89 Fed. Appx. 656 (9th Cir. 2004); Polack v. Commissioner,
T.C. Memo. 2002-145 n.7, affd. on this issue 366 F.3d 608, 613
(8th Cir. 2004).
III.
Petitioners’ Bases With Respect to Sidal
A.
Principal Statutory Provisions
Section 1366(a)(1) provides that a shareholder of an S
corporation shall take into account his pro rata share of the S
corporation’s items of income, loss, deduction, or credit for the
S corporation’s taxable year ending with or in the shareholder’s
taxable year.
Section 1366(d)(1), however, limits the amount of
such losses and deductions (without distinction, losses) that a
shareholder may take into account for any taxable year to an
aggregate amount not exceeding the sum of (1) his adjusted basis
in the stock of the S corporation and (2) his adjusted basis in
any indebtedness of the S corporation to the shareholder.
Any
losses so disallowed may be carried forward indefinitely.
See
sec. 1366(d)(2).
B.
Summary of the Parties’ Arguments
Petitioners contend that all of the 1997-2000 payments
were, in substance, direct loans from them (one-half each) to
Sidal that increased their debt bases in Sidal, under section
1366(d)(1)(B), by an amount sufficient to sustain the deductions
for Sidal’s operating losses reported on their returns for the
audit years.
Respondent contends that all of those payments were
- 20 interentity loans from Paulan to Sidal that did not increase
petitioners’ debt bases in Sidal, and that petitioners had zero
bases in Sidal during the audit years.
C.
Applicable Caselaw
1.
Introduction
There are two types of payments at issue:
(1) the wire
transfer payments, which were made by Paulan to petitioners and,
then, by petitioners to Sidal, and (2) the Paulan direct
payments, which, in form, were made by Paulan directly to Sidal.
In each case, for petitioners to prevail, the evidence must show
that they, not Paulan, made loans to Sidal, and that Sidal’s
resulting indebtedness ran directly to them, not to Paulan.
See,
e.g., Prashker v. Commissioner, 59 T.C. 172, 176 (1972) (“[t]he
key question is whether or not the debt of the corporation runs
‘directly to the shareholder’”.).
A finding that Sidal’s
indebtedness ran to Paulan, a partnership with passthrough
characteristics, rather than directly to petitioners, its
partners, would not satisfy that requirement.
See Frankel v.
Commissioner, 61 T.C. 343 (1973), affd. without published opinion
506 F.2d 1051 (3d Cir. 1974).
Moreover, the evidence must show
that the payments created indebtedness from Sidal to petitioners
on the dates of each payment to Sidal.
Petitioners’ subsequent
recharacterization of those payments as back-to-back loans,
through them, would not, on account of that recharacterization,
- 21 give petitioners any debt-financed bases in Sidal.
See Underwood
v. Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468
(1975); Bhatia v. Commissioner, T.C. Memo. 1996-429; Shebester v.
Commissioner, T.C. Memo. 1987-246; see also Hitchins v.
Commissioner, 103 T.C. 711, 716-718 (1994).
2.
Paulan Direct Payments
Because the Paulan direct payments were, in fact, payments
from Paulan directly to Sidal (and Sidal repaid Paulan directly),
petitioners must prove that Paulan, in making those payments (and
in receiving the repayments), was acting on behalf of (i.e., as
agent of) petitioners, who were the actual lenders to Sidal.
Put
another way, petitioners must establish facts sufficient for us
to draw the legal conclusion that, on account of the Paulan
direct payments, Sidal was indebted to them, not to Paulan.
Petitioners claim that it is Indiana law that governs whether a
debtor-creditor relationship exists and, under Indiana law,
intent governs.
Petitioners cite Union Sec., Inc. v. Merchants’
Trust and Sav. Co., 185 N.E. 150, 153 (Ind. 1933), in which the
Supreme Court of Indiana set forth the test for distinguishing
between a loan and a sale:
“The test which determines whether
the real transaction between the parties was a loan or a sale is
the intention of the parties, and their intention is to be
ascertained from the whole transaction, including the conduct of
the parties as well as their written agreement.”
Intent is,
- 22 indeed, important.
We have said:
“Whether a transfer of money
creates a bona fide debt depends upon the existence of an intent
by both parties, substantially contemporaneous to the time of
such transfer, to establish an enforceable obligation of
repayment.”
Delta Plastics Corp. v. Commissioner, 54 T.C. 1287,
1291 (1970).
