UNITED STATES TAX COURT
Agency decision
Ask Donna
What actually matters in this document.
Text
T.C. Memo. 2000-93
UNITED STATES TAX COURT
ROBERT T. AND KAY F. GOW, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 25651-96.
Filed March 20, 2000.
Craig D. Bell and James C. Roberts, for petitioners.
William Henck and Timothy B. Heavner, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge:
In a notice of deficiency dated August 29,
1996, respondent determined the following deficiencies in, and
additions to, petitioners’ Federal income taxes:
- 2 Year
Deficiency
1989
1990
1991
1992
$522,221
334,663
109,047
103,224
Penalties
Sec. 6662(a)1
Sec. 6663(a)
$104,444
66,933
21,809
20,645
$391,666
250,997
81,785
77,418
1
The sec. 6662(a) accuracy-related penalties were determined
as an alternative to the sec. 6663(a) fraud penalties.
Subsequently, by an amendment to answer, respondent asserted
increased deficiencies and penalties for 1989 and 1991, as follows:
Penalties
Sec. 6663(a)
Year
Deficiency
Sec. 6662(a)
1989
1991
$877,054
153,214
1
1
1
$657,791
114,911
20 percent of the underpayment to which this section applies.
After concessions by each party, the issues remaining for
decision are:
(1) The value of shares of stock of Williamsburg
Vacations, Inc. (WVI), awarded to Kay F. Gow (800 shares on
February 16, 1989, and 400 shares on February 15, 1990) as bonuses;
(2) whether WVI’s payments of travel and entertainment expenditures
for certain trips taken by petitioners constitute constructive
dividends to them; (3) whether WVI’s payments of expenditures for
the
procurement
of
an
animal
trophy
collection
constitute
constructive dividends to petitioners; and (4) whether petitioners
are liable for fraud penalties pursuant to section 6663(a), or in
the alternative, accuracy-related penalties pursuant to section
6662(a).
- 3 All section references are to the Internal Revenue Code as in
effect for the years in issue.
All Rule references are to the Tax
Court Rules of Practice and Procedure.
All dollar amounts are
rounded.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The
stipulations of facts, stipulations of settled issues, and attached
exhibits are incorporated herein by this reference.
Background
Petitioners, husband and wife, resided in Norfolk, Virginia,
at the time they filed their petition.
Kay F. Gow (Dr. Gow) earned a doctor of education (Ed.D.)
degree from Virginia Tech., specializing in business education. As
part of her curriculum she took courses in accounting.
Before
1983, she taught and supervised a business education program at a
public high school in Virginia.
At the time of trial, Robert T.
Gow (Mr. Gow) was a retired civil service employee.
Williamsburg Vacations, Inc. (WVI)
WVI was incorporated under the laws of Virginia on July 21,
1983.
In November of 1986, WVI became a partner in a joint venture
known as Powhatan Associates.
(The other two members of the joint
venture were Offsite International (Offsite) and Bush Construction
Co. (Bush).
None of the joint venturers were related; each held a
one-third interest in Powhatan Associates.)
issue,
WVI’s
sole
income-producing
During the years in
property
was
its
indirect
- 4 interest in Powhatan Plantation, a time-share resort project of
Powhatan Associates.
WVI was authorized to issue 50,000 shares of common stock.
Initially, 650 shares of its stock were issued to Dr. Gow and 350
shares to Horace E. Henderson (Mr. Henderson).
Dr. Gow exchanged
previously acquired land located in North Carolina for her stock.
Mr. Henderson exchanged his note with a face value of $192,230.1
The initial officers of WVI were:
Mr. Henderson, president;
Mr. Gow, executive vice president; Robert E. Lee, secretary; and E.
Corbell Jones (Mr. Jones), treasurer.
During the years in issue,
Dr. Gow was president and chairman of the board of directors; Mr.
Gow was the secretary and a director of the company.
On September 30, 1983, Dr. Gow sold 200 shares of her WVI
stock to Mr. Jones and received in exchange Mr. Jones’ agreement to
cancel Mr. Gow’s note in the amount of $119,000.
As a condition of
sale, Mr. Jones agreed that if during his lifetime he desired to
dispose of all or any part of his 200 shares of WVI stock, Dr. Gow
would have the right to repurchase the 200 shares, and upon Mr.
Jones’ death, his estate or successor in interest would sell Dr.
Gow the 200 shares for $119,000, or $595 per share.
1
Mr. Henderson defaulted on the payment of his note, and
as a result, WVI instituted suit against him in the Circuit Court
of Virginia Beach on Oct. 20, 1988. Mr. Henderson countersued,
alleging violation of his shareholder rights and requested the
dissolution of WVI.
- 5 Simultaneously with the sale of the 200 shares, Dr. Gow and
Mr. Jones executed a voting trust agreement (VTA).
Under the terms
of the VTA, Dr. Gow and Mr. Jones agreed to, and did, transfer all
of their shares in WVI to Mr. Gow, as trustee of the voting trust.
The trust was to continue until September 30, 1993.
1988, the VTA was amended.
agreed
to,
and
did,
On October 24,
Pursuant to this amendment, Dr. Gow
transfer
all
stock
issued
to
her
since
September 30, 1983 (the date the VTA was executed) to Mr. Gow, as
trustee.
Moreover, Dr. Gow agreed to transfer to the trustee all
stock subsequently issued to, or owned by, her.
On October 19, 1983, Dr. Gow, Mr. Henderson, and Mr. Jones
signed an agreement to purchase a 256-acre tract of land located 1
mile west of the restored colonial area of Williamsburg, Virginia,
known as Powhatan Plantation. (This property was acquired for
development as a time-share resort.
See infra.)
On January 16,
1984, they assigned their rights in Powhatan Plantation to WVI.
By early 1984, WVI was in need of operating funds.
In an
attempt to provide working capital to WVI, Dr. Gow lent the company
$120,000.
WVI was unable to repay this loan, and on August 1,
1985, Dr. Gow accepted 50 shares of WVI’s stock in satisfaction of
the company’s obligation to her.
On February 16, 1988, WVI’s board of directors approved a
stock bonus plan for Dr. Gow.
Under the terms of the plan, Dr. Gow
was entitled to receive as a bonus up to 10,000 shares of WVI
- 6 stock, at a maximum rate of 1,000 shares per year, for 10 years.
The number of shares to be issued annually as a bonus was to be
determined by Dr. Gow.
In accordance with the stock bonus plan, on February 16, 1989,
WVI issued 800 shares of WVI common stock to Dr. Gow.
On February
15, 1990, WVI issued an additional 400 shares of its common stock
to her as a bonus.
It is the value of these shares at the time of
award that is subject to dispute--the first issue.
Financing History
WVI borrowed $100,000 from Central Fidelity Bank. These funds
were used to cover startup expenses and other administrative costs.
In late 1983, WVI received an acquisition/development loan from
First American Savings & Loan (First American) in the amount of
$1.75
million;
it
also
received
a
financing
commitment
from
Berkeley Federal Savings (Berkeley) for $10 million.
In 1984, Bush began construction of, and Offsite marketed, the
time-share project. In early 1985, Berkeley withdrew its loan
commitment,
making
it
difficult
for
WVI
to
timely
meet
its
financial obligations to Bush for construction and to Offsite for
marketing.
WVI became delinquent in its payments to Bush, and in
May 1985, Bush filed a mechanics lien against the project.
The
project further became mired in financial difficulties when, in
early 1986, over its concern with Bush’s mechanics lien, First
American threatened to terminate its loan to WVI.
Eventually,
- 7 Security Pacific (a local financial institution) agreed to provide
development financing, as well as a bridge loan, to refinance the
First American loan.
Security Pacific conditioned its financing
agreement
ability
on
WVI’s
to
reduce
its
outstanding
debt.
Consequently, in order to obtain debt forgiveness and secure
additional guarantors, WVI proposed a joint venture with Bush and
Offsite.
Powhatan Associates
On November 19, 1986, WVI, Bush, and Offsite formed Powhatan
Associates.
WVI
contributed
the
development
assets
(which
consisted of the Powhatan Plantation time-share project, land,
unsold inventory, and contractual and other rights associated with
the project net of project liabilities) as well as its services and
expertise as a developer and administrator.
Bush and Offsite each
agreed to forgive the debt owed them by WVI; they further agreed to
guarantee certain liabilities of WVI to repurchase defaulting timeshare contracts under several financial agreements. Offsite agreed
to continue to provide marketing services to the joint venture in
exchange for an allocation of the fees and expenses relating to its
marketing
operations.
Bush
agreed
to
continue
to
provide
construction services to Powhatan Plantation so long as it was
allocated the profits and expenses associated with construction.
