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JRN
T.C. Memo. 2017-213
UNITED STATES TAX COURT
DANA D. MESSINA AND NANCY G. MESSINA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
KYLE R. KIRKLAND AND STEPHANIE LAYNE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 25510-15, 25567-15.
Filed October 30, 2017.
As of the 2012 tax year, M and K together owned 80% of S1, an S
corporation, which owned Q, a qualified subchapter S subsidiary. Q
was the borrower under a loan from an unrelated entity. M and K
formed S2, a wholly owned S corporation, to acquire the loan. M and
K contend that S2 should be disregarded for I.R.C. sec. 1366(d)(1)(B)
purposes and the loan deemed indebtedness of S1 to them, allowing
them to increase their bases in Sl's indebtedness and take into
account its pass-through losses. R maintains that S2's separate
corporate existence should be respected and the loan not be treated as
indebtedness of S1 to M and K.
IJeM: S2 is not the incorporated pocketbook of M and K.
IJeM, further, S2 is neither an agent of M and K nor a conduit.
SERVED Oct 30 2017
-2[*2]
Hel_d, further, M and K had made an actual economic outlay to S2,
which in turn made an actual economic outlay to S1 and Q.
H_eld, further, the step transaction doctrine does not apply.
H_eld, further, M and K are bound by the form of their transaction.
Newhall Unitrust v. Commissioner, 104 T.C. 236 (1995), aff'd, 105
F.3d 482 (9th Cir. 1997), followed.
Craig Alan Houghton, for petitioners.
Adam B. Landy, Audra M. Dineen, and Thomas R. Mackinson, for
respondent.
MEMORANDUM OPINION
LARO, Judge: These cases arise out of respondent's adjustments to
petitioners' returns for the 2012 tax year. The cases were consolidated for trial,
briefing, and opinion and were submitted fully stipulated under Rule 122.¹
Respondent determined a $161,316 deficiency in Dana D. and Nancy G.
Messina's Federal income tax for the 2012 tax year. He also determined a
¹Unless otherwise indicated, section references are to the Internal Revenue
Code (Code) applicable for the relevant year. Rule references are to the Tax Court
Rules of Practice and Procedure.
-3[*3] $182,096 deficiency in Kyle R. Kirkland and Stephanie Layne's Federal
income tax for the same year.
The sole issue before this Court is whether respondent properly disallowed
the deduction by petitioners of certain pass-through losses from Club One
Acquisition Corp. (Club One), an S corporation 80% of which was owned by
Messrs. Messina and Kirkland, by reducing their respective adjusted bases in
indebtedness of the corporation to them. We hold that respondent's disallowance
of petitioners' deduction of the pass-through losses is proper. By the parties'
agreement, respondent's correlative adjustments are also upheld.
Background
I.
Overview
The parties submitted these cases fully stipulated under Rule 122. The first
stipulation of facts (and the facts drawn from stipulated exhibits) and the
stipulation of settled issues are incorporated herein. Petitioners are residents of
California. These cases are appealable to the Court of Appeals for the Ninth
Circuit absent stipulation of the parties to the contrary.
II.
Club One's 2012 Tax Year
During the 2012 tax year Club One had an ordinary business loss of
$1,425,709. Of this amount, $570,284 was passed through to each of Messrs.
-4[*4] Messina and Kirkland. Club One also had interest income of $1,135, of
which $454 was passed through to each of Messrs. Messina and Kirkland. Club
One reported $38,984 of deductible charitable contributions for the 2012 tax year,
$15,594 of which was passed through to Mr. Messina and $15,593 of which was
passed through to Mr. Kirkland.
III.
Petitioners
Messrs. Messina and Kirkland first met as colleagues at Dabney Resnick &
Wagner in 1993. Their first joint venture was the acquisition of the Selmer Co.
They organized Kirkland Messina, Inc., a California corporation, on February 28,
1994, as an investment advisory firm that assisted clients with arranging leveraged
buyouts and corporate financing. Before their venture with Club One out of which
these cases arise, Messrs. Messina and Kirkland provided investment advisory
services to the Bicycle Casino in Bell Gardens, California. Mr. Kirkland also
provided investment advisory services to the Commerce Casino in Commerce,
California, and the Vineyard Casino in Fowler, California.
A.
Dana and Nancy Messina
Mr. Messina is a 1983 graduate of Tufts University with a degree in
mechanical engineering and a 1987 graduate of Harvard Business School. Before
attending Harvard Business School, Mr. Messina was employed as a nuclear
-5[*5] engineer for Combustion Engineering. He formerly held Series 7, Series 63,
Series 24, and Series 27 securities licenses and was licensed in multiple State
jurisdictions to initiate and handle securities transactions. He is also an owner of
GLCR, Inc., d.b.a. Deuce Lounge and Casino, in Visalia, California.
Mr. and Mrs. Messina timely filed a joint Federal income tax return for the
2012 tax year. In preparing their return they used their adjusted basis in Club One
stock and a $7,000,670 adjusted basis in Club One's indebtedness to them to claim
deductions for the amounts of the losses, charitable contributions, and other items
passed through to them from Club One for that tax year. Mr. and Mrs. Messina
reported itemized deductions totaling $640,687 on Schedule A, Itemized
Deductions, of their return. They also reported a foreign tax credit totaling $4,655
on Form 1116, Foreign Tax Credit, and a prior-year minimum tax credit totaling
$29,431 on Form 8801, Credit for Prior Year Minimum Tax--Individuals, Estates,
and Trusts, to their return. Respondent audited the return and issued a 30-day
letter dated July 7, 2014, proposing certain adjustments thereto. Mr. and Mrs.
Messina timely challenged the proposed adjustments with the Internal Revenue
Service (IRS) Office of Appeals. The parties could not resolve the matter
administratively, and respondent on July 8, 2015, issued a notice of deficiency.
-6[*6] In the notice of deficiency respondent reduced by $560,794 the amount of
losses Mr. and Mrs. Messina could take into account for the 2012 tax year, thus
increasing their taxable income by that amount. Respondent further determined
that Mr. and Mrs. Messina's itemized deductions should be reduced by $26,551,
$15,335 of which was attributable to a reduced charitable contribution deduction
and $11,216 to reduced excess miscellaneous deductions. Respondent also
determined that Mr. and Mrs. Messina no longer owe alternative minimum tax and
are entitled to a $20,416 minimum tax credit. Accordingly, respondent determined
a $161,316 deficiency in Mr. and Mrs. Messina's 2012 Federal income tax. The
parties have stipulated that all but the first of the adjustments are correlative or
computational and should be resolved by this Court's decision with respect to the
first adjustment, which is the sole one at issue here.
Mr. and Mrs. Messina timely petitioned this Court for redetermination of
the deficiency.
B.
Kyle Kirkland and Stephanie Layne
Mr. Kirkland graduated from Harvard College in 1984 and the Stanford
Graduate School of Business in 1988. He formerly held Series 7, Series 63, Series
24, and Series 27 securities licenses and was licensed in multiple State
jurisdictions to initiate and handle securities transactions. Mr. Kirkland is a board
-7[*7] member and president of the Califomia Gaming Association, a trade
organization representing licensed card rooms in the State of California. He is
also an owner of GLCR, Inc., d.b.a. Deuce Lounge and Casino, in Visalia,
California.
Mr. Kirkland and Ms. Layne timely filed a joint Federal income tax return
for the 2012 tax year. In preparing their return, they used their adjusted basis in
Club One stock and a $7,000,670 adjusted basis in Club One's indebtedness to
them to claim deductions for the amounts of the losses, charitable contributions,
and other items passed through to them from Club One for that tax year. Mr.
Kirkland and Ms. Layne reported itemized deductions totaling $147,868 on
Schedule A of their return. They also reported a foreign tax credit totaling $146
on Form 1116 attached to their return. Respondent audited the return and issued a
30-day letter dated September 25, 2014, proposing certain adjustments thereto.