We also agree with the Supreme Court of Indiana
that the we must make an objective appraisal of intent.
See,
e.g., Hubert Enters., Inc. & Subs. v. Commissioner, 125 T.C. 72,
91 (2005) (“The subjective intent of the parties to a transfer
that the transfer create debt does not override an objectively
indicated intent to the contrary.”).
are not necessarily determinative.
Thus, petitioners’ beliefs
See, e.g., Bhatia v.
Commissioner, supra (stipulated conclusory statements by sole
shareholder of two S corporations in respect of bookkeeping
entries evidencing shareholder’s assumption of indebtedness
running from one corporation to the other insufficient to
establish bona fides of the transactions in question and their
economic substance); Burnstein v. Commissioner, T.C. Memo. 198474 (testimony of sole shareholders of two S corporations that,
when they caused one corporation to transfer money to the other,
they intended and believed that they were actually transferring
their own money is not relevant to the question of whether they
actually incurred risk of nonrepayment).
- 23 Moreover, transfers between related parties are examined
with special scrutiny.
Hubert Enters., Inc. and Subs. v.
Commissioner, supra at 91.
In the circumstances of this case,
where the entities involved in the transactions are wholly owned
by petitioners, petitioners bear a heavy burden of demonstrating
that the substance of the transactions differs from their form.
See, e.g., Bergman v. United States, 174 F.3d 928, 933 (8th Cir.
1999).
Nevertheless, “[t]he existence of a close relationship
between the parties to the transaction `is not necessarily fatal
if other elements are present which clearly establish the bona
fides of the transactions and their economic impact’”.
(quoting Bhatia v. Commissioner, supra).
Id.
In Culnen v.
Commissioner, T.C. Memo. 2000-139, revd. on another issue 28 Fed.
Appx. 116 (3d Cir. 2002), the uncontradicted testimony was that
the taxpayer had for many years used his controlled, profitable
corporation as an incorporated pocketbook, having the corporation
make payments on his behalf that were posted to the corporation’s
books as loans to the taxpayer, creating a loan balance, which,
periodically, the taxpayer would liquidate by making payments to
the corporation.
We found that, in substance, the corporation’s
advances to a loss corporation (an S corporation) in which the
taxpayer was a shareholder constituted economic outlays or
payments on the taxpayer’s behalf, thereby creating a tax basis
for the taxpayer in the S corporation under section
- 24 1366(c)(1)(B).
We reached a similar conclusion in Yates v.
Commissioner, T.C. Memo. 2001-280.
3.
The Wire Transfer Payments
In the case of the wire transfer payments, the issue is
whether the payments were (1) in substance, as well as in form,
back-to-back loans from Paulan to petitioners and from
petitioners to Sidal or (2) direct loans from Paulan to Sidal,
with petitioners serving as mere conduits for the transfer of
funds.
If we find the latter to be the case, we must apply the
so-called step transaction doctrine and ignore, as without
independent legal significance, the same-day wire transfers from
Paulan to each petitioner and from each petitioner to Sidal.
See
Aiken Indus. Inc. v. Commissioner, 56 T.C. 925, 934 (1971)
(doctrine applied to disregard an intermediate back-to-back loan
designed to avoid the withholding of U.S. tax on interest
payments to a foreign corporation).
If we ignore petitioners’
participation in the transactions, as without legal significance,
then, as in the case of the Paulan direct payments, the issue
will be whether Paulan made funds available for the use of (and
collected repayments of principal and interest from) Sidal as
agent for or on behalf of petitioners.
- 25 D.
Discussion
1.
The Economic Outlay Requirement
Respondent’s principal argument is that petitioners failed
to satisfy the requirement, referred to in a number of cases,
e.g., Bergman v. United States, supra at 932; Hitchins v.
Commissioner, 103 T.C. at 715, that an increased basis in an S
corporation must entail an “actual economic outlay” by the
shareholder taxpayer.
In respondent’s view, that requirement is
met only if the taxpayer invests in or lends to the S corporation
his own funds, or funds borrowed from an unrelated party, to whom
he is personally liable.
We reject that view.
As we made clear
in Yates v. Commissioner, supra, and Culnen v. Commissioner,
supra, the fact that funds lent to an S corporation originate
with another entity owned or controlled by the shareholder of the
S corporation does not preclude a finding that the loan to the S
corporation constitutes an “actual economic outlay” by the
shareholder.
