UNITED STATES TAX COURT
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T.C. Memo. 2004-272
UNITED STATES TAX COURT
ERIC B. BENSON, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
585-98, 19416-98,
19417-98, 19421-98,
12967-00, 14171-01.
Filed November 29, 2004.
John M. Youngquist, for petitioners.
Michael E. Melone and Charlotte Mitchell, for respondent.
1
Cases of the following petitioners are consolidated
herewith: Brad D. Benson, docket No. 19416-98; Mark D. Benson,
docket No. 19417-98; Eric B. Benson, docket No. 19421-98; Burton
O. and Elizabeth C. Benson, docket Nos. 12967-00 and 14171-01.
- 2 MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge:
These cases were consolidated for purposes of
trial, briefing, and opinion.
Respondent determined deficiencies
in petitioners’ Federal income taxes, additions to tax pursuant
to section 6651(a)(1),2 accuracy-related penalties, and additions
to tax/fraud penalties pursuant to sections 6653(b) and 66633 for
the docket numbers, taxable years, and in the following amounts
as stated:
Eric B. Benson, Docket No. 585-98:
1
Year
Deficiency
1993
$236,997
Additions to Tax/Penalties
Sec. 6651(a)
Sec. 6663(a)
$59,793
$177,748
1
Respondent asserts the accuracy related penalties as
an alternative in the event that the Court does not find
fraud.
Brad D. Benson, Docket No. 19416-98:
Year
Deficiency
Penalty
Sec. 6662(a)
1994
$43,906
$8,781
2
All section references are to the Internal Revenue Code in
effect for the taxable years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
3
In the notices of deficiency, respondent took an
alternative position that accuracy-related penalties pursuant to
sec. 6662(a) for the tax years 1989, 1990, 1993, and 1994 apply
to the extent additions to tax/fraud penalties do not. See also
infra note 70.
- 3 Mark D. Benson, Docket No. 19417-98:
Year
Deficiency
Penalty
Sec. 6662(a)
1994
$50,158
$10,032
Eric B. Benson, Docket No. 19421-98:
Year
Deficiency
Penalty
Sec. 6662(a)
1994
$36,853
$7,370
Burton O. and Elizabeth C. Benson, Docket No. 12967-00:
1
Year
Deficiency
Additions to Tax/Penalties
Sec. 6651(a)
Sec. 6653(b)
Sec. 6663(a)
1988
1989
1990
1993
$125,578
168,666
2
113,559
3
1,500,523
–
$42,173.50
28,390.25
–-
$100,654.50
–––-
–$126,499.50
85,169.25
1,125,392.25
1
Respondent asserts the accuracy related penalties as an
alternative in the event that the Court does not find fraud.
2
In his second amendment to answer to petition as amended,
docket No. 12967-00, respondent asserted an increase in the
deficiency amount, addition to tax, and fraud penalty for 1990 of
$122,930, $30,733, and $92,197.50, respectively. See infra p. 5,
table, note 2.
3
In his second amendment to answer to petition as amended,
docket No. 12967-00, respondent decreased the amount of the
deficiency and fraud penalty for 1993 to $1,499,627 and
$1,124,720.25, respectively.
Burton O. and Elizabeth C. Benson, Docket No. 14171-01:
Year
1994
1
Deficiency
1
$118,429
Penalty
Sec. 6663(a)
$88,821.75
In his amendment to answer, docket No. 14171-01, respondent
asserted an increase in the deficiency amount and fraud penalty
- 4 for 1994 of $129,902 and $97,426.50, respectively.
5, table, note 2.
See infra p.
In the notices of deficiency, respondent asserted many
alternatives and whipsaw positions.
For ease of explanation, we
address only those issues which we decide.
Additionally, there
are numerous computational issues which we omit from our
discussion.
Because of the interconnected nature of these cases,
our findings and holdings as to some petitioners will have
ramifications to other petitioners.
As a result, there will be
extensive adjustments made by the parties under a Rule 155
computation.
After numerous concessions by respondent and petitioners,4
the issues remaining for decision are as follows:
1.
Whether petitioners Burton O. and Elizabeth C. Benson
(the Bensons) received and failed to report constructive
dividends.
The transactions still at issue for the years and the
amounts are listed as follows:
4
Because of their number, a summary of the parties’
concessions is attached hereto and incorporated herein as an
appendix.
- 5 Description
1988
ERG-Recreation acct.