Mr. Kirkland and Ms. Layne timely challenged the proposed adjustments with the
IRS Office of Appeals. The parties could not resolve the matter administratively,
and respondent on July 8, 2015, issued a notice of deficiency.
In the notice of deficiency respondent reduced by $560,794 the amount of
losses Mr. Kirkland and Ms. Layne could take into account for the 2012 tax year,
thus increasing their taxable income by that amount. Respondent further
-8[*8] determined that Mr. Kirkland's and Ms. Layne's itemized deductions should
be reduced by $15,682, of which $31 was attributable to a denied deduction for
net medical and dental expenses, $15,335 to a reduced charitable contribution
deduction, and $316 to denied excess miscellaneous deductions. Respondent also
adjusted Mr. Kirkland's and Ms. Layne's alternative minimum tax and determined
that their foreign tax credit should be increased from $146 to $524. Accordingly,
respondent determined a $182,096 deficiency in Mr. Kirkland's and Ms. Layne's
2012 Federal income tax. The parties have stipulated that all but the first of the
adjustments are correlative or computational and should be resolved by this
Court's decision with respect to the first adjustment, which is the sole one at issue
here.
Mr. Kirkland and Ms. Layne timely petitioned this Court for
redetermination of the deficiency.
IV.
Acquisition of Club One Casino, Inc. (Casino)
A.
Casino
Casino is a California corporation which since 1995 and throughout 2012
has operated a card room in Fresno, California, licensed by the State of California.
Before February 22, 2008, Casino was owned by George Sarantos and Elaine R.
Long and taxed as an S corporation for Federal and State income tax purposes.
-9[*9] B.
Club One
Club One is a California corporation organized on February 6, 2007. Since
its incorporation, it has elected to be taxed as an S corporation for Federal and
State income tax purposes. During February 2008 the following individuals
acquired the listed numbers of shares of the issued and outstanding common stock
of Club One, which they continued to hold during the 2012 tax year:
Name
Number of shares
Ownership (percent)
Dana D. Messina
Kyle R. Kirkland
40,000
40,000
40
40
George Sarantos
Haig Kelegian
17,000
3,000
17
3
C.
Club One's Acquisition of Casino
On February 22, 2008, Club One acquired from Mr. Sarantos and Ms. Long
100% of the issued and outstanding stock of Casino. This was accomplished by
the merger of Club One Merger Sub, Inc. (Merger Sub), a California corporation
and wholly owned subsidiary of Club One, into Casino pursuant to a February 24,
2007, stock purchase agreement between Club One as buyer and Mr. Sarantos and
Ms. Long as sellers. The agreement provided for aggregate consideration of $27
million, subject to certain purchase price adjustments. Part of the consideration
was to be paid in the form of two $2.5 million promissory notes issued by Merger
- 10 [*10] Sub, one to Mr. Sarantos and one to Ms. Long, each note bearing interest at
the rate of 10% per annum and due seven years from the sale's closing date.
Upon Merger Sub's merger into Casino, Club One became the owner of
100% of Casino's issued and outstanding stock, and Casino became the obligor
under both promissory notes. Immediately after the merger, having become a
subsidiary of Club One, Casino made an election to be treated for Federal and
State income tax purposes as the latter's qualified subchapter S subsidiary (QSub).
D.
Financing the Acquisition
Club One's acquisition of Casino was funded in part by a loan of
$21,856,435.37 from D.B. Zwirn Special Opportunities Fund, L.P. (D.B. Zwirn).
The loan was evidenced by a financing agreement dated February 22, 2008, by and
among Club One, Merger Sub, Casino, and D.B. Zwirn, the latter as agent for the
lenders (at the time of the agreement's execution, D.B. Zwirn was also the sole
lender). Under the agreement, the borrower was Merger Sub until its merger into
Casino, whereupon Casino became the borrower.
The financing agreement required that accrued interest be paid monthly in
arrears on the first day of each month and the principal be repaid in quarterly
installments until February 22, 2012, when all amounts payable under the
agreement were to become due immediately. As evidenced by a security
- 11 [*11] agreement and guaranty, each dated February 22, 2008, repayment of the
D.B. Zwirn loan was secured by Casino's assets, a pledge of 100% of the stock of
Casino, and the limited personal guaranties of Messrs. Messina and Kirkland.
Under the financing agreement, Mr. Sarantos and Ms. Long were required
to execute a subordination agreement dated February 22, 2008, under which they
subordinated their respective promissory notes to the D.B. Zwirn loan.
E.
State Approval of the Acquisition
California law requires the owner of a gambling enterprise to be licensed by
the State. Cal. Bus. & Prof. Code secs. 19850 and 19851(a) (West 2016). An
owner that is a corporation cannot be licensed unless "each officer, director, and
shareholder, other than a holding or intermediary company, of the owner",
individually applies for and obtains a State gambling license. E sec. 19852(a).
The license should be obtained before engaging in a licensed gambling activity or
occupying a position requiring licensure. R sec. 19855.
Messrs. Messina and Kirkland believed that Club One's acquisition of
Casino required the approval of the California Gambling Control Commission
(CGCC), an agency of the State of California with jurisdiction over the operation,
concentration, and supervision of gambling establishments and over all persons
having to do with the operations of gambling establishments within the State.
- 12 [*12] See 4 sec. 19811. The CGCC on May 31, 2007, approved Club One's
acquisition of Casino and on January 31, 2008, approved the issuance of gambling
licenses to each of Messrs. Messina, Kirkland, Sarantos, and Kelegian.
Furthermore, Messrs. Messina and Kirkland believed that D.B. Zwirn's loan
to Casino and Merger Sub's pledge of Casino stock to D.B. Zwirn as collateral
thereto also required the CGCC's approval. It is unlawful in California to enter
into an agreement with a licensee in connection with a licensed gambling
operation except as allowed by CGCC regulations. E sec. 19901. Another
statute provides that a purported sale, assignment, transfer, pledge, or other
disposition of any security issued by a corporation holding a gambling license is
void unless approved in advance by the CGCC. R sec. 19904. On July 26, 2007,
and February 21, 2008, the CGCC approved D.B. Zwirn's loan to Merger Sub and
Casino.
V.
Postacquisition Events
A.
The D.B. Zwirn Loan
On or about June 1, 2009, Fortress Investment Group, LLC (Fortress)
replaced D.B. Zwirn & Co., L.P., as the manager of various funds and accounts,
including among others D.B. Zwirn. In connection with this, D.B. Zwirn was
converted into Fortress Value Recovery Funds I LLC (Fortress Fund).
- 13 [*13] During 2009 and 2010 Casino paid additional amounts to D.B. Zwirn and
the Fortress Fund to remain in compliance with certain loan covenants set forth in
the financing agreement. Casino hoped to reduce the principal balance of the loan
to improve its ability to refinance it with a new loan at a lower rate of interest or a
longer maturity.
B.
Refinancing the Loan
Beginning in 2010, at least 18 months before the D.B. Zwirn loan's
February 22, 2012, maturity date, Messrs. Messina and Kirkland attempted to find
investors or lenders who would either refinance or acquire the D.B. Zwirn loan
from Fortress Fund before the loan matured. In early 2010 Mr. Messina contacted
Global Hunter Securities, LLC (Global Hunter), to assist Casino and Messrs.
Messina and Kirkland in finding such investors or lenders.
On January 28, 2010, Mr. Messina informed Fortress representative Clint
Lofman by electronic mail, with copies to Fortress representative Bradley Brown
and to Mr. Kirkland, that it appeared, on the basis of Casino's preliminary
financial statements, that Casino would violate the earnings before interest, taxes,
depreciation, and amortization (EBITDA) covenant in the financing agreement.
On November 18, 2010, Mr. Lofman stated to Mr. Messina by electronic mail that
he remained concerned about the EBITDA covenant violation.