It is not unusual for an individual to conduct multiple
businesses through multiple entities, some or all of which are
passthrough entities (e.g., S corporations or partnerships).
Nor
is it unusual for one or more of those entities to be profitable
and one or more to be unprofitable.
Where the loss entity is an
S corporation, we find no categorical rule, under section
1366(d)(1)(B), the regulations thereunder, see sec. 1.1366-2(a),
- 26 Income Tax Regs., the applicable caselaw, or, indeed, as a matter
of plain common sense, requiring a common shareholder to fund the
S corporation’s losses with funds from his mattress or with funds
borrowed by him from a bank or other unrelated party, rather than
with funds obtained from another controlled entity, in order to
obtain a basis in the unprofitable S corporation to the extent of
the funding.
Recognizing, as he must, that Culnen v. Commissioner, supra
supports petitioners’ position in principle, respondent attempts
to distinguish that case on the ground that, in Culnen, the funds
lent to the unprofitable S corporation were derived from the
after-tax profits of a related corporation, whereas the funds
supplied by Paulan were, in a preliminary step, borrowed from
unrelated banks or, in one instance, from Bavaria, Inc., a
corporation wholly owned by Robert and Lovella.
A profitable
entity’s use of undistributed after-tax profits that, in essence,
belong to its controlling shareholders or partners, for advances
to an S corporation in which those same shareholders or partners
are investors, is consistent with the argument that the
profitable entity is acting on their behalf.
indispensable to that argument.
It is not, however,
Even though Paulan borrowed
money to fund Sidal’s losses, Paulan might still have been acting
on petitioners’ behalf in advancing the borrowed funds to Sidal.
In that connection, we note that, although Paulan did not possess
- 27 the cash or cash equivalent resources necessary to fund Sidal’s
losses, it did own valuable real property that could be (and was)
used on petitioners’ behalf as collateral for the bank loans.
Where the controlled entity owns assets that, in essence, belong
to the controlling shareholders or partners and can be used to
obtain loans on behalf of the controlling shareholders or
partners, we see no need to distinguish Culnen on the basis of
the liquidity of the controlled entity’s assets.
2.
Sufficiency of Petitioners’ Evidence
a.
The Paulan Direct Payments
(1)
Introduction
We have placed a high bar before any taxpayer who would
disavow the form of a direct loan between two entities he
controls and, instead, treat the loan as back-to-back loans
through him.
See, e.g., Shebester v. Commissioner, T.C. Memo.
1987-246 (the taxpayer “may not so easily disavow the form of * *
* [his] transaction”); Burnstein v. Commissioner, T.C. Memo.
1984-74 (“‘A transaction is to be given its tax effect in accord
with what actually occurred and not in accord with what might
have occurred.’” (quoting Don E. Williams Co. v. Commissioner,
429 U.S. 569, 579 (1977))).
In both Shebester and Burnstein, the
taxpayer’s attempt to recast a direct loan between commonly
controlled entities as back-to-back loans through the taxpayerowner was unsuccessful.
In Yates v. Commissioner, T.C. Memo.
- 28 2001-280, and Culnen v. Commissioner, T.C. Memo. 2000-139, that
attempt was successful.
Petitioners argue that their
circumstances are controlled by Yates and Culnen.
Petitioners’ argument that the Paulan direct payments
constituted bona fide back-to-back loans through them
individually is essentially premised on two grounds:
(1) Like
the taxpayers in Yates and Culnen they have historically used
Paulan as an “incorporated pocketbook”, to discharge their
personal obligations, and the advances to Sidal are merely
another example of that practice; and (2) after respondent’s
denial of shareholder basis for Paulan’s pre-1997 advances to
Sidal, petitioners, at Michel’s direction, structured all
subsequent Paulan advances to Sidal in a manner intended to
constitute bona fide back-to-back loans, an intent that was
clearly manifested by the promissory notes, the minutes, and the
accounting for those advances by Paulan and Sidal.
We shall
consider those grounds in turn.
(2)
Status of Paulan as an “Incorporated Pocketbook”
In Yates v. Commissioner, supra, over a 4-year period, the
taxpayers wrote 409 checks on the payor corporation’s account
totaling $1,831,156 for various personal expenses and, at the
taxpayer husband’s direction, the payor corporation’s personnel
wrote 113 checks totaling $2,231,248 “to or for the * * *
- 29 [taxpayers].”