The parties agreed that WVI would receive all of its administration
costs (including reasonable salaries), plus 1-1/2 percent of the
- 8 gross proceeds after a certain level of development had been
reached.
This
development
fee
was
designed
to
equalize
the
estimated profit margins among Offsite, Bush, and WVI.
As the administrative partner of Powhatan Associates, WVI was
responsible for the strategic planning and day-to-day operation of
Powhatan
Plantation.
WVI’s
Reviewing
and
all
approving
responsibilities
time-share
sales
included:
(1)
contracts;
(2)
obtaining financing for the joint venture; (3) preparing all
required reports and accountings; (4) servicing and collecting
joint venture mortgage portfolios; (5) monitoring product quality
and customer satisfaction; and (6) coordinating the construction
schedules and inventory availability.
Nonroutine matters required the approval of all three members
of the joint venture.
The joint venture agreement contained restrictions on the
transferability or sale of an interest in the joint venture.
pertinent part, it provided:
In
- 9 RESTRICTIONS ON TRANSFER
2.
Transfer of Venture Interest After Bona Fide Offer
(a) Notice of Offer. In the event * * *
[Bush, WVI, or Offsite] desires to transfer
all or some of its Venture Interest after
receiving
a
bona
fide
offer
from
an
independent third party, it must first: (i)
obtain the express prior written consent of
all Venturers, or (ii) notify each of the
other Venturers * * * in writing, of all of
the relevant facts of the proposed transaction
and its intention with respect to such Venture
Interest or any right or interest therein * *
* The * * * [nontransferring partner] shall
have a right of first refusal to purchase the
Subject Interest at a price and pursuant to
the procedures and conditions set forth
hereinafter.
(b) Purchase Price. The purchase price
to be paid to the Transferring Venturer for
the Subject Interest, if the Non-Transferring
Venturer(s) exercise their rights of first
refusal * * * shall be the price set forth in
the Notice of Offer, or the appraised value;
provided, that if the consideration to be paid
by the proposed transferee is other than the
payment of cash in full within thirty (30)
days of the acceptance of the offer of the
proposed
transferee
by
the
Transferring
Venturer, the Joint Venture shall cause an
independent appraiser * * * to establish the
cash equivalent of such other consideration.
In 1997, the joint venture sold Powhatan Plantation and
another time-share resort they owned to Signature Resorts, Inc., a
publicly traded company now known as Suntera Resorts, Inc., for
$59.1 million.
- 10 Powhatan Plantation Resort
Powhatan Plantation was part of an original land grant that
was conveyed to a prominent colonial family in 1640.
Located on
the property is a manor house that was built circa 1735 and
occupied by Mary Toliver.
The manor house, as restored, was the
centerpiece of Powhatan Plantation.
On the 20 acres surrounding
the manor house were formal gardens, numerous outbuildings, indoor
and outdoor pools, athletic facilities, meeting rooms, and three
food establishments, including a gourmet restaurant. The remaining
236 acres included open lands, a ring of woods, private roads, and
the time-share condominiums and townhouses.
The
Powhatan
plantation theme.
Plantation
resort
has
a
colonial
working
It was marketed as a luxury resort suitable for
families to discover and explore the history of the surrounding
area.
The first sale of a time-share unit occurred in late 1984.
As of February 1989, a total of 106 residential units had been
sold; that number increased to 140 the following year.
The time-share program offered by Powhatan Associates conveyed
either a 1/52 or a 1/104 undivided interest in an annual or
biannual time-share estate.
A purchaser of a time-share unit at
Powhatan Plantation was entitled to the exclusive use and enjoyment
of a unit during a designated and fixed week each year.
The
purchaser became a member of the Powhatan Plantation Owner’s
Association, which allowed the purchaser (or vacationer) to use
- 11 designated common and recreation areas, as well as the resources of
Resorts Condominium International, a time-share exchange network.
Hawaii and Key West Trips
Petitioners
believed
that
firsthand
observation
of
other
vacation resorts was necessary to maintain a competitive edge in
the time-share industry.
Between 1984 and 1992, on at least seven
occasions, WVI’s board of directors approved the expenditure of:
such sums as are necessary in travel and
entertainment to visit other luxury resorts
and
hotels
in
order
to
keep
Powhatan
Plantation competitive in product, services,
and to remain knowledgeable about innovations
in the resort industry and to seek new
business opportunities and to engage in or
sponsor retreats with political or business
persons affecting the resort industry.
WVI bore all these expenses, with no commitment of reimbursement
from Powhatan Associates.
Beginning in 1986, and continuing through the years in issue,
petitioners made numerous trips to Hawaii and Key West, Florida.
Most of these trips were taken around the Thanksgiving, Christmas,
and New Year’s holidays and often lasted between 2 and 3 weeks.
During these trips, petitioners conducted “interviews” with
guests of the resorts, took tours of the resort facilities and
premises,
and
compatibility
examined
with
the
Powhatan
kitchen
amenities
Plantation.
The
and
menus
purpose
of
for
the
interviews and inspections was to gauge customer service and
determine the level and efficiency of those services each resort
- 12 was
providing.
Petitioners
rarely,
if
ever,
spoke
with
the
management of these resorts.
On a number of occasions, other members of the “WVI management
team” accompanied petitioners on these trips.
On at least one
occasion each, David Legere (president of Offsite) and Senator
Stanley Walker, along with their spouses, traveled with petitioners
and had their expenses paid by WVI.
On these trips, petitioners
and their associates stayed at first-class resorts and dined at the
finest restaurants.
During their December 1990 trip to Hawaii,
petitioners stayed at the Halekulani Hotel for $850 per night and
dined at the La Mer restaurant for meals costing $900 or more; the
next month they stayed at the Lodge at Koele for $900 per night and
dined at expensive restaurants, with one meal costing over $2,000.
On these trips, petitioners enjoyed room service and many of
the local attractions. Over the course of 4 days, petitioners
incurred $462 in room service charges.
During this same period,
petitioners visited local tourist attractions such as Sea Life
Park, Ala Moana shopping center, and the Waipio Valley historical
site.
During the audit for the years in question (discussed infra),
Dr. Gow was requested to provide itineraries for the trips to
Hawaii and Key West. These itineraries, which purport to summarize
petitioners’ activities during those trips, were reconstructed by
- 13 Dr. Gow between 1993 and 1995, on the basis of invoices and
“whatever records” petitioners maintained.
The total cost of travel, lodging, meals, and other related
expenses WVI incurred for trips to Hawaii during the years in issue
were as follows:
Year
Expenditures
1989
1990
1991
1992
$71,700
67,454
44,857
83,929
WVI deducted these amounts, subject to the statutory limits on
travel and entertainment expenses.
The total cost of travel, lodging, meals, and other related
expenses WVI incurred for trips to Key West during the years in
issue were as follows:
Year
Expenditures
1989
1990
1991
1992
$7,536
14,256
14,395
11,281
WVI deducted these amounts, subject to the statutory limits on
travel and entertainment expenses.
- 14 Procurement and Use of Animal Trophies
WVI incurred expenditures for travel, food, lodging, and
professional guide fees in connection with the procurement of a
world-class
animal
trophy
collection
(as
well
as
taxidermy
expenses) as follows:
Year
Expenditures
1989
1990
1991
1992
$130,376
124,803
242,498
74,696
Under Dr. Gow’s direction, Deborah Lee (Ms. Lee), WVI’s controller
and accountant, recorded these costs in the company’s general
ledger as an “expense” rather than in an asset account.
The animal trophy collection was to be used purportedly as a
marketing strategy for the time-share project; namely, (1) as an
amenity at Powhatan Plantation, and (2) as a traveling display to
generate time-share leads at State and regional chapter meetings of
the Safari Club and the National Rifle Association.
In order to acquire a world-class animal trophy collection,
Mr. Gow hunted the animals in their natural habitat, mostly at the
Y.O. Ranch.
(Y.O. Ranch is a 500,000-acre tract of property
located in Texas that housed over 60 species of imported African
plains wildlife.)
Mr. Gow also traveled to Alaska and other
locations within the United States in search of exotic game such as
moose, Armenian red sheep, sable, kudu, caribou, and elk.
Mr. Gow
employed hunting guides on these trips and usually took Dr. Gow
- 15 along
because
he
“[enjoyed]
spending
time
with
her”.
Also
accompanying Mr. Gow on the hunting trips were Louis Schreiner and
his wife.
owned
the
(Mr. Schreiner was on the board of the Safari Club and
Y.O.
Ranch.)
Upon
returning
from
these
hunting
excursions, Mr. Gow would hire a taxidermist to create the animal
mounts.
The planned animal trophy museum to be located on Powhatan
Plantation was never built. Nor was there ever a traveling display
of the mounts.
