UNITED STATES TAX COURT
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T.C. Memo. 1996-168
UNITED STATES TAX COURT
NORTHWESTERN INDIANA TELEPHONE COMPANY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
ROBERT G. MUSSMAN AND MYRTIS MUSSMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent1
Docket Nos. 7970-91, 7971-91.
Filed April 2, 1996.
R determined that NITCO, a local telephone
company, unreasonably accumulated its earnings and
profits and, therefore, was subject to accumulated
earnings tax. R further disallowed business deductions
NITCO claimed for legal expenses and determined that
NITCO was liable for certain additions to tax.
R determined that M, NITCO’s president and major
shareholder, had constructive dividend income and that
M and M’s wife were liable for certain additions to
tax.
1. Held: NITCO is liable for accumulated
earnings tax because its accumulated earnings exceeded
its reasonable business needs and NITCO was availed of
1
This Court granted petitioners' motion to consolidate.
- 2 to avoid income tax with respect to its shareholders.
2. Held, further, most of the legal expenses in
issue are not deductible under sec. 162, I.R.C.
3.
income.
Held, further, M had constructive dividend
4. Held, further, NITCO is liable for the
additions to tax.
5. Held, further, M and M’s wife are liable for
the additions to tax.
David J. Duez, Gail H. Morse, and Roger W. Wenthe, for
petitioners.
Marjory A. Gilbert, Linda Grobe, and Claire McKenzie, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge:
Respondent determined deficiencies in
petitioners' Federal income taxes and additions to tax as
follows:
Northwestern Indiana Telephone Co.
docket No. 7970-91
Year
Deficiency
Sec.
6653(a)(1)(A)
1987
1988
1989
$786,115.00
429,006.00
329,369.00
$39,305.75
21,450.30
--
1
Additions to Tax
Sec.
Sec.
6653(a)(1)(B)
6661
1
---
50 percent of the interest due on $55,412.
$182,675.75
101,935.50
--
Sec.
6662
--$23,509.40
- 3 Robert G. and Myrtis Mussman
docket No. 7971-91
Year
Deficiency
Sec.
6653(a)(1)
1988
1989
$74,850.00
127,004.00
$3,742.50
--
Additions to Tax
Sec.
6661
Sec.
6662
$18,712.50
--
-$25,400.80
After concessions, the issues we must decide are:
(1)
Whether petitioner Northwestern Indiana Telephone Co. (NITCO)
permitted its earnings to accumulate beyond the reasonable needs
of the business during the years 1987, 1988, and 1989; (2)
whether NITCO was availed of for the proscribed purpose of
avoiding income tax with respect to its shareholders and is
liable for the accumulated earnings tax under section 531,2 for
1987, 1988, and 1989; (3) whether NITCO, for 1987, 1988, and
1989, is entitled to business deductions for certain legal
expenses it incurred and/or paid; (4) whether petitioner Robert
G. Mussman received constructive dividend income in the years
1988 and 1989; and (5) whether petitioners are liable for
additions to tax.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, first and second supplemental
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code as in effect for the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
- 4 stipulations of fact, and attached exhibits are incorporated
herein by this reference.
At the time their petitions were filed, NITCO maintained its
principal office in Hebron, Indiana, and petitioners Robert G.
and Myrtis Mussman resided in Hebron, Indiana.
Mr. and Mrs.
Mussman filed joint individual income tax returns for 1988 and
1989.
A.
Background on NITCO and the Mussman Family
NITCO, an Indiana corporation, is an independent telephone
company that provides local wire-based telephone services in the
five following rural areas located in northwestern Indiana:
(1)
Roselawn, (2) Mt. Ayr, (3) Demotte, (4) Lakes of the Four
Seasons, and (5) Hebron.
It operates a local telephone company
office or exchange in each of these areas.
In each of the years
1987, 1988, and 1989, NITCO had a total of 7,238, 8,099, and
8,634 access lines, respectively.
were for residential customers.
multiline business customers.
Most of these access lines
NITCO had relatively few
As of 1989, NITCO had 16 multiline
business customers, none of whom had lines in excess of 10.
Since 1982, petitioner Robert G. Mussman (Mr. Mussman) has
been NITCO's president and chief executive officer.
He has owned
approximately 95 percent of NITCO's outstanding shares of stock
since at least 1982.
The balance of NITCO's outstanding shares
has been owned by Mr. Mussman's brother, Gerald Mussman.
Since
- 5 1982, Gerald Mussman served as NITCO's vice president, and
petitioner Myrtis Mussman (Mrs. Mussman) served as its secretarytreasurer.
During the years in issue, Mr. and Mrs. Mussman and
Gerald Mussman were NITCO's only directors and officers.
During 1987 through 1989 and in prior and subsequent years
relevant to these instant cases, Mr. Mussman was the primary
decision maker at NITCO.
He made all final major decisions
concerning NITCO's operation and how its earnings were spent.
Mr. and Mrs. Mussman have two sons, Rhys Mussman (Rhys) and
Kyle Mussman (Kyle).
Rhys was born in 1956 or 1957; Kyle was
born in 1965 or 1966.
Each son, at various times pertinent to
the instant cases, worked as a full-time employee of NITCO.
They
also, at various times pertinent to the instant cases, left
NITCO's employ to pursue other business ventures for their own
accounts, including a cable television company business and
various cellular telephone company businesses.
NITCO's local telephone business has been a family-owned
and-operated business.
The business was originally owned and
operated by Mr. Mussman's father.
Mr. Mussman began working in
the business as a teenager in 1938.
From about 1947 through the
time of the trial in the instant cases, Mr. Mussman worked as a
full-time employee in the business.
Gerald Mussman left the
family business in 1947 when he took a job with AT&T.
When Mr. Mussman's father died in 1954, Mr. Mussman
inherited his father's NITCO shares.
At various times since
- 6 1954, NITCO offered additional shares of its stock to Mr. Mussman
and his brother, Gerald Mussman.
Mr. Mussman purchased the
shares offered to him, but his brother declined to purchase
additional shares.
Throughout the 1950's, NITCO's earnings were fairly
moderate.
In 1951, NITCO's annual net income was about $9,800.
By 1987, however, NITCO's annual revenue exceeded $5 million.
In the early 1960's, Interstate Highway 65 was constructed
through NITCO's service area.
The completion of the highway
spurred development and economic growth in NITCO's service area,
which resulted in increased annual revenue for NITCO.
New
subdivisions of homes were built, and portions of NITCO's service
area eventually included bedroom communities composed of
individuals who worked in the Gary, Indiana, area, and in the
Chicago, Illinois, area.
NITCO's annual revenue and profits began to increase
significantly in late 1985, as a result of the breakup of the
Bell system and the entry of other companies into the longdistance telephone service market in competition with AT&T.
Generally, when a long-distance telephone service company, like
AT&T, originates or places a long-distance call into or from an
area serviced by a local telephone company, it pays the local
telephone company an access charge for the use of its lines.
Prior to the breakup of the Bell system, AT&T alone established
and prescribed the access charges it paid to local telephone
- 7 companies.
Following the breakup of the Bell system, an
independent entity, the National Exchange Carriers Association,
was established and given responsibility over deciding how longdistance call revenues were divided among all telephone service
providers.
B.
NITCO's Principal Business Office and Headquarters
From about 1980 through the time of the trial, NITCO
maintained its principal business office and headquarters in an
office building at 205 North Washington Street, Hebron, Indiana.
NITCO leased the office building from Mr. Mussman, who owned the
building and the parcel of land on which the building is
situated.
Mr. Mussman also owned another smaller office building
situated on the same parcel of land, with the address 301 North
Washington Street, Hebron, Indiana.
Prior to its moving into and
occupying the newer and larger building at 205 North Washington
Street, NITCO maintained its principal business office at the 301
North Washington Street building, which it leased from Mr.
Mussman.
From 1980 through 1993, NITCO continued to lease the
301 North Washington Street building from Mr. Mussman.
From 1983
until about July 1989, NITCO subleased the 301 North Washington
Street office building to Rhys' cable television company.
After
Rhys' cable television company vacated the premises in July 1989,
NITCO used the 301 North Washington Street building for storage
- 8 and later, in the fall of 1993, moved some of its marketing
division employees into the building.
From 1987 through 1989, NITCO had no plans to build other
principal office facilities for itself or to expand and enlarge
its offices at 205 North Washington Street.
In securing office
facilities for NITCO, Mr. Mussman's longstanding practice was to
own individually the office building and lease it to NITCO.
As
the building's owner, Mr. Mussman, rather than NITCO, financed
and constructed the building.
NITCO's respective lease
agreements with Mr. Mussman on the 205 and 301 North Washington
Street buildings were entered into prior to each building's
construction, so that Mr. Mussman could use the executed lease
agreement to secure financing from a lender to construct the
building.
Mr. Mussman experienced no difficulty in obtaining
loans to construct the 205 and 301 North Washington Street
buildings.
The lease agreements and the mortgages on the
buildings served as the security for the lender's loans to Mr.
Mussman.
No enlargement of NITCO's offices at 205 North Washington
Street occurred from 1987 through 1994.
C.
NITCO's Alcatel Telephone Switching Equipment
During 1985 through 1987, NITCO replaced the old switching
systems at its five exchanges with new digital switching
equipment it purchased from Alcatel, a French manufacturer of
- 9 telephone switching equipment.
After it replaced the old
switching equipment at its exchanges with the new Alcatel
switching equipment, NITCO paid off the remaining purchase money
debt of $669,530 that it owed on the old equipment to the old
equipment's manufacturer.
When NITCO ordered the Alcatel E10-5 switching equipment for
its five exchanges in 1985, Alcatel had represented to NITCO that
Alcatel would continue to engage in research and development
efforts that would allow the Alcatel equipment that was purchased
to be upgraded in future years so as to offer enhanced and
improved telephone services.
In 1988, NITCO purchased and
installed another piece of Alcatel switching equipment, an
Alcatel 1210 access tandem toll switch, at its central office.
The Alcatel E10-5 switching equipment installed in NITCO's five
exchanges performs switching functions in each exchange and is
connected to the Alcatel 1210 tandem toll switch, which provides
access to long-distance telephone service carriers, equal access,
and 800 call capability to all of NITCO's exchanges.
With the
E10-5 switches and the 1210 switch, NITCO can provide equal
access, touch-tone services, direct long-distance dialing, call
forwarding, call waiting, three-way calling, speed dialing,
foreign exchange lines, pbx services, call tracing, and 911
services to all its exchanges.
In various 1990 NITCO publications circulated to NITCO's
customers and employees, NITCO stated that the Alcatel switching
- 10 equipment it had installed within the past 5 years was state of
the art equipment that offered the latest calling features.
NITCO's operating experience with its Alcatel equipment has been
good.
In an August 17, 1990, response that was submitted by NITCO
to a service audit report issued by the engineering staff of the
Indiana Utility Regulatory Commission (IURC), NITCO indicated
that Alcatel was continuing future research and development
efforts with respect to NITCO's Alcatel equipment.
To support
this representation, NITCO attached to its response a copy of a
letter dated August 14, 1990, from Mr. James V. Parish, national
sales account manager--ITT-Alcatel--stating that Alcatel was not
withdrawing from the North American switching market, had no
plans to do so, and was providing a complete line of support for
its switching systems equipment.
From 1987 through sometime in 1992, NITCO did not obtain any
bids on new switching equipment to replace its Alcatel switching
equipment.
In 1992, NITCO for the first time obtained a firm
quotation on the price of possible replacement equipment.
As of
the time of trial, however, NITCO has not purchased new switching
equipment to replace its Alcatel switching equipment.
D.
NITCO's Installation of Fiber Optic Cable
Although it is more costly than the traditional copper cable
still extensively used by local telephone companies, fiber optic
- 11 cable has certain definite advantages over copper cable.
The
fiber optic cable is much smaller in size and has a greater
transmission capacity than copper cable.
It further allows
higher speed transmissions and requires less maintenance than
copper cable.
However, from 1987 through the time of trial, it was not
economically feasible for NITCO to install fiber optic cable in
the homes or business premises of its customers.
From 1986 until
sometime in 1987 or 1988, Kyle was NITCO's fiber optic cable
specialist.
During 1989, while he was employed as NITCO's
general manager, Kyle authored and published a white paper for
the independent telephone industry stating that, at that time and
for the immediate future, installation of fiber optic cable by
local telephone companies in residences was not economically
feasible.
In the paper, Kyle expressed the opinion that there
was then no economic justification for local telephone companies
to incur the high cost of installing the fiber optic cable in
residences, because no significant additional revenues would yet
be produced for them from their installation of the cable in
residences.
From 1987 through the time of trial, NITCO has not installed
fiber optic cable in residences or in the business premises of
its customers.
However, NITCO has installed and utilized fiber
optic cable in connection with other parts of its telephone
service system.
Its employees have laid and installed the fiber
- 12 optic cable.
During 1987 through 1989, NITCO was installing
fiber optic cable to connect its five exchanges.
Most of this
work to connect its exchanges was completed in 1987 and 1988.
In
1989, NITCO installed fiber optic cable to a point in its service
area where it located a switching device to handle calls to homes
using traditional copper cables.
Since 1990, NITCO has installed
fiber optic cables in a few new subdivision areas to service
homes in the subdivisions that had copper cables.
In addition to
the fiber optic cable's better performance and reliability and
its potential future capacity for offering other new or enhanced
services that might become available, the fiber optic cable was
cheaper to install in these subdivision areas because of its
smaller size.
E.
NITCO's Billing and Collections Work
Prior to 1986, in addition to billing and collecting
payments for its own local telephone services, NITCO billed and
collected payments for long-distance calls from customers in its
service area who utilized AT&T's long-distance telephone
services.
With respect to the long-distance payments it
collected on behalf of AT&T, NITCO subtracted the access charges
due to it, as well as an administrative and collection fee, and
then was required to remit the balance of the long-distance
payments to AT&T.
- 13 NITCO owned an IBM computer, which it used to help perform
its billing and collections work.
In late 1986, AT&T took back
the long-distance billing and collections function that NITCO
previously performed for AT&T with respect to long-distance
calls.
In October 1989, NITCO and Bank of Illinois entered into a
3-year contract under which Bank of Illinois agreed to perform
NITCO's billing and collections work.
In a November 1989 NITCO
publication circulated to its employees, NITCO announced that the
new NITCO billing system to be operated by Bank of Illinois would
help to (1) improve service to NITCO's customers, and (2)
increase the productivity of NITCO's employees.
Another reason
why NITCO entered into the contract was because the IBM computer
that NITCO owned could not provide all the information on longdistance calls that NITCO was required to furnish to AT&T.
The
contract was subsequently taken over from Bank of Illinois by
another company, Communications Data Group (CDG).
As of September 1991, although it had experienced some
problems with the billing and collections work done, NITCO was
still utilizing CDG's billing and collections services.
At a
meeting on October 25, 1991, attended by NITCO personnel and CDG
personnel at the offices of NITCO's attorneys, NITCO and CDG
agreed that NITCO would continue to utilize CDG's billing and
collections services.
However, the problems with the billing and
collections work done for NITCO persisted.
- 14 In 1992, NITCO purchased and paid approximately $781,000 for
a new computer to perform its own billing and collections work.
NITCO also hired additional employees to operate the new computer
and to perform this work.