We concluded that the taxpayers “used * * * [the
payor corporation] as an incorporated pocketbook.”
In Culnen v. Commissioner, supra, we found that “for many
years (including the years in question), the * * * [taxpayer] had
used * * * [the payor corporation] as an incorporated pocketbook,
having the corporation make payments on his behalf, which
payments were posted to * * * [the payor corporation’s] books as
loans to * * * [the taxpayer].”
In both Yates and Culnen, we understood the term
“incorporated pocketbook” to describe the taxpayer’s habitual
practice of having his wholly owned corporation pay money to
third parties on his behalf.
Whether that practice is habitual
and whether it is probative of whether any ambiguous payment is
being made by the corporation on behalf of its owner (as opposed
to on its own behalf) are questions of fact to be resolved on the
basis of the particular facts of the case.
The term
“incorporated pocketbook” describes a set of facts, not a legal
conclusion.
It is not a term of art.
The evidence indicates that, over a 5-year period (19962000), Paulan wrote 55 checks (the 55 checks) to or on behalf of
petitioners totaling $689,784 (summarized in a schedule entitled
“Paulan Properties Summary of Partners Draw Checks”).15
15
Of those
The schedule lists 20 additional checks totaling
$169,364, but it is not clear that any of those checks were
(continued...)
- 30 checks, 21 (totaling $195,286) were written to various taxing
authorities in payment of petitioners’ personal tax liabilities
(11 for Al, 10 for Sid), and three (totaling $6,593) went to pay
insurance premiums for Sid.
The other 31 checks (totaling
$487,905) (the 31 checks) were written to petitioners (16 to Al,
15 to Sid, all listed under the heading “General”), presumably,
to use in any way they saw fit.
There is no evidence that the 55
checks were treated on Paulan’s books as anything other than
distributions to petitioners.
We do not consider the 31 checks as anything other than
distributions of accumulated profits or, if more than accumulated
profits, as return of capital.
Being written to petitioners,
those checks are not evidence of their use of Paulan as an
incorporated pocketbook; i.e., to make payments directly to third
parties on behalf of one or the other of petitioners.
Moreover,
the 24 Paulan checks paid over a 5-year period for petitioners’
taxes and insurance (approximately five checks a year) are not of
a volume or of such a general nature that we are convinced that
Paulan habitually paid petitioners’ bills.
In sum, the 55 checks
and the conclusions to be drawn from them are insufficient to
convince us that the Paulan direct payments were made by Paulan
to Sidal on petitioners’ behalf.
15
(...continued)
written for or on behalf of either Sid or Al, personally.
- 31 (3)
Analysis of Petitioners’ Evidence of Loans by
Them to Sidal
(a)
Introduction
Both Michel and petitioners gave uncontradicted testimony
that they believed the wire transfer and Paulan direct payments
were structured so as to constitute back-to-back loans from
Paulan to petitioners and from petitioners to Sidal, thereby
generating bases for petitioners in Sidal equal to the loan
amounts.
As we have already noted, however, supra section
III.C.2. of this report, petitioners’ beliefs are not necessarily
determinative, and we must be objective in judging intent.
Before we address the particular facts in front of us, we make
some preliminary observations.
Yates v. Commissioner, supra, and Culnen v. Commissioner,
supra, instruct us that we are not required to find that Sidal’s
indebtedness ran to Paulan, rather than to petitioners, solely
because the flow of the borrowed funds ran directly from Paulan
to Sidal, and the flow of the principal and interest payments ran
directly from Sidal to Paulan.
See also Gilday v. Commissioner,
T.C. Memo. 1982-242 n.8, in which we were untroubled by such
direct payments and characterized a scenario in which the S
corporation repays the shareholder who in turn repays the lender
as “the utilization of fruitless steps.”
Nor do we consider it fatal to petitioners’ position that
the back-to-back loan structure was adopted in order to enable
- 32 petitioners to acquire tax bases in Sidal; i.e., for tax
minimization or avoidance purposes.
This case does not involve a
brief, circular flow of funds beginning and ending with the
original lender, the sole purpose of which is to generate a tax
basis in an S corporation.
See Kaplan v. Commissioner, T.C.
Memo. 2005-218, and Oren v. Commissioner, T.C. Memo. 2002-172,
affd. 357 F.3d 854 (8th Cir. 2004), in both of which we found
that such an arrangement had no economic substance and,
therefore, did not involve the actual economic outlay required to
create a basis in the S corporation.