- 14 [*14] On January 4, 2011, Messrs. Messina and Kirkland organized KMGI, Inc.
(KMGI), a California corporation, to raise additional capital to either refinance or
acquire the D.B. Zwirn loan from the Fortress Fund. Since its incorporation,
KMGI has elected to be taxed as an S corporation for Federal and State income tax
purposes. The entity was organized with the assistance of Robert S. Tabor,
formerly of the Law Offices of Robert S. Tabor. Mr. Tabor in 2008 had served as
California gaming law counsel to Club One and reviewed the financing agreement
to ensure its compliance with State gaming laws. During 2011 and 2012 he served
as KMGI's consultant on California gaming issues.
Because California law gives the CGCC power to approve or disapprove
transactions involving gaming enterprises, see Cal. Bus. & Prof. Code sec.
19824(c) (West 2016), Messrs. Messina and Kirkland believed that KMGI could
not acquire the D.B. Zwirn loan from the Fortress Fund or lend money to Casino
without the CGCC's prior approval. In February 2011 Messrs. Messina and
Kirkland, through Mr. Tabor, began discussions with the CGCC to obtain
approval to use KMGI to refinance a portion of the D.B. Zwirn loan. And during
August of2011 KMGI, with Mr. Tabor as consultant, began the formal process of
applying to the CGCC for approval to purchase some portion of the loan from the
Fortress Fund. On September 2, 2011, Mr. Kirkland transferred $10,000 to KMGI
- 15 [*15] in exchange for 50% of its common stock. On September 22, 2011, the
CGCC authorized KMGI to purchase $200,000 of the D.B. Zwirn loan from the
Fortress Fund. On September 28, 2011, Mr. Kirkland lent $100,000 to KMGI. On
that same day Mr. Messina transferred $110,000 to KMGI, $10,000 of which was
used to acquire 50% of its common stock and $100,000 of which was a loan.
KMGI recorded the transferred funds in its books and records as $20,000 of
"capital stock" and $200,000 as "shareholder loans". The Fortress Fund, however,
refused to sell the loan piecemeal, insisting that any sale must be of the entire loan.
At the same time, despite their efforts, neither Global Hunter nor Messrs. Messina
and Kirkland had been successful in finding an acceptable investor or lender who
would refinance or acquire the loan.2
Before July 2011 neither Mr. Messina nor Mr. Kirkland had the personal
liquidity to refinance or acquire the D.B. Zwirn loan from the Fortress Fund.
During July 2011, however, Messrs. Messina and Kirkland each closed the sale of
all the stock they held in Steinway Musical Instruments, Inc., pursuant to a stock
transfer agreement they had entered into on April 29, 2011. This sale provided
them with sufficient funds to acquire the loan from the Fortress Fund. Thus, their
2Although Diamond Creek Capital, LLC, expressed interest in acquiring the
D.B. Zwirn loan from the Fortress Fund, the parties were unable to consummate
the transaction due to disagreement about certain representations and warranties.
- 16 [*16] other efforts futile, Messrs. Messina and Kirkland each agreed to acquire
50% of KMGI's stock and lend it sufficient funds to purchase the D.B. Zwirn loan
from the Fortress Fund. On October 14, 2011, Mr. Kirkland met with Kareem
Benjamin and Jeff Slahor from the Fortress Fund at Fortress' office in Irving,
Texas, to discuss the D.B. Zwirn loan's acquisition.
Messrs. Messina and Kirkland believed that if they lent funds directly to
Casino to acquire the loan from the Fortress Fund, the loan would not be senior in
priority to the promissory notes held by Mr. Sarantos and Ms. Long without their
consent. Similarly, if they contributed funds to Club One intending that the funds
be lent to Casino to repay the D.B. Zwirn loan in full, they would require Mr.
Sarantos' and Mr. Kelegian's consent thereto. However, Messrs. Messina and
Kirkland believed that if they lent money to KMGI to purchase and hold the D.B.
Zwirn loan, repayment of the funds lent to KMGI would be senior to Mr. Sarantos'
and Ms. Long's promissory notes, which remained subordinated to the note
backing the D.B. Zwirn loan. Messrs. Messina and Kirkland understood that any
of these three options would require the CGCC's prior approval. Before and
during the 2012 tax year, neither of them had applied for or obtained authorization
from the CGCC to lend money to Casino or acquire any of its indebtedness and
- 17 [*17] thus believed that they could not purchase the D.B. Zwirn loan from the
Fortress Fund in their individual capacities.
Between September 2011 and April 2012 Messrs. Messina and Kirkland
negotiated the purchase of the D.B. Zwirn loan from the Fortress Fund. Because
KMGI was authorized by the CGCC to acquire $200,000 of the loan, to avoid
delays Messrs. Messina and Kirkland caused KMGI to agree to purchase the entire
loan from the Fortress Fund, subject to the CGCC's approval. On February 3,
2012, KMGI applied to the CGCC for approval to increase the amount of the loan
it could purchase from $200,000 to the estimated entire unpaid principal amount
that would be due under the loan as of the purchase date.
While the loan purchase negotiations were underway, the Fortress Fund on
January 10, 2012, notified Casino that events of default under the financing
agreement had occurred as a result of (1) the January 4, 2012, filing of a writ of
execution by Mr. Sarantos and Ms. Long against Club One and the D.B. Zwirn
collateral and (2) a November 14, 2011, notice of amended judgment filed by Mr.
Sarantos and Ms. Long.3 By letter dated January 10, 2012, the Fortress Fund
notified (1) Casino and Club One to cease all payments to Mr. Sarantos and Ms.
3See infra for the background of Club One's dispute with Mr. Sarantos and
Ms. Long out of which the amended judgment and writ of execution arose.
- 18 [*18] Long and (2) Mr. Sarantos and Ms. Long as subordinated creditors to
immediately cease all attempts to (a) obtain funds or other assets from Casino or
Club One or (b) enforce the writ of execution or amended judgment against Casino
or Club One. The Fortress Fund demanded that this cessation continue until the
D.B. Zwirn loan had been paid in full. By notice dated January 19, 2012, the
Fortress Fund notified Casino that it was exercising its right to convert and
increase the interest rate on the loan effective January 4, 2012. On February 7,
2012, the Fortress Fund notified Casino that certain payments to Club One were
restricted and could no longer be made.
On February 22, 2012, the D.B. Zwirn loan's maturity date, all amounts
payable under the financing agreement became immediately due and payable by
Casino to the Fortress Fund. On February 23, 2012, the Fortress Fund notified
Casino of an event of default, in that the loan's maturity date had passed, and
demanded immediate payment of all amounts due. Also on February 23, 2012, the
Fortress Fund advised Casino that its February 1, 2012, interest payment was
deficient in the amount of $57,361.11 and demanded immediate payment thereof.
On March 8, 2012, the CGCC authorized KMGI to purchase the entire D.B.
Zwirn loan from the Fortress Fund. On April 9, 2012, Mr. Kirkland transferred
$7,150,000 and Mr. Messina transferred $7,300,000 to KMGI to provide it with a
- 19 [*19] portion of the funds necessary to purchase the loan. On April 10, 2012, Mr.
Kirkland transferred an additional $227,980.55 to KMGI. KMGI recorded these
transferred funds in its books and records as "shareholder loans" as of the dates
Messrs. Messina and Kirkland completed the transfers.
As of April 11, 2012, Casino owed the Fortress Fund $14,475,105.84 under
the D.B. Zwirn loan. On April 11, 2012, KMGI paid that amount to the Fortress
Fund by wire transfer to acquire the loan pursuant to a loan purchase agreement
dated that same day. Thus KMGI on April 11, 2012, became the holder of the
D.B. Zwirn loan. Immediately after its acquisition of the loan, KMGI on April 11,
2012, released Messrs. Messina and Kirkland from any and all obligations under
their personal guaranties. On April 12, 2012, KMGI transferred $249,902.63 to
Mr. Kirkland and $171,922.08 to Mr. Messina, for a total of $421,824.71,
representing the amounts of their earlier transfers that were not used to fund the
purchase of the D.B. Zwirn loan from the Fortress Fund.