–Transfers ERG to NPI $180,000
143 Alice Lane
–Prop. taxes Alice Ln.
–Check ref: Carroll
–Automobile deductions
9,465
Charitable deduction
–Excess rent--Stanford1
–Rent--Lowell plant
31,850
Director’s fees
Elizabeth Benson
–Related parties
–Esther Benson check
–Townsend check
–Travel expenses
–Legal expenses
–Employee relations
–Total
221,315
1989
Tax Year
1990
1993
–$483,098
––96,749
10,624
––29,400
––$336,500
––8,676
–2
40,067
29,400
$8,000
3,600,000
–3,879
–14,808
50,000
46,560
31,020
$2,698
160,063
–8,196
–14,723
–63,444
3
41,376
3,000
3,000
–––––625,871
12,000
11,000
–––––437,643
12,000
30,000
–––––3,796,267
12,000
25,000
12,000
15,000
6,690
4,159
4,027
369,376
1994
1
The record and briefs contain inconsistencies with respect to
respondent’s determinations for the Stanford and Lowell plants. Indeed,
generally, the notices of deficiency list the amounts stated above for
Stanford as that for Lowell, and vice versa. For example, on one page of the
Bensons’ notice of deficiency for 1994, the adjustment for “Excess rents for
Stanford plant” is listed as $41,736 and for “ERG’s payments for Lowell plant”
as $35,316. On the very next page, the excess rent for Stanford is listed as
$35,316 and for Lowell as $41,736. Respondent’s answers, amendments thereto,
and brief mimic the amounts stated above. We assume a clerical error and
assign no substantive significance to this error.
2
On brief, respondent explained that he amended his answers in docket
Nos. 12967-00 and 14171-01, which amendments caused respondent to assert
increased deficiencies for the Bensons, for tax years 1990 and 1994. See
supra p. 3, tables, notes 1 & 2. However, for 1993 his amendment caused a
decrease in the amount determined; respondent determined in the notice of
deficiency that the Bensons failed to report $48,758 in rent for the Stanford
plant. See supra p. 3, table, note 3.
3
Clearly, there is a clerical error in the amount stated in respondent’s
brief, $41,376, as the amount listed in the notice of deficiency is $41,736.
2.
whether the Bensons received and failed to report other
income.
The transactions still at issue for the years and in the
amounts are as follows:
Description
1988
1989
Tax Year
1990
1993
Dividend income
Discharge debt
––-
––-
––-
––-
1994
$1,072
88,291
1
- 6 1
Respondent alternatively argues that this amount is includable in 1988.
3.
whether the Bensons are entitled to deduct expenses with
respect to a ski cabin owned by the Baden Spiel Haus partnership
in the amount of $2,635 for 1994;
4.
whether the Bensons are entitled to claim a deduction
for residential rental expenses in excess of the amounts allowed
by respondent;
5.
whether Burton Benson is liable for fraud penalties for
the years at issue;5 or
(a) alternatively, whether the Bensons are liable for
accuracy-related penalties for the years 1989, 1990, 1993, and
1994;
6.
whether Eric B. (Eric), Brad D. (Brad), and Mark D.
(Mark) Benson are liable for accuracy-related penalties as
determined;
7.
whether the Bensons and/or Eric are liable for additions
to tax for failure to file a Federal income tax return pursuant
to section 6651(a)(1) as determined;
8.
whether the period of limitations bars assessment of the
Bensons’ taxes reported on their 1988, 1989, 1990, 1993, and 1994
Federal tax returns;
5
We use the term “fraud penalties” to include the addition
to tax for 1988 under sec. 6653(b).
- 7 9.
whether Eric, Brad, and Mark received and failed to
report distributions from an S corporation in excess of their
stock basis;
10.
whether Eric, Brad, and Mark are subject to the passive
loss rules with respect to passthrough rental losses from an S
corporation.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, the supplemental stipulations of facts,
the stipulations of settled issues, and the attached exhibits are
incorporated herein by this reference.
At the time of filing the
petitions, each petitioner’s legal residence was Orinda,
California.
1.
Background
Burton O. Benson (Burton) served 9 years as an officer in
the U.S. Navy and 23 years as an officer in the U.S. Naval
Reserve, retiring with the rank of Rear Admiral.
Burton earned a
B.S. degree in mechanical engineering from the University of
Minnesota.