The loans to Sidal had a
valid business purpose; i.e., to provide working capital for the
operation and expansion of Sidal’s business.
Although the back-
to-back loan structure was adopted in order to achieve tax bases
for petitioners in Sidal equal in amount to the loans, that is a
permissible motivation for that structure.
See Helvering v.
Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (“Anyone may so arrange
his affairs that his taxes shall be as low as possible”), affd.
293 U.S. 465 (1935).
See also Gilday v. Commissioner, supra, in
which we sustained the taxpayer-shareholder’s loan basis in an S
corporation despite the parties’ agreement that the transaction
which gave rise to that basis “was motivated by tax
considerations.”
It is necessary, however, that petitioners’ intent to
establish a back-to-back loan structure in connection with the
- 33 Paulan direct payments be clearly manifested by the actions of
the parties to those transactions; viz, petitioners, Paulan, and
Sidal.
With that thought in mind, we examine the parties’
actions as evidenced by the promissory notes, the minutes, and
the accounting entries.
(b)
The Promissory Notes
Petitioners point to the promissory notes as documentary
evidence of the back-to-back loan structure and, in particular,
of “real, enforceable loan obligations between * * * [them] and
Sidal.”
Respondent argues that because the promissory notes
reflected loans that were unsecured, yet provided for the same
interest rates as the secured bank loans to Paulan (i.e., because
the terms of those loans were not arm’s-length), and because the
execution dates of the notes are uncertain, they cannot be
considered “genuine”.
We do not find the alleged failure of the promissory notes
to satisfy an arm’s-length standard to be of much help in
deciding the issue of whether those notes do, in fact, reflect
bona fide indebtedness from Sidal to petitioners and from
petitioners to Paulan, which is the issue in this case.
If, as
respondent argues, the interest rates on the unsecured
indebtedness from Sidal to petitioners and from petitioners to
Paulan, as set forth in the promissory notes, are too low, those
rates may be subject to increase pursuant to section 482.
See
- 34 sec. 1.482-2(a)(1), Income Tax Regs.
Nonetheless, we agree with
respondent that the promissory notes are entitled to little or no
weight in our consideration of whether the back-to-back loans
claimed by petitioners actually existed.
Neither petitioner could recall the actual dates upon which
the promissory notes were executed.
They could only agree that
the notes were executed sometime between 1997 and 2000.
We infer
from that testimony that the notes were not executed
contemporaneously with the wire transfer and the Paulan direct
payments but were, instead, backdated to appear contemporaneous
with those payments.
Moreover, none of the eight sets of
promissory notes bears an effective date that corresponds to the
Paulan direct payment to which it relates.
Five sets of notes bear effective dates that are between 3
days and more than 9 months subsequent to the corresponding
Paulan direct payments.
Even if we were to accept as accurate
the stated effective dates of those notes, the notes are more
reflective of attempts to recharacterize prior debts from Sidal
to Paulan as back-to-back loans through petitioners than they are
of back-to-back loans as of the dates of the actual Paulan direct
payments.
Therefore, at best, those notes suggest the creation
of a back-to-back loan structure after the Paulan direct payments
to which they relate.
Such a finding would not justify treatment
of those notes as anything more than guaranties of Sidal’s
- 35 existing indebtedness to Paulan, which would be ineffective to
create bases in Sidal under section 1366(d)(1)(B).
See Bergman
v. United States, 174 F.3d 928 (8th Cir. 1999); Underwood v.
Commissioner, 535 F.2d 309 (5th Cir. 1976).
Conversely, the other three sets of promissory notes predate
the Paulan direct payments to which they relate.
Those
promissory notes also fail to support a finding that the
corresponding Paulan direct payments, in substance, created bona
fide indebtedness from Sidal to petitioners and from petitioners
to Paulan in the amounts set forth and on the dates thereof.
See
Perry v. Commissioner, 392 F.2d 458 (8th Cir. 1968) (predated
notes insufficient to prove indebtedness from an S corporation to
the taxpayer shareholder), affg. 47 T.C. 159 (1966); Thomas v.
Commissioner, T.C. Memo. 2002-108 (promissory note bearing a date
prior to the transaction to which it relates given no weight),
affd. 67 Fed. Appx. 582 (11th Cir. 2003).
(4)
The Minutes
The Paulan minutes, in essence, reflect meetings at which
petitioners, acting on behalf of Paulan, authorized loans to
themselves individually, and the Sidal minutes, in essence,
reflect meetings at which petitioners, acting on behalf of Sidal,
authorized borrowings from themselves individually.