Thereafter, employees of NITCO
utilized this computer to perform NITCO's billing and collections
work.
During 1987 through 1989, NITCO had no specific and definite
plans to buy a computer to perform its billing and collections
work.
F. Long Range Planning and Discussions Concerning
a Proposed Airport in or Near NITCO's Service Area
At various times during 1987 through 1989, long-range
planning and discussions were taking place concerning a proposed
new airport in Indiana to service the Chicago, Illinois, area.
Proponents of the airport project anticipated that the proposed
airport eventually would be needed, because Chicago's O'Hare
airport was already being heavily used.
The proponents believed
that, as O'Hare airport's maximum air traffic capacity was
reached (which some of them predicted could occur as early as
2010 through 2020), much of the increased air traffic to the
Chicago area would have to be accommodated at a new Indiana
airport.
During the years in issue, 4 of the 15 possible sites in
Indiana discussed for the proposed airport were either in or near
NITCO's service area.
However, a final decision concerning the
- 15 building of the airport and the selection of its site was not
likely to be made for a number of years.
As of the time of
trial, no decision had yet been made concerning the building or
site of the proposed airport, and there were no current plans to
build the airport in or near NITCO's service area.
G. Cellular Telephone and Long-Distance Telephone
Service License Applications Filed by Mr. Mussman,
NITCO, and Another Company Mr. Mussman Controlled
In order to offer cellular telephone or long-distance
telephone services in a specific area, the potential service
provider must first apply for and obtain authorization from
either the Federal Communications Commission (FCC) or an
appropriate State regulatory agency.
During the 1980's, the FCC held lotteries to select the
applicants to whom it would issue licenses to build and operate
cellular telephone systems serving various areas of the United
States.
The FCC issued two types of cellular telephone licenses:
(1) On frequency B, only to local wire-line telephone companies,
their owners, and affiliates who were under the common control of
local telephone companies and/or their owners; and (2) on
frequency A, to anyone else other than local telephone companies,
owners of local telephone companies, and their affiliates.
If a
cellular telephone licensee failed to provide the required level
of cellular telephone service to the entire area covered under
the license issued to it within a 5-year period, then the FCC
- 16 could take back the license to the unserviced portion of the
licensee's service area and issue a new license to another
qualified applicant to provide cellular telephone service to the
unserviced portion of the area.
In 1988, Lukas, McGowan, Nace & Gutierrez (LMN&G), a
Washington, D.C., law firm that specializes in communications
law, prepared and filed with the FCC at least 78 cellular
telephone license applications on behalf of either Mr. Mussman,
Kyle, or Rhys.
Previously, in 1986, Rhys applied for and was
tentatively selected to be awarded two licenses to furnish
cellular telephone services in Enid, Oklahoma, and in Asheville,
North Carolina, respectively.
Rhys' Enid, Oklahoma, and
Asheville, North Carolina, cellular telephone business activities
were conducted by him through Dial One Mobile, a company Rhys
solely owned.
Almost all the 78 applications LMN&G filed in 1988
were for Kyle and Rhys.
During 1988, NITCO paid the filing fees
with respect to the 78 license applications and deducted the
payments.
Petitioners have conceded that NITCO should not have
deducted these payments of Mr. Mussman's, Kyle's, and Rhys'
license application filing fees.
LMN&G also performed a substantial amount of other legal
work for NITCO and the Mussman family during the years in issue.
- 17 Mr. Mussman's Hagerstown, Maryland, and Cumberland, Maryland-West
Virginia Cellular Telephone License Applications
On or about January 6, 1988, Mr. Mussman filed with the FCC
two cellular telephone license applications to provide cellular
telephone services in the Hagerstown, Maryland, and the
Cumberland, Maryland-West Virginia, areas, respectively.
An
LMN&G attorney prepared the two applications.
NITCO had no interest in the above license applications.
The applications stated that Mr. Mussman was the applicant and
that NITCO had no interest in the licenses being sought.
NITCO's Indiana Rural Statistical Area Number One Cellular
Telephone License Application and Serv-U-Cellular, Inc.
In 1988, NITCO, certain other local wire-line telephone
companies, and/or affiliates of other local wire-line telephone
companies, filed competing applications with the FCC for a
license to provide cellular telephone service in the rural
statistical number one area in Indiana.
Mr. Mussman's intention
and plan was to transfer the cellular telephone license rights
that NITCO obtained to Serv-U-Cellular, Inc. (Serv-U-Cellular), a
corporation that he and one or more of his sons, individually,
would own.
At that time, when competing cellular telephone
license applications were filed by local wire-line telephone
companies and/or their affiliates, it was a common occurrence for
some license applicants to join subsequently in a partnership to
- 18 build and operate the cellular telephone system that serviced the
area.
As a result of an agreement among various applicants who
sought the rural statistical number one area cellular telephone
license, they agreed to withdraw their license applications to
service the area as follows:
(1) All the applicants except a
company called Ameritech would withdraw their applications to
service the area's northern portion; and (2) all the applicants
would either withdraw or amend their applications so that NITCO
and certain of the other applicants could form and participate in
a partnership to service the area's southern portion.
Subsequently, RSA #1, a limited partnership, was formed for this
purpose.
Ameritech further agreed to pay the other applicants
$750,000 each for their agreement to cede the northern portion of
the rural statistical number one area to Ameritech.
On or about September 24, 1990, an LMN&G attorney sent
letters advising the other participants in RSA #1 that Serv-UCellular, rather than NITCO, would be a limited partner in the
RSA #1 limited partnership.
The attorney's letter to them stated
that Serv-U-Cellular was a newly formed “subchapter S
corporation” whose shares of stock were owned by individual
members of the Mussman family and that Mr. Mussman would own and
vote 51 percent of Serv-U-Cellular's shares.
By October 9, 1990, the RSA #1 partnership agreement was
amended to reflect Serv-U-Cellular's substitution in place of
- 19 NITCO as a limited partner in the RSA #1 limited partnership.
Under the original RSA #1 partnership agreement entered in mid1989, NITCO and the other partners had agreed that subsidiaries
or affiliates of a partner would be allowed to assume the
partner’s rights and obligations in and to the partnership.
In 1990, Serv-U-Cellular received $750,000 as a result of
the agreement to cede the northern portion of the rural
statistical number one area to Ameritech.
NITCO received the
$750,000 from Ameritech and paid it to Serv-U-Cellular.
Pursuant to Mr. Mussman's plan, Serv-U-Cellular was to be
owned individually by him and Rhys.
Mr. Mussman was to own 6
percent and Rhys was to own 94 percent of Serv-U-Cellular's
outstanding shares of stock.
Mr. Mussman subsequently decided to abandon his plan that he
and Rhys individually own Serv-U-Cellular, as a result of the
Internal Revenue Service’s (IRS) commencement of the examinations
that led to the instant proceedings.
On its 1990 return dated
September 12, 1991, NITCO reported in its income $696,772 of the
$750,000 payment that Serv-U-Cellular had received from
Ameritech.
Attached to its Form 1120 for the tax year 1991,
Serv-U-Cellular notified the IRS of the termination of Serv-UCellular's S corporation status as a result of the transfer of
all its shares to NITCO on January 1, 1991.
However, on its
annual reports for 1990, 1991, and 1992, to the FCC and the
Indiana Utility Regulatory Commissioner (IURC), NITCO did not
report that it had any subsidiaries.
- 20 Dial One USA, Inc.
Dial One USA, Inc. (Dial One USA), was a wholly owned
subsidiary of Intelcom, Inc. (Intelcom).
Mr. Mussman was the
principal stockholder of Intelcom.
In 1989, Dial One USA petitioned the IURC for a certificate
of territorial authority for authorization to be a reseller of
long-distance telephone services.
In connection with the
petition, Mr. Mussman essentially acknowledged that he owned Dial
One USA through Intelcom but stated that there was no affiliation
between NITCO and Dial One USA.
At that time, the IURC had
certain concerns with respect to a local telephone company's
having a long-distance telephone service affiliate.
After reviewing Dial One USA's application, the IURC staff
requested further information concerning the allocation of Dial
One USA's expenses between it and NITCO.
In September 1989, Dial
One USA moved to dismiss its application and did not provide the
information the IURC staff requested.
NITCO had paid certain
legal and other expenses of Dial One USA and had paid certain
legal expenses attendant to the incorporation of Dial One USA's
parent, Intelcom.
H. Possible Acquisition of Other Local
Telephone Companies by NITCO or the Mussman Family
During the years in issue, Mr. Mussman, on several
occasions, had asked certain individuals with whom he was
- 21 acquainted, including an accountant, an attorney, and a
communications consultant, to apprise Mr. Mussman of potential
opportunities to acquire other local telephone companies.
On the
record presented in the instant cases, it is not clear whether
Mr. Mussman intended and planned to have NITCO or individual
members of the Mussman family ultimately acquire other telephone
companies.
In 1990, NITCO contacted two local telephone companies about
the possibility of acquiring them.
One telephone company replied
that it was not for sale; the other company never responded to
NITCO's inquiry.
Additionally, in 1990, Rhys visited another local telephone
company located in Tennessee to examine its operations and to
discuss its possible purchase.
Rhys' trip took place after the
IRS’ commencement of the examinations that resulted in the
instant cases.
From 1987 through the time of trial, NITCO did not enter
into a contract to purchase another local telephone company.
I. NITCO's Provision of Financial Assistance to
Mr. Mussman's Sons and Various Companies the Sons Owned
Rhys and Northwestern Indiana CATV, Inc.
Prior to 1983, Northwestern Indiana CATV, Inc. (NICATV), a
corporation that Rhys owned, applied for and was issued a license
by the FCC to offer cable television services in certain areas in
- 22 Indiana.
areas.
NITCO provided local telephone services in these same
To help Rhys and NICATV obtain the financing needed to
build NICATV's cable television system, Mr. Mussman personally
guaranteed the bank loan to NICATV.
From 1983 through 1988, NITCO's employees helped construct
NICATV's cable television system.
From 1983 through about July
1989, NICATV maintained its offices at the 301 North Washington
Street building that it subleased from NITCO.
It further leased
or subleased from NITCO a small area of cleared land located
behind NITCO's office building at 205 North Washington Street and
telephone pole space for cable television attachments.
In 1988
and 1989, NITCO paid a total of at least $6,119.95 and $3,263.51,
respectively, in utility bills at the 301 North Washington Street
building.
NITCO had no ownership interest in NICATV or in NICATV's
cable television facilities.
In 1983, Rhys, NICATV, and NITCO became involved in a
dispute before the FCC concerning whether NICATV was an affiliate
of NITCO.
The FCC later took the position that NICATV was a
NITCO affiliate, in large part because of the extensive financial
support and other assistance NICATV and Rhys received from Mr.
Mussman and NITCO.
This dispute continued for a number of years
and was not resolved until after Rhys sold NICATV to an unrelated
party in July 1989.
The FCC proceedings and other related legal
proceedings that arose from this dispute are discussed more fully
- 23 infra.
The cable television system construction work and other
various activities NITCO engaged in, from 1983 to 1989, with
respect to NICATV were not undertaken by NITCO with a profit
motive.
As of about 1989, NITCO's books reflected that Rhys and
NICATV owed NITCO in excess of $122,000.
NICATV for about $4 million.
In July 1989, Rhys sold
Although Rhys received sufficient
cash from his sale of NICATV to discharge this $122,000 "debt" to
NITCO, the "debt" owed to NITCO remained unpaid.
On the 1989
annual report it filed with the IURC in May 1990, NITCO indicated
that it had written off as uncollectible its $122,000
"receivable" with respect to Rhys and NICATV and stated that this
was a "Non-deductible write-off" for tax purposes.
NITCO's 1988 Payment to Rhys and its 1989 Purchase of a Country
Club Membership for Rhys
Rhys left NITCO's employ and was no longer an employee of
NITCO after December 31, 1983.
However, during 1984, NITCO
continued to pay Rhys a "salary", provided him with health
insurance coverage, and allowed him to participate in NITCO's
retirement plan.
As a result of the FCC's taking issue with
these payments and benefits that NITCO provided to Rhys, on or
about May 31, 1985, an attorney representing NITCO advised the
FCC that Rhys would no longer serve as a "consultant" to NITCO
and indicated that NITCO's provision of such money and benefits
to Rhys would cease.
As indicated above, the dispute between
- 24 NICATV, NITCO, and the FCC continued for some time and was not
resolved until after Rhys' July 1989 sale of NICATV.
Additionally, in the March 24, 1988, complaint NITCO and Rhys
filed in the constitutional challenge action discussed infra,
NITCO alleged that Rhys did not receive compensation from NITCO
and had no formal responsibilities at NITCO.
On December 20, 1988, NITCO paid $22,646 to Rhys.
In early
1989, NITCO purchased individual memberships at a local country
club on behalf of several of its employees and on behalf of Rhys.
NITCO paid an $1,800 initiation fee to obtain Rhys' club
membership.
At this point, Rhys had not yet sold NICATV and was
not an employee of NITCO.
Blue Mountain Cellular Telephone, Inc., FiberComm, Inc., and
BMCT, L.P.
In 1988, FiberComm, Inc. (FiberComm), a corporation solely
owned by Kyle, applied to the FCC for a license to provide
cellular telephone services in the rural statistical number three
area in Oregon.
On October 20, 1989, the FCC issued FiberComm a
cellular telephone license to the area.
FiberComm previously had
obtained a financing commitment from an unrelated party to help
it construct its Oregon cellular telephone system.
Although
FiberComm's cellular telephone system began operating in January
1991, and as of March 31, 1991, FiberComm had 105 subscribers to
the system's cellular telephone services, further construction
work with respect to the system was needed.
In April 1991,
- 25 FiberComm assigned its Oregon rural statistical area number three
cellular telephone license to Blue Mountain Cellular Telephone,
Inc. (BMCT), another corporation solely owned by Kyle.
BMCT was formed in October 1990.
In late 1990, BMCT entered
into an agreement to purchase for $3,615,771 a cellular telephone
license and other assets from WKBN Broadcasting Corp. (WKBN).
BMCT and WKBN were unrelated parties.
During its negotiations
with BMCT, WKBN was advised and represented by a large nationally
known law firm.
The above purchase of the cellular telephone license and
other assets would allow BMCT to operate a cellular telephone
system in the rural statistical number eight area of Washington
State.
Although WKBN's cellular telephone system for the area
began operating in January 1991, and as of March 31, 1991, there
were 85 subscribers to the system's cellular telephone services,
further extensive construction work with respect to the system
was needed.
To help effectuate its purchase of the Washington rural
statistical area number eight cellular telephone license and
other assets, in late 1990, BMCT applied to a local Indiana bank
for a letter of credit for approximately $2.99 million.
The bank
issued the letter of credit after Mr. Mussman executed an
agreement pledging certain of NITCO's assets, including certain
certificates of deposit and interests in various governmental
securities, to cover the bank's potential liability under the
- 26 letter of credit.
In addition, in 1990, NITCO loaned BMCT
$500,000 to use as a downpayment on BMCT's purchase of the
cellular telephone license and other assets.
On or about April 22, 1991, NITCO loaned BMCT another $3.1
million, so that the principal amount of NITCO's outstanding
loans to BMCT totaled in excess of $3.6 million.