Eric, Mark, and Brad are the sons of the Bensons.6
Glendon M. Benson (Glendon) is the elder brother of Burton.
Esther V. Benson (Esther) was the mother of Burton and Glendon.
6
Eric, Mark, and Brad were born on July 24, 1974, Aug. 26,
1976, and Aug. 11, 1981, respectively.
- 8 Energy Research & Generation, Inc. (ERG) is a corporation
incorporated by Glendon, his wife, Janet Benson, and Burton in
California on January 5, 1967.
During the years at issue, ERG
utilized the accrual method of accounting for tax purposes.
ERG is the only company in the world that manufactures
various forms of foam metal and foam metal baffles.7
Duane Walz
and Glendon invented the process known as foam metal which
Glendon then developed into a product.
However, Walz was given
sole credit as the inventor in the patent, and on March 23, 1976,
he assigned his patent rights to ERG.
On each of the tax returns filed by ERG for 1988 through
1994, Burton is listed on Schedule E, Compensation of Officers,
as owning 100 percent of the common stock of ERG.
Throughout the
years 1988 through 1994, Burton was a director of ERG.
Throughout the years 1988 through 1994, ERG maintained a money
market account with Merrill Lynch Pierce, Fenner & Smith, Inc.,
account No. 280-07888-2 (ERG’s bank account).
New Process Industries, Inc. (NPI) was originally
incorporated in Minnesota in 1922 by Burton and Glendon’s father
under the name New Process Laundries, Inc.
the name was changed to NPI.
7
On January 6, 1967,
During the years at issue, NPI
Foam metal baffles are used in the U.S. Navy’s fleet of
ballistic missiles.
- 9 utilized the cash method of accounting for tax purposes and was
an S corporation.
The Benson family’s percentage of ownership in NPI was
listed on its tax returns for the individuals, for the years, and
in the amounts as stated:
Individuals
1988
1989
Burton
Esther
Eric
Brad
Mark
66.7
33.3
–––-
66.7
33.3
–––-
Year of NPI Return
1990 1991 1992
66.7
33.3
–––-
66.7
33.3
–––-
50.0
50.0
-––-
1993
1994
66.7
–11.1
11.1
11.1
50.0
–16.7
16.7
16.7
Throughout the years at issue, there was no written
agreement between ERG and NPI relating to engineering, design, or
management services, NPI did not treat anyone as an employee, and
no Form 941, Federal Payroll Tax Returns, was filed or Form 1099
was issued.
During this same period, NPI maintained a money
market account with Merrill Lynch Pierce, Fenner & Smith, Inc.,
account No. 280-07017-8 (NPI’s bank account).
During the years at issue, NPI owned three parcels of real
property located in Oakland, California:
(1) 952 57th Street
(Lowell plant); (2) 900-960-962-964 Stanford Avenue (Stanford
plant); and (3) vacant land adjacent to 900 Stanford Avenue
fronting on Lowell Street.
Before and after July 1, 1987, ERG
conducted its foam metal manufacturing operations from the
Stanford Plant.
- 10 In the mid-1980s, a dispute arose between Burton and Glendon
over the operation and ownership of ERG.
On April 4, 1985, the
Bensons filed a lawsuit against Glendon, his wife Janet, and ERG.
In or about September 1985, Glendon convened an ERG board meeting
during which the directors in attendance supposedly voted to
terminate Burton’s employment with ERG.
Immediately thereafter,
Glendon hired security personnel to bar Burton from entering
ERG’s facilities.
In October 1985, Burton and Glendon executed an agreement
delineating their respective responsibilities concerning
contracts with two major ERG clients, Hercules Aerospace Co.,
Inc. (Hercules),8 and Gas Research Institute (GRI).
Essentially
under that agreement, Burton was granted all rights to and
responsibility for contracts with Hercules, and Glendon was
granted all rights to and responsibility for contracts with GRI.
In May 1986, Burton and Glendon initiated binding
arbitration.
On July 9, 1986, the arbitration panel issued an
interim decision.
In October 1986, Burton and Glendon entered
into an agreement to adjourn the arbitration proceedings choosing
instead to mediate the dispute with the aid of Winston E. Miller
(Miller or WEM) as mediator.
On June 28, 1987, during the course
of mediation, Burton and Glendon entered into an agreement
8
Hercules and all predecessors and successors in interest
will be referred to throughout this opinion as Hercules.
- 11 entitled “Memorandum Re: Unbundling of ERG”.