As mere
authorizations, those meetings are not evidence that the loans,
- 36 in fact, occurred, but they can be evidence of an intent to make
the loans.
The purported meeting dates all precede the stipulated
date(s) when the minutes were drafted.
Although it is
necessarily the case that meeting minutes cannot be drafted until
after the meeting, we give little or no evidentiary weight to
minutes that follow the alleged
meetings to which they relate by
periods of anywhere from a month to more than 3 years.
Those
delays, in this case, indicate an attempt to provide an afterthe-fact paper trail of back-to-back loans through petitioners
rather than corroboration of an actual intent to make such loans,
which existed at the time of the Paulan direct payments.
Even
the Sidal minutes drafted with respect to the October 31, 2000,
Paulan direct payments are stipulated to have been “drafted and
executed sometime after * * * [that date].”
There is no evidence
as to how long after October 31, 2000, the minutes were drafted.
Therefore, we have no reason to give more evidentiary weight to
those minutes than to the minutes relating to the earlier
payments.
We also note that, because the minutes of each of Sidal’s
board of directors meetings specify as the meeting date the
alleged effective date of the corresponding set of promissory
notes, five of the eight Sidal board meetings are necessarily
alleged to have been held after the borrowings authorized during
- 37 those alleged meetings.
(As noted supra, five of the eight sets
of promissory notes bear effective dates subsequent to the Paulan
direct payment(s) to which they relate.)
Because after-the-fact
authorizations (as opposed to genuine ratifications) are not
credible, that aspect of a majority of the minutes further
supports our conclusion that the minutes merit little or no
evidentiary weight.
In fact, it supports the conclusion that
none of the alleged Paulan or Sidal partner/board meetings
actually took place in the manner or at the times stated in the
minutes.16
(5)
The Accounting Entries
Neither the promissory notes nor the minutes furnish
significant evidentiary support for petitioners’ claim that the
Paulan direct payments constituted back-to-back loans, which
would give them tax bases in Sidal.
Therefore, their claim that
the Paulan direct payments constituted back-to-back loans
(through them, to Sidal), rests solely upon the accounting for
those payments.
16
Because all of the alleged meetings of the Paulan and
Sidal partners/directors (i.e., petitioners) are alleged to have
occurred on the alleged effective dates of the promissory notes
to which they relate, we infer that those meeting dates were
selected to be consistent with the promissory note effective
dates and not because they represent dates when petitioners, in
their capacities as partners/directors of Paulan and Sidal,
actually held meetings.
- 38 Freyberger, the BR Associates, Inc. controller, testified
that one of his functions, particularly on behalf of Sidal, was
to track the cashflow in and out.
He stated that the “tax
characterization” of any cash transfer, on the books of both
Paulan and Sidal, was made by Michel.
In that connection, he
testified that he prepared the annual trial balances, which he
gave to Michel, who was responsible for making any adjustments.
Michel testified that he followed that procedure (yearend
adjusting entries) with respect to the Paulan direct payments by
recharacterizing, as back-to-back loans through petitioners, the
notes payable and notes receivable that had been
initially
recorded by Freyberger (consistent with the actual cashflow) as
debt obligations running from Sidal directly to Paulan.
Contrary to Michel’s testimony, not all of the Paulan direct
payments, which were originally recorded by Freyberger as giving
rise to notes payable from Sidal to Paulan, were the subject of
yearend adjusting entries on the Sidal and Paulan adjusted trial
balances.
The July 11, 1997, Paulan direct payment of $1.2
million and the 1998 Paulan direct payments to the extent of
$928,000 are reflected on all of the Paulan and Sidal trial
balances in evidence (subsequent to those payments) as Sidal
notes payable (“N/P”) to Paulan or Paulan notes receivable
(“N/R”) from Sidal.
The 1999 and 2000 Paulan direct payments,
like their 1997 and 1998 counterparts, were also initially
- 39 recorded on Sidal’s adjusted trial balances as notes payable
(“N/P”) to Paulan; but those payments were reclassified at
yearend on those trial balances as notes payable (“N/P”) to
petitioners (one-half of each payment constituting a note payable
to each petitioner).
We assume corresponding entries and yearend
adjusting entries were made on Paulan’s 1999 and 2000 adjusted
trial balances (which are not in evidence) to convert receivables
from Sidal into receivables from petitioners.