With this
additional $3.1 million loan from NITCO, BMCT was then able to
conclude its purchase of the cable telephone license and other
assets from WKBN on April 22, 1991.3
As a result, the above
letter of credit issued by the local Indiana bank was canceled.
At about the time of its April 22, 1991, acquisition of the
Washington rural statistical area number eight cellular telephone
business, BMCT arranged to borrow another $2.8 million from an
unrelated third party, to finance further construction of the
Washington cellular telephone system.
To help BMCT obtain the
$2.8 million loan from this third party, NITCO agreed to
subordinate its prior loans to BMCT to the third party's loan.
3
An explanatory note to the Dec. 31, 1991, financial
statements of BMCT, L.P., the limited partnership that BMCT,
FiberComm, and NITCO subsequently formed, reflects that the
$3,615,771 purchase price paid by BMCT was allocated to the
license and other assets that were acquired as follows:
Land and buildings
Cellular license
Equipment
Warranties
Consulting agreement
Noncompete agreement
Total
$151,143
2,217,265
147,363
500,000
100,000
500,000
$3,615,771
- 27 Thus, the third party generally would enjoy priority over NITCO
with respect to having the third party's $2.8 million loan repaid
by BMCT.
Kyle ceased being an employee of NITCO around the middle of
1990.
He then moved to the Pacific Northwest and resided there
in 1991 and 1992 in order to conduct BMCT's and FiberComm's
respective operations.
In 1991 and 1992, NITCO paid Kyle an
annual "salary" of $73,292 and $77,283, respectively.
Additionally, from the middle of 1990 through February 1993, Kyle
continued to be covered under NITCO's retirement plan and
continued to receive coverage under NITCO's dental and health
insurance plans.
During 1991 and 1992, BMCT made no interest and principal
payments on the loans it received from NITCO.
During the latter part of 1991, Mr. Mussman proposed to Kyle
that BMCT, FiberComm, and NITCO form a limited partnership that
would undertake to build and operate the Oregon rural statistical
area number three and Washington rural statistical area number
eight cellular telephone systems.
Mr. Mussman told Kyle that he
just wanted NITCO to have a short-term investment that paid a
guaranteed annual return.
In late 1991, Kyle sold to Rhys:
(1) A 46-percent stock
interest in BMCT for $61,000, and (2) a 46-percent stock interest
in FiberComm for $61,000.
By the end of 1991, BMCT owed a total
of approximately $3.8 million in principal and interest on the
- 28 loan it received from the unrelated third party, in addition to
the $3.6 million it owed to NITCO.
By about April 1992, BMCT, FiberComm, and NITCO had formed
BMCT, L.P. (the BMCT limited partnership).
Although the BMCT
limited partnership's formation was actually concluded and
finalized by them in April 1992, the BMCT limited partnership's
written partnership agreement stated that the partnership
agreement was made and entered into by them as of November 30,
1991.
The partnership agreement provided that BMCT and FiberComm
would serve as the general partners and that NITCO would be a
limited partner in the BMCT limited partnership.
There were no
other partners in the BMCT limited partnership.
BMCT and FiberComm contributed all their assets, subject to
all their liabilities, to the BMCT limited partnership.
NITCO
contributed to the BMCT limited partnership the loans it had
previously made to BMCT, interest that had accrued with respect
to the loans, and certain equipment.
The formation of the partnership was not an arm's-length
transaction among BMCT, FiberComm, and NITCO.
The respective
partnership interests that BMCT, FiberComm, and NITCO received in
the BMCT limited partnership were not commensurate with and bore
no reasonable relationship to their relative capital
contributions to the BMCT limited partnership.
Considering the
relative amount of NITCO's capital contribution, NITCO's limited
partnership interest was a substantially lesser interest than
- 29 what NITCO should have obtained had it been dealing at arm's
length with the other two partners, BMCT and FiberComm.
In
addition, to NITCO's detriment, the partnership agreement greatly
overvalued BMCT’s and FiberComm's capital contributions to the
BMCT limited partnership.
The partnership agreement provided that NITCO would receive
annual guaranteed payments from the limited partnership equal to
10 percent of NITCO's capital contribution.
The partnership
agreement also provided that any remaining cash flow and
operating profits would be allocated 99 percent to BMCT and
FiberComm, the general partners, and 1 percent to NITCO, the only
limited partner.
In the event that the BMCT limited partnership
was liquidated, the proceeds were to be distributed to the extent
of and in proportion to the positive balances in the partners'
capital accounts.
Prior to the latter part of 1991, Mr. Mussman and NITCO had
not engaged in any discussions with Kyle about the formation of a
cellular telephone partnership between BMCT and NITCO.
In April
1991, the IRS issued the respective notices of deficiency to
petitioners that are the subject of the instant cases.
As a
result of certain legal advice he and NITCO received from
attorneys with the law firm of McDermott, Will & Emery (MW&E),
Mr. Mussman decided to have NITCO's loans to BMCT converted to a
limited partnership interest in a partnership to be formed among
BMCT, FiberComm, and NITCO.
A MW&E attorney previously had
- 30 represented Mr. Mussman and NITCO during the examinations that
led to the IRS’ issuances of the notices of deficiency in the
instant cases.
MW&E attorneys also represented NITCO in the
formation of the limited partnership.
Pursuant to their partnership agreement, the partners valued
their respective capital contributions to the BMCT limited
partnership as follows:
General Partner
Description
Value
BMCT
All assets subject to all
liabilities
$-0-
FiberComm
All assets subject to all
liabilities
6,507,353
Limited Partner
NITCO
Description
Value
Subordinated promissory note
$3,972,553
dated Apr. 22, 1991, from
BMCT, in the principal amount
of $3,615,771, together with
interest accrued thereon of
$210,920 and the contribution
of equipment worth $145,862
On the BMCT limited partnership's December 31, 1991,
financial statements, the partners' formation of the partnership
was not treated as being an arm's-length transaction among the
partners.
Certain notes to the BMCT limited partnership's
December 31, 1991, financial statements concerning the relative
capital contributions made by BMCT, FiberComm, and NITCO,
explained, in pertinent part:
- 31 The shareholders of * * * [BMCT] and FiberComm are also
related to the majority shareholder of NITCO. Because
the partners are all related entities, the assets
contributed to the partnership were recorded at book
value for financial reporting purposes.
Contributed assets and liabilities at book value are
summarized as follows:
BMCT
Cash
$(834)
Other current assets
402,145
Cellular communica2,591,958
tions assets
Licenses &
3,099,068
intangibles
Current liabilities
(510,420)
Long-term debt
(6,382,521)
Net capital
(800,604)
contributions
FiberComm
NITCO
$25
-4,075
$3,615,771
---
43,331
--
-(12,093)
35,338
-210,920
3,826,691
* * * * * * *
The limited partner has contributed certain equipment
for use by * * * [the BMCT limited partnership], the
value of which has not been reflected in the assets or
capital accounts. In addition, interest of $210,920
was accrued on the note to the limited partner prior to
its conversion to a capital contribution.
On June 9, 1994, shortly before the trial in the instant
cases, NITCO's interest in the BMCT limited partnership was
redeemed for about $3.6 million.
Although petitioners offered expert witness testimony at
trial as to the value of the Oregon rural statistical area number
three and Washington rural statistical area number eight cellular
telephone businesses, as of March 31, 1991, their experts’
appraisal reports grossly inflated the actual value of these
cellular telephone businesses.
One appraisal report concluded
- 32 that FiberComm's Oregon rural statistical area number three
cellular telephone business, "free and clear of any
encumbrances", was worth $12,039,000, as of March 31, 1991.
The
other appraisal report concluded that the Washington rural
statistical area number eight cellular telephone business, "free
and clear of any encumbrances", was worth $8,253,000, as of March
31, 1991.
These inflated valuations were based on revenue projections
of the mean annual revenue produced by certain other cellular
telephone businesses and were not based on revenue projections of
the subject cellular telephone businesses' expected future
financial operating results.
The appraisal reports failed to
elaborate specifically with respect to exactly how comparable
these other cellular telephone businesses were to the subject
businesses.4
As indicated above, the subject businesses'
cellular telephone systems still required further extensive
4
Each of the appraisal reports stated, in pertinent part:
The subscriber and financial projections presented
in this report and used to value * * * [the subject
cellular telephone business] are intended to reflect
mean expectations in the marketplace. These
projections are based on information contained in
financial analyses of the industry and the expectations
implied by recent comparable sales. These assumptions
may differ from projections made for operational
purposes. The projections presented in this report
therefore include both the current industry results and
the significant upside potential of the industry.
- 33 construction work.5
Moreover, while the Washington cellular
telephone business was appraised to be worth in excess of $8.25
million, BMCT, in late 1990, had contracted to purchase this
business for approximately $3.6 million following arm's-length
negotiations between BMCT and the seller, an unrelated party.
See note 3, supra p. 26.
The record does not show that the
Washington cellular telephone business appreciated greatly in
value shortly after BMCT purchased it in late 1990.
Additionally, as indicated above, Kyle sold 46-percent stock
interests in BMCT and FiberComm, the two corporations that owned
the two businesses, to Rhys for $61,000 apiece in late December
1991.
Kyle testified that the price paid to him by Rhys for the
FiberComm shares represented "what a willing buyer would have
paid a willing seller".
5
An explanatory note to the Dec. 31, 1991, financial
statements of BMCT, L.P., stated, in pertinent part:
Operations
BMCT, L.P. is principally engaged in the ownership and
operation of cellular telephone systems. The Company
has been in a start-up phase in which its activities
have primarily concentrated on the acquisition of
cellular licenses and the construction and initial
operation of cellular systems. As a result, the
Company has experienced substantial net losses and has
had insufficient internally generated funds to cover
capital and operating expenditures and debt service.
Management anticipates that it will continue to incur
substantial losses and will not be able to generate
sufficient cash from operations to meet expenditure
requirements over the next few years.
- 34 J.
Certain Legal Expenses Which NITCO Paid
During the years in issue, NITCO paid substantial fees to
various attorneys and law firms in connection with certain legal
proceedings and other legal matters.
Most of the legal expenses
that are in dispute between the parties are attributable to
proceedings that were commenced before the FCC in 1983,
concerning whether NICATV (the cable television company Rhys
owned) was an affiliate of NITCO or are attributable to
subsequent related legal proceedings that were brought as a
result of the FCC proceedings.
Divestiture Action
On October 13, 1983, another cable television company that
was a competitor of NICATV filed a complaint with the FCC against
Rhys Mussman d/b/a NICATV and NITCO.
The complaint alleged that
NICATV and NITCO were affiliated companies engaged in
discriminatory and anticompetitive conduct in violation of the
Communications Act and the FCC's telephone company/cable
television company cross-ownership rules.6
In its complaint, the
other cable television company sought damages and a cease and
6
The FCC’s cross-ownership rules generally prohibited a
local telephone company from offering cable television services
to the viewing public within its telephone service area, either
directly or indirectly through an affiliated company. The FCC’s
rules broadly defined affiliation to include any financial or
business relationship between the telephone company and the cable
television company, except the common carrier-user relationship.
- 35 desist order against NICATV and NITCO.
On March 18, 1985, the FCC, after concluding that NICATV and
NITCO were affiliated companies and that they had violated the
FCC's cross-ownership rules, ordered NICATV and NITCO to:
(1)
Divest all cable television facilities constructed in violation
of the FCC's rules and terminate all improper affiliations
between NICATV and NITCO, and (2) undertake to negotiate a good
faith settlement of the cable television company-complainant's
claim for damages.
The FCC further proposed to impose a $20,000
fine against NITCO.
On August 13, 1985, the FCC denied NITCO's
motion for reconsideration and reaffirmed its prior March 12,
1985, order.
In November 1985, NICATV and NITCO concluded a settlement
with the cable television company-complainant that disposed of
the complainant's claim against them.
The FCC, however, declined
to terminate the proceedings and rescind its prior orders
requiring NICATV and NITCO to divest themselves of the cable
television facilities.
Until about 1990, NITCO and NICATV continued to dispute the
validity of the FCC orders requiring a divestiture of the cable
television facilities.
At various times during the period from
August 1985 through 1990, they sought to have the FCC's actions
reviewed and invalidated by the United States Court of Appeals
for the District of Columbia Circuit and the United States
Supreme Court.
Ultimately, the Court of Appeals upheld the FCC's
- 36 actions, and the Supreme Court denied NITCO and NICATV's petition
for a writ of certiorari.
See Northwestern Ind. Tel. Co. v. FCC,
872 F.2d 465 (D.C. Cir. 1989), cert. denied 493 U.S. 1035-1036
(1990).
These proceedings involving NICATV and NITCO before the
FCC, the Court of Appeals for the District of Columbia Circuit,
and the Supreme Court, are collectively referred to for
convenience as the divestiture action.
Enforcement Action
During 1985 and 1986, after learning that NICATV and NITCO
were commencing appellate proceedings to have the FCC's 1985
orders reviewed by the Court of Appeals for the District of
Columbia Circuit, the FCC offered to them the option of placing
the alleged unlawfully constructed cable television facilities in
trust, pending the outcome of the appellate proceedings.
NICATV
and NITCO, however, were unable to reach an agreement with the
FCC concerning such a trust, as the FCC, among other things,
proposed that any appreciation in the cable television
facilities, during the period that the facilities were held in
the trust, be contributed to charity if the FCC's position were
sustained.
The Court of Appeals for the District of Columbia
Circuit subsequently declined NICATV and NITCO's request to have
the FCC orders stayed.
When NICATV and NITCO further declined to
divest themselves of the cable television facilities, the FCC
referred the matter to the Department of Justice for purposes of
- 37 enforcing the FCC's divestiture orders against NICATV and NITCO.
In early 1987, the United States brought suit against NICATV
and NITCO in the United States District Court for the Northern
District of Indiana for enforcement of the FCC's divestiture
orders.
These proceedings before the District Court are referred
to for convenience as the enforcement action.
Constitutional Challenge Action
During the course of the above divestiture action, NICATV
and NITCO later tried to raise certain issues with respect to the
constitutionality of the Communications Act and the FCC's crossownership rules.
The FCC and the Court of Appeals for the
District of Columbia Circuit, however, essentially held that
these constitutional issues were not properly before them.
Northwestern Ind. Tel. Co. v. FCC, 872 F.2d at 471-472.
On March 24, 1988, Rhys and NITCO filed a declaratory
judgment action against the FCC in the United States District
Court for the Northern District of Indiana, requesting that the
District Court declare unconstitutional an FCC cross-ownership
rule imposed against Rhys.
In the complaint, it was alleged that
Rhys wished to buy shares of stock in NITCO from Mr. Mussman, but
was unable to do so under the FCC’s cross-ownership rules, in
light of his ownership of NICATV.
These proceedings before the
District Court are referred to for convenience as the
constitutional challenge action.