Burton and Glendon
executed a document entitled “Supplemental Memorandum Re:
Unbundling of ERG (December 4, 1987)”.
On December 5, 1987,
Burton and Glendon executed a document entitled “Memorandum Re:
Other Commitments made to WEM”.9
By letter dated March 18, 1988, ERG and NPI, through Burton,
gave instructions to their patent counsel of the firm Townsend &
Townsend to transfer certain patents, patent applications, and
intellectual property to Glendon.
The parties stipulated that on
December 29, 1988, Glendon incorporated Aker Industries, Inc.
(Aker).10
After July 1987, and during all periods relevant to
these cases, Burton exercised almost sole control over the
management and operations of ERG and NPI.
On March 23, 1993, Glendon and his wife, Janet, filed a
motion asking a California court to enforce the unbundling
agreement as a settlement agreement.
In response to a 1994
petition filed by Burton, the court ordered the parties to
recommence arbitration.
recommenced.
In 1994, arbitration proceedings
On June 7, 1995, a second interim arbitration
9
Except as otherwise noted to the contrary, we refer to the
documents executed by Burton and Glendon during mediation
collectively as the “unbundling agreement”.
10
On Feb. 29, 1988, Burton signed a City of Oakland Business
Tax Declaration stating that ERG’s research and development
division had been established as a new company, “Acker [sic]
Industries”. However, Glendon testified that Aker was
incorporated in July 1987.
- 12 decision was issued.
On November 8, 1996, a third interim
arbitration decision was issued.
On March 5, 1999, a final arbitration decision was issued.
The final arbitration decision comprehensively decided the issues
between the brothers, and the arbitrators found, inter alia,
that:
During the period from and after July 1, 1987,
* * * [Burton]/ERG/NPI was extremely successful * * *.
As a result, in the period from 1988 through 1996,
* * * [Burton] and his family obtained in excess of
$6,500,000 in salaries, director’s fees and cash
distributions from ERG/NPI.
* * * [F]rom and after July 1, 1987, * * *
[Burton] had total control over both ERG and NPI * * *
Accordingly, the arbitrators held that Burton became the 100percent owner of ERG on July 1, 1987.
The arbitrators found that
Burton owed Glendon a gross amount of $3,119,475 for his interest
in ERG.
The arbitrators awarded the Lowell plant to
Glendon/Aker, for which Burton received a credit of $185,500.
The tribunal found that Glendon/Aker should have paid NPI rent
for the Lowell plant at $2,000 per month for the period July 1,
1987, to December 31, 1994, and $2,500 thereafter.
Accordingly,
Burton was credited with the rent payments plus interest,
$420,650.
The final arbitration decision awarded Glendon a net
$2,412,172 after credits and deductions.
- 13 2.
Constructive Dividend Issues
(a) The ERG-Recreation Fund Account
On or about April 5, 1985, Burton submitted an application
to open an account with the Franklin Group of Funds (Franklin)
under the name “ERG-Recreation Fund”.
The account was opened and
assigned money fund account No. 1110267091-7 (the ERG-Recreation
fund account).
During the years 1988 through 1994, Burton was
the only person with signature authority over the ERG-Recreation
fund account.
Checks written against the account were payable
through Bank of America.
In 1988, numerous checks were deposited into the ERGRecreation fund account aggregating $4,387.34.
checks were written from this account.
Additionally,
For example, check No. 6,
dated September 7, 1988, payable to NPI for the amount of $3,000
was signed by Burton.
This check was deposited into NPI’s bank
account during the period August 27 to September 30, 1988.
In 1990, numerous checks were deposited into the ERGRecreation fund account aggregating $11,097.53.
In 1990, three
checks were written on this account, all signed by Burton, for
example:
(1) Check No. 7, dated April 5, 1990, for $3,128 was
written to Michael’s Reno Suzuki; and (2) check No. 8, dated June
16, 1990, for $597.44 made payable to Anytime Power Sports
Equipment.
- 14 In 1993, numerous checks were deposited into the ERGRecreation fund account aggregating $8,819.73.
In 1993, five
checks were drawn on this account, all signed by Burton, for
example:
(1) Check No. 27, dated March 8, 1993, for $9,000 made
payable to ERG; (2) check No. 29, dated June 11, 1993, for $356
made payable to Siegle’s;11 (3) check No. 30, dated July 15,
1993, for $9,000 made payable to petitioner Mark;12 and (4) check
No. 31, dated August 16, 1993, for $8,000 made payable to ERG
Retirement Trust.