Because the 1997 and 1998 Paulan direct payments were always
reflected on Sidal’s and Paulan’s books as giving rise to notes
payable from Sidal to Paulan, those accounting entries furnish no
support for treating those payments as, in substance, back-toback loans from Paulan to petitioners and from petitioners to
Sidal.
The issue with respect to the 1999 and 2000 Paulan direct
payments is whether the yearend adjusting entries alone justify
such back-to-back loan treatment for those payments.
We find
that they do not.
In both Yates v. Commissioner, T.C. Memo. 2001-280, and
Culnen v. Commissioner, T.C. Memo. 2000-139, we reviewed
accounting systems that entailed temporary postings or entries by
a bookkeeper reflecting direct loans from the taxpayer’s
controlled entity to an S corporation in which the taxpayer was a
shareholder (which entries were consistent with the actual
cashflow), followed (before yearend) by adjusting entries
- 40 reclassifying the loans as back-to-back loans through the
taxpayer.
In both cases, we found that the system was indicative
of the contemporaneous treatment of the transactions as back-toback loans through the taxpayer.
In those cases, however, the
adjusting entries were consistent with an established course of
conduct whereby the payor corporation routinely made payments on
behalf of the taxpayer shareholder.
As noted supra, petitioners
have established no such course of conduct for Paulan.
Moreover, in each of Yates, and Culnen, the taxpayershareholder was intimately involved in recording the intercompany
advances to the S corporation as giving rise to payables from the
S corporation to him.
In Yates, it was the taxpayer who directed
his accountant to make intercorporate funds transfers and, by
yearend, to record those transfers either as distributions to him
followed by capital contributions to the payee S corporation or
as back-to-back loans to the S corporation through him.
In
Culnen, the taxpayer’s regular accountant testified that it was
the taxpayer who routinely, over a 20-year period, directed the
bookkeeper for the payor corporation to have that corporation
write checks on his behalf and charge the amounts to his loan
account with the corporation; and the taxpayer’s outside
accountant testified that she made the adjusting entries
classifying the payor corporation’s payments to the loss S
corporation as back-to-back loans through the taxpayer on the
- 41 basis of conversations with the taxpayer.
In this case, there is
no evidence that petitioners were even aware of the Paulen and
Sidal accounting entries designed to show back-to-back loans
through them or of the fact that the appropriate adjusting
entries were not made in connection with the July 11, 1997 and
1998, Paulan payments to Sidal.
Rather, the testimony at trial
indicated that petitioners relied completely upon Michel for all
tax planning, and that it was Michel who, alone, was responsible
for making the accounting entries consistent with his plan to
generate tax bases for petitioners in Sidal.
Petitioners, who
lacked any hands-on involvement with the accounting for the
Paulan direct payments, cannot, like the taxpayers in Yates, and
Culnen, rely on those accounting entries to prove the existence
of binding debt obligations from Sidal to them and from them to
Paulan arising out of those payments on the dates thereof.
In Burnstein v. Commissioner, T.C. Memo. 1984-74, we
rejected the taxpayer’s attempt to reclassify intercorporate
loans as back-to-back loans through the taxpayers, commenting as
follows.
All [the taxpayers] really did was make journal
adjustments at the end of each year (when it could be
determined that * * * [the transferee S corporation]
would have a net operating loss) to reclassify the
transferred funds on the books of * * * [the transferor
corporation] as accounts receivable due from [the
taxpayers] and on the books of * * * [the transferee S
corporation] as accounts payable due [the taxpayers].
* * *
- 42 * * * such reclassification is insufficient to
create “indebtedness of the corporation to the
shareholder” withing the meaning of * * * [the
predecessor of section 1366(d)(1)(B)]. * * *
Similarly, we do not believe that the yearend adjusting entries
overseen by Michel with respect to some, but not all, of the
Paulan direct payments were sufficient to justify treating those
payments as giving rise to indebtedness from Sidal to petitioners
on the dates the payments were made.
At best, they caused a
yearend reclassification of Sidal’s original debt to Paulan,
which was insufficient to provide petitioners with debt bases in
Sidal under section 1366(d)(1)(B).
See Underwood v.
Commissioner, 535 F.2d 309 (5th Cir. 1976); Bhatia v.
Commissioner, T.C. Memo. 1996-429; Shebester v. Commissioner,
T.C. Memo. 1987-246; Burnstein v. Commissioner, supra.