- 38 Attribution of Legal Expenses NITCO Incurred and/or Paid to
Various Legal Proceedings and Other Legal Matters
During 1987 and 1988, the attorney’s fees in issue, that
NITCO incurred and/or paid to the law firm of Baker & Hostetler
(B&H), were attributable to the following legal proceedings and
other legal matters:
Year
Amount
1987
$2,762.65
1,500.00
4,337.50
130.00
172,756.85
1,000.00
1988
1989
2,500.00
15,959.48
Proceeding or Matter
AT&T negotiations
Constitutional challenge
action
Dial One Mobile
Divestiture action
Enforcement action
NITCO business plan
3,022.96
7,009.89
AT&T negotiations
Constitutional challenge
and divestiture action
Dial One Mobile
RSA #1
10,117.80
1,365.44
Postal Service Investigation
Unknown
Respondent concedes that the above fees paid to B&H for AT&T
negotiations and the NITCO business plan are deductible by NITCO.
The Dial One Mobile matters concerned the company that Rhys
owned, which was engaged in activities with respect to cellular
telephone systems in Asheville, North Carolina, and Enid,
Oklahoma.
NITCO had no interest in Dial One Mobile.
The Postal
Service investigation involved a matter in which certain
documents and records of NICATV's were seized from NICATV's
business offices.
- 39 During 1987, 1988, and 1989, the attorney’s fees in issue,
that NITCO incurred and/or paid to the law firm of LMN&G, were
attributable to the following legal proceedings and other legal
matters:
Year
Amount
1987
$169,686.00
5,000.00
1988
98,212.00
1,000.00
38,020.00
1,400.00
1989
214,201.00
5,393.00
31,249.00
32,240.00
14,650.00
Proceeding or Matter
Constitutional challenge,
divestiture, and
enforcement actions
Unknown
Constitutional challenge,
divestiture, and
enforcement actions
Dial One USA trademark
RSA #1
Unknown
Constitutional challenge,
divestiture, and
enforcement actions
Dial One USA
RSA #1
Sprint contract
Unknown
The Sprint work referred to above concerned the negotiation of a
contract between Dial One USA and Sprint.
During 1988 and 1989, NITCO incurred and/or paid to the law
firm of Williams & Connolly (W&C) attorney’s fees that were
attributable to the following legal proceedings and other legal
matters:
Year
Amount
1988
$32,144.50
Proceeding or Matter
Constitutional challenge
action
- 40 1989
13,742.45
2,239.85
Constitutional challenge
action
Dial One Mobile
The Dial One Mobile work listed above was billed by W&C to Rhys,
not to NITCO.
Petitioners concede that the $2,239.85 is not
deductible by NITCO and represents constructive dividend income
to Mr. Mussman.
During 1989, NITCO made certain legal expenditures totaling
$88,484, for which it claimed no deduction.
A portion of these
expenditures in the amount of $75,342 was recorded by NITCO in an
account called "Cellular Telephone Investment".
The remaining
$13,052 of the expenditures was recorded by NITCO in an account
called "Other Investments".
The $88,484 in legal expenditures
was attributable to the following matters:
Payee
Amount
Andrew & Kurth
B&H
EMCI
$1,166.59
32,363.64
3,327.50
Handlon & Handlon
1,525.81
132.00
229.00
234.00
LMN&G
2,982.58
2,564.05
4,400.00
Unknown
39,968.83
Matter
Dial One Mobile
Dial One Mobile
Purchase of cellular
telephone publications
Work for Dial One USA and
Intelcom
Work for FiberComm
Unknown
Incorporation of
Northwestern
Indiana Cellular
Work for Rhys
Indiana RSA #1 venture
Conceded by petitioners to
be constructive dividend
to Mr. Mussman
Unknown
On the record presented in the instant cases, it is not clear
- 41 whether the purchase of cellular publications referred to above
furthered NITCO's interests and was of direct and substantial
benefit to NITCO or, instead, was primarily of benefit to
individual members of the Mussman family.
The Northwestern
Indiana Cellular matter referred to above concerned a corporation
that was originally formed to hold cellular telephone interests,
but which subsequently was abandoned.
It is not clear whether
Mr. Mussman planned to have NITCO, rather than the individual
members of the Mussman family, own Northwestern Indiana Cellular,
and whether Mr. Mussman planned to have it hold cellular
telephone interests that NITCO, rather than individual members of
the Mussman family, owned.
K. NITCO's Earnings and Dividend Payment History,
Current Liquid Assets, Working Capital Needs, and Records
Documenting Its Specific Future Business Needs and Plans
NITCO maintained its books and filed its income tax returns
on a calendar year basis, utilizing an accrual method of
accounting.
During 1982 through 1993, NITCO's gross receipts and
its accumulated earnings and profits (Accum. E&P) were as
follows:
Year
Gross Receipts
Accum. E&P
Yearly Increase
In Accum. E&P
1982
1983
1984
1985
1986
1987
1988
$3,172,182
3,684,425
4,247,606
4,019,355
4,575,760
5,754,822
6,134,837
$3,176,521
3,929,694
4,895,862
5,406,973
6,240,031
7,807,835
9,226,900
-$753,173
966,168
511,111
833,058
1,567,804
1,419,065
- 42 1989
1990
1991
1992
1993
5,281,159
6,305,070
6,860,118
7,780,380
8,726,683
9,939,632
11,675,809
12,688,043
14,544,105
15,250,005
712,732
1,736,177
1,012,234
1,856,062
705,900
During 1987 through 1989, NITCO's current assets consisted
mostly of cash or other liquid assets.
Its customer accounts
receivable and National Exchange Carriers Association accounts
receivable (i.e., long-distance call access charges) were billed
monthly.
During 1987 through 1989, NITCO's net current liquid assets,
as adjusted by two loans it made, respectively, to a local
Indiana bank's employee stock option plan and to the bank's
president,7 and if not depleted by certain payments it made to
support the individual Mussman family members during these years,
would have been as follows:
Year
Net Current Liquid Assets
1987
1988
1989
$5,183,131
4,726,973
4,455,217
NITCO's working capital requirements for 1987, 1988, and
1989, were $75,569, $278,646, and $190,312, respectively.
7
After its renegotiation in August 1987, the ESOP loan
essentially was required to be repaid to NITCO on NITCO's demand.
The $400,000 loan to the bank president occurred on June 15,
1987, and was made out of a loan repayment NITCO received from
the ESOP. Although a promissory note bearing a December 1988
execution date was later issued by the bank president, the note
obligated the bank president to repay the $400,000 loan to Mr.
Mussman, rather than to NITCO, in 4 years.
- 43 From 1980 through 1989, NITCO maintained no written records
documenting its specific future business needs and plans.
From 1954 through 1994, NITCO did not declare and pay any
formal dividends to its shareholders.
L. Examinations Conducted of Petitioners' Returns, Notices of
Deficiency, NITCO's Petition, and Subsequent Formal Discovery
Conducted by Respondent in the Instant Cases
On or about August 3, 1990, a revenue agent contacted and
apprised Mr. Mussman and NITCO that the agent would be conducting
an examination.
In an Information Document Request dated October
31, 1990, to NITCO, the revenue agent, among other things, asked
NITCO to elaborate with respect to its plans concerning the use
of its accumulated earnings.
The agent's request, in pertinent
part, stated:
1. During my first visit, you enumerated the following
potential uses of the company's retained earnings:
At the present time, the Company is involved in
expansion:
(1) The Company has a plan to introduce fiberoptics to
its system. Engineering estimates have not been made
for the system.
(2) The Company is developing a cellular telephone
capability for the area. This area is a RSA, Rural
Statistical Area. This development is being shared
with two other companies, Monan and Pulaski-White.
However, the family members, not the Company, made the
investment.
(3) The Company would like to acquire the Monan
telephone exchange. There have been negotiations but
nothing has been put in writing about this. The
Company is closely held. As a result, there are no
- 44 formal annual meetings or minutes.
Are there any other planned uses of these funds?
On or about December 12, 1990, two MW&E attorneys advised
the revenue agent that they would be representing NITCO during
the examination.
By letter dated December 17, 1990, one of the
MW&E attorneys further advised the revenue agent, among other
things:
(1) NITCO had not yet completed its review of the
planned uses for its accumulated earnings, and (2) NITCO was not
willing to consent to an extension of the period of limitations
on assessment and collection of its tax liability with respect to
1987.
The MW&E attorney's December 17, 1990, letter, in
pertinent part, stated:
You have also asked the company to identify the
potential uses of net liquid assets [and accumulated
earnings]. We have recently been retained by the
company for purposes of this representation and are in
the process of reviewing the corporate documentation
and interviewing the officers. When that process has
been completed, we will provide you with a full
statement concerning the historic purposes for
accumulating net liquid assets [and earnings].
Although the process is far from complete, the list
included in your [October 31, 1990] document request
overlooks the largest and most obvious need for net
liquid assets. That is, the preservation of financial
strength to cope with the uncertainty present in the
telecommunications industry during the period under
audit. Those uncertainties concern technical
developments and regulatory governance and management
succession.
As counsel to the company, we have advised them
not to extend the statute of limitation for the year
1987 for purposes of audit. While we generally
recommend extensions of the statute for purposes of
appellate review of a case, we do not recommend
- 45 extension of the statute for purposes of audit. In our
view, the time pressure you face for the year 1987 is
the product of your (or your supervisor's) decision to
open 1987 with so little time remaining on the statute.
Respondent subsequently notified NITCO of the proposed
determination against NITCO with respect to accumulated earnings
tax liability for 1987, 1988, and 1989.
NITCO chose not to
respond and did not file a statement concerning the grounds on
which it relied to establish that its earnings were accumulated
to meet its reasonable business needs.8
In April 1991, respondent issued respective notices of
deficiency to Mr. and Mrs. Mussman for 1988 and 1989, and to
NITCO for 1987, 1988, and 1989.
With respect to the accumulated
earnings tax liability asserted against NITCO, the notice of
deficiency issued to NITCO stated, in pertinent part:
10(b.) Section 531 Tax
It is determined that you were availed of for the
purpose of avoiding the income tax with respect to your
shareholders by permitting earnings and profits to
accumulate instead of being divided or distributed
during the taxable years 1987, 1988, and 1989.
Accordingly, the accumulated earnings tax provided by
Section 531 of the Internal Revenue Code is being
asserted for 1987, 1988, and 1989. In determining your
accumulated earnings credit under the provisions of
section 535 of the Internal Revenue Code, your failure
or refusal to respond to the notification sent to you
by certified mail on January 15, 1991 pursuant to
[section] 534(b) explaining the capital needs of your
business has been considered. Therefore, accumulated
8
As a result, in the instant cases, NITCO has the burden of
proof in establishing that it is not liable for the accumulated
earnings tax liabilities determined against it by respondent in
the notice of deficiency. See sec. 534(a)(2).
- 46 earnings tax is increased $540,044.00, $322,147.00, and
$195,917.00, respectively for the tax years ended
December 31, 1987, December 31, 1988, and December 31,
1989. * * *
The notice of deficiency indicated that respondent computed
NITCO's above 1987, 1988, and 1989 accumulated earnings tax
liabilities as follows:
1987
1988
Taxable income
as adjusted
$1,431,283.00
$1,150,524.00
$699,703.00
Less dividends
0.00
0.00
0.00
1,431,283.00
1,150,524.00
699,703.00
--
250,000.00
Current earning
and profits retained
Accumulated earnings
Credit
1. Minimum
250,000.00
accumulated
earnings allowed
2. Less
(6,240,031.45)
accumulated
earnings as of the
close of the preceding
taxable year
3. Reduced by dividends
0.00
considered paid during
preceding taxable year
4. Allowable credit
0.00
5. Current earnings and
0.00
profits determined to be
retained for reasonable
needs of the business
6. Less: deduction for
0.00
long-term capital gains
7. Allowable credit under
0.00
IRC sec. 535(c)(1)
Tax on accumulated
earnings
(7,800,101.00) (9,266,900.00)
0.00
0.00
0.00
0.00
0.00
0.00
--
--
0.00
0.00
0.00
0.00
0.00
$1,431,283.00
$1,150,524.00
$699,703.00
540,044.00
322,147.00
195,916.84
Accumulated earnings credit
(greater of item 4 or item 7)
Accumulated taxable
income subject to tax
1989
- 47 Petitioners subsequently filed their respective petitions
commencing the instant cases.
In its petition, NITCO did not
allege any specific business needs for which it was accumulating
its earnings.
During pretrial discovery, on March 4, 1992, respondent
propounded certain interrogatories to NITCO asking it to
elaborate fully with respect to the alleged specific business
needs for which NITCO contended it was accumulating its earnings
during 1987 through 1989.
In its April 17, 1992, response to the
interrogatories, NITCO generally objected to having to answer the
interrogatories and declined to provide the information
respondent sought, except that in partial response to some of the
interrogatories, NITCO referred to an April 8, 1992, memorandum
concerning NITCO's reasonable business needs that had been
prepared by NITCO's counsel and that recently had been furnished
by NITCO's counsel to respondent's Appeals officer.
The April 8,
1992, memorandum provided to the Appeals officer stated:
This is a summary of the items we intend to rely on as
justification of * * * NITCO's accumulation of working
capital [and earnings] for years 1987 through 1989. It
is based upon documents we have reviewed and
discussions we have had to date with NITCO personnel
and outside advisors (including NITCO's accountant,
outside counsels [sic] and independent telephone
industry consultants).
The memorandum did not indicate that NITCO, during the years in
issue, planned to:
(1) Replace its Alcatel switches, (2) acquire
- 48 SS7 signaling technology,9 (3) offer CLASS services,10 (4) save in
order to provide increased local telephone services in the event
the proposed Indiana airport was built in or near NITCO's service
area, (5) save for expansion of NITCO's principal office
facilities, or (6) purchase a computer to meet its alleged office
equipment needs.
Subsequently, on August 4, 1992, the Court
granted respondent's motion to compel NITCO to answer the
interrogatories and issued an order requiring NITCO to answer the
interrogatories on or before September 4, 1992.
It was not until about December 1992 that NITCO first
advised respondent of its alleged plans, during the years in
issue, to:
(1) Save in order to provide increased telephone
services in the event the proposed Indiana airport was built, and
(2) save for an expansion of its principal office facilities.
Similarly, it was not until November 1993 that NITCO first
advised respondent that its alleged office equipment needs during
the years in issue included a billing and collections computer.
9
SS7 signaling technology uses a data network separate from
the voice network to carry information about telephone call setup
and accounting.
10
CLASS services are a group of telecommunication services
consisting of selective call forwarding, selective call
rejection, distinctive ringing, customer originated trace,
automatic callback, automatic recall, and calling number delivery
and calling number delivery blocking.
- 49 OPINION
Petitioners bear the burden of proof and must establish that
the determinations made in respondent's notices of deficiency are
erroneous.
Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).
I.
Accumulated Earnings Tax
Section 532(a) provides that every corporation formed or
availed of for purposes of avoiding the income tax with respect
to its shareholders, by permitting earnings and profits to
accumulate instead of being divided or distributed, shall be
subject to the accumulated earnings tax imposed by section 531.
The accumulated earnings tax is a way of discouraging
corporations from accumulating earnings not needed in conducting
the business.
Snow Manufacturing Co. v. Commissioner, 86 T.C.
260, 268 (1986).
The tax is considered to be a penalty and,
therefore, is to be strictly construed.
Ivan Allen Co. v. United
States, 422 U.S. 617, 626 (1975); see generally Technalysis Corp.
v. Commissioner, 101 T.C. 397, 402-403 (1993).
The most important factor in deciding if the accumulated
earnings tax applies is whether a corporation accumulates
earnings and profits beyond the reasonable needs of the business.