On May 1, 2012, Casino paid $255,655.81 of principal due under the D.B.
Zwirn loan to KMGI. On that same day KMGI transferred $127,407.90 each to
Messrs. Messina and Kirkland, for a total of $254,815.80, as a payment on its
shareholder loans. Also on May 1, 2012, KMGI separately transferred $800 to
Mr. Kirkland to reimburse him for the California minimum tax that he had paid on
- 20 [*20] its behalf. Upon the completion of all payments, KMGI's shareholder loans
from Messrs. Messina and Kirkland had an unpaid principal balance of
$14,001,340.04. In preparing their 2012 Federal income tax returns, they treated
their halves of this amount, or $7,000,670.02 each, as their respective bases in a
liability of Club One owing to each of them and not as bases in KMGI. On May
22, 2012, KMGI's bookkeeper posted an entry in the corporation's books and
records reclassifying the entire $14,001,340.04 amount from "shareholder loans"
to "additional paid in capital". On December 14, 2012, Mr. Kirkland lent an
additional $1,000 to KMGI, which the corporation recorded in its books and
records as an additional "shareholder loan" from Mr. Kirkland as of that date.
Since its incorporation, KMGI has used a Los Angeles, California, address,
the same address as used for Kirkland Messina, Inc. From its incorporation until
April 10, 2012, KMGI's sole asset was cash contributed or lent by Messrs.
Messina and Kirkland to fund the purchase of the D.B. Zwirn loan from the
Fortress Fund. On and after April 11, 2012, KMGI's only assets (excluding funds
received from Casino that were promptly paid or distributed to Messrs. Messina
and Kirkland) were the D.B. Zwirn loan and a small amount of cash used to pay
bank service charges and other nominal expenses. In summary, after KMGI
- 21 [*21] became the holder of the D.B. Zwirn loan on April 11, 2012, it received the
following payments from Casino due under the loan during the 2012 tax year:
Date of payment
Amount of payment
5/1/2012
6/1/2012
$255,655.81
207,600
7/2/2012
66,000
12/12/2012
25,000
Obligation paid
Principal
Accrued interest and
agency fee
Accrued interest and
agency fee
Principal, accrued
interest, and agency fee
In turn, KMGI paid or distributed the following amounts to its shareholders:
Date of
payment or
distribution
Amount of
payment or
distribution
Nature of
payment or
distribution
Amount paid
or distributed
to Messina
Amount paid
or distributed
to Kirkland
4/12/2012
$421,824.71
Repayment of
$171,922.08
$249,902.63
127,407.90
127,407.90
103,780
103,870
32,980
32,980
excess funds
5/1/2012
254,815.80
Repayment of
shareholder
loans
6/1/2012
207,560
Return of
capital
7/5/2012
65,960
Return of
capital
12/12/2012
12/14/2012
11,015
11,015
Return of
capital
Return of
capital
11,015
---
11,015
---
- 22 [*22] In early 2015, Messrs. Messina and Kirkland applied to the CGCC for
approval to acquire the D.B. Zwirn loan from KMGI. On December 10, 2015, the
CGCC authorized an assignment of partial interests in the loan, allowing Messrs.
Messina and Kirkland to purchase the D.B. Zwirn loan from KMGI.
C. Dispute with the Sellers
After Club One's acquisition of Casino, Club One discovered certain
discrepancies in Casino's financial statements provided by Mr. Sarantos and Ms.
Long before closing, along with several previously undisclosed operational and
legal issues. Club One believed that these discrepancies and issues violated the
sellers' representations and warranties made in connection with the stock purchase
agreement. Consequently Club One requested a reduction in the Casino purchase
price. Mr. Sarantos and Ms. Long rejected the proposed reduction and requested
an increase in the purchase price, which Club One in turn rejected.
Club One and Mr. Sarantos and Ms. Long submitted their dispute to binding
arbitration for resolution as required by the stock purchase agreement. On April
12, 2011, the arbitrator issued an interim award ruling against Club One, denying
its proposed purchase price adjustment and granting the sellers' proposed
adjustment. On June 27, 2011, the arbitrator issued an interim award granting
attorney's fees and costs to Mr. Sarantos and Ms. Long. On that same day,
- 23 [*23] counsel for the sellers sent correspondence to Club One requesting
immediate payment of the interim arbitration awards. On July 8, 2011, the
arbitrator issued a final award incorporating the interim awards.
After oral notice and correspondence with Club One's controlling
shareholders, the Fortress Fund sent a letter dated July 13, 2011, to Club One, Mr.
Sarantos, and Ms. Long stating that, notwithstanding the arbitration award, the
parties to the financing agreement remained subject to the subordination
agreement executed by Mr. Sarantos and Ms. Long, and the arbitration award was
subordinated indebtedness. The Fortress Fund emphasized that an order issued by
the arbitrator to Club One or Casino to pay the award would constitute an event of
default under the financing agreement, in which event no subordinated debt could
be repaid, including any interest payments under the sellers' promissory notes.
Accordingly, the Fortress Fund prohibited Club One and Casino from (1) paying
the arbitration award of purchase price adjustments until there was no event of
default continuing, or (2) paying the arbitration award of interest, attorney's fees,
and other costs until all obligations under the financing agreement had been paid
in full.
On September 26, 2011, Mr. Sarantos and Ms. Long obtained a judgment in
the Fresno County Superior Court confirming the final arbitration award; the
- 24 [*24] judgment was amended on November 8, 2011. See Amended Judgment,
Sarantos v. Club One Acquisition Corp., No. 11CECG02432 (Cal. Super. Ct. Nov.
8, 2011). On January 9, 2012, Club One filed an action in the Supreme Court of
the State of New York for New York County, seeking to affirm that Mr. Sarantos'
and Ms. Long's arbitration award judgment and promissory notes were subject to
the subordination agreement. On October 21, 2014, that court ruled that while the
promissory notes were subordinated, the arbitration award was not. See Post-Trial
Decision and Order, Club One Acquisition Corp. v. Sarantos, No. 650049/2012
(N.Y. Sup. Ct. Oct. 21, 2014). On November 19, 2014, Club One and KMGI as
intervenor appealed certain portions of the court's ruling to the Appellate Division
of the New York Supreme Court.
On October 14, 2015, Club One and Casino separately filed a voluntary
petition under chapter 11 of title 11 of the U.S. Code in the U.S. Bankruptcy Court
for the Eastern District of California. The Casino bankruptcy petition listed Mr.
Sarantos' and Ms. Long's promissory notes as disputed claims of $4,150,000. In
January 2016 Club One, Casino, Mr. Sarantos, and Ms. Long reached a settlement
regarding, among other things, the dispute surrounding the promissory notes. That
same month, Club One and KMGI withdrew their appeal of the New York
Supreme Court's ruling.
-25[*25]
I.
Discussion
Overview
The operative points of these cases can be summarized tersely as follows.
As of the 2012 tax year, Messrs. Messina and Kirkland owned 80% of an S
corporation, Club One, which in turn owned a QSub, Casino. The QSub was the
borrower under the D.B. Zwirn loan. Messrs. Messina and Kirkland organized
another S corporation, KMGI, of which they were the sole shareholders, to acquire
the D.B. Zwirn loan. This was intended to make repayment of the loan to KMGI
senior to Casino's repayment of the promissory notes to Mr. Sarantos and Ms.
Long. Thus the indebtedness of Club One and its disregarded QSub, Casino, was
held not directly by Messrs. Messina and Kirkland but indirectly through KMGI.
Petitioners argue that KMGI should be disregarded and the D.B. Zwirn loan
deemed to be indebtedness of Club One to Messrs. Messina and Kirkland. This
would allow petitioners to count their adjusted bases in the loan in calculating the
amounts of Club One's flow-through losses they can deduct for the 2012 tax year.