The parties stipulated that in 1994, numerous checks were
deposited into the ERG-Recreation fund account aggregating
$6,068.13
In 1994, eight checks were drawn on this account, all
signed by Burton, for example:
(1) Check No. 32, dated May 13,
1994, for $100 made payable to Mt. Diablo Silverado Council, BSA;
(2) check No. 34, dated August 13, 1994, for $206.38 made payable
to Berkeley Yamaha; (3) check No. 35, dated September 15, 1994,
11
In 1993, Siegle’s Guns was a firearms retailer in Oakland,
Ca.
12
On July 19, 1993, check No. 30 was deposited into a
custodial account into which Burton deposited his payroll checks
and other checks from ERG.
13
The parties stipulated that in 1994 “numerous checks from
various sources were deposited into the ERG Recreation Fund
Account in the aggregate amount of $6,068" and referenced an
exhibit in the record. The referenced exhibit contains copies of
an annual account statement for this account which shows
aggregate deposits of $5,864.42 for 1994. Additionally, the
referenced exhibit contains copies of checks apparently deposited
into this account in the aggregate amount of $4,411.85.
- 15 for $274.66 made payable to Bobbi Judson; (4) check No. 37, dated
September 24, 1994, for $265 made payable to Marc Dronkers; (5)
check No. 38, dated November 23, 1994, for $650 made payable to
Donald J. Holleran; and (6) check No. 39, dated December 14,
1994, for $724.10 made payable to Marc Dronkers.
Check Nos. 35
and 39 note Risktaker in the memo section of the checks, which
refers to a sailboat partly owned by Burton.
(b) Payments From ERG to NPI
During the years 1988 through 1994, Burton caused ERG to
transfer significant funds to NPI on the dates and in the amounts
as follows:
Date Transferred
Amount
Date Deposited
12/30/88
4/15/93
4/15/93
4/20/93
12/30/93
4/15/94
6/17/94
Total
$180,000
750,000
190,000
2,060,000
600,000
129,414
30,649
3,940,063
Unknown
4/21/93
4/21/93
4/26/93
1/10/94
4/19/94
6/22/94
Burton never told his accountant and return preparer, Edward
Bradac (Bradac), about ERG’s 1988 transfer of $180,000 to NPI.
Bradac was unaware of the transfer until late 1995 or early 1996
when he worked on compiled financial statements for ERG.
All the aforementioned transfers were made from ERG’s bank
account and deposited into NPI’s bank account.
- 16 (c) Payment for Increased Baffle Production
One of ERG’s principal customers was Hercules.
During the
years at issue, ERG produced a baffle system on behalf of
Hercules with respect to the Trident II D-5 U.S. Navy Fleet
Ballistic Missile Program.14
At some point, Hercules requested
an increase in the production of baffle sets.
ERG, through
Burton, indicated that to increase production ERG would require
additional equipment and materials.
On or about November 22, 1989, Hercules and ERG entered into
a memorandum of agreement (MOA), whereby Hercules agreed to pay
$483,098 as an add-on cost to increase production of the baffle
sets delivered by ERG.15
The MOA was unique because it called
for Hercules to “facilitize” or fund ERG’s plant and equipment,
the cost of which is normally paid for by the owner of the plant
and equipment.
Attached to the MOA is “schedule 1", which lists
the equipment and their associated prices as contemplated by the
14
The baffles were made from ERG’s foam metal.
15
Under the MOA, the add-on cost was spread over the
invoicing of the baffle sets delivered. The MOA states in
pertinent part:
The add-on cost per Baffle per year will be the sum of
the seven year double declining schedule amount for
that particular year plus the Cost Accounting Standards
cost of money, * * * evenly divided among the number of
Baffles that are scheduled to be delivered within that
year. * * *
- 17 MOA.16
Some of the items listed involve proprietary processes.
The projected prices in schedule 1 include the cost of time and
engineering to specify the details of the equipment, to design
the assembly, modifications, and installations of the equipment,
and to do debugging on the production process to make sure the
equipment worked properly.
Some of the equipment was supposedly
to be created by ERG.17
On or about December 20, 1989, ERG and NPI entered into a
“Plant Equipment & Facilities Purchase Agreement”.