United States v. Donruss Co., 393 U.S. 297, 307 (1969).
Section
533(a) establishes a presumption that a corporation that permits
earnings and profits to accumulate beyond the reasonable needs of
- 50 the business does so with the purpose of avoiding income tax with
respect to its shareholders.
The presumption can be rebutted by a preponderance of
evidence to the contrary.
Sec. 533(a); Snow Manufacturing Co. v.
Commissioner, supra at 269.
Therefore, the accumulated earnings
tax does not apply if a corporation has allowed an unreasonable
accumulation but lacks the proscribed purpose or intent.
Technalysis Corp. v. Commissioner, supra at 403; Pelton Steel
Casting Co. v. Commissioner, 28 T.C. 153, 173 (1957), affd. 251
F.2d 278 (7th Cir. 1958).
However, it has been recognized that
without the presumption provided in section 533(a), the
accumulated earnings tax would largely, as a practical matter, be
unenforceable.
Ivan Allen Co. v. United States, supra at 628.
Section 1.533-1(a)(2), Income Tax Regs., sets forth factors
to be considered in determining whether a corporation had the
proscribed purpose.
Some of the relevant factors are:
(1)
Dealings between the corporation and its shareholders for the
personal benefit of the shareholders; for example, personal
loans; (2) corporate investment of undistributed assets in
unrelated businesses or investments; and (3) the corporation's
dividend history.
Section 535(a) defines "accumulated taxable income" (the
recomputed taxable income of the corporation against which tax
under section 531 is imposed) as the taxable income of the
corporation, as adjusted in section 535(b), less the dividend-
- 51 paid deduction (as defined in section 561) and the accumulated
earnings credit (as defined in section 535(c)).
Insofar as
relevant to the instant cases, this accumulated earnings credit
is the amount of the corporation's earnings and profits that are
retained for the reasonable needs of the business.
Where a
taxpayer can show that all its current earnings were accumulated
for the reasonable needs of the business, there is no accumulated
earnings tax since the accumulated earnings credit eliminates the
amount against which the tax is imposed.
E.g., Magic Mart, Inc.
v. Commissioner, 51 T.C. 775, 799 (1969); Faber Cement Block Co.
v. Commissioner, 50 T.C. 317, 336 (1968); John P. Scripps
Newspapers v. Commissioner, 44 T.C. 453, 474 (1965).
Whether a taxpayer's accumulation of earnings and profits is
in excess of its reasonable business needs is a factual question.
Helvering v. National Grocery Co., 304 U.S. 282 (1938).
The
"reasonable needs of the business" includes the reasonably
anticipated needs of the business.
Sec. 537(a)(1); sec. 1.537-
1(a), Income Tax Regs.
With respect to a corporation's reasonably anticipated
future business needs, section 1.537-1(b), Income Tax Regs,
provides:
(b) Reasonably anticipated needs. (1) In order for
a corporation to justify an accumulation of earnings
and profits for reasonably anticipated future needs,
there must be an indication that the future needs of
the business require such accumulation, and the
corporation must have specific, definite, and feasible
- 52 plans for the use of such accumulation. Such an
accumulation need not be used immediately, nor must the
plans for its use be consummated within a short period
after the close of the taxable year, provided that such
accumulation will be used within a reasonable time
depending upon all the facts and circumstances relating
to the future needs of the business. Where the future
needs of the business are uncertain or vague, where the
plans for the future use of an accumulation are not
specific, definite, and feasible, or where the
execution of such a plan is postponed indefinitely, an
accumulation cannot be justified on the grounds of
reasonably anticipated needs of the business.
(2) Consideration shall be given to reasonably
anticipated needs as they exist on the basis of the
facts at the close of the taxable year. Thus,
subsequent events shall not be used for the purpose of
showing that the retention of earnings or profits was
unreasonable at the close of the taxable year if all
the elements of reasonable anticipation are present at
the close of such taxable year. However, subsequent
events may be considered to determine whether the
taxpayer actually intended to consummate or has
actually consummated the plans for which the earnings
and profits were accumulated. * * *
Upon determining the amount necessary to satisfy the
"reasonable needs of the business", we shall not simply compare
this amount with the corporation's total accumulated earnings and
profits, but shall examine the amount of accumulated earnings and
profits that is reflected in business-related assets or in idle
net liquid assets of the corporation.
Ivan Allen Co. v. United
States, supra at 628; Smoot Sand & Gravel Corp. v. Commissioner,
274 F.2d 495, 501 (4th Cir. 1960), affg. T.C. Memo. 1958-221.
In
other words, we must consider whether the corporation's
accumulated earnings and profits have been translated into assets
related to the business, so as to have been employed to meet the
- 53 corporation's reasonable business needs.
In Smoot Sand & Gravel
Corp. v. Commissioner, 274 F.2d at 500-501, the Court of Appeals
for the Fourth Circuit explained:
the size of the accumulated earnings and profits or
surplus is not the crucial factor; rather, it is the
reasonableness and nature of the surplus. * * *
Again, to the extent the surplus has been translated
into plant expansion, increased receivables, enlarged
inventories, or other assets related to its business,
the corporation may accumulate surplus with impunity.
* * *
In Ivan Allen Co. v. United States, supra, the taxpayer had
substantial accumulated earnings and profits and owned certain
readily marketable securities that had considerably appreciated
in value.
The issue presented to the Supreme Court was whether
in determining the applicability of the rebuttable presumption
provided in section 533(a) (i.e., whether the taxpayer's earnings
had accumulated beyond the reasonable needs of the business so
that the taxpayer should be presumed to have the purpose to avoid
income with respect its shareholders), the taxpayer's securities
were to be taken into account at their cost to the corporation or
at their net liquidation value.
Id. at 619.
In holding that the securities were to be taken into account
at their net liquidation value, rather than cost, the Supreme
Court recognized that a comparison of the taxpayer's liquidity to
its business needs was highly significant in deciding the
reasonableness of the taxpayer's accumulation of earnings.
explained:
It
- 54 -
It is important to emphasize that we are concerned
here with a tax on "accumulated taxable income," § 531,
and that the tax attaches only when a corporation has
permitted "earnings and profits to accumulate instead
of being divided or distributed," § 532(a). What is
essential is that there be "income" and "earnings and
profits." This at once eliminates, from the measure of
the tax itself, any unrealized appreciation in the
value of the taxpayer's portfolio securities over cost,
for any such unrealized appreciation does not enter
into the computation of the corporation's "income" and
"earnings and profits."
The corporation's readily marketable portfolio
securities and their unrealized appreciation,
nonetheless, are of profound importance in making the
entirely discrete determination whether the corporation
has permitted, what, concededly, are earnings and
profits to accumulate beyond its reasonable business
needs. If the securities, as here, are readily
available as liquid assets, then the recognized
earnings and profits that have been accumulated may
well have been unnecessarily accumulated, so far as the
reasonable needs of the business are concerned. * * *
Upon this analysis, not only is such accumulation as
has taken place important, but the liquidity otherwise
available to the corporation is highly significant. In
any event--and we repeat--the tax is directed at the
accumulated taxable income and at earnings and profits.
The tax itself is not directed at the unrealized
appreciation of the liquid assets in the securities
portfolio. The latter becomes important only in
measuring reasonableness of accumulation of the
earnings and profits that otherwise independently
exist. What we look at, then, in order to determine
its reasonableness or unreasonableness, in the light of
the needs of the business, is any failure on the part
of the corporation to distribute the earnings and
profits it has.
Ivan Allen Co. v. United States, 422 U.S. at 627-628.
What is required, then, is a comparison of accumulated
earnings and profits with "the reasonable needs of the
business." Business needs are critical. And need,
- 55 plainly, to use mathematical terminology, is a function
of a corporation's liquidity, that is, the amount of
idle current assets at its disposal. The question,
therefore, is not how much capital of all sorts, but
how much in the way of quick or liquid assets, it is
reasonable to keep on hand for the business. * * *
The taxpayer itself recognizes, and accepts, the
liquidity concept as a basic factor, for it "has agreed
that the full amount of its realized earnings invested
in its liquid assets--their cost--should be taken into
account in determining the applicability of Section
533(a)." * * * It concedes that if this were not so,
"the tax could be avoided by any form of investment of
earnings and profits." * * * But the taxpayer would
stop at the point of cost and, when it does so, is
compelled to compare earnings and profits--not the
amount of readily available liquid assets, net--with
reasonable business needs.
We disagree with the taxpayer and conclude that
cost is not the stopping point; that the application of
the accumulated earnings tax, in a given case, may well
depend on whether the corporation has available readily
marketable portfolio securities; and that the proper
measure of those securities, for purposes of the tax,
is their net realizable value. Cost of the marketable
securities on the assets side of the corporation's
balance sheet would appear to be largely an irrelevant
gauge of the taxpayer's true financial condition.
Certainly, a lender would not evaluate a potential
borrower's marketable securities at cost. Realistic
financial condition is the focus of the lender's
inquiry. It also must be the focus of the
Commissioner's inquiry in determining the applicability
of the accumulated earnings tax.
This taxpayer's securities, being liquid and
readily marketable, clearly were available for the
business needs of the corporation, and their fair
market value, net, was such that, according to the
stipulation, the taxpayer's undistributed earnings and
profits for the two fiscal years in question were
permitted to accumulate beyond the reasonable and
reasonably anticipated needs of the business.
Ivan Allen Co. v. United States, 422 U.S. at 629-630 (fn. refs.
omitted.)
- 56 NITCO's Net Liquid Assets
Petitioners contend that NITCO's accumulated earnings and
profits are "irrelevant" and that only NITCO's net liquid assets
should be considered in connection with NITCO's reasonable
business needs and its liability for accumulated earnings tax
during the years in issue.
They argue that the accumulated
earnings tax is directed at "economic reality" and that this
relevant economic reality (NITCO's dividend-paying capacity) is
to be determined solely by examining NITCO's available net liquid
assets.
Respondent, on the other hand, asserts that NITCO's true
dividend-paying capacity is not accurately reflected by NITCO's
remaining net liquid assets, because of NITCO's substantial
expenditures, during 1987 through 1989, for the personal benefit
of Mr. Mussman's family.
We agree with respondent.
We have no quarrel with, and the case law completely
supports, the proposition that where a corporation's net liquid
assets have been invested in nonliquid, business-related assets,
the corporation has appropriately diminished its dividend-paying
capacity for accumulated earnings tax purposes.
In such
instances, the corporation's accumulated earnings have been
applied to meet its reasonable business needs.
However, this is
not the same situation that we are presented with in the instant
cases.
- 57 In our findings, we have made certain adjustments to reflect
what NITCO's net liquid assets would have been (i.e., its true
dividend-paying capacity), during the years in issue, if NITCO
had not made certain nonbusiness-related payments to benefit the
individual Mussman family members.11
These expenditures did not
further NITCO's business interests and were not of substantial
and direct benefit to NITCO.
Petitioners' arguments in this connection misapply and
misinterpret the pertinent case law.
NITCO's remaining net
liquid assets do not reflect its true dividend-paying capacity
because of substantial nonbusiness-related expenditures it made.
Indeed, many of these expenditures may have been constructive
dividends to Mr. Mussman.
These expenditures do not represent
translations of NITCO's accumulated earnings into assets related
to the conduct of NITCO's business.
Cf. Smoot Sand & Gravel
11
Petitioners, on the other hand, contend that for 1987,
1988, and 1989, NITCO's net liquid assets were as follows:
Year
Net Liquid Assets
1987
1988
1989
$3,190,325
4,251,470
3,991,669
We note that even these respective amounts of net liquid assets
well exceed the current earnings that NITCO accumulated during
each of these years. We are further aware that to the extent we
sustain respondent's determinations with respect to the Mussmans'
having constructive dividend income for the years in issue, there
will be a resulting decrease in NITCO's accumulated taxable
income and current earnings. See secs. 535(a), (c)(1);
301(c)(1); 316(a).
- 58 Corp. v. Commissioner, 274 F.2d at 501.
In other words, rather
than being positive evidence demonstrating that NITCO's earnings
were, in fact, accumulated to meet its reasonable business needs,
these expenditures indicate NITCO's earnings were accumulated for
the proscribed purpose of avoiding income tax with respect to its
shareholders.
See sec. 1.533-1(a)(2), Income Tax Regs.
To
accept petitioners' contention would be tantamount to holding
that the accumulated earnings tax could be avoided by making
nonbusiness expenditures to benefit a shareholder or
shareholder's family.
NITCO's Reasonable Business Needs
The parties have stipulated, and we have so found, what
NITCO's working capital requirements were during the years in
issue.
In addition to these working capital requirements,
petitioners contend that a number of other reasonably anticipated
business needs of NITCO justified NITCO's accumulation of
earnings during the years in issue.12
12
Petitioners contend that NITCO's "reasonably anticipated
business needs" during the years in issue were as follows:
Business Need
Working capital
Retirement of longterm debt
Plant modernization:
Fiber to the exchange
1987
1988
1989
$75,569
557,505
$278,646
170,760
$190,312
-0-
1,000,000
same
same
(continued...)
- 59 Respondent generally disputes that NITCO, during 1987
through 1989, had the reasonable business needs that petitioners
allege.
Respondent agrees with the working capital requirements
and agrees that, for 1987, NITCO needed $669,530 to retire its
long-term debt on the old switching equipment it replaced.
Respondent further agrees that NITCO's reasonable business needs
required the accumulation of some earnings to install fiber optic
cable between its exchanges, but contends that petitioners have
failed to offer convincing evidence establishing the precise
amount.
Respondent contends that NITCO, during the years in
issue, had no actual definite plans with respect to meeting the
other alleged business needs and that those alleged needs were
not reasonably anticipated business needs of NITCO.
We generally
agree with respondent.
12
(...continued)
Fiber optic cable to
support broadband
Switches for
SS7/Class
Broadband switch
Telephone acquisition
Airport risk:
In NITCO's exchange
Near NITCO's
exchanges
Cellular
diversification
Billings & collections
computer
Building expansion;
furnished
500,000
1,000,000
6,000,00010,000,000
8,000,00020,000,000
1,000,0005,000,000
same
same
same
same
same
same
same
same
same
same
300,000,000
25,000,00050,000,000
2,000,0002,500,000
850,0001,000,000
2,000,0002,500,000
same
same
same
same
same
same
same
same
same
same
- 60 In evaluating what NITCO's reasonable business needs were
during the years in issue, we have been faced with a lack of
forthrightness on petitioners' part.
For instance, Mr. Mussman
testified that, during 1987 through 1989, NITCO planned to
replace its Alcatel switches, because the French manufacturer had
decided to abandon the U.S. market and stop conducting future
research and development efforts with respect to upgrading the
switches.
He claimed that NITCO learned of the French
manufacturer's decision shortly after NITCO had purchased and
installed its Alcatel switches.
Yet, when questioned by
respondent's counsel on cross-examination about NITCO's contrary
representations concerning the switches to the IURC's engineering
staff in late 1990, Mr. Mussman maintained that the statements in
the August 1990 letter issued to NITCO by Alcatel's U.S.
representative were untrue.