Respondent urges this Court to conclude that KMGI's separate corporate existence
should be respected and that the D.B. Zwirn loan should not be treated as
indebtedness of Club One to Messrs. Messina and Kirkland. We agree with
respondent.
- 26 [*26] II.
Legal Background
Section 1366(a)(1) generally provides that an S corporation's shareholder
takes into account, for his taxable year in which the corporation's taxable year
ends, his pro rata share of the corporation's items of income, loss, deduction, or
credit, as well as the corporation's non-separately computed income or loss. The
character of the items passed through is preserved. Sec. 1366(b). However, the
aggregate amount of losses and deductions taken into account by the shareholder
is limited: It may not exceed the sum of the adjusted basis of the shareholder's
stock in the S corporation and the shareholder's adjusted basis of any indebtedness
of the S corporation to the shareholder. Sec. 1366(d)(1). Any disallowed loss or
deduction is treated as incurred by the corporation in the succeeding taxable year
with respect to that shareholder. Sec. 1366(d)(2)(A).
A QSub is a domestic corporation which (1) is not an ineligible corporation
under section 1361(b)(2); (2) is owned 100% by an S corporation; and (3) elects to
be treated as a QSub. Sec. 1361(b)(3)(B). Under section 1361(b)(3)(A) a QSub
generally is not treated as a separate corporation, and all of its assets, liabilities,
and items of income, deduction, and credit are treated as assets, liabilities, and
such items of the S corporation. Thus for purposes of section 1366(d)(1)(B), a
QSub's debt issued to its parent S corporation's shareholder is treated as the
- 27 [*27] parent's debt to determine the amount of losses that may flow through to the
parent's shareholders. H.R. Rept. No. 104-586, at 89 (1996), 1996-3 C.B. 331,
427.
The Code does not define "indebtedness of the S corporation to the
shareholder" as used in section 1366(d)(1)(B). The legislative history of the
statute's predecessor states that losses are limited "to the adjusted basis of the
shareholder's investment in the corporation; that is, to the adjusted basis of the
stock in the corporation owned by the shareholder and the adjusted basis of any
indebtedness of the corporation to the shareholder." S. Rept. No. 85-1983 (1958),
1958-3 C.B. 922, 1141. This Court has construed "investment" in the section
1366(d)(1)(B) context to mean an actual economic outlay of the shareholder. h
g, Spencer v. Commissioner, 110 T.C. 62, 78-79 (1998) (citing Hitchins v.
Commissioner, 103 T.C. 711, 715 (1994)). The shareholder bears the burden of
establishing his basis in the indebtedness of the S corporation to him. Broz v.
Commissioner, 137 T.C. 46, 60 (2011), aff d, 727 F.3d 621 (6th Cir. 2013). In
these cases, we need not address whether under section 7491(a) the burden of
proof has shifted from petitioners to respondent because, first, petitioners have not
so contended, and second, these cases having been submitted under Rule 122,
there are no outstanding factual issues relevant to ascertaining petitioners' tax
- 28 [*28] liability--the only issues that remain are legal ones as to which the burden of
proof is irrelevant. See Petersen v. Commissioner, 148 T.C. __, __ (slip op. at
9) (June 13, 2017).
III.
Acquisition of Basis in Indebtedness of Club One
Respondent argues that a basis in an S corporation can be acquired either by
contributing capital or directly lending funds to the company. See Bergman v.
United States, 174 F.3d 928, 931-932 (8th Cir. 1999). The loan must be direct,
respondent maintains, and thus no basis is created where funds are lent by a
separate entity, even one closely related to the shareholder in question. See id. at
932. Respondent relies on this Court's caselaw for that proposition. See Hitchins
v. Commissioner, 103 T.C. at 715 ("[T]he indebtedness of the S corporation must
run directly to the shareholders: an indebtedness to an entity with passthrough
characteristics which advanced the funds and is closely related to the taxpayer
does not satisfy the statutory requirements."); Prashker v. Commissioner, 59 T.C.
172, 176 (1972) ("Clearly there must be a debt running directly to the shareholder
in order to permit the deduction from income of a corporate net operating loss.");
see also Frankel v. Commissioner, 61 T.C. 343 (1973), aff'd without published
opinion, 506 F.2d 1051 (3d Cir. 1974); Thomas v. Commissioner, T.C. Memo.
2002-108, aff'd, 67 F. App'x 582 (11th Cir. 2003); Burnstein v. Commissioner,
- 29 [*29] T.C. Memo. 1984-74; Lee v. Commissioner, T.C. Memo. 1976-265, 35
T.C.M. (CCH) 1157 (1976). Respondent emphasizes that the D.B. Zwirn loan ran
to Club One and Casino from KMGI, not from Messrs. Messina and Kirkland.
According to respondent, all the evidence indicates that the debt does not run
directly from the shareholders to Club One and Casino and so cannot be
considered in computing the bases of any indebtedness of Club One to Messrs.
Messina and Kirkland.
For their part, petitioners concede that this Court and others have interpreted
section 1366(d)(1)(B) generally to require that indebtedness of an S corporation be
owed directly to the shareholder. However, petitioners assert, form is but one-half
of the inquiry, and the transaction's substance also needs to be considered. Thus
petitioners posit that caselaw allows an intermediary such as KMGI to be
disregarded where it (1) is acting as the taxpayer's incorporated pocketbook, (2) is
a mere conduit or agent of the taxpayer, or (3) has failed to make an actual
economic outlay to the loss S corporation that has made the intermediary poorer in
a material sense as a result of the loan. Petitioners also argue that the step
transaction doctrine should apply to determine the true creditor in the transaction
for Federal income tax purposes. We address petitioners' theories in turn.
- 30 [*30] A. Incorporated Pocketbook
Petitioners urge that this Court find that KMGI acted as the incorporated
pocketbook for Messrs. Messina and Kirkland in purchasing the D.B. Zwirn loan
from the Fortress Fund and holding it thereafter. Petitioners rely on a theory
distilled from caselaw as summarized in Broz v. Commissioner, 137 T.C. at 62,
that direct payments from a related entity to the taxpayer's S corporation constitute
payments on the taxpayer's behalf where the taxpayer used the related entity as an
"incorporated pocketbook." See Yates v. Commissioner, T.C. Memo. 2001-280;
Culnen v. Commissioner, T.C. Memo. 2000-139, rev'd on other grounds, 28 F.
App'x 116 (3d Cir. 2002). This Court has held that the term "incorporated
pocketbook" refers to the taxpayer's habitual practice of having his wholly owned
corporation pay money to third parties on his behalf and that whether an entity is
an incorporated pocketbook is a question of fact. See Broz v. Commissioner, 137
T.C. at 62 (citing Ruckriegel v. Commissioner, T.C. Memo. 2006-78).
While petitioners acknowledge that Messrs. Messina and Kirkland did not
habitually use KMGI to pay their personal expenses or to pay Casino's expenses,
they argue that this Court's caselaw suggests that habitual use of a corporate entity
to make payments on an S corporation shareholder's behalf is not a requirement
but merely evidence that indebtedness runs directly to the shareholder. Petitioners
- 31 [*31] also emphasize that unlike the entities in Culnen or Yates, KMGI had no
business activities other than holding the D.B. Zwirn loan and acting as a conduit
for payments made by Casino.
Respondent, on the other hand, asserts that Messrs. Messina and Kirkland
ought to be bound by the form of the transaction they have chosen. See Burnstein
v. Commissioner, T.C. Memo. 1984-74, 47 T.C.M. (CCH) 1100, 1106 ("A
transaction is to be given its tax effect in accord with what actually occurred and
not in accord with what might have occurred." (quoting Don E. Williams Co. v.
Commissioner, 429 U.S. 569, 579-580 (1977))); see also Thomas v.