Under this
agreement, in exchange for $483,098, NPI agreed to purchase,
deliver, install, and place into operation as a “turnkey
operation” the items listed on schedule 1 of the MOA, which was
incorporated into the agreement.
On or about December 29, 1989,
ERG issued check No. 20498 to NPI for $483,098.
On August 8, 1990, Burton, as president of ERG, executed a
document entitled “Certification That Plant
Equipment/Facilitization Items Are in Place and Operational”.
By this document, Burton certified to Hercules that the equipment
listed on schedule 1 of the MOA was in place and operational at
ERG, or would be by December 31, 1990.
16
ERG’s chief engineer, Bryan Leyda, testified that he
created the prices on schedule 1 with the help of an associate
engineer.
17
Mr. Leyda testified: “There’s no way that you can buy
this kind of * * * [equipment] off the shelf. You might buy
pieces, but not the entire piece of equipment.”
- 18 Hercules paid ERG the $483,098 agreed to in the MOA in
increments included in the amounts it paid to ERG for each baffle
set purchase order during the period 1990 through 1997.
However,
neither NPI nor ERG purchased the equipment listed on schedule 1
of the MOA.
On its original 1989 Form 1120S, U.S. Income Tax Return for
an S Corporation, NPI did not report any portion of the $483,098
payment from ERG.
On its 1989 Form 1120, U.S. Corporation Income
Tax Return, ERG deducted $248,097 of the $483,098 payment to NPI
as a royalty.
On its amended 1989 Form 1120S, NPI reported
income of $248,097 with respect to the $483,098 payment from ERG.
On its original 1990 Form 1120S, NPI reflected the $483,098
payment from ERG as an increase in liabilities; i.e., a security
deposit.
On its 1990 Form 1120, ERG deducted $193,508 of the
$483,098 payment to NPI as a royalty.
(d) Exclusive Royalty Agreement Between ERG and NPI
ERG owned and/or was assigned certain patent technologies.
Additionally, Glendon assigned to NPI numerous patents which were
issued for technologies he invented.
On or about March 10, 1990,
Burton executed as president of both NPI and ERG, a document
entitled “Agreement of Sale and Exclusive License” (exclusive
license agreement).18
18
The document had a retroactive effective
The agreement also bears the signatures of Elizabeth and
Esther.
- 19 date of July 1, 1987, and a 40-year term.19
The document
purports to sell certain “patent rights” owned by ERG to NPI and
simultaneously grants ERG an exclusive license to use the patent
rights transferred.
The patent rights are described as the
“technology, technique, show-how, and know-how” relating to foam
metal, RVC foam, and SIC foam.
Pursuant to the agreement, NPI purchased ERG’s patent rights
for $5,000 and 50 percent of all consideration that NPI received
from the “assignment, licensing, sublicensing, leasing, or other
commercial exploiting” of the patent rights.
Under the
agreement, ERG would pay to NPI, inter alia, 10 percent of its
net sales of any product incorporating the patent rights licensed
to ERG by NPI.
(e) 143 Alice Lane
During the years at issue, the Bensons owned, and used as
their principal residence, real property located at 5 Evans
Place, Orinda, California.
The Bensons entered into an agreement
with Dover Construction, dated June 13, 1990, to purchase a
portion of real property adjacent to their residence (the Dover
19
During arbitration proceedings, Miller gave testimony
concerning this agreement. On Apr. 7 and 8, 1997, Miller
testified that it was his advice to Burton to create the
agreement. In fact, Miller testified that he gave Burton a
“model” license agreement from which to fashion the agreement
between ERG and NPI. Furthermore, Miller testified that there
was nothing unusual about backdating the agreement.
- 20 property).20
Abutting the Dover property is the real property
located at 143 Alice Lane, Orinda, California (143 Alice Lane).
In June 1990, ERG purchased 143 Alice Lane for $335,000.21
ERG took title to the property in the name “Burton O. Benson,
Trustee” of the ERG Retirement Trust.22
The ERG Retirement Trust
neither paid for the purchase nor reflected the property as an
asset on any tax return or financial statement.
ERG’s purchase
of 143 Alice Lane, along with the Bensons’ purchase of the Dover
property, gave the Bensons a large, uninterrupted piece of land
behind and abutting their residence.
On or about April 10 and December 10, 1993, ERG paid
$1,925.57 and $1,953.14, respectively, for property taxes on 143
Alice Lane.
In 1994, ERG paid $8,196 in property taxes for 143
Alice Lane.