Rather, the animal mounts were displayed at both
the Y.O. Ranch and Bob’s Gun & Tackle Shop (Bob’s) in Norfolk,
Virginia. (A total of 31 animal mounts were displayed at Bob’s and
more than 31 others were displayed at the Y.O. Ranch.)
Initially,
the animal mounts at Bob’s were identified with note cards bearing
the name of Mr. Gow and certifying the animal mounts’ world record
status. Approximately a year later, and at the advice of their tax
preparers, petitioners sent Bob’s a letter indicating that the
animal
mounts
were
the
property
of
Powhatan
Plantation.
Subsequently, the note cards were replaced with formal plaques
bearing the name “Powhatan Plantation”.
In 1991, Bob’s placed 18 of the animal mounts in storage.
In
1997, Signature Resorts, Inc., purchased all the assets of WVI,
including the animal trophy collection.
In 1989, 1990, and 1992, WVI deducted all costs incurred for
the procurement and display of the animal trophy collection, except
- 16 for $220 in 1990 and $1,760 in 1992, which were not deducted by
virtue of travel and entertainment statutory limitations in effect
for those years.
In 1991, WVI capitalized $137,410 in animal
trophy collection expenses and deducted $104,175.
The remaining
$913 was not deducted because of the travel and entertainment
statutory limitations.
WVI’s and Petitioners’ Audits for 1989-92
In July 1991, Revenue Agent Richard Puchaty audited WVI’s tax
returns. Petitioners’ tax returns were included in the audit after
Revenue Agent Puchaty noticed an unusual pattern of recording
expenses relating to the animal trophy collection across four
different accounts in the company’s general ledger.
Revenue Agent
Puchaty concluded that in light of continual mischaracterization of
the animal trophy accounts throughout the company’s ledger, as well
as his difficulty in locating the animal trophy expenses entries,
these expenses were intentionally being hidden.
In an effort to
clarify WVI’s ledger system, Revenue Agent Puchaty sought an
interview with both Dr. Gow and Ms. Lee; his request was denied.
Petitioners’ 1989-92 Tax Returns
On their 1989 and 1990 returns, petitioners reported the
values of the stock awarded to Dr. Gow as $40,000 and $20,000,
respectively.
They did not seek an expert valuation of the stock
before reporting the aforementioned values on their tax returns.
Petitioners reported no dividend income for 1989 and 1990, and
- 17 reported $420 and $2,094 of dividend income for 1991 and 1992,
respectively. The dividend income reported for 1991 and 1992 was
not attributable to any distributions from WVI.
Notice of Deficiency
In the notice of deficiency, respondent determined that the
fair market value of the stock awarded to Dr. Gow on February 16,
1989, was $1,600,000, and the fair market value of the stock
awarded to her on February 15, 1990, was $800,000.
After the
issuance
valuation
of
the
notice
of
deficiency,
respondent’s
experts revalued the stock awards at $2,142,313 and $597,353 at
their respective valuation dates.
Respondent
also
determined
that
petitioners
received
constructive dividends from WVI for 1989, 1990, 1991, and 1992 in
the
amounts
respectively.
of
$305,072,
$395,225,
$341,521,
and
$323,281,
By amendment to answer, respondent increased the
amount for 1991 to $479,844.
In his posttrial brief, respondent
concedes that certain expenses paid by WVI in 1989-92 do not
constitute constructive dividends to petitioners.
On the basis of respondent’s redetermination of the values of
the stock awards and the increase in the amount of the 1991
constructive dividend, the deficiencies asserted for 1989 and 1991
increased to $877,054 and $153,214, respectively.
- 18 OPINION
Issue 1.
The Fair Market Value of WVI’s Common Stock
The first issue presented involves the valuation of shares of
WVI’s stock awarded to Dr. Gow as a bonus.
The parties agree that
the value of these shares constitutes income to Dr. Gow.
The standard for valuation is fair market value, which is
defined as “the price at which the property would change hands
between a willing buyer and a willing seller, neither being under
any compulsion to buy or to sell and both having reasonable
knowledge of relevant facts.”
United States v. Cartwright, 411
U.S. 546, 551 (1973); Collins v. Commissioner, 3 F.3d 625, 633 (2d
Cir. 1993), affg. T.C. Memo. 1992-478; Estate of Newhouse v.
Commissioner, 94 T.C. 193, 217 (1990). This standard is objective,
using a purely hypothetical willing buyer and willing seller, each
of whom would seek to maximize his or her profit.
See Estate of
Watts v. Commissioner, 823 F.2d 483, 486 (11th Cir. 1987), affg.
T.C. Memo. 1985-595; Estate of Simplot v. Commissioner, 112 T.C.
130, 151-152 (1999); Estate of Mitchell v. Commissioner, T.C. Memo.
1997-461. The hypothetical buyer and seller are not specific
individuals and their characteristics are not necessarily the same
as the personal characteristics of an actual seller or a particular
buyer.
See Propstra v. United States, 680 F.2d 1248, 1251-1252
(9th Cir. 1982); Estate of Newhouse v. Commissioner, supra at 218.
However, the hypothetical sale should not be construed in a factual
- 19 vacuum.
See Estate of Andrews v. Commissioner, 79 T.C. 938, 956
(1982).
The two WVI stock awards are from a private, closely held
corporation.
There were no arm’s-length sales of the stock before
the date of the stock award.
Accordingly, we determine the value
of the stock awarded indirectly by considering the following
factors:
“(a) The nature of the business
enterprise from its inception.
and
the
history
of
the
(b) The economic outlook in general and the condition and
outlook of the specific industry in particular.
(c) The book value of the stock and the financial condition
of the business.
(d)
The earning capacity of the company.
(e)
The dividend-paying capacity * * *.
(f) Whether or not the enterprise has goodwill or other
intangible value.
(g) * * * the size of the block of stock to be valued.
[and]
(h) The market price of stocks of corporations engaged in the
same or similar line of business having their stocks actively
traded in a free and open market, either on an exchange or
over-the-counter.”
Estate of Simplot v. Commissioner, supra at 153 (quoting Rev. Rul.
59-60, 1959-1 C.B. 237, 238).
Ultimately, valuation is a question of fact; all facts and
circumstances are to be examined on the date of valuation without
regard to hindsight.
See Commissioner v. Scottish Am. Inv. Co.,
- 20 323 U.S. 119, 123-125 (1994); Estate of Jung v. Commissioner, 101
T.C. 412, 423-424 (1993); Skripak v. Commissioner, 84 T.C. 285, 320
(1985).
However, future events that are reasonably foreseeable at
the valuation date may be considered in determining fair market
value.
See Estate of Newhouse v. Commissioner, supra at 218.
Both respondent and petitioners rely upon the report and
testimony of their respective expert witnesses to establish the
value of the shares of WVI’s stock awarded to Dr. Gow.
We weigh
the expert’s testimony in light of the expert’s qualifications as
well
as
other
credible
evidence.
See
Estate
of
Christ
v.
Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C. 493
(1970); Estate of Newhouse v. Commissioner, supra at 217.
We are
not bound by the opinion of any expert witness; we may reach a
decision as to the value of property based upon our own analysis of
all the evidence in the record, see Silverman v. Commissioner, 538
F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-285, using all
of one party’s expert analysis, or selectively using any portion of
either analysis, see Estate of Simplot v. Commissioner, supra at
155; Parker v. Commissioner, 86 T.C. 547, 562 (1986); Buffalo Tool
& Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980).
Additionally, we may derive the fair market value of property from
within a permissible range of values that may be arrived at from
consideration of all the evidence.
See Silverman v. Commissioner,
supra; Estate of Simplot v. Commissioner, supra.
- 21 A.
Valuation by Petitioners’ Expert
Petitioners’
expert,
Peter
Gampel
(Mr.
Gampel),
is
the
director of the Florida and Caribbean valuation services group of
Arthur Andersen & Co.
In determining the value of the shares of
WVI stock awarded to Dr. Gow (800 shares on February 16, 1989, and
400 shares on February 15, 1990), Mr. Gampel first valued WVI’s
one-third interest in Powhatan Associates, and then adjusted the
book
values
of
WVI’s
assets
to
their
fair
market
values
to
determine the equity value of WVI as of the applicable valuation
date.
Next, Mr. Gampel applied discounts to the shares of stock
awarded
to
Dr.
marketability.
Gow
to
reflect
Mr.
Gampel
lack
ultimately
of
control
arrived
at
and
lack
of
a
value
of
$685,000 for the 800 shares of WVI stock awarded to Dr. Gow on
February 16, 1989, and $299,000 for the 400 shares awarded to Dr.
Gow on February 15, 1990.