Commissioner, T.C. Memo. 2002-108, 2002 WL 799871, at *6 ("Ordinarily,
taxpayers are bound by the form of the transaction they have chosen; taxpayers
may not in hindsight recast the transaction as one that they might have made in
order to obtain tax advantages." (quoting Harris v. United States, 902 F.2d 439,
443 (5th Cir. 1990))), aff'd without published opinion, 67 F. App'x 582 (11th Cir.
2003). Moreover, respondent points out, where the entities involved in
transactions are owned wholly by the taxpayer, that taxpayer bears "a heavy
burden of demonstrating that the substance of the transactions differs from their
form." Ruckriegel v. Commissioner, T.C. Memo. 2006-78, 2006 WL 1007628, at
*8 (citing Bergman, 174 F.3d at 933).
- 32 [*32] Respondent also argues that the "incorporated pocketbook" cases cited by
petitioners, Culnen and Yates, do not apply here. First, respondent maintains, that
line of cases deals with frequent and habitual payments made on behalf of the
taxpayer by the related entity, often for personal expenses. Second, he contends,
those cases involved back-to-back loans, where a related entity lends or distributes
assets to the taxpayers, followed by a loan from the taxpayer to the S corporation.
There, this Court found that the payments were not in substance direct loans from
the related entity to the S corporation with the taxpayer serving as a mere conduit
from the transfer of funds. Here, respondent asserts, there was a one-time transfer
from each of Messrs. Messina and Kirkland to KMGI, followed by a single
payment to acquire the D.B. Zwirn loan, all of this being insufficient to
demonstrate a habitual practice of the entity paying on its owners' behalf.
We agree with respondent. The "incorporated pocketbook" rationale is
inapposite here. In both of the cases petitioners cite--Culnen and Yates--the
taxpayers sought to regularly direct funds from one of their entities through
themselves and on to an S corporation. Here, petitioners concede that Messrs.
Messina and Kirkland did not use KMGI habitually to pay Casino's or their
personal expenses. Instead, they argue that this is not a requirement but only
evidence of indebtedness running directly to the shareholder. To the extent we
- 33 [*33] would agree with that statement, the fact that KMGI did not make payments
habitually does not help petitioners' case. To the contrary, it would be evidence
against a finding that indebtedness runs from Club One and Casino directly to
Messrs. Messina and Kirkland. At any rate, we disagree with petitioners'
interpretation of Culnen and Yates. Frequent and habitual payments are key to a
finding that a corporation served as an incorporated pocketbook. KMGI did not
make frequent and habitual payments on behalf of its shareholders. Accordingly,
we find that it did not function as Messrs. Messina and Kirkland's incorporated
pocketbook.
B. Conduit or Agent
Petitioners cite Commissioner v. Bollinger, 485 U.S. 340 (1988), for the
proposition that corporations, when serving as agents of taxpayers, may be ignored
for tax purposes. In Bollinger the taxpayers formed two corporations to secure
financing at higher rates than allowed by State usury laws. Under a nominee
agreement, the corporations held title to real property as the taxpayers' agents for
the sole purpose of securing financing and had no assets, liabilities, employees, or
bank accounts. Commissioner v. Bollinger, 485 U.S. at 342-344. The real
property's operation over several tax years generated income and losses, which
were reported by the taxpayers on their tax returns. Id. The Supreme Court held
- 34 [*34] that the corporations were agents of the taxpayers, who in turn were entitled
to claim the real property income and losses directly. The Supreme Court
determined that to reach such a result, the agent-principal relationship must be
genuine, as evidenced by (1) a written agreement setting forth the fact that a
corporation is acting as agent for its shareholders with respect to a particular asset,
(2) the corporation's functioning as agent and not principal with respect to the
asset for all purposes, and (3) the corporation's holding itself out as the agent and
not principal in all dealings with third parties relating to the asset. Id. at 349-350.
Petitioners point out that in Lee v. Commissioner, 35 T.C.M. (CCH) at 1159
n.3, this Court suggested that in a true conduit or agency situation, such as with a
nominee, a loan running through a corporate intermediary may be considered to
run directly from the shareholder instead for purposes of the predecessor to section
1366(d)(1)(B). Petitioners argue that their cases involve facts similar to those in
Bollinger and that this Court's suggestion in Le_e should be brought to bear here.
Petitioners emphasize that Messrs. Messina and Kirkland contributed to KMGI,
which had no assets or other business activity besides the loan acquisition, all the
funds necessary to purchase the D.B. Zwirn loan and that KMGI served effectively
as a conduit for payments from Casino. Petitioners also contend that Messrs.
Messina and Kirkland advised the parties involved in the loan acquisition that
- 35 [*35] KMGI was purchasing the loan on behalf of Messrs. Messina and Kirkland
and that doing so allowed the CGCC to grant its approval to the transaction more
quickly than if the two owners had applied to CGCC in their individual capacities.
Petitioners thus would have us hold that KMGI acted as agent for Messrs. Messina
and Kirkland in purchasing the D.B. Zwirn loan from the Fortress Fund.
Respondent retorts that this Court in past cases, such as in Hitchins or
Burnstein or Thomas, has been reluctant to apply the agency exception to the rule
that indebtedness must run directly from the S corporation to its shareholder.
Moreover, respondent argues, Club One, Casino, KMGI, and Messrs. Messina and
Kirkland were sophisticated parties who consulted with their counsel and advisers
before undertaking the D.B. Zwirn loan purchase from the Fortress Fund.
Respondent points out that they consciously chose the form of the transaction to
maintain the D.B. Zwirn loan's seniority with respect to other Casino obligations.
Respondent asserts that the record does not indicate that the CGCC or any other
third party was aware of KMGI's being an agent for Messrs. Messina and
Kirkland, nor was any agency agreement executed; the corporate minutes of Club
One and KMGI do not reflect any agency relationship. Respondent also
emphasizes that Messrs. Messina and Kirkland were released from their individual
guaranties of the D.B. Zwirn loan upon KMGI's acquisition thereof. Finally,
- 36 [*36] respondent believes that the record shows that KMGI conducted itself as a
principal in its interactions with the CGCC, Fortress, and other parties.
We agree with respondent that KMGI did not act as agent of Messrs.
Messina and Kirkland. The Supreme Court has set forth several factors to
consider when evaluating whether a corporation is another's agent: (1) whether it
operates in the name and for the account of the principal, (2) whether it binds the
principal by its actions, (3) whether it transmits money received to the principal,
(4) whether receipt of income is attributable to the services of employees of the
principal and to assets belonging to the principal, (5) whether its relations with the
principal depend upon the principal's ownership of it, and (6) whether its business
purpose is the carrying on of an agent's normal duties. Nat'l Carbide Corp. v.
Commissioner, 336 U.S. 422, 437 (1949). In Commissioner v. Bollinger, 485 U.S.
at 349-350, the Supreme Court found it sufficient to establish the existence of
agency that: (7) there was a written agreement setting forth that a corporation was
acting as agent for its shareholders with respect to a particular asset, (8) it
functioned as agent and not principal with respect to the asset for all purposes, and
(9) it was held out as agent and not principal in all dealings with third parties
relating to the asset. This Court has held that the nine indicia put forward in Nat'l
Carbide and Bollinger are not dispositive requirements for agency status but rather
- 37 [*37] factors leading to the conclusion that that status exists in a given case. See
Barnhart Ranch Co. v. Commissioner, T.C. Memo. 2016-170, at *23.
In reviewing the Nat'l Carbide and Bollinger indicia, we conclude that no
agency relationship existed between KMGI and Messrs. Messina and Kirkland.
We examine each of the nine factors in turn. First, the record demonstrates that
KMGI, while owned by Messrs. Messina and Kirkland, operated in its own name
and for its own account. For instance, it stood on its own in its dealings with the
CGCC and was the sole purchaser of the D.B. Zwirn loan from the Fortress Fund.