(6)
Conclusion
For the reasons stated, we find that, despite petitioners’
overall intent to take the steps necessary to establish tax bases
in Sidal beginning in 1997, the steps taken (the promissory
notes, the minutes, and the accounting entries) were ineffective
to carry out that intent.
At best, those steps amounted to a
reclassification of initial indebtedness from Sidal to Paulan.
Put quite simply, petitioners, in conjunction with Michel, paid
insufficient attention to detail.
Another example of that
failing is exemplified by the failure to have Sidal issue
information returns (IRS Forms 1099) to petitioners in connection
- 43 with its interest payments (actually made to Paulan) on the
alleged indebtedness.
We find that petitioners have failed to provide credible
evidence that the Paulan direct payments entitled them to any
bases in Sidal under section 1366(d)(1)(B).
3.
The Wire Transfer Payments
Unlike the Paulan direct payments, the wire transfer
payments, in form, suggest a back-to-back loan structure through
petitioners as the intermediate borrowers (from Paulan) and
lenders (to Sidal).
Moreover, the adjusted trial balance for
1997 (and for all subsequent years) always reflected the payments
as giving rise to payables from Sidal to petitioners and from
petitioners to Paulan.
Therefore, there was no necessity for a
1997 yearend adjusting entry.
Nonetheless, consistent with the
Paulan direct payments, Sidal made all principal and interest
payments directly to Paulan.
As in the case of the Paulan direct payments, and largely
for the same reasons, we give no significant evidentiary weight
to the promissory notes and minutes relating to the wire transfer
payments.
Petitioners cannot recall when the promissory notes,
dated December 18, 1997, were executed (except insofar as they
could agree upon an execution date sometime between 1997 and
2000), and petitioners have stipulated that the applicable
minutes authorizing those November 24, 1997, payments were
- 44 drafted no earlier that June 30, 2000.
Moreover, both the Paulan
and the Sidal minutes specify a meeting date (December 18, 1997)
on which the alleged loans (from Paulan to petitioners and from
petitioners to Sidal) were authorized that is more than 3 weeks
after the wire transfer payments actually occurred.
Thus, it is the form of the wire transfer payments and the
manner in which they were consistently recorded on both Paulan’s
and Sidal’s books that furnish the evidentiary support for
petitioners’ position that those payments constituted back-toback loans giving petitioners bases in Sidal to the extent
thereof.
We find that that evidence is sufficient to sustain
petitioners’ position.
Although we would normally be inclined to
view petitioners’ participation in the transactions, if they were
essentially conduits for transfers of funds from Paulan to Sidal,
as without independent legal significance, in this instance
petitioners’ involvement, at some personal inconvenience,17
represented a concrete manifestation of an intent to create debt
from Sidal to them and from them to Paulan.18
The
17
Petitioners decided to abandon the wire transfer
structure for subsequent payments from Paulan to Sidal as an
inconvenient (to them) interruption of the interentity flow of
funds.
18
As discussed supra, were we to view the same-day wire
transfers from Paulan to petitioners and from petitioners to
Sidal as without independent legal significance, we would
disregard those intermediate payments under the so-called step
transaction doctrine.
- 45 contemporaneous (and subsequent) bookkeeping for the wire
transfer payments represented a further manifestation of that
intent.19
As noted supra (note 7), the amounts of basis attributable
to the wire transfer payments that carried over to 1999 are not
certain.
It is certain, however, that those basis amounts are
substantially less than Sidal’s 1999 ordinary loss, thereby
enabling each petitioner to deduct only a small portion of that
loss and none of Sidal’s 2000 ordinary loss.
We assume that the
parties will be able to arrive at agreed carryover basis figures
in the Rule 155 computation.
E.
Conclusion
The Paulan direct payments did not provide petitioners with
any bases in Sidal under section 1366(d)(1)(B).
The wire
transfer payments did provide petitioners with carryover bases in
Sidal under that section sufficient to enable them to deduct a
small portion of Sidal’s 1999 ordinary loss and none of Sidal’s
2000 ordinary loss.
Decisions will be entered
under Rule 155.
19
As in Gilday v. Commissioner, T.C. Memo. 1982-242 n.8,
we regard the payments of principal and interest by Sidal
directly to Paulan rather than to petitioners who, in turn, would
have had to transmit those payments to Paulan, as the permissible
avoidance of “fruitless steps”.
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