In valuing WVI’s interest in Powhatan Associates, Mr. Gampel
first determined the aggregate value of Powhatan Associates as of
February 16, 1989, and February 15, 1990, and in doing so he used
the income approach, adopting the discounted cash-flow method. The
discounted cash-flow method is based upon the premise that a
business is worth the present value of all future benefits it will
produce
for
its
owner(s),
with
each
expected
future
benefit
discounted at a rate that reflects the risk that those benefits
will not be realized.
The discount rate selected is generally
- 22 based on rates of return available (as of the valuation date) from
alternative investments of similar type and quality.
Application
of this method requires forecasting future benefits from the
ownership of the operations as well as future investments required
to maintain the level of benefits.
Mr. Gampel determined Powhatan Associates’ anticipated income
stream by (1) projecting the number of time-share intervals sold as
of the respective valuation dates, and (2) estimating the sale
price for those intervals.
sold
by
averaging
the
He projected the number of intervals
interval
preceding each valuation date.
sales
for
the
2-year
period
(The interval sales were 1,408 for
1987, 1,754 for 1988, and 1,749 for 1989.)
Next, he divided total
sales by intervals sold for each of 1987, 1988, and 1989 in order
to arrive at the average interval price for each year.
By using
this methodology, Mr. Gampel determined the average interval price
to be $11,400 for 1987, $13,100 for 1988, and $13,300 for 1989, and
the average interval price for the 1987-88 period to be $12,250,
and for the 1988-89 period to be $13,200.
Mr. Gampel then considered cost of sales for the intervals,
taking into account construction costs, project amenities, sales
commissions, and the development fee payable by Powhatan Associates
to WVI.
He estimated cost of sales to be 71 percent for the 1989
valuation date and 69 percent for the 1990 valuation date.
In
making this determination, Mr. Gampel considered interest income,
- 23 interest
expense,
income
taxes,
administration
amortization for financing commitments.
costs,
and
After estimating Powhatan
Associates’ net income for both valuation dates, in order to arrive
at Powhatan Associates’ estimated annual cash-flow stream, Mr.
Gampel considered noncash charges, capital expenditures, changes in
net working capital, and debt.
Next,
Mr.
Gampel
developed
a
discount
rate
through
the
summation method that combined:
a risk-free rate of return of
a market risk premium of
a small stock risk premium of
a company specific risk premium of
Total
Rounded
The
32-percent
discount
8.93%
3.97
9.02
10.0
31.92
32.0
rate
was
then
applied
to
Powhatan
Associates’ estimated cash-flow stream for both valuation dates.
On the basis of his discounted cash-flow analysis, Mr. Gampel
opined that (1) the fair market value of Powhatan Associates was
approximately $11.7 million as of February 16, 1989, and $14
million as of February 15, 1990; and (2) WVI’s one-third interest
in Powhatan Associates (before discounts to reflect lack of control
and lack of marketability) was approximately $3.9 million as of
February 16, 1989, and $4.7 million as of February 15, 1990.
Mr. Gampel reduced the value of WVI’s one-third interest in
Powhatan Associates by two discounts: A minority interest (or lack
of control) discount and a lack of marketability discount.
These
- 24 discounts were applied separately. After examining data on control
premium studies, Mr. Gampel concluded that a 15-percent minority
interest discount was appropriate for both valuation dates.
In
addition,
of
Mr.
Gampel
concluded
that
a
30-percent
lack
marketability discount for both valuation dates was appropriate on
the
basis
of
the
following
factors:
The
lack
of
“special
purchasers” in the time-share industry, the restrictive nature of
the buy-sell provision in the joint venture agreement, the overall
restrictions placed on transferability of the joint venture’s
interest, and the size and composition of each partner’s one-third
interest. Accordingly, after applying discounts to reflect lack of
control and lack of marketability, Mr. Gampel opined that the value
of WVI’s one-third interest in Powhatan Associates was $2,321,690
as of February 16, 1989, and $2,770,320 as of February 15, 1990.
After determining the value of WVI’s one-third interest in
Powhatan Associates, Mr. Gampel adjusted the book value of WVI’s
other assets to fair market value as of February 16, 1989, and
February 15, 1990.
After making these adjustments, Mr. Gampel
determined that WVI’s adjusted book value was $3,328,707 as of
February 16, 1989, and $4,040,947 as of February 15, 1990.
To
these values, Mr. Gampel applied a 15-percent contingency discount
that further reduced the adjusted book values of WVI to $2,829,401
as of February 16, 1989, and $3,434,805 as of February 15, 1990.
- 25 Mr. Gampel’s final step in valuing the stock bonuses was to
apply a second level (at the WVI level) of minority interest and
lack of marketability discounts.
Mr. Gampel believed that for the
February 16, 1989, stock issuance, a 20-percent minority interest
discount and a 30-percent lack of marketability discount were
appropriate. For the February 15, 1990, stock issuance, Mr. Gampel
believed that a 30-percent minority interest discount and a 30percent
lack
of
marketability
discount
were
appropriate.
In
determining the extent of the minority interest discount, Mr.
Gampel considered the following factors: (1) The size of the stock
issuance (800 and 400 shares), which represents only a minority
interest in WVI; (2) the existence of the VTA at both valuation
dates; (3) a lack of “swing vote” characteristics in each stock
issuance; (4) a lack of “special purchasers” in the marketplace;
(5) WVI’s historical reluctance to distribute dividends; (6) the
terms of the buy-sale agreement and other restrictions on the
transferability of WVI’s stock; (7) the lack of recent sales of
similar interests in WVI; and (8) the existence of the ongoing
litigation.
In determining the marketability discount, Mr. Gampel
reviewed a number of empirical studies that were performed in an
effort
to
quantify
average
levels
of
discounts
for
lack
of
marketability in the marketplace and considered the following
factors:
(1)
The
lack
of
an
organized
market
for
the
purchasing/selling of interests; (2) lack of sales of similar
- 26 interests; (3) the remoteness of a sale of Powhatan Associates; and
(4) the probability of an event giving rise to a dispute among the
venturers.
By applying these discounts, Mr. Gampel concluded that the
fair market value of the stock bonus to Dr. Gow was $685,000
($856.25 per share) on February 16, 1989, and $299,000 ($747.50 per
share) on February 15, 1990.
B.
Valuation by Respondent’s Experts
Respondent relied upon two expert witnesses:
Diane Maiden
(Ms. Maiden) and Deborah Kalmar (Ms. Kalmar), both of whom are
employed full time by the Internal Revenue Service.
Ms. Maiden, a
real estate appraiser, valued Powhatan Associates’ inventory of
time-share intervals and the land yet to be developed as time-share
property.2
Ms. Kalmar, a business valuation expert, used Ms.
Maiden’s valuations to complete respondent’s valuation of the stock
bonuses awarded to Dr. Gow.
Ms. Maiden valued the income-producing property of Powhatan
Plantation using the discounted cash-flow method because of the
2
On Feb. 16, 1989, the project was in phase III of its
planned development, with approximately 50 acres (146 units) of
the 256-acre site devoted to the project. By Feb. 15, 1990, 65
acres (196 units) had been devoted to the project. According to
the zoning and final site plan, approved by the James City County
Board of Supervisors in April 1984, only 500 residential units
could be built on the 256 acres. Therefore, in 1989, 206 acres
remained to be developed with a maximum of 354 residences and in
1990, 191 acres remained which could be developed with 304
residences.
- 27 income-producing nature of the property.
To project the number of
time-share sales, she relied on Powhatan Associates’ annual reports
to
the
Virginia
Department
of
Professional
and
Occupational
Regulation’s real estate board, the public offering statement for
the project, and computer printouts of 1989 and 1990 sales provided
by petitioners.
Ms. Maiden determined that potentially 500 units
could be built, and after taking into account the number (5,497) of
intervals which had been sold as of February 16, 1989, 20,003
intervals remained for sale.3
She projected annual sales of 1,800
intervals for 1989 and 1,900 intervals for each of the subsequent
years until the total number of intervals (20,003) that remained to
be sold as of February 1989 was sold.
To determine a weighted
average interval sales price, Ms. Maiden used the audited financial
statements of Powhatan Associates and a price list for sale in 1997
(the only existing price list), in addition to the information used
to project the number of time-share units sold.
On the basis of
this information, Ms. Maiden determined a weighted average sale
price of $14,000 for all years in the projection period.
The net
operating income per interval was then estimated, using Powhatan
3
In calculating the number of intervals which could be
sold, both experts used 51 intervals per unit.