KMGI had its own bank accounts and held shareholders and directors meetings.
In short, it was very much a separate entity. This factor does not favor petitioners.
Second, petitioners have presented no evidence of any instance where
KMGI bound Messrs. Messina and Kirkland by its actions. Indeed, on acquiring
the D.B. Zwirn loan, KMGI in its role as counterparty immediately released its
shareholders from their personal guaranties of the loan, thus unbinding them from
any personal responsibility therefor. This factor does not favor petitioners.
Third, while KMGI did promptly transmit to Messrs. Messina and Kirkland
substantially all the funds received in relation to the D.B. Zwirn loan, it was under
no legal or contractual obligation to do so. This factor is neutral for petitioners, at
best favoring them weakly.
- 38 [*38] Fourth, KMGI's income was attributable to an asset that it held, the D.B.
Zwirn loan. The income was attributable to neither Messrs. Messina and
Kirkland's services, nor assets belonging to them. This factor does not favor
petitioners.
Fifth, KMGI's relations with Messrs. Messina and Kirkland depended on
their ownership thereof. Their contribution to KMGI of the funds necessary to
acquire the D.B. Zwirn loan initially was classified by KMGI on its schedule of
shareholder loans as a "Loan from Shareholders" and later treated as "Additional
Paid in Capital"; similarly the payments from KMGI to Messrs. Messina and
Kirkland were classified on the corporation's cashflow statement as "Repayment
of Shareholder Loan" and subsequently as "Return of Capital (Distribution of
Income)". Thus the financial flows between KMGI and Messrs. Messina and
Kirkland were as those between a corporation and its lenders or shareholders, not
as between an agent and its principal. This factor does not favor petitioners.
Sixth, KMGI's business purpose was to hold the D.B. Zwirn loan and
maintain the related note's seniority to Mr. Sarantos' and Ms. Long's promissory
notes. KMGI did not have a business purpose of carrying on an agent's normal
duties. This factor does not favor petitioners.
- 39 [*39] Seventh, there is no evidence of any agreement, written, oral, or implied,
establishing KMGI as an agent for Messrs. Messina and Kirkland. This factor
does not favor petitioners.
Eighth, KMGI acted as principal in relation to the D.B. Zwirn loan. For
instance, it was the sole purchaser of the asset from the Fortress Fund and alone
received all payments due under the terms of that loan. No other person, not even
Mr. Messina or Mr. Kirkland, had any legal or contractual right to or interest in the
asset. This factor does not favor petitioners.
And ninth, KMGI was not held out as an agent of Messrs. Messina and
Kirkland in its dealings with third parties. There is nothing in the record to
suggest otherwise.4 While it may have been known to others that KMGI was
4Petitioners make much of a part of Mr. Sarantos' January 16, 2013,
deposition testimony in the course of the New York State court proceeding where
he alluded to his belief that it was Messrs. Messina and Kirkland, not KMGI, who
purchased the loan from the Fortress Fund:
Q.
You're aware that sometime in the spring of2012 KMGI
purchased the loan from Fortress, are you not, sir?
A.
You mean Kirkland and Messina, don't you?
Q.
No. I said KMGI.
A.
I know what you said, but it's Kirkland and Messina.
(continued...)
- 40 [*40] funded, owned, and controlled by Messrs. Messina and Kirkland, funding,
ownership, or control is insufficient to establish an agency relationship; else, every
closely held entity and subsidiary would be considered its owner's or parent's
agent, an absurd result. Indeed, Messrs. Messina and Kirkland had every incentive
to place as much separation between themselves and KMGI as they could for
purposes of the arbitration between Club One and Mr. Sarantos and Ms. Long and
the subsequent action in New York State court. This factor does not favor
petitioners.
Petitioners have at most established the existence of one of the nine Nat'l
Carbide and Bollinger indicia with respect to KMGI's relationship with Messrs.
Messina and Kirkland. This is inadequate to persuade us that this relationship was
4(...continued)
Q.
So, in your view, the corporate form doesn't matter?
A.
I would imagine it's going to come into play.
Q.
When you incorporated George Sarantos, Inc., did you expect
that folks would understand that they're dealing with a
corporation rather than you personally?
*
A.
*
*
*
*
*
*
Anybody that dealt with GS Management got George Sarantos.
This deposition testimony, however, does not address whether KMGI was held out
as the agent of Messrs. Messina and Kirkland.
- 41 [*41] that of an agent to its principals. The weight of the factors instead shows
KMGI to be a distinct corporate entity. Accordingly, we find that KMGI was not
Messrs. Messina and Kirkland's agent, nor was it a conduit.
C. Actual Economic Outlay
Petitioners argue that KMGI--similarly to the taxpayers in cases such as
Bergman and Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004), § T.C.
Memo. 2002-172, where the Court of Appeals for the Eighth Circuit determined
that to increase his basis in an S corporation the stockholder must make an actual
economic outlay and be left poorer in a material sense--made no actual economic
outlay to purchase the D.B. Zwirn loan. Rather, petitioners maintain, it was
Messrs. Messina and Kirkland who provided the funds used by KMGI to purchase
the loan. Petitioners emphasize that Messrs. Messina and Kirkland fully owned
and controlled KMGI and were released from their guaranties of the loan upon its
acquisition by the corporation. Moreover, they assert, KMGI was a shell
corporation with no business or other activity besides holding the D.B. Zwirn loan,
and the corporation's net worth both before and after the loan's acquisition was
approximately $20,000, the amount of Mr. Messina's and Mr. Kirkland's initial
capital contributions. Petitioners add that KMGI functioned as a conduit for
payments received from Casino, retaining only nominal amounts to pay bank
- 42 [*42] charges and other de minimis expenses. Consequently, petitioners urge that
we find that KMGI made no actual economic outlay in purchasing the D.B. Zwirn
loan on behalf of its shareholders and that it was not poorer in a material sense
afterwards because all the funds used to purchase the loan had been lent to it by
Messrs. Messina and Kirkland.
Respondent argues that Messrs. Messina and Kirkland each made an actual
economic outlay and contribution to KMGI and that the amounts they contributed
to KMGI were reclassified from shareholder loans to additional paid-in capital,
which increased their bases in the stock of KMGI. See Nathel v. Commissioner,
131 T.C. 262, 267 (2008) ("Generally, a shareholder in an S corporation has a tax
basis in his stock equal to the amount of the contributions he makes to the capital
of the S corporation, and the shareholder's capital contributions are not included
in the income of the S corporation."), aff'd, 615 F.3d 83 (2d Cir. 2010). Thus,
respondent maintains, the amounts contributed to KMGI by Messrs. Messina and
Kirkland, minus any repayments of shareholder loans before May 22, 2012, when
the $14,001,340.04 of outstanding shareholder loans was reclassified by KMGI's
bookkeeper to additional paid-in capital, were capital contributions. See id. at
271. Respondent points out that this reclassification is borne out by the journal
entries in KMGI's general ledger and KMGI's 2012 Federal income tax return.
- 43 [*43] Accordingly, respondent contends that we should hold that Mr. Messina and
Mr. Kirkland made capital contributions to KMGI, thereby increasing their stock
bases in that corporation, and thus cannot use the same contribution dollars to
increase their debt bases in Club One.
Respondent also disputes petitioners' characterization of KMGI as a shell
corporation, arguing that Messrs. Messina and Kirkland had a significant business
purpose in structuring the transaction as they did: the maintenance of the D.B.
Zwirn loan's seniority to Mr. Sarantos' and Ms. Long's promissory notes.
We agree with respondent that Messrs. Messina and Kirkland did make
actual economic outlays, see, e.g., Thomas v. Commissioner, T.C. Memo. 2002108, 2002 WL 799871, at *6, and that these outlays were to KMGI. Petitioners,
by their argument about actual economic outlay, essentially rehash the conclusion
of their other two theories that KMGI was nothing more than a conduit or
incorporated pocketbook that ought to be disregarded. We have already disposed
of those theories. KMGI was a corporation with its own separate existence.