Mr. Mussman, however, offered no
convincing explanation why, if NITCO knew the statements made
were untrue, NITCO then had provided a copy of the letter to the
IURC's staff.13
On the record presented, it is questionable whether during
13
In another instance, Mr. Mussman testified that
architectural plans of new principal office facilities for NITCO
were drawn up in 1989. On cross-examination, however, he claimed
that the plans were not provided to respondent during pretrial
discovery, because the plans were his personal property and did
not belong to NITCO. He further offered no convincing
explanation with respect to why petitioners had failed to produce
the alleged plans and information concerning the alleged
architect who drew them in response to respondent's pretrial
discovery requests.
- 61 the years in issue, NITCO had actual plans concerning many of the
purported business needs petitioners have alleged.
NITCO
produced practically nothing in terms of documents that were
prepared during the years in issue that reflect its alleged plans
and future needs.
Indeed, we view these claimed future needs to
be largely afterthoughts advanced by petitioners to avoid the
imposition of accumulated earnings tax liability against NITCO.
Moreover, almost all the asserted future needs are too vague and
uncertain to be considered reasonably anticipated business needs
of NITCO.
Additionally, considerably undercutting petitioners'
position that NITCO's earnings were accumulated to meet these
alleged reasonably anticipated business needs of NITCO, is the
fact that, notwithstanding these alleged future needs, NITCO, in
late 1990 and early 1991, loaned approximately $3.6 million to
BMCT, a corporation solely owned by Mr. Mussman's son Kyle, to
enable BMCT to acquire a Washington State cellular telephone
business.
The $3.6 million loaned was an investment unrelated to
NITCO's business and was of dubious economic benefit to NITCO,
considering NITCO's later agreement to subordinate its rights
with respect to BMCT's repayment of the loan in order for BMCT to
borrow an additional $2.8 million from another lender.
Although
NITCO subsequently converted its $3.6 million loan to a limited
partnership interest in the BMCT limited partnership, pursuant to
the advice of its attorneys following the issuances of the
- 62 notices of deficiency in the instant cases, the limited
partnership's formation was not an arm's-length transaction
between the partners, and the limited partnership interest NITCO
obtained was not commensurate with its relative capital
contribution to the limited partnership.
With respect to the retirement of NITCO's long-term debt,
petitioners have established that in 1988 and 1989, NITCO made
respective payments of $575,505 and $170,700 to retire the debt.
Although the debt's outstanding principal amount was $669,530,
NITCO was required to pay some additional interest and a
prepayment penalty to retire the debt.
With respect to NITCO's installation of fiber optic cable to
connect its exchanges, Mr. Mussman testified that NITCO spent
about $1 million to install the fiber optic cable during 1987
through 1989.
On cross-examination, however, he admitted that
his $1 million figure included NITCO's overhead costs, as NITCO's
employees performed the installation work.
Further, most of the
cable to connect the exchanges was installed in 1987 and 1988.
By 1989, NITCO was in the final stages of the connection work,
and only a relatively short segment of cable remained to be
installed once NITCO resolved an easement problem.
Mussman's $1 million figure is high.
We think Mr.
Petitioners offered no
specific additional evidence concerning the actual amounts NITCO
spent to install the fiber optic cable during 1987 through 1989.
Doing the best we can on the record presented, and bearing
- 63 heavily against petitioners because this inexactitude is of their
own making, we estimate that the accumulation of earnings
justified to meet NITCO's reasonable business need for installing
fiber optic cable to connect its exchanges was $300,000 for 1987
and was $100,000 for each of the years 1988 and 1989.
With respect to broadband switches and the fiber optic cable
to support broadband switches, petitioners maintain that NITCO
planned to eventually acquire the broadband switches at about the
time it commenced to rewire the homes of its residential
customers with fiber optic cable.14
Yet, in the white paper Kyle
14
In a letter dated Sept. 28, 1992, to respondent's counsel
that elaborated on certain of NITCO's alleged business needs,
petitioners' counsel stated:
During the years in issue * * * [NITCO] also
determined that ultimately it would be required to
retrowire individual housing for fiber optic cable and
to move on to the next generation of digital switching.
Fiber optic cable coupled with the next generation of
digital switching will allow NITCO to provide service
option features to its customers comparable to
adjoining telephone companies such as Call blocking,
caller I.D., and call-me-back services. This next
generation of digital switches is generally described
as broad-band switches which have the capacity for
greater programming flexibility in order to provide
multiple services to each line. While no copper wire
in existing residential and commercial installation has
been retrofitted with fiber optic cable to date to
allow use of the new generation switches, such program
is anticipated in the near future to enable NITCO to
remain competitive.
These broadband switches apparently could also be used to
provide television or video services to customers. On reply
(continued...)
- 64 authored and published in 1989 while he was NITCO's general
manager, Kyle was of the view that the installation of fiber
optic cable in residences by local telephone companies was not
then economically feasible.
His paper estimated that using fiber
optic cables to provide "plain old telephone service" to
individual homes, at that time, would cost from $4,000 to $10,000
per residential customer.
Respondent offered the expert witness report of Dr. Charles
L. Jackson and Dr. Jeffrey H. Rohlfs, each of whom has had
extensive experience in the telecommunications industry.
Dr.
Jackson is an engineer with 25 years of experience in the
computer and telecommunications industry.
consultant for the past 13 years.
He has worked as a
Dr. Rohlfs is an economist
with over 20 years experience in the telecommunications industry.
He worked for 14 years at Bell Labs where he became a department
head for economic modeling research and subsequently has worked
for the last 10 years as a consultant.
Drs. Jackson and Rohlfs were of the opinion that, as of
1989, vast uncertainty existed about the future cost and
availability of systems that would provide fiber connections to
14
(...continued)
brief, petitioners state that they are not contending that "NITCO
* * * sought to provide wideband (video) services in 1987 to
1989, only that it saw a need * * * to provide video services in
the mid to late 1990s to meet the threat of competition from
cable companies."
- 65 residential customers.15
They further opined that it would be a
number of years before it was economically justifiable for NITCO
even to consider seriously investing in the technology to provide
broadband switch services over fiber lines to its business and
residential customers.
They noted that during 1987 through 1989,
NITCO had few, if any, business customers who would demand such
services.
Petitioners offered the expert witness opinion of Warren A.
Liss.
Mr. Liss has extensive experience in the
telecommunications industry.
He has held a variety of management
positions involving the design and development of telephone
switching hardware and software, telephone networks, and
telecommunications services.
He worked for over 20 years at Bell
Labs and then was employed as a director of advanced systems
engineering at MCI Telecommunications.
Since 1987, he has worked
as a consultant to various local, long distance, and
international telephone service companies.
Mr. Liss was of the opinion that the wideband switch
services now currently offered to certain businesses, hospitals,
schools, and other institutions, would inevitably migrate to
residential applications.
15
He noted that the FCC's recent "Video
According to Drs. Jackson and Rohlfs, during 1987 through
1989, experts in their field were predicting that, in the
telephone service industry as a whole, by the end of the century
there would be a 10-to-20 percent penetration of fiber optic
technology into the "copper loop" that connects customers to
telephone company networks.
- 66 Dial Tone" ruling removed certain regulatory restrictions that
prevented telephone companies from entering that business area.
He opined that, although the time frame could not be well
defined, it could take 5 to 10 years for serious penetration of
the residential market for broadband switch services to occur.
The above expert opinions of Drs. Jackson and Rohlfs and Mr.
Liss, along with the 1989 white paper Kyle authored, reflect
that, during 1987 through 1989, NITCO's rewiring of residences
with fiber optic cable and its purchase of broadband switches,
would only become economically justified following the occurrence
of future commercial, legal, and technological developments that
would permit NITCO to derive substantial additional revenue from
offering new services, such as television services, over fiber
optic lines.
NITCO's plans to employ broadband switches could
hardly be considered to be specific and definite during the years
in issue.
We conclude that NITCO's future needs to install
broadband switches and the fiber optic cable to support such
switches, were too vague and uncertain to be reasonably
anticipated business needs of NITCO during 1987 through 1989.
Sec. 1.537-1(b)(1), Income Tax Regs.
Similarly, we are not convinced that NITCO, during 1987
through 1989, had any actual plans with respect to SS7/Class
switches, "Airport risk", a billing and collections computer, and
headquarters building expansion.
As indicated above, we think
that these purported business needs are mere afterthoughts on
- 67 petitioners' part, rather than actual future needs that NITCO
anticipated and planned to meet during 1987 through 1989.
It was
not until late 1992 and 1993 that petitioners first advised
respondent's counsel that these asserted needs were among NITCO's
alleged reasonable business needs.
Moreover, these asserted
future needs were too vague and uncertain to be considered
reasonably anticipated business needs of NITCO during 1987
through 1989.
Sec. 1.537-1(b)(1), Income Tax Regs.
With respect to possible telephone company acquisition and
cellular telephone diversification, the record is not clear
whether Mr. Mussman intended to have NITCO or individual members
of the Mussman family, undertake and benefit from such activities
or ventures.
Although NITCO applied for a cellular telephone
license with respect to the Indiana RSA #1 area in 1988, the
record reflects that Mr. Mussman's plan and intention was to
transfer the cellular telephone license rights that were obtained
to Serv-U-Cellular, another corporation that he and one or more
of his sons, individually, would own.
Petitioners have failed to
establish that telephone company acquisition and cellular
telephone diversification were reasonable business needs of NITCO
during 1987 through 1989.
Rule 142(a).
In conclusion, we find that NITCO's reasonable business
needs, during 1987 through 1989, were as follows:
- 68 Business Need
Working capital
Retirement of long-term
debt
Fiber optic to
the exchange
1987
1988
1989
$75,569
557,505
$278,646
170,760
$190,312
--
300,000
100,000
100,000
Petitioners have failed to establish that NITCO, during these
years, had reasonable business needs in excess of these amounts.
Rule 142(a).
NITCO's Liability for Accumulated Earnings Tax
For 1987, 1988, and 1989, NITCO's accumulated earnings and
adjusted net liquid assets exceeded the reasonable needs of the
business.
NITCO is therefore presumed to have accumulated its
earnings with the purpose of avoiding income tax with respect to
its shareholders.
Sec. 533(a).
NITCO has failed to rebut this presumption of proscribed
purpose.
Sec. 533(a); Technalysis Corp. v. Commissioner, 101
T.C. at 403.
Indeed, the record in the instant cases reflects
the existence of factors that strongly indicate NITCO had this
proscribed purpose.
NITCO engaged in extensive nonbusiness-
related activities to benefit and support Mr. Mussman's two sons.
NITCO made investments that were unrelated to its business.
From
1954 through 1994, NITCO never declared and paid a formal
dividend to its shareholders.
Regs.
See sec. 1.533-1(a)(2), Income Tax
We hold that NITCO, for 1987, 1988, and 1989, is liable
for accumulated earnings tax.
- 69 II. NITCO's Deduction of Legal Expenses
On its 1987, 1988, and 1989 returns, NITCO claimed
substantial business deductions for legal expenses.
To be
deductible by NITCO under section 162, NITCO must establish that
these outlays were ordinary and necessary expenses incurred in
carrying on NITCO's trade or business.
However, before, during,
and after the years in issue, NITCO engaged in extensive
nonbusiness-related activities to benefit and support Mr.
Mussman's sons.
Whether a taxpayer is engaged in a trade or business is a
question of fact.
Although there are various factors that are
important in making this determination, the most prominent of
these factors are a profit motive and the carrying on of
activities in a businesslike fashion.
See International Trading
Co. v. Commissioner, 275 F.2d 578, 584-585 (7th Cir. 1960), affg.
T.C. Memo. 1958-104.
In United States v. Gilmore, 372 U.S. 39, 48 (1963), the
Supreme Court held legal expenses to be deductible if the claim
arises in connection with the taxpayer's profit-seeking
activities.
In the words of the Supreme Court in Gilmore, "the
origin and character of the claim with respect to which an
expense was incurred, rather than its potential consequences upon
the fortunes of the taxpayer, is the controlling basic test of
whether the expense was 'business' or 'personal'"; i.e.,
nonbusiness within the meaning of section 162(a).
Id. at 49.
In
- 70 the instant cases, application of the Gilmore origin-of-the-claim
test is crucial because NITCO, while a corporation, engaged in
various activities, some of which were business activities and
others of which were nonbusiness activities.
See Accardo v.
Commissioner, 942 F.2d 444, 449-451 (7th Cir. 1991), affg. 94
T.C. 96, 99-100 (1990)
Implicit in the Gilmore test is the further requirement
that, for an expenditure to be deductible under section 162, it
must be an ordinary and necessary expense, directly connected
with or proximately resulting from the taxpayer's business.
Kornhauser v. United States, 276 U.S. 145, 153 (1928).
Petitioners contend that the disputed legal expenses NITCO
incurred and paid, during the years in issue, are deductible
ordinary and necessary business expenses under section 162.
They
argue that the litigation expenses with respect to the
constitutional challenge, enforcement, and divestiture actions
are deductible, because NITCO was a named party in the proceeding
before the FCC, was the subject of the FCC's divestiture order,
and was faced with the prospect of being fined or otherwise
sanctioned by the FCC.
Respondent, on the other hand, contends that the disputed
legal expenses are not deductible, because they fail to meet the
Gilmore origin-of-the-claim test.
Respondent maintains that the
claims in the constitutional challenge, divestiture, and
enforcement actions arose from nonbusiness activities that NITCO
engaged in to benefit Mr. Mussman's son, Rhys, by assisting Rhys'
- 71 cable television company NICATV.
Respondent also asserts that
petitioners have failed to establish that the disputed legal
expenses were directly connected with or proximately resulted
from NITCO's business activities.
We essentially agree with
respondent.
We think that the mere naming of NITCO as a party in the FCC
proceedings does not suffice to make the legal expenses
deductible.
270.16
16
The Synanon Church v. Commissioner, T.C. Memo. 1989-
In Gilmore, the Supreme Court noted:
But cf. Kopp's Co. v. United States, 636 F.2d 59, 61 (4th
Cir. 1980), where the Court of Appeals for the Fourth Circuit
distinguished United States v. Gilmore, 372 U.S. 39 (1963),
reversed the lower court's holding that the legal expense in
dispute failed to meet the origin-of-the-claim test, and allowed
the taxpayer-corporation to deduct certain legal expense. In
Kopp's Co., the corporation incurred the legal expense in
defending itself and a shareholder's son in a tort suit stemming
from an accident involving a company car driven by the son. The
son had not been a corporate employee, nor had he been engaged in
performing corporate business. The court distinguished Gilmore
on the basis that the taxpayer-corporation had been named as a
party defendant and was alleged to have negligently permitted the
son to operate its car. We think that Kopp's Co. v. United
States is inapposite to the instant cases. Unlike the instant
cases, the taxpayer-corporation in Kopp's Co. apparently engaged
only in business activities. The activity giving rise to the
lawsuit, although arguably unrelated to the taxpayer’s business,
was an isolated incident. In contrast, NITCO engaged in
substantial nonbusiness activities before, during, and after the
years in issue. Indeed, the precise activities giving rise to
the proceedings in issue were NITCO’s nonbusiness activities.
For example, the FCC based its conclusion that NITCO and NICATV
were affiliated, inter alia, upon the following nonbusiness
activities: (1) NITCO’s construction and maintenance of signal
distribution facilities for NICATV, (2) Rhys’ responsibility,
while serving as NITCO’s executive vice president, for
negotiating pole attachment agreements with competing cable
companies, (3) the fact that all contractual agreements between
NITCO and NICATV were oral, and (4) Rhys’ oral “consulting
agreement”.