- 28 Associates’ financial statements and Powhatan Associates’ marketing
and construction agreements, as follows:
Average interval sales price:
Expenses:
Sales/marketing
Cost of construction
Development fees
Reserves for amenities
$14,000
45.0
25.0
1.5
1.5
Total
73.0
Net operating income per interval
($14,000 - (73% x 14,000 = $10,220))
$3,780
On the basis of the assumptions that (1) as of February 1989,
20,003 intervals
remained
for
sale,
(2)
1,800
of
the
20,003
intervals would be sold in year 1, 1,900 of the intervals would be
sold in each of the years 2-10, and 1,103 intervals would be sold
in year 11, and (3) the net operating income per interval would be
$3,780, Ms. Maiden calculated the income stream that could be
generated
from
the
sale
of
Powhatan
Plantation’s
time-share
properties to be $75,611,340 for 1989 and $69,586,020 for 1990.
Ms. Maiden then considered the proper discount rate to be used
to bring the estimated future income stream to present value.
Ultimately, Ms. Maiden determined that a 25-percent discount rate
was appropriate, using “the band of investment” method, which is a
“synthesis of mortgage and equity * * * [yield] rates, which market
data discloses as applicable to comparable properties”. The method
selected is “a weighted average of rates of return by the lender
and equity investor”. In arriving at the 25-percent discount rate,
- 29 Ms. Maiden combined the safe rate of return from the 10-year U.S.
Treasury bond (9.17 percent and 8.47 percent on the two valuation
dates) and the equity rate expected by land and real estate
developers (between 15 and 30 percent).
Believing that the risk
and lack of liquidity inherent in the time-share industry increases
the discount rate, Ms. Maiden selected the higher end of the range.
Use of the 25-percent discount rate resulted in Powhatan
Associates’ inventory of time-share intervals and the land yet to
be developed having a fair market value of $28,732,000 as of
February 16, 1989, and $28,402,000 as of February 15, 1990.
Respondent’s experts adjusted (increased) Powhatan Associates’
yearend audited balance sheet to reflect the fair market values of
the inventory and land. Using the first-in first-out (FIFO) method
of inventory, they determined the division between inventory and
land fair market values to be as follows:
2/16/89 Inventory on hand–-1,949 intervals
Sales (projected)
Remaining inventory
Value allocated to
inventory of
intervals
Total FMV
Value allocated
to land
Number
(Rounded)
Net Value
1,800
149
$3,381
2,705
1,949
Discounted Value (25%)
$6,085,498
403,045
6,488,543
28,732,000
22,243,457
- 30 2/15/90 Inventory on hand–-2,905 intervals
Sales (projected)
Remaining inventory
Value allocated to
inventory of
intervals
Total FMV
Value allocated
to land
Number
(Rounded)
Net Value
1,900
1,005
$3,381
2,705
Discounted Value (25%)
2,905
$6,423,581
2,718,525
9,142,106
28,402,000
19,259,894
Powhatan Associates’ balance sheet line items (other than
inventory
and
land
devoted
to
time-share
development)
were
interpolated from the close of the end of the prior year to the
applicable valuation date (at a straight-line rate) to reflect the
difference.4
time
(No provision for taxes was included in
determining the overall value of Powhatan Associates on the basis
that no tax is paid at the joint venture level.)
After making
these adjustments, respondent’s experts concluded that (1) the
venturers’ equity in Powhatan Associates was $32,866,718 as of
February 16, 1989, and $35,001,760 as of February 15, 1990, and (2)
WVI’s one-third pro rata interest in Powhatan Associates (before
discounts to reflect lack of control and lack of marketability) was
$10,955,573 as of February 16, 1989, and $11,667,253 as of February
15, 1990.
4
The interpolation factor for Feb. 16, 1989, was 47
days/365 days, and for Feb. 15, 1990, was 46 days/365 days.
- 31 Next,
respondent’s
experts
considered
whether
discounts
(either for lack of marketability or for minority interest, or
both) were appropriate.
Initially, the experts did not believe a
discount for lack of marketability was appropriate at the joint
venture level. Subsequently, they concluded that a 10-percent lack
of marketability discount was appropriate, stating:
The chief asset of Powhatan Associates is the
inventory and land to be developed for time shares, and
ample allowance for lack of marketability was taken into
account for that asset, both in the projections of income
and in the application of a relatively large discount
rate. There is judicial precedent for this judgment not
to duplicate discounts already taken.
The experts further concluded that at the joint venture level only
a relatively small discount (5 percent) for a minority interest was
appropriate, stating:
The history of the joint venture displays a careful
attention to conservative development: inventory was kept
low, and areas were built in clusters close to one
another and the amenities, to allow for maximum use of
the residual acreage should the time share development
slow or cease. This history was taken into account in
the real estate appraiser’s finding of fair market value
of the time share property.
There is no reason that
these practices should change if another entity stepped
into the shoes of WVI as administrator of the project.
The exit provisions of the joint venture agreement
provide for a purchase (by the other venturers) of a
selling venturer’s interest at fair market value or at
the price offered by a bona fide third party.
A
purchaser of a 1/3 interest might have the opportunity to
purchase the entire entity under those exit provisions.
We apply a 5% discount for the WVI minority interest to
account for the risk that a purchaser of 1/3 interest
might be invited to purchase all of the venture but be
unwilling to do so, thus cancelling the 1/3 interest
purchase. Because of the profitability of the venture to
the other two “partners”, this scenario is unlikely.
- 32 After application of these two discounts, respondent’s experts
opined
that
WVI’s
one-third
pro
rata
interest
in
Powhatan
Associates was $9,367,015 as of February 16, 1989, and $9,975,502
as of February 15, 1990.
This discounted value of WVI’s interest in Powhatan Associates
was incorporated into the balance sheet of WVI.
The experts
further adjusted WVI’s balance sheet (1) to account for the fair
market value of a 1-1/2-percent development fee payable to WVI from
Powhatan Associates, (2) to apply a provision for the present value
of taxes to be paid at the time of the time-share sales, and (3) to
reduce from book to fair market value the interest WVI held in a
parcel of undeveloped land in North Carolina.
On the basis of
these adjustments, the experts determined (1) the fair market value
of WVI was $6,880,694 as of February 16, 1989, and $7,466,913 as of
February 15, 1990, and (2) the pro rata value of the 800 shares and
the
400
shares
was
$2,975,435
as
of
February
16,
1989,
and
$1,327,451 as of February 15, 1990.
In arriving at the value of the 1989 and 1990 stock issuance,
respondent’s experts’ final step was to sequentially apply (1) a
20-percent ($595,087) minority interest discount and a 10-percent
lack of marketability discount ($238,035) for 1989, and (2) a 50percent ($663,726) minority interest discount and a 10-percent
($66,373) lack of marketability discount for 1990. Having done so,
respondent’s experts determined that the fair market value of the
- 33 February 16, 1989, stock issuance to Dr. Gow was $2,142,313 ($2,678
per share), and the fair market value of the February 15, 1990,
stock issuance to Dr. Gow was $597,353 ($1,493 per share).
In determining the fair market value of the stock bonus, the
experts considered the VTA agreement and the fact that Dr. Gow, at
her election, could receive within 10 years up to 10,000 shares, at
a maximum of 1,000 shares per year.
before
purchase
an
informed
The experts believed that
hypothetical
buyer
would
require
protection against the potential dilution effect of the share
authorization, as well as the placing of the stock in a voting
trust.
C.
Court’s Analysis and Conclusion
For ease of understanding, we have set forth in the appendices
hereto a comparison of Mr. Gampel’s and Ms. Maiden’s-Ms. Kalmar’s
valuations.
Giving
due
consideration
to
the
totality
of
the
evidence before us, and in particular the testimony and reports of
the expert witnesses, we find the analysis and conclusions of
respondent’s experts more persuasive than those of petitioners’
expert.
Consequently, we accept, with modifications discussed
hereinafter, Ms. Maiden’s and Ms. Kalmar’s valuations.
We agree with respondent that Mr. Gampel’s report contains
fatal errors.
These errors include: (1) His understatement of
- 34 Powhatan Associates’ anticipated income stream;5 (2) the size of
the discount rate (32 percent) he developed through the summation
method;
and
(3)
his
application
of
a
15-percent
contingency
discount to reduce the adjusted book values of WVI as of the
valuation dates.