Likewise it was not simply a shell corporation but a distinct entity with at least one
substantial asset, the D.B. Zwirn loan, and a significant business purpose. CL
Ashdown v. Commissioner, T.C. Memo. 1989-40, 56 T.C.M. (CCH) 1160, 1161
n.5 (1989) ("Neither party defined the term shell corporation although each of
- 44 [*44] them used it. We assume it means a corporation which has no assets or has
assets of very little value although it appears to be prosperous and successful on
paper."). And the reclassification, from shareholder loans to additional paid-in
capital, of Mr. Messina's and Mr. Kirkland's contributions of funds to KMGI in its
books and records is further evidence as to the transaction's substance. Mr.
Messina's and Mr. Kirkland's capital contributions, combined with KMGI's other
indicia of actual corporate existence, are compelling evidence of economic outlay.
Taxpayers generally are bound to the form of the transaction they have
chosen. See Newhall Unitrust v. Commissioner, 104 T.C. 236, 243 (1995) ("[I]t is
well established that taxpayers are ordinarily bound by the form of their
transaction while the government can attack that form if it does not represent the
substance of the transaction."), M, 105 F.3d 482 (9th Cir. 1997); see also, e.g.,
CMI Int'l, Inc. v. Commissioner, 113 T.C. 1, 4 (1999) ("Generally, taxpayers are
bound to the form of their transaction."). Petitioners have failed to establish that
Messrs. Messina and Kirkland should not be held to the form of the transaction
they deliberately chose. Therefore, any economic outlays by Messrs. Messina and
Kirkland are fairly considered to have been made to KMGI, a distinct corporate
entity, which in turn made an economic outlay to Club One and Casino.
- 45 [*45] D. Step Transaction Doctrine
Petitioners also argue that we should apply the step transaction doctrine, see
Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945), to hold that
Messrs. Messina and Kirkland and not KMGI became the new holders of the D.B.
Zwirn loan after its purchase from the Fortress Fund. Petitioners look to Packard
v. Commissioner, 85 T.C. 397 (1985), as an instance of this Court's reliance on the
step transaction doctrine to ignore the formation, sale, and liquidation of an S
corporation. In support of their position, they assert that KMGI's only substantial
asset had been and was the D.B. Zwirn loan, that KMGI was a conduit, and that it
released Messrs. Messina and Kirkland from their personal guaranties of the loan,
something that a third-party purchaser of the loan would not have done.
Respondent disputes petitioners' application of the step transaction doctrine
to these cases, arguing that Messrs. Messina and Kirkland consciously and
intentionally chose the form of the transaction and should not be able to argue
against their own form to achieve a more favorable tax result. Respondent adds
that KMGI was not an agent of or a mere conduit for Messrs. Messina and
Kirkland. Thus, respondent argues, the form and the substance of the D.B. Zwirn
loan acquisition are the same, and the step transaction doctrine should not apply.
- 46 [*46] We agree with respondent. Petitioners' step transaction doctrine argument
is yet another permutation of their other theories, of which we have disposed.
KMGI was not Messrs. Messina and Kirkland's incorporated pocketbook, nor was
it their agent or a conduit. Each had made an actual economic outlay to KMGI,
and they intended that the corporation be respected as an entity distinct and
separate from them. There is no ambiguity in their intent, nor is there ambivalence
in Messrs. Messina and Kirkland's care to organize and maintain KMGI as a
discrete body corporate. Cf Estate of Leavitt v. Commissioner, 875 F.2d 420,
423-424 (4th Cir. 1989), § 90 T.C. 206 (1988).
Long has the rule been recognized by the courts that taxpayers are bound by
the form of their transaction and may not argue that the substance triggers
different tax consequences. Id. at 423; see also Commissioner v. Nat'l Alfalfa
Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) ("This Court has observed
repeatedly that, while a taxpayer is free to organize his affairs as he chooses,
nevertheless, once having done so, he must accept the tax consequences of his
choice, whether contemplated or not[.]"). While taxpayers might at first blush
plead inequity that they may not attack the form of their transactions while the
Government can do so, see Newhall Unitrust v. Commissioner, 104 T.C. at 243
("[I]t is well established that taxpayers are ordinarily bound by the form of their
- 47 [*47] transaction while the government can attack that form if it does not represent
the substance of the transaction."), such an argument is doomed to fail. Taxpayers
have the benefit of forethought and strategic planning in structuring their
transactions, Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) ("Any one
may so arrange his affairs that his taxes shall be as low as possible; he is not
bound to choose that pattern which will best pay the Treasury; there is not even a
patriotic duty to increase one's taxes."), affd, 293 U.S. 465 (1935), whereas the
Government can only retrospectively enforce its revenue laws.
Although the step transaction doctrine is not a "one-way ratchet" and
taxpayers in certain instances may benefit from it too, Falconwood Corp. v. United
States, 422 F.3d 1339, 1352 n.6 (Fed. Cir. 2005); see also MAS One Ltd. P'ship v.
United States, 271 F. Supp. 2d 1061, 1067 (S.D. Ohio 2003) ("Indeed, the step
transaction doctrine is not merely a method preventing tax avoidance, but can also
be used for a taxpayer's benefit."); Sooner Fed. Sav. & Loan Ass'n, 4 Cl. Ct. 746,
753 (1984) ("That the step transaction rule cuts both ways has been generally
assumed and decided."), petitioners' cases do not present such an instance.
Indeed, petitioners misconstrue the step transaction doctrine, perhaps
confusing it with broader substance-over-form principles, of which the step
transaction doctrine is but one part. See, e.g., CNT Investors, LLC v.
- 48 [*48] Commissioner, 144 T.C. 161, 193 n.33 (2015) ("We have described the step
transaction doctrine, for example, as simply an extension or application of the
'substance over form' doctrine."); Penrod v. Commissioner, 88 T.C. 1415, 1428
(1987) ("The step transaction doctrine is in effect another rule of substance over
form[.]"). Under the step transaction doctrine "interrelated yet formally distinct
steps in an integrated transaction may not be considered independently of the
overall transaction." Commissioner v. Clark, 489 U.S. 726, 738 (1989). The
acquisition of the D.B. Zwirn loan consisted of only two steps: Mr. Messina's and
Mr. Kirkland's transfers of funds to KMGI and the latter's purchase of the loan
from the Fortress Fund. KMGI did not go on to resell the loan to Messrs. Messina
and Kirkland or any other entity. Therefore, there was no step the consolidation of
which with the other steps would allow the D.B. Zwirn loan to be treated as
running directly from Messrs. Messina and Kirkland to Club One and Casino.
Accordingly, we find that petitioners may not invoke the step transaction doctrine
to hold that Messrs. Messina and Kirkland and not KMGI became the holders of
the D.B. Zwirn after its acquisition from the Fortress Fund.
IV.
Conclusion
We have found that KMGI was not Messrs. Messina and Kirkland's
incorporated pocketbook, nor was it their conduit or agent. Messrs. Messina and
- 49 [*49] Kirkland had made actual economic outlays to KMGI, which in turn made
an actual economic outlay to Club One and Casino. And the step transaction
doctrine does not apply to cause KMGI to be disregarded in Messrs. Messina and
Kirkland's transactional arrangement. Accordingly, we hold that the form of the
D.B. Zwirn loan's acquisition corresponds to its substance and should be
respected for Federal tax purposes as it was implemented. Petitioners have not
carried their burden of establishing that Mr. Messina's and Mr. Kirkland's bases in
Club One's indebtedness to them were other than those determined by respondent.
By the parties' stipulation, respondent's correlative adjustments also are upheld.
We have considered all of the parties' arguments, and to the extent not
discussed above, conclude that those arguments are irrelevant, moot, or without
merit.
To reflect the foregoing,
Decisions will be entered for
respondent.
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