- 72 “Legal expenses do not become deductible merely
because they are paid for services which relieve a
taxpayer of liability. That argument would carry us
too far. It would mean that the expense of defending
almost any claim would be deductible by a taxpayer on
the ground that such defense was made to help him keep
clear of liens whatever income-producing property he
might have. For example, it suggests that the expense
of defending an action based upon personal injuries
caused by a taxpayer's negligence while driving an
automobile for pleasure should be deductible. * * *
* * * * * * *
“It is not a ground for * * * [deduction] that the
claim, if justified, will consume income-producing
property of the defendant.” * * * [United States v.
Gilmore, 372 U.S. at 46-47 (quoting Lykes v. United
States, 343 U.S. 118, 125-126 (1952)).]
Thus, the fact that NITCO may have been subject to being fined or
otherwise sanctioned by the FCC is not controlling under the
Gilmore origin-of-the-claim test, because those potential actions
by the FCC concern only the attendant consequences of the
litigation.
We have found that the activities that NITCO engaged in with
respect to NICATV were not undertaken by NITCO with a profit
motive.
Indeed, NITCO's 1989 annual report to the IURC reflects
that NITCO wrote off the approximately $122,000 "debt" that
NICATV "owed" to NITCO.
The purported debt was written off,
despite the fact that Mr. Mussman knew that Rhys had realized
sufficient cash from his sale of NICATV to discharge the "debt".
In addition, in its 1989 annual report to the IURC, NITCO stated
- 73 that the writeoff was not deductible for tax purposes.17
We
conclude that the activities that NITCO engaged in with respect
to NICATV were nonbusiness activities of NITCO.
See
International Trading Co. v. Commissioner, 275 F.2d at 584-585.
As the claim in the divestiture and enforcement actions arose in
connection with these nonbusiness activities that NITCO engaged
in with respect to NICATV, the legal expenses of the divestiture
and enforcement actions are not deductible by NITCO under section
162.
See United States v. Gilmore, supra; Accardo v.
Commissioner, supra; Dower v. United States, 668 F.2d 264, 266
(7th Cir. 1981); Anchor Coupling Co. v. United States, 427 F.2d
429, 431-433 (7th Cir. 1970).
Petitioners have further failed to
establish that the constitutional challenge action arose in
connection with or proximately resulted from a business activity
17
At trial, Mr. Mussman claimed that the writeoff occurred
due to an inadvertent error on the part of NITCO's accountant.
He related that the accountant, unlike Mr. Mussman, did not know
that Rhys had realized sufficient cash from the sale of NICATV to
discharge the "debt". We find Mr. Mussman's tale of mere
inadvertence to be incredible and not worthy of belief. We doubt
that the accountant would write off as uncollectible this large
$122,000 "receivable", without consulting Mr. Mussman and NITCO's
other top management. Moreover, even if the "receivable" were
inadvertently written off on NITCO's books, this still does not
adequately explain why NITCO never took action to collect the
"debt", as Mr. Mussman knew that Rhys possessed sufficient cash
to discharge the "debt". Additionally, we are not convinced that
Mr. Mussman was unaware of the accountant's "error". In signing
NITCO's 1989 annual report to the IURC, Mr. Mussman represented
that the information contained in the report, to the best of his
knowledge, was true and correct under penalty of perjury. We
think that Mr. Mussman all along never intended that NITCO
actually be paid by NICATV and Rhys for much of the work and
other assistance that NITCO provided to NICATV.
- 74 of NITCO.18
The legal expenses incurred in the constitutional
challenge action are thus not deductible by NITCO under section
162.
United States v. Gilmore, supra; Kornhauser v. United
States, supra.
Similarly, petitioners have failed to establish that the RSA
#1, Dial One Mobile, Dial One USA, Sprint contract, and Postal
Service investigation matters arose in connection with or
proximately resulted from a business activity of NITCO.
With
respect to the RSA #1 venture, Mr. Mussman's intention and plan
was to have the cellular license rights that were obtained
transferred to Serv-U-Cellular, a corporation that he and one or
more of his sons, individually, would own.
Much of this plan was
then implemented with Serv-U-Cellular, rather than NITCO,
becoming a partner in the RSA #1 limited partnership.
NITCO
reported on its return substantially all the $750,000 paid to
Serv-U-Cellular only after Mr. Mussman was forced to abandon the
plan as a result of the examinations that resulted in
respondent's issuances of the notices of deficiency in the
instant cases.
With respect to the Dial One Mobile matters, Dial
One Mobile was a company owned by Rhys that was conducting
activities with respect to cellular telephone systems in
18
From petitioners' briefs, we gather that they are not
contending that the claim in the constitutional challenge action
arose in connection with Rhys' alleged desire to purchase shares
of NITCO's stock from Mr. Mussman. As we understand their
contentions, the constitutional challenge action was brought by
Rhys and NITCO in order to challenge the constitutionality of the
FCC's cross-ownership rules, as the constitutional issues could
not be litigated in the divestiture action.
- 75 Asheville, North Carolina, and Enid, Oklahoma.
interest in Dial One Mobile.
NITCO had no
According to the application that
Dial One USA filed with the IURC to sell long-distance services,
NITCO had no interest in Dial One USA.
The Postal Service
investigation matter involved a seizure of NICATV's records from
NICATV's business offices.
Accordingly, the legal expenses that
NITCO incurred in the RSA #1, Dial One Mobile, Dial One USA,
Sprint contract, and Postal Service investigation matters are not
United States v. Gilmore, supra;
deductible under section 162.
Kornhauser v. United States, supra.
Finally, petitioners have failed to establish that the legal
expenses incurred in certain other unknown matters or proceedings
arose in connection with or were proximately related to a
business activity of NITCO.
Therefore, the legal expenses that
NITCO incurred in these unknown matters or proceedings are not
deductible under section 162.
United States v. Gilmore, supra;
Kornhauser v. United States, supra.
In conclusion, with respect to the legal expenses for which
NITCO claimed 1987, 1988, and 1989 business deductions, we hold
that only those legal expenses that respondent has conceded are
deductible by NITCO under section 162.
III.
Constructive Dividend Income
In the notice of deficiency issued to Mr. and Mrs. Mussman,
respondent determined that certain payments made by NITCO
represented constructive dividend income to Mr. Mussman for 1988
- 76 and 1989.
It is well established that a payment made to a
shareholder's family member can constitute a section 301
distribution by a corporation with respect to the stock of the
shareholder.
Green v. United States, 460 F.2d 412, 419 (5th Cir.
1972); Epstein v. Commissioner, 53 T.C. 459, 474-475 (1969).
Under proper circumstances, it is appropriate to hold that a
corporate payment made to or on behalf of a shareholder's family
member represents a distribution by the corporation to the
shareholder, because the shareholder enjoys the use of the
property as much as if the corporation had distributed the
property directly to the shareholder.
supra.
Epstein v. Commissioner,
In determining whether an expenditure by a corporation
represents income to the shareholder, it is necessary to decide
whether the expenditure primarily benefited the shareholder
personally rather than furthered the interest of the corporation.
Hagaman v. Commissioner, 958 F.2d 684, 690-691 (6th Cir. 1992),
affg. on this issue T.C. Memo. 1987-549; Ireland v. United
States, 621 F.2d 731, 735 (5th Cir. 1980).
Legal Expenses for which Respondent Disallowed Business
Deductions to NITCO
In the notice of deficiency issued to the Mussmans,
respondent determined that the legal expenses for which
respondent disallowed business deductions to NITCO for 1988 and
1989 represented constructive dividend income to Mr. Mussman.
Respondent further determined that these legal expenses were
- 77 unrelated to NITCO's business.
We previously have held that substantially all these legal
expenses were not deductible under section 162 by NITCO, because
petitioners failed to establish the expenses were deductible
under the Gilmore origin-of-the-claim test.
Most of these legal
expenses were incurred in the constitutional challenge,
divestiture, and enforcement actions discussed supra.
To the extent a substantive difference exists between the
Gilmore origin-of-the-claim test discussed at pages 67-68, supra,
and the analysis for whether a particular payment should be
treated as constructive dividend income, petitioners in the
instant cases have failed to meet their burden in proving that
NITCO's payment of the legal expenses:
(1) Did not primarily
benefit Mr. Mussman's son Rhys, (2) furthered the interest of
NITCO, and (3) was of direct and substantial economic benefit to
NITCO.
Compare Hagaman v. Commissioner, supra, and
Ireland v.
United States, supra, with Parker v. Commissioner, 365 F.2d 792,
801-802 (8th Cir 1966), affg. in part, revg. in part, and
remanding T.C. Memo. 1965-77.19
19
In Parker v. Commissioner, 365 F.2d 792, 801-802 (8th Cir.
1966), affg. in part, revg. in part, and remanding Foundation for
Divine Meditation, Inc. v. Commissioner, T.C. Memo. 1965-77, the
founder and head of a religious organization was prosecuted for
contributing to the delinquency of a minor. Following his
acquittal, he brought an action for slander. The religious
organization paid the expenses of both the criminal and civil
actions. This Court viewed the legal expenses as a personal
expense of the founder and held that their payment by
the organization represented taxable income to the founder. In
reversing, the Court of Appeals for the Eighth Circuit stated
(continued...)
- 78 With respect to the legal expenditures for the
constitutional challenge, divestiture, and enforcement actions,
petitioners contend the expenditures directly benefited NITCO,
because they prevented NITCO from being subjected to a fine and
protected its business reputation with the FCC.
We consider the hundreds of thousands of dollars in legal
expenditures that NITCO incurred in litigating the constitutional
challenge, divestiture, and enforcement actions, to have been of
dubious benefit to NITCO and its business, particularly since, as
indicated above, the activities that NITCO engaged in with
respect to NICATV were not undertaken by NITCO with a profit
motive.
We are thus not convinced that the litigation of the
constitutional challenge, divestiture, and enforcement actions
furthered NITCO's interest and was of direct and substantial
benefit to NITCO.
Rather, the litigation primarily benefited
Rhys, by giving Rhys' company NICATV the further time it needed
to build up its cable television system business.
Moreover, we perceive the protracted litigation to have been
actually more harmful to NITCO's good reputation with the FCC,
19
(...continued)
that because the reputation and business of the organization were
inextricably bound up with its founder, the payment of the
expenses was of direct and substantial benefit to the
organization. Although the Court of Appeals for the Eighth
Circuit further stated, in dicta, that the expenses would be
deductible by the organization as an ordinary and necessary
business expense, the issue of the expenses' deductibility had
not been raised. Thus, the Court of Appeals for the Eighth
Circuit did not have the deductibility issue before it and did
not address the Gilmore origin-of-the-claim test.
- 79 rather than helpful.
In view of NICATV's and NITCO's refusal to
comply with the FCC's orders in the divestiture action, the FCC
referred the matter to the Department of Justice for appropriate
enforcement proceedings.
Ultimately, in July 1989, Rhys sold
NICATV.
With respect to the legal expenses for which we sustained
respondent's disallowance of business deductions by NITCO for
1988 and 1989, we sustain respondent's determination that NITCO's
payment of those legal expenses represented constructive dividend
income to Mr. Mussman for 1988 and 1989.
Petitioners have failed
to establish that NITCO's payment of the expenses did not
primarily benefit the Mussman family, furthered NITCO's interest,
and was of direct and substantial benefit to NITCO.
Rule 142(a).
Amount NITCO Paid to Rhys on December 20, 1988
In the notice of deficiency issued to the Mussmans,
respondent determined that $22,646, which NITCO paid to Rhys on
December 20, 1988, was constructive dividend income to Mr.
Mussman.
On brief, petitioners have advanced only a vague
argument that Rhys served as a "consultant" to NITCO in 1985 and
in 1989.
Petitioners have failed to establish that the payment
furthered NITCO's interest and was of direct and substantial
benefit to NITCO.
They have not offered any details or specific
information concerning what, if any, actual "consulting work"
Rhys performed for NITCO.
Indeed, in NITCO and Rhys' March 24,
- 80 1988, complaint in the constitutional challenge action, they
alleged that Rhys received no compensation from NITCO and had no
formal responsibilities at NITCO.
We hold that the $22,646
payment was constructive dividend income to Mr. Mussman in 1988.
Rule 142(a).
"Open Account Loans"
NITCO on its books recorded certain payments that it had
made as "open loan account payments" to Mr. Mussman.
In the
notice of deficiency issued to the Mussmans, respondent
determined that $13,814 in "open account loans" that NITCO made
for 1988 and $16,792 in "open account loans" that NITCO made for
1989, represented constructive dividend income to Mr. Mussman.
Respondent has now conceded that certain of the 1988 and 1989
payments NITCO made were not constructive dividend income to Mr.
Mussman.
Petitioners, on the other hand, have conceded that
certain other of the 1988 and 1989 payments NITCO made were
constructive dividend income to Mr. Mussman.
Still at issue
between the parties is whether the remaining $7,058.11 of 1988
"open account loans" and the remaining $3,263.51 of 1989 "open
account loans" were constructive dividend income to Mr. Mussman.
Of the remaining $7,058.11 in disputed 1988 payments, the
parties agree that at least $6,119.95 of the payments was for
utility bills with respect to the 301 North Washington Street
property that NITCO was subleasing to NICATV, Rhys's cable
television company.
The parties cannot agree on the
- 81 identification of the balance of the disputed 1988 payments.
Similarly, of the remaining $3,263.51 of disputed 1989 payments,
the parties agree that the entire $3,263.51 was paid by NITCO for
utility bills with respect to the 301 North Washington Street
property that NITCO was subleasing to NICATV.
All the 1989
utility bill expenses covered the period from January 1 through
June 30, 1989, when NICATV occupied the 301 North Washington
Street building.
We have previously determined that NITCO's activities with
respect to NICATV were not undertaken by NITCO with a profit
motive.
Petitioners, however, contend that NITCO's payments of
the utility bills directly benefited NITCO, because NITCO also
stored certain telephone equipment in the 301 North Washington
Street building.
Mr. Mussman testified that NITCO paid these utility bills
because it had stored some of its telephone equipment in the 301
North Washington Street building that it was subleasing to
NICATV.
The revenue agent, however, testified that, during his
visit to the building during the fall of 1992, he found only a
few pieces of office furniture stored there.
On brief,
petitioners have tried to explain this conflict by claiming the
agent was only able to observe the space in the building to which
he was given access.
More importantly, however, petitioners have
failed to adequately explain why the utility bill payments were
recorded as "open account loans" to Mr. Mussman if the payments
were, in fact, business expenses of NITCO.
- 82 We conclude that petitioners have failed to establish that
these 1988 and 1989 utility bill payments with respect to the 301
Washington Street property furthered NITCO's interest and were of
direct and substantial benefit to NITCO.
benefited Rhys and NICATV.
The payments primarily
On the record presented, we also are
not able to determine the extent of the storage use NITCO made of
the building.
We decline to speculate and allocate a portion of
the utility bill payments to a business use of NITCO.20
Petitioners have further failed to establish that the remaining
balance of the disputed 1988 "open account loans" furthered
NITCO's interest and directly and substantially benefited NITCO.