We conclude that these errors resulted in an
unacceptable understatement of fair market value for the stock
bonuses awarded to Dr. Gow.6
We agree with the valuation methodology used by Ms. Maiden and
Ms. Kalmar (respondent’s experts) but disagree with the quantum of
the discounts they determined for lack of control and lack of
5
Mr. Gampel determined Powhatan Associates’ anticipated
income stream by (1) projecting the number of intervals sold, and
(2) estimating the sale price for those units. He projected the
number of intervals sold by averaging the interval sales for the
2-year period preceding each valuation date. He then divided
total sales by intervals sold for each of 1987, 1988, and 1989 in
order to arrive at the average interval price for the applicable
valuation date. By using this methodology, he used $12,250 as
the average interval sale price for the 1987-88 period and
$13,200 for the 1988-89 period. We believe Mr. Gampel’s
methodology to be flawed. The yearly interval sale price was
trending upward, and by 1989 it was $13,300. The interval sale
price used by Mr. Gampel for the 1989 and 1990 valuation dates
was clearly understated, which in turn, resulted in the
understatement of Powhatan Associates’ income stream.
6
We are mindful that besides the value of Powhatan
Associates, there are other differences between the experts in
valuing WVI, such as Mr. Gampel’s reducing to 90 percent of face
Mr. Henderson’s note to WVI, whereas Ms. Maiden and Ms. Kalmar
did not. Additionally, Mr. Gampel increased WVI’s adjusted book
value to include WVI’s estimated earnings from the close of the
end of the prior year to each of the respective valuation dates.
We have chosen to disregard these differences but note that they
would result in an overall increase in the value of WVI’s stock.
- 35 marketability at both the Powhatan Associates and WVI levels.
The
discounts they used were as follows:
At Powhatan Associates Level
Lack of control
Lack of marketability
1989
1990
5%
10
5%
10
At WVI Level
Lack of control
Lack of marketability
1989
1990
20%
10
50%
10
In contrast to these discounts, Mr. Gampel used the following
discounts:
At Powhatan Associates Level
Lack of control
Lack of marketability
1989
1990
15%
30
15%
30
At WVI Level
Lack of control
Lack of marketability
1989
1990
20%
30
30%
30
We have duly considered and studied the factors and reasoning
used by the experts in determining their respective discount
amounts.
In this regard, we found Mr. Gampel’s reasoning to be
well founded and more persuasive than that of Ms. Maiden and Ms.
Kalmar.
Mr. Gampel used empirical studies and factors (stated
supra pp. 24-26) that we believe appropriate in formulating his
- 36 opinion as to the discount amounts, whereas respondent’s experts
did not.
We are not persuaded by respondent’s experts’ reasoning
in determining the quantum of the discounts.
The quantum of the
discount for lack of control ranged from a low of 5 percent at the
joint venture level to a high of 50 percent at the WVI level.
Moreover,
we
are
mindful
that
initially
respondent’s
experts
believed a discount for lack of marketability was not appropriate
at the joint venture level, but eventually changed their minds and
applied a 10-percent discount.
In contrast, Mr. Gampel’s discount
rates were consistent and uniform, ranging from 15 percent for lack
of control at the joint venture level (20 percent for lack of
control at the WVI level) to 30 percent for lack of marketability
at
both
levels.
Consequently,
we
adopt
the
quantum
of
the
discounts for lack of control and lack of marketability at both
levels for both valuation dates as determined by Mr. Gampel.
Thus,
the valuation conclusions of Ms. Maiden and Ms. Kalmar should be
adjusted (reduced) to reflect Mr. Gampel’s discount amounts.
This
adjustment
155
can
be
made
by
the
parties
in
their
Rule
computation.
In reaching our conclusions, we have considered all arguments
raised by the parties in their posttrial briefs.
apparently
did
petitioners’
own
expert,
the
We reject, as
argument
(which
petitioners’ counsel alleges was conceded by Ms. Kalmar during her
testimony) that the shares of WVI stock awarded to Dr. Gow have no
- 37 value because of the existence of the voting trust agreement and
the potential dilution of WVI stock as a consequence of Dr. Gow’s
right to have 10,000 shares of WVI stock issued to her.
Issues 2 and 3.
We
next
Constructive Dividends
examine
whether
WVI’s
payments
of
petitioners’
expenses for trips to Key West and Hawaii, as well as WVI’s
payments for the acquisition of the animal trophy collection,
constitute constructive dividends to petitioners.
The amount of these expenditures is not in dispute.
Rather,
the dispute centers upon whether these expenditures were made
primarily to advance petitioners’ personal interests or were for
legitimate business interests of WVI.
Petitioners maintain that
the trips to both Key West and Hawaii generated numerous ideas and
concepts that were considered and later incorporated by Powhatan
Associates in the time-share resort. Further, petitioners maintain
that the amounts expended on the procurement of the animal trophy
collection created an amenity intended to attract buyers of the
time-share intervals.
that
these
Respondent, on the other hand, maintains
expenditures
were
made
primarily
to
provide
a
substantial personal benefit to petitioners.
It has long been recognized that when a corporation makes an
expenditure
or
(without
expectation
an
distribution
of
out
of
its
repayment)
earnings
primarily
and
to
profits
confer
a
substantial personal benefit to a shareholder, the value of the
- 38 benefit conferred is taxable as a constructive dividend. See secs.
61(a)(7), 301, 316; Ireland v. United States, 621 F.2d 731, 735
(5th Cir. 1980); Loftin & Woodard, Inc. v. United States, 577 F.2d
1206, 1214 (5th Cir. 1978); Hash v. Commissioner, 273 F.2d 248, 250
(4th
Cir.
1959),
affg.
T.C.
Memo.
1959-96;
Falsetti
v.
Commissioner, 85 T.C. 332, 356-357 (1985). A constructive dividend
can take the form of either a distribution of corporate funds, the
use of corporate property for personal purposes, or paying off a
personal
expense
of
the
shareholder
by
the
corporation.
See
Ireland v. United States, supra; Wall v. United States, 164 F.2d
462 (4th Cir. 1947); Martin v. Commissioner, T.C. Memo. 1997-492;
Yarbrough Oldsmobile Cadillac, Inc. v. Commissioner, T.C. Memo.
1995-538.
Control of a corporation by a shareholder as well as a
corporate history of not paying dividends weighs strongly in favor
of
finding
a
constructive
dividend.
See
Yarbrough
Oldsmobile
Caddillac, Inc. v. Commissioner, supra; Thielking v. Commissioner,
T.C. Memo. 1987-227, affd. 855 F.2d 856 (8th Cir. 1988).
In determining whether or not the expenditure related to the
business of the corporation, we must ascertain whether the payment
or expenditure has independent and substantial importance to the
paying corporation.
See T.J. Enters., Inc. v. Commissioner, 101
T.C.
An
581
independent
(1993).
and
expenditure
substantial
generally
importance
to
does
the
not
have
distributing
corporation if it is not deductible under section 162.
See, e.g.,
- 39 P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1089 (9th Cir.
1987), affg. T.C. Memo. 1984-549; Gill v. Commissioner, T.C. Memo.
1994-92, affd. 76 F.3d 378 (6th Cir. 1996).
Thus, our analysis
begins by focusing upon whether WVI’s expenditures were ordinary
and necessary in the context of the time-share resort industry.
An
expense is ordinary if it is common or frequent in the context of
the particular business out of which it arose.
DuPont, 308 U.S. 488, 495 (1940).
See Deputy v.
An expense is necessary if it is
appropriate and helpful to the operation of the taxpayer’s trade or
business.
See Carbine v. Commissioner, 83 T.C. 356, 363 (1984),
affd. 777 F.2d 662 (11th Cir. 1985).
A.
Expenditures for the Hawaii and Key West Trips
Petitioners’ evidence substantiating their activities of their
Key West and Hawaii trips consisted of their testimony and prepared
itineraries.
We view petitioners’ testimony with caution, as it
was self-serving.
In addition, the itineraries were prepared by
petitioners at least a year after the trips and in response to a
tax
audit;
understandably,
we
question
their
reliability.
Moreover, we are unable to ascertain from the itineraries the
business
relevance
of
many
of
petitioners’
activities.
Accordingly, petitioners failed to persuade us that the purpose of
these trips was not primarily their personal benefit. See Grossman
v. Commissioner, T.C. Memo. 1996-452, supplemented by T.C. Memo.
1997-451, affd. 182 F.3d 275 (4th Cir. 1999); Fong v. Commissioner,
- 40 T.C. Memo. 1991-180. Respondent, on the other hand, produced
numerous billing statements and invoices as well as testimony
regarding WVI’s expenditures for 1991.
We find respondent’s
evidence persuasive.
According to petitioners, these trips were undertaken to
investigate and research Powhatan Plantation’s competition in order
to incorporate comparable resort features and services that would
make them more attractive to potential customers.
assertion with skepticism.
We view this
In our opinion, the innovations and
research petitioners sought could have been obtained without the
elements
of
substantial
personal
pleasure.
To
illustrate,
petitioners spent a large amount of time on these trips enjoying
shopping malls, theme parks, and historical locations.