On October 28, 1997, Burton as trustee of the ERG Retirement
Trust deeded 143 Alice Lane to the Bensons as husband and wife.
20
The Bensons were deeded the Dover property on or about May
23, 1991.
21
The price paid inclusive of fees and taxes was
$336,410.72.
22
During the years at issue, ERG maintained a single plan
qualified under ch. 1, subch. D of the Code, the Energy Research
& Generation, Inc., Profit Sharing Plan (the plan). The plan
assets were invested in a single trust, the ERG Retirement Trust.
ERG maintained Franklin Money Fund accounts under the names ERG
Ford Retirement Trust and ERG Retirement Trust. The ERG Dynar
Retirement Trust and the ERG Ford Retirement Trust are not
separate trusts.
- 21 The deed shows no consideration for the transfer and indicates
the transfer was a “gift to spouse”.
(f) ERG Check to Burton (Ref. Carroll)
On May 17, 1989, a petition for confirmation of arbitration
award and entry of judgment was filed in the California Superior
Court, San Francisco County.
According to that document, Michael
Brooks Carroll (Carroll) provided advice and legal services with
respect to the disagreement Burton had with his brother
concerning the ownership, management, and control of NPI and ERG.
Burton withheld payment for such services.
The arbitrators
rendered a decision that Burton owed Mr. Carroll $96,748.98, plus
interest thereon.
On May 19, 1989, ERG issued Burton check No. 19888 for
$96,748.98.
Carroll.”
The check bears the notation “for Michael B.
The check was endorsed “For Deposit Only Wells Fargo
Bank 740-6070466," an equity credit line of the Bensons (the
Bensons’ Wells Fargo bank account).
The check was deposited and
accepted for payment on May 24, 1989.23
On or about May 23,
1989, Burton purchased a Wells Fargo Bank cashier’s check No.
13499 made payable to Carroll for $97,467.21 from the Bensons’
23
The check was initially presented for payment on May 19,
1989, but not honored because of insufficient funds. On May 24,
1989, the check was again presented for payment.
- 22 Wells Fargo bank account.24
On their 1989 Form 1040, U.S.
Individual Income Tax Return, the Bensons claimed a deduction for
a portion of the legal fees paid to Mr. Carroll of $77,973.
(g) Automobile and Truck Deductions
ERG claimed deductions for automobile and truck expenses for
the following years in the amounts stated:
Amount of Deduction
Tax Year
1988
1989
1990
1993
1994
$9,645
10,624
23,676
28,308
14,723
ERG bought a Jeep for Eric for $15,000 in 1990 and a Ford Bronco
for Mark for $13,500 in 1993.
ERG’s claimed deductions included
the cost of purchasing these two vehicles, as well as DMV fees,
insurance, gasoline, and repairs for four family cars.
The
Bensons conceded that the purchase of the automobiles constituted
constructive dividends.
See appendix.
The Bensons were authorized signators on a First Interstate
checking account No. 804-2-01477, which was used exclusively to
pay for gasoline purchases through Interlink bank debit card(s)
linked to that account.
During the years listed, ERG paid the
following amounts for gasoline:
24
The record does not disclose why there is a difference
between the amount of the arbitration award and the amount of the
payment. We assume since the arbitrators’ award included
“interest thereon” that the additional money is accrued interest
from the date of the decision to the date of payment.
- 23 Tax Year
Amount
1990
1993
1994
$1,853.00
4,194.09
4,383.16
(h) Charitable Contributions
In 1989, ERG donated $6,000 to the Moraga Valley
Presbyterian Church (MVPC).
On its 1989 Form 1120, ERG claimed
the $6,000 as a charitable deduction.
On their 1989 Form 1040,
the Bensons also claimed a $6,000 charitable deduction for MVPC.
In 1990, ERG donated $6,000 to MVPC.
ERG did not claim the
donation as a deduction on its 1990 Form 1120; however, the
Bensons did claim the donation as a deduction on their 1990
individual Federal income tax return.
In 1993, ERG issued checks payable to MVPC totaling $6,000.
ERG issued check No. 23554, dated December 31, 1992, for $50,000
made payable to Bank of America.
March 3, 1993.
The check was negotiated on
On March 5, 1993, Burton purchased cashier’s
check No. 8006822409 for $50,000 from Bank of America made
payable to MVPC.
MVPC deposited the check on March 12, 1993.