We hold that Mr. Mussman had constructive dividend income of
$7,058.11 for 1988 and $3,263.51 for 1989, as a result of the
"open account loans".21
Country Club Initiation Fee
In early 1989, NITCO paid an $1,800 initiation fee on behalf
of Rhys to obtain a country club membership for Rhys.
Petitioners have acknowledged that Rhys was not a NITCO employee
until after July 1, 1989.
However, they argue that the club
20
The utility bill payments were for electricity, gas,
sewage, and water services provided to the 301 Washington Street
property. To the extent that NITCO made some incidental use of
the building for storage, it is difficult to quantify the actual
benefit that resulted to NITCO from the payments.
21
From petitioners' arguments in their posttrial briefs
concerning this issue, we gather that petitioners are not
contending that NITCO had made a bona fide loan to Mr. Mussman
with respect to these payments.
- 83 membership was purchased in anticipation of Rhys' returning to
NITCO's employ, because a waiting list existed at the country
club for memberships.
They assert that, following his resumption
of employment with NITCO, the membership would be used by Rhys in
connection with NITCO's business activities.
In view of the substantial expenditures NITCO made for
NICATV's and Rhys' benefit that we have held to be constructive
dividend income to Mr. Mussman, we are extremely skeptical of
petitioners' claims with respect to NITCO's payment of the club
initiation fee for Rhys.
Petitioners have failed to establish
that the expenditure was a business expenditure of NITCO, rather
than constructive dividend income to Mr. Mussman.
Consequently,
we sustain respondent's determination that the $1,800 expenditure
to obtain a country club membership for Rhys was constructive
dividend income to Mr. Mussman.
Rule 142(a).
Cellular Telephone and Other Investments
In the notice of deficiency issued to the Mussmans,
respondent determined that $88,484 of legal expenditures that
NITCO made with respect to certain "cellular telephone and other
investments" was constructive dividend income to Mr. Mussman in
1989.
NITCO claimed no deduction for these expenditures.
Petitioners contend that a substantial portion of the
$88,484 in total expenditures was actually paid by NITCO in 1988,
rather than in 1989, and that these 1988 payments were
erroneously determined by respondent to be constructive dividend
- 84 income to Mr. Mussman in 1989.
They point out that in the notice
of deficiency issued to the Mussmans, respondent failed to treat
any portion of the $88,484 in payments as dividend income to Mr.
Mussman in 1988.
They assert that the $75,432 of cellular
telephone investment account expenditures NITCO recorded includes
$33,445.68 in payments made by NITCO in 1988.
Similarly, they
assert that the $13,052 of other investment account expenditures
NITCO recorded includes $9,562.42 in payments NITCO made in 1988.
Respondent, on the other hand, disputes that any of the $88,484
in expenditures was made by NITCO during 1988.
The record does not support petitioners' claim that the
$88,484 in expenditures includes cellular telephone expenditures
that were made by NITCO during 1988, rather than during 1989.
In
the Schedule B-8 to the 1989 annual report it filed with the
IURC, NITCO reported that it had $75,342 of "deferred cellular
charges" and $13,052 of deferred "other" charges.
Yet, in the
Schedule B-8 to the 1988 annual report it filed with the IURC,
NITCO reported that it had $390,000 of "extraordinary
retirements" and $39,599 of deferred "other" charges.
The
Schedule B-8 to the 1988 report reflected no "deferred cellular
charges" for 1988.
We conclude that petitioners have failed to
establish that the $88,484 in expenditures includes payments that
were made by NITCO in 1988.
At pages 39-40, supra, of our findings, we have attempted to
allocate and attribute the $88,484 of expenditures to specific
matters as best as we can on the record presented.
We
- 85 essentially have attributed the $88,484 only to those specific
matters the parties agree upon.
With respect to the $1,166.59 NITCO expended to Andrew &
Kurth for Dial One Mobile, petitioners have conceded that the
payment was constructive dividend income to Mr. Mussman in 1989,
and we so hold.
NITCO also expended $32,363.64 to B&H for Dial
One Mobile work.
Dial One Mobile was a company Rhys owned, which
was conducting activities with respect to cellular telephone
systems in Asheville, North Carolina, and Enid, Oklahoma.
had no interest in Dial One Mobile.
NITCO
Petitioners have failed to
show that the payment was of direct and substantial benefit to
NITCO.
We hold that the $32,363.64 in payments made to B&H was
constructive dividend income to Mr. Mussman for 1989.
With respect to the $3,327.50 NITCO expended to EMCI for
cellular telephone publications, it is not clear whether the
cellular telephone publications were purchased and used to
benefit NITCO, as opposed to individual members of the Mussman
family.
Petitioners have failed to establish that the
expenditure furthered NITCO's interest and was of direct and
substantial benefit to NITCO.
We hold that the $3,327.50 payment
was constructive dividend income to Mr. Mussman in 1989.
Rule
142(a).
With respect to the expenditures NITCO made to Handlon &
Handlon for various matters, petitioners concede that a $264
payment was for work performed for Kyle's corporation, FiberComm,
and that such payment was constructive dividend income to Mr.
- 86 Mussman for 1989.
As to the remaining balance of the
expenditures NITCO made to Handlon & Handlon, petitioners have
failed to establish that these payments furthered NITCO's
interest and were of direct and substantial benefit to NITCO.
NITCO paid Handlon & Handlon $1,525.81 for work with respect
to Dial One USA and Intelcom, which were corporations that Mr.
Mussman owned.
According to the 1988 application that Dial One
USA filed with the IURC in seeking authorization to sell longdistance services, NITCO had no affiliation with Dial One USA and
Intelcom.
Although Mr. Mussman, at trial, claimed that he later
planned to have Intelcom become the parent holding company of
Dial One USA and NITCO, we do not find his self-serving testimony
credible, as this testimony is inconsistent with the statements
made on Dial One USA's application to the IURC.
NITCO also paid Handlon & Handlon $234 for the incorporation
of Northwestern Indiana Cellular, a corporation formed to hold
various cellular telephone interests.
On the record presented,
it is not clear whether Mr. Mussman intended that Northwestern
Indiana Cellular be owned by NITCO or by individual members of
the Mussman family.
It is also not clear whether the cellular
telephone interests Mr. Mussman planned to have held by
Northwestern Indiana Cellular would be cellular telephone
interests that NITCO or individual members of the Mussman family
owned.
We hold that the entire $2,120.81 in the above payments that
NITCO made to Handlon & Handlon, including the $229 expended for
- 87 an unknown matter, was constructive dividend income to Mr.
Mussman for 1989.
With respect to the expenditures NITCO made to LMN&G,
petitioners concede that $4,400 was constructive dividend income
to Mr. Mussman in 1989.
As to the work LMN&G performed in
connection with the Indiana RSA #1 venture and for Rhys,
petitioners have failed to establish that NITCO's payment for the
work furthered NITCO's interest and was of direct and substantial
benefit to NITCO.
As we have found, Mr. Mussman intended and
planned to have the cellular telephone rights held by Serv-UCellular, a corporation that he and one or more of his sons,
individually, would own.
Rhys was not an employee of NITCO until
after July 1, 1989, and the work LMN&G performed for Rhys was
billed before that date.
Consequently, we hold that all the
expenditures that NITCO made to LMN&G were constructive dividend
income to Mr. Mussman for 1989.
Rule 142(a).
With respect to the balance of NITCO's expenditures that has
not been attributed to specific matters, petitioners have failed
to establish that these payments furthered NITCO's interest and
were of direct and substantial benefit to NITCO.
Consequently,
we hold that these payments were constructive dividend income to
Mr. Mussman for 1989.22
22
Rule 142(a).
These constructive dividends to Mr. Mussman, of course,
will increase NITCO’s dividend paid deduction in computing
NITCO’s accumulated earnings tax liability. See sec. 535(a).
- 88 IV. Additions to Tax
Sections 6653(a) and 6662 Additions For Negligence Or Intentional
Disregard of Rules and Regulations
In the notice of deficiency issued to NITCO, respondent
determined that NITCO was liable for additions to tax for
negligence or intentional disregard of rules or regulations (1)
under section 6653(a), equal to 5 percent of the respective
underpayments for 1987 and 1988, and (2) under section 6662,
equal to 20 percent of a portion of the underpayment for 1989.
Respondent determined that the 20-percent addition under section
6662 should apply with respect to a $117,547 portion of the
underpayment for 1989.
Respondent further determined that NITCO
was liable for an addition to tax under section 6653(a)(1)(B) for
1987.
Under section 6653(a)(1)(B), an addition to tax (equal to
50 percent of the interest payable under section 6601) is imposed
with respect to the portion of the underpayment attributable to
negligence.
Respondent determined that the portion of the 1987
underpayment resulting from NITCO's improper deduction of
$467,673 in legal expenses was attributable to negligence on
NITCO's part.
In the notice of deficiency issued to the Mussmans,
respondent determined the Mussmans were liable for additions to
tax for negligence or intentional disregard of rules or
regulations (1) under section 6653(a), equal to 5 percent of the
underpayment for 1988, and (2) under section 6662, equal to 20
- 89 percent of the underpayment for 1989.
Respondent determined that
the 20-percent addition under section 6662 should apply with
respect to the entire underpayment for 1989.
Negligence has been defined as the failure to exercise the
due care that a reasonable and ordinarily prudent person would do
under the circumstances.
(1985).
Neely v. Commissioner, 85 T.C. 934, 947
Petitioners bear the burden of showing that they are not
negligent.
Rule 142(a); Bixby v. Commissioner, 58 T.C. 757, 791-
792 (1972).
Petitioners argue that NITCO and the Mussmans are not liable
for additions to tax for negligence.
Their contentions are as
follows:
Respondent has not rebutted any of the facts
supporting the reasonableness of NITCO's accumulations.
Imposition of the * * * [accumulated earnings tax] and
any additional penalty is therefore unwarranted.
Similarly, imposing penalties for deducting the
allegedly nondeductible attorneys' fees and other costs
attributable to billing errors by outside attorneys or
oversight by the independent accountant would also be
improper. None of any underpayment ultimately
determined is attributable to negligence or intentional
disregard. * * *
We have previously held that NITCO is liable for accumulated
earnings tax for 1987, 1988, and 1989, because NITCO accumulated
its earnings beyond the reasonable needs of the business and was
availed of for the purpose of avoiding income tax with respect to
its shareholders.
We further held that, for 1987, 1988, and
1989, substantial business deductions for legal expenses that
NITCO claimed were not allowable to NITCO under section 162,
- 90 because the expenditures failed to meet the Gilmore origin-ofthe-claim test.
We also held that Mr. Mussman had large amounts
of constructive dividend income for 1988 and 1989, including the
1988 and 1989 legal expenses NITCO had paid in litigating the
constitutional challenge, divestiture, and enforcement actions.
Petitioners have failed to establish:
(1) NITCO acted
reasonably in claiming deductions for these legal expenses; and
(2) the Mussmans acted reasonably in not reporting NITCO's
payments of the 1988 and 1989 legal expenses as constructive
dividend income to Mr. Mussman.
Petitioners imply that the
attorneys’ fees in the constitutional challenge, divestiture, and
enforcement actions were deducted because the outside law firms
had billed their work to NITCO, rather than to Rhys and NICATV.
We are not convinced that NITCO acted reasonably in deducting the
fees it paid merely because the work had been billed to NITCO.
Indeed, in one instance NITCO still claimed a 1989 deduction with
respect to its payment of $2,239.85 to W&C for certain Dial One
Mobile work, even though W&C billed the legal work to Rhys and
not to NITCO.
Petitioners have now conceded that the $2,239.85
payment is not deductible by NITCO and was constructive dividend
income to Mr. Mussman.
With respect to the purported advice petitioners received
from the accountant, we are not satisfied that the accountant was
apprised of all the relevant facts, including the fact that the
activities NITCO engaged in with respect to NICATV were not
undertaken by NITCO with a profit motive.
See Collins v.
- 91 Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister
v. Commissioner, T.C. Memo. 1987-217.
The record fails to
disclose what specifically the accountant was told or was not
told by NITCO and Mr. Mussman.
Although reliance on the advice of qualified professional
advisers may defeat a finding of negligence under certain
circumstances, petitioners have not established that the reliance
in the instant cases was reasonable.
Freytag v. Commissioner, 89
T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd.
501 U.S. 868 (1991).
Petitioners generally have failed to carry their burden in
establishing that all or parts of their respective underpayments
were not attributable to negligence.
Rule 142(a).
We hold that NITCO is liable for additions to tax for
negligence (1) under section 6653(a)(1)(A) and (B), for 1987 and
1988, and (2) under section 6662 for 1989.
The section 6662
addition applies with respect to that part of the $117,547
portion of the underpayment for 1989 that respondent determined
to be attributable to negligence or intentional disregard of
rules or regulations, which we have sustained.
We further hold
that NITCO will be liable for an addition to tax under section
6653(a)(1)(B) for 1987 with respect to the portion of the
underpayment for 1987 attributable to NITCO's improper deduction
of certain legal expenses.
Similarly, we hold that the Mussmans are liable for
additions to tax for negligence (1) under section 6653(a) for
- 92 1988 and (2) under section 6662 for 1989.
The section 6662
addition applies with respect to the entire underpayment for
1989.
Section 6661 Additions for Substantial Understatement
In the notice of deficiency issued to NITCO, respondent
determined that NITCO was liable for additions to tax for
substantial understatement of income tax liability under section
6661 for 1987 and 1988.
In the notice of deficiency issued to
the Mussmans, respondent determined the Mussmans were liable for
an addition to tax for substantial understatement under section
6661 for 1988.
Section 6661 provides for an addition to tax for substantial
understatement of income tax equal to 25 percent of the amount of
the underpayment attributable to such understatement for the
taxable year.
To be considered substantial, the understatement
must exceed the greater of $5,000 ($10,000 in the case of a
corporation like NITCO) or 10 percent of the tax required to be
shown on the return.
Sec. 6661(b)(1).
The amount of the
understatement is reduced by the portion of the understatement
attributable to any nontax shelter item for which there is either
substantial authority for the taxpayer's return position or
adequate disclosure on the return.
Sec. 6661(b)(2)(B).
NITCO understated its tax for 1987 and 1988; the Mussmans
understated their tax for 1988.
were substantial.
These respective understatements
Petitioners have not asserted that the
- 93 understatements should be reduced under section 6661(b)(2)(B) or
that respondent should have waived all or any part of the
additions to tax under section 6661(c).23
We hold that NITCO is
liable for additions to tax under section 6661 for 1987 and 1988
and that the Mussmans are liable for an addition to tax under
section 6661 for 1988.
Decisions will be entered
under Rule 155.
23
On brief, petitioners make the vague argument that they
should not be held liable for the sec. 6661 additions to tax,
because "the substantial understatement penalty is computational,
and thus may not apply; if it does, the penalty is inappropriate
because reasonable cause can be found for the understatement."
However, "reasonable cause", standing alone, is not a sufficient
basis for avoiding liability with respect to the sec. 6661
addition. See H. Conf. Rept. 97-760 at 575 (1982), 1982-2 C.B.
600, 650. At any rate, petitioners have failed to establish:
(1) There was substantial authority for their return positions or
reasonable disclosure on their returns; or (2) respondent should
have waived all or part of the additions. Rule 142(a).
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