Many of
these trips were taken around the Thanksgiving, Christmas, or New
Year’s holidays and were the only time during the year petitioners
managed to escape their everyday routine.
WVI subsidized many of
the incidental expenses incurred by the spouses of members of the
“management team”.
During some of the activities, dinners costing
$1,000 or more, as well as room service bills of almost $500,
became the norm.
Although it might be ordinary and necessary for
Powhatan Plantation to investigate its competition in the same
geographic area, it has not been shown to be ordinary and necessary
for petitioners to examine resorts that are located in distant
areas and are not in direct competition with Powhatan Plantation.
- 41 In light of petitioners’ control of WVI, such expenses become
especially suspect.
We conclude that the primary purpose of these
trips was petitioners’ personal enjoyment.
Petitioners’ visits were, at best, of marginal benefit to WVI
and the joint venture.
As we have previously stated:
a trip that is primarily for the taxpayer’s
individual pleasure is not converted into a
business trip merely because some short
portions
of
the
trip
involve
business
activities, even when it is clear that the
asserted business activities actually occurred
and that those business activities actually
affected the cost of the trip.
Grossman v. Commissioner, supra (citing George R. Holswade, M.D.,
P.C. v. Commissioner, 82 T.C. 686 (1984)).
In Grossman, a case whose facts are similar to those in this
case, we found that corporate expenses for trips taken by the
taxpayer
and
his
wife
that
had
a
slight
business
component
constituted constructive dividends. In Grossman, the taxpayer and
his wife, the two principal owners in a closely held corporation,
took multiple trips to resort locations across North America,
ostensibly to conduct discussions regarding corporate business.
The taxpayers subsequently caused their corporation to reimburse
them for their expenses.
Relying solely upon the taxpayer’s
assurances that there were no personal expenses involved, the
corporation’s
accountant
entertainment expenses.
claimed
deductions
for
travel
and
In finding that the corporation made
constructive dividends to the taxpayer, we disagreed with the
- 42 taxpayer’s characterization of the trips as relating to business,
and held that the predominant purpose of most of the trips, despite
having an incidental business purpose, was personal pleasure.
We
find no reason or distinction that compels a different result in
the case before us.
the
expenditures
Petitioners have failed to persuade us that
were
predominantly
for
business
purposes.
Accordingly, we sustain respondent’s determination that for the
years in issue, the total amounts expended by WVI for petitioners’
entertainment
expenses
to
Hawaii
and
Key
West
constitute
constructive dividends to petitioners.
B.
Expenditures for the Animal Trophy Collection
We now turn our attention to WVI’s expenditures for the
procurement of the animal trophy collection. Once again, our
factual analysis focuses upon whether the expenditures have an
independent and substantial importance to the payor corporation.
See Gill v. Commissioner, T.C. Memo. 1994-92.
Although amounts
spent advancing a personal interest of a taxpayer may constitute
constructive
dividends,
amounts
expended
for
the
legitimate
improvement of a corporation’s trade or business do not.
Petitioners suggest that because the expenditures for the
animal trophy collection constitute capital expenditures, they
should receive different treatment than deductible expenses with
regard to constructive dividend treatment.
We disagree.
Even if
we were to accept the premise that these expenses otherwise were
- 43 amortizable under section 263, capital expenditures, if made for
the
personal
benefit
constructive dividends.
of
the
shareholder,
can
constitute
See, e.g., Challenge Manufacturing Co. v.
Commissioner, 37 T.C. 650, 663 (1962); Gill v. Commissioner, supra.
The expenses incurred for the animal trophy collection were
composed mainly of costs associated with the acquisition and
display of the animal trophy mounts; i.e., acquisition and mounting
costs.
Petitioners contend that the animal trophy collection was
to be used both as a marketing tool and as an amenity of Powhatan
Plantation.
They allege the collection was to tour selected sites
around the country as well as to be placed in a “museum” located on
Powhatan Plantation.
Petitioners assert that such displays would
attract potential buyers of the time-share intervals.
However,
most of the animal trophy mounts were put on display at Bob’s and
the Y.O. Ranch.
We
find
petitioners’
argument
unconvincing.
Powhatan
Plantation had a colonial working plantation theme, emphasizing the
history of the Williamsburg-Jamestown, Virginia, area. The “worldclass” animal trophy mounts collection was designed to be composed
of
exotic
animals
whose
natural
tidewater area of Virginia.
habitat
did
not
include
the
We do not believe the display of
exotic animals such as elk, caribou, or Armenian red sheep furthers
the historical colonial theme that was in place as a marketing
strategy.
In this respect we are mindful that notably absent from
- 44 the marketing brochure created by Offsite to highlight the salient
amenities of the time-share resort was the mention of an animal
trophy collection.
Also revealing is the fact that the other
members of the joint venture were unaware of the acquisition of an
animal trophy collection, which is of significance in view of the
fact that the joint venture agreement required a majority of the
venturers to decide nonroutine matters.
In acquiring the animal trophy collection, Mr. Gow personally
hunted the animals and made numerous trips to Y.O. Ranch and
Alaska. On several occasions he took his wife along as a traveling
companion.
He used a customized handgun and spent many hours
practicing his shooting skills at a range.
hunting.
He obviously enjoyed
Although the mere enjoyment of one’s work may not alone
transform a work assignment into a hobby, see Sanitary Farms Dairy,
Inc.
v.
Commissioner,
25
T.C.
463,
468
(1955),
petitioners’
enjoyment, along with the questionable business purpose, strongly
suggests
the
hunting
activities
were
for
Mr.
Gow’s
personal
benefit.
In viewing the entire record, we are convinced that all
expenditures
incurred
for
the
animal
trophy
collection
were
primarily for the personal benefit of petitioners and thus should
be treated as a constructive dividend.
In an attempt to convince
us otherwise, petitioners cite Sanitary Farms Dairy, Inc., as
support that
costs
associated
with
hunting
trips
can
have
a
- 45 legitimate business purpose.
In Sanitary Farms Dairy, Inc., we
found that “The cost of a big game hunt in Africa does not sound
like an ordinary and necessary expense of a dairy business in Erie,
Pennsylvania, but the evidence in this case shows clearly that it
was and was so intended.”
Id. at 467.
Unlike here, in Sanitary
Farms Dairy, Inc., we were satisfied from the evidence in the
record that costs associated with the safari actually assisted in
the marketing of the product line of the business.
Thus, Sanitary
Farms Dairy, Inc., is distinguishable from this case and offers no
support to petitioners’ cause.
In sum, we hold that WVI’s payments of petitioners’ expenses
for trips to Key West and Hawaii, as well as WVI’s payments for the
acquisition
of
the
animal
trophy
collection,
constitute
constructive dividends to petitioners.
Issue 4.
Imposition of the Fraud or Accuracy-Related Penalty
We now address whether petitioners are liable for the fraud
penalty under section 6663(a) or alternatively the accuracy-related
penalty
under
section
6662(a).
Section
6662(a)
imposes
an
accuracy-related penalty in an amount equal to 20 percent of the
portion of the underpayment attributable to negligence or disregard
of rules or regulations or to a substantial understatement of tax.
However, if section 6663(a) is applicable, a penalty in an amount
equal to 75 percent of the underpayment is imposed.
Respondent
relies primarily on the record in its entirety and concludes that
- 46 petitioners engaged in a pattern of conduct that illustrates their
intent
fraudulently
to
evade
payment
of
Federal
income
tax.
Petitioners obviously disagree.
Fraud is defined as an intentional act of a taxpayer to evade
the payment of tax that is believed to be owing by conduct that
conceals, misleads, or otherwise prevents the collection of such
tax. See Sadler v. Commissioner, 113 T.C. 99, 102 (1999); McGee v.
Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th
Cir. 1975); Snavely v. Commissioner, T.C. Memo. 1994-256.
The
Commissioner
and
has
the
burden
of
proving
fraud
by
clear
convincing evidence. See sec. 7454(a); Rule 142(b); Rowlee v.
Commissioner, 80 T.C. 1111, 1123 (1983); Beddow v. Commissioner,
T.C. Memo. 1999-232. To satisfy this burden, the Commissioner must
show: (1) That an underpayment exists; and (2) that the taxpayer
intended to evade taxes known to be owing by engaging in conduct
intended to conceal, mislead, or otherwise prevent the collection
of taxes.
See Parks v. Commissioner, 94 T.C. 654, 660-661 (1990).
The existence of fraud is a question of fact to be resolved
from
the
evidence.
entire
record
and
can
be
proven
by
circumstantial
See Recklitis v. Commissioner, 91 T.C. 874, 909 (1988);
Grosshandler v. Commissioner, 75 T.C. 1, 19 (1980); Gajewski v.