ERG’s 1993 Form 1120 contained a deduction for charitable
contributions of $4,800 and no charitable contribution carryover.
On their 1993 personal Federal income tax return, the Bensons
claimed a charitable contribution deduction for the $6,000 paid
to MVPC by ERG and the $50,000 cashier’s check paid to MVPC.
- 24 In 1994, ERG paid $13,500 to MVPC and $2,000 to Camp
Timberwolf.
On their personal return, the Bensons claimed a
charitable contribution deduction of $33,374, which included
$2,000 to Camp Timberwolf and $18,000 to MVPC.
ERG’s 1995 Form
1120 reflected charitable contribution carryovers of $102,646
from 1991, $13,200 from 1992, $1,984 from 1993, and $20,000 from
1994.
The $20,000 shown as a carryover from 1994 included a
$10,000 contribution to MVPC and a $2,000 contribution to Boy
Scouts of America (Timberwolf).
(i) Rent Paid to NPI for Stanford and Lowell Plants
Throughout 1988-94, ERG occupied the Stanford plant which
was owned by NPI.
In 1988, a commercial lease for the Stanford
plant was prepared but not executed.
Similarly, in 1988, a
commercial lease for the Lowell plant was prepared but not
executed.
The Lowell plant was used by Glendon/Aker.25
During
the period 1988-94, ERG paid monthly rent to NPI for both the
Stanford and Lowell plants.26
The parties stipulated that the
25
Glendon testified that he did not pay rent to NPI during
the period July 1987 through December 1994.
26
Burton testified that before the arbitrators’ final
decision in March 1999, he considered it ERG’s responsibility to
pay the rent for ERG’s research and development division, Aker
Industries. In the final arbitration decision, the arbitrators
decided that Glendon/Aker was liable to NPI for rent for the
period July 1, 1987, through Dec. 31, 1998, in an amount
including interest, totaling $420,650.
- 25 rent was paid and allocated between the properties for the years
as follows:
Year
ERG Payments to NPI
Stanford
Lowell
1988
1989
1990
1993
1994
$98,917
83,699
137,917
146,400
1
168,360
$67,067
56,749
106,067
112,560
129,444
$31,850
26,950
31,850
33,840
38,296
1
The amounts stated above are those listed in a joint
exhibit offered by the parties. However, it is clear that
$129,444 plus $38,296 does not equal $168,360, but instead
$167,740.
(j) Director’s Fees27
As detailed below, ERG paid purported “director’s fees”
during the years at issue.28
ERG did not file Forms 1099 with
respect to payment of any of the director’s fees.
(i)
Elizabeth C. Benson
In 1989, ERG issued three $1,000 checks payable to
Elizabeth, which she deposited into the Bensons’ Wells Fargo bank
account.
In 1990, ERG issued twelve $1,000 checks payable to
Elizabeth, of which she deposited seven into the Bensons’ Wells
Fargo bank account and five into Franklin account No. 11100025476
(Franklin account).
In 1993, ERG issued twelve $1,000 checks
27
Petitioners concede that amounts that ERG paid should have
been included in the returns of the purported directors.
28
Our categorization is based solely upon the stipulations
and characterizations made by the parties. With the exception of
two checks issued to Eric, the ERG checks issued do not indicate
their intended purpose.
- 26 payable to Elizabeth, which she deposited into various bank
accounts.29
In 1994, ERG issued twelve $1,000 checks payable to
Elizabeth, which she deposited into the Franklin account.
(ii) Esther V. Benson
In 1989, ERG issued three $1,000 checks payable to Esther.
Each check was deposited in 1990 into a Merrill Lynch Ready Asset
account No. 280-72453 (ML RAT account).
In 1990, ERG issued
eleven $1,000 checks payable to Esther.
Those checks were
deposited into various bank accounts.30
In 1993, ERG issued (at
least31) eleven $1,000 checks payable to Esther.
One check,
check no. 23662, was endorsed and deposited into a bank account
held in the names Burton and Elizabeth.32
In 1993, eleven $1,000
checks were deposited into a bank account which Esther held with
Burton as joint tenants with the right of survivorship.33
29
In
See infra note 32.
30
Seven checks were deposited into the ML RAT account and
four checks were deposited into a First Bank account No. 7112005165.
31
See infra note 33.
32
On brief, petitioners explained that there was a “mix-up”
in the delivery of the director’s fees checks in