Commissioner, 67 T.C. 181, 199 (1976), affd. 578 F.2d 1383 (1978).
But fraud is not presumed; it is required to be shown through
- 47 affirmative evidence.
See Beaver v. Commissioner, 55 T.C. 85, 92
(1970).
Courts have developed various factors or badges which tend to
establish fraud.
These include:
(1) A pattern of understatement
of income; (2) inadequate records; (3) concealment of assets; (4)
income from illegal activities; (5) attempting to conceal illegal
activities;
(6)
implausible
or
inconsistent
behavior; and (7) dealings in cash.
explanations
of
See McGee v. Commissioner,
supra at 260; Snavely v. Commissioner, supra.
In addition, the
taxpayer’s sophistication, education, and intelligence may also be
considered in determining the existence of fraud.
Commissioner, supra.
See Sadler v.
No single factor or any combination of
factors will necessarily lead us to the conclusion that fraud
exists. We must examine whether a pattern of fraudulent intent was
established on the basis of an examination of the entire record.
Respondent argues that the record is replete with indicia of
fraud
by
petitioners,
including
the
following:
(1)
Gross
undervaluation of the 1989 and 1990 stock bonus awards; (2) the
hiding of the animal trophy collection expenditures by recording
them in different accounts in the company’s general ledger at the
direction of Dr. Gow; (3) lack of petitioners’ credibility in
statements made both at audit and at trial; and (4) charging of
personal items as business expenses.
Moreover, respondent claims
that petitioners’ knowledge of tax and accounting issues supports
- 48 a
conclusion
that
they
structured
their
dealings
in
WVI
and
Powhatan Associates in such a way as to purposely evade the payment
of taxes.
We disagree.
We do not find petitioners to be tax sophisticated.
Although
marginally experienced in business matters, neither Dr. nor Mr. Gow
had substantial knowledge or training in tax law.
Dr. Gow’s
advanced degrees were in the field of education, not business.
Before the formation of WVI, her experience and training dealt more
in the operational management and planning side of business than
with the accounting or economic side.
not make one an expert.
Several courses in tax do
Additionally, we draw no inferences
regarding Dr. Gow’s tax sophistication from a letter she wrote to
her personal accountant (Mr. Bielat) regarding her entitlement to
specific deductions.
Although we find petitioners’ testimony self-serving, we do
not necessarily find their testimony untruthful or devious.
Nor
are we convinced that petitioners deliberately caused their travel
and entertainment expenses to be hidden in the company’s books in
a way designed to avoid taxes.
The fact that Revenue Agent Puchaty
could not find the expenses in the accounts where he expected them
to be does not persuade us that petitioners intentionally “hid
them”.
Respondent cites Grossman v. Commissioner, T.C. Memo. 1996452, for the proposition that in circumstances similar to those
- 49 presented here, we upheld the imposition of the fraud penalty under
section 6663(a).
Within the fraud context, we find the situation
in Grossman distinguishable from that involved herein. The taxpayer
in Grossman was a practicing lawyer specializing in Federal income
taxation.
He held an LL.M. in taxation from New York University
and had previously worked for the Internal Revenue Service.
He
obviously possessed a substantial level of sophistication in the
area of tax law.
Here, petitioners, although highly intelligent,
do not possess the same level of tax expertise.
We recognize that petitioners have grossly undervalued the
stock bonus awards and charged personal items as business expenses.
We have no doubt that petitioners’ conduct in this case comes close
to the line that separates a conscious “disregard of rules or
regulations” from an “intent to evade taxes believed to be owing”.
However, even where there is a strong suspicion of an intent to
evade taxes, we are hesitant to impose the section 6663(a) penalty
unless we are convinced that the Commissioner satisfied his burden
of proof.
See Toussaint v. Commissioner, 743 F.2d 309, 312 (5th
Cir. 1984), affg. T.C. Memo. 1984-25; Petzoldt v. Commissioner, 92
T.C. 661, 700 (1989).
Here, a complete review of the record has
convinced us that respondent has failed to do so.
Accordingly, we
decline to impose the fraud penalty upon petitioners.
Petitioners, however, have failed to prove that they acted
with reasonable cause and in good faith.
Evidence in the record
- 50 persuades us that petitioners negligently disregarded rules or
regulations.
sec.
See Neely v. Commissioner, 85 T.C. 934, 947 (1985);
1.6662-3(b)(1),
Income
Tax
Regs.
Accordingly,
we
hold
petitioners liable for the accuracy-related penalty on the entire
underpayment for the years in issue pursuant to section 6662(a).
In reaching our conclusions herein, we have considered all of
the arguments presented and, to the extent not discussed above,
find them to be irrelevant or without merit.
To reflect the foregoing and concessions of the parties,
Decision will be
entered under Rule 155.
- 51 APPENDIX A
Comparison of Experts’ Valuation of
Williamsburg Vacations, Inc. Stock
As of February 16, 1989
Valuation Of Powhatan Associates
“Pre-tax” value of Powhatan
“Post-tax” value of Powhatan
Pro-rata value of 1/3 joint
venture interest
Discount for lack of control
Discount for lack of
marketability
Petitioners’
Expert
Respondent’s
Experts
$18,817,787
11,704,663
$32,866,718
15%
3,902,000
(585,300)
5%
30%
(995,010)
10% (1,040,779)
2,321,690
9,367,015
Petitioners’
Expert
Respondent’s
Experts
$840,100
359,324
2,321,690
$840,086
Fair market value of Powhatan
1/3 interest
10,955,573
(547,779)
Valuation Of WVI
Shareholders’ equity, 12/31/88
Estimated earnings to 2/16/89
Fair market value of Powhatan
Fair market value of development
fee income
FMV promissory note from shareholder
Land held for investment
Other changes to assets
Cost basis of Powhatan joint venture
Book amount of promissory note
Land held for investment at cost
Tax adjustment
Other changes to liabilities
697,000
19,223
10,000
(369,400)
(192,230)
(357,000)
9,367,015
1,596,262
10,000
22,127
(369,421)
(357,000)
(4,228,419)
207
3,328,707
6,880,857
15%
(499,306)
---
Fair market value of Williamsburg
Vacations, Inc.
2,829,401
6,880,857
Contingency discount
- 52 Valuation Of The Shareholdings
Petitioners’
Expert
Per share pro-rata value
Pro-rata value of 800 shares
Discount for lack of control
Discount for lack of
marketability
Respondent’s
Experts
$1,529
1,223,525
20% (244,705)
20%
$3,719
2,975,506
(595,101)
30%
10%
(238,040)
(293,646)
Fair market value of 800
shares in WVI
685,174
Rounded
685,000
Per share
856.25
2,142,364
2,678
- 53 APPENDIX B
Comparison of Experts’ Valuation of
Williamsburg Vacations, Inc. Stock
As of February 15, 1990
Valuation Of Powhatan Associates
“Pre-tax” value of Powhatan
“Post-tax” value of Powhatan
Pro-rata value of 1/3 joint
venture interest
Discount for lack of control
Discount for lack of
marketability
Petitioners’
Expert
Respondent’s
Experts
$22,456,921
13,968,205
$35,001,760
15%
4,656,000
(698,400)
5%
30%
(1,187,280)
10% (1,108,389)
2,770,320
9,975,502
Petitioners’
Expert
Respondent’s
Experts1
$1,189,400
348,794
2,770,320
$1,189,397
799,000
19,223
10,000
1,557,915
Fair market value of Powhatan
1/3 interest
11,667,253
(583,363)
Valuation Of WVI
Shareholders’ equity, 12/31/89
Estimated earnings to 2/15/90
Fair market value of Powhatan
Fair market value of development
fee income
FMV promissory note from shareholder
Land held for investment
Other changes to assets
Cost basis of Powhatan joint venture
Book amount of promissory note
Land held for investment at cost
Tax adjustment
Other changes to liabilities
10,000
22,126
(546,556)
(357,000)
(4,391,591)
(12,881)
4,040,947
7,466,912
15%
(606,142)
---
Fair market value of Williamsburg
Vacations, Inc.
3,434,805
7,466,912
Contingency discount
1
(546,560)
(192,230)
(357,000)
9,975,502
We are mindful that several mathematical errors exist in
respondent’s computation. We do not believe these discrepancies are
material.
- 54 Valuation Of The Shareholdings
Per share pro-rata value
Pro-rata value of 400 shares
Discount for lack of control
Discount for lack of
marketability
Petitioners’
Expert
Respondent’s
Experts
30%
$1,527
610,632
(183,190)
50%
$3,319
1,327,451
(663,725)
30%
(128,233)
10%
(66,373)
Fair market value of 400
Shares in WVI
299,210
Rounded
299,000
Per share
747.50
597,353
1,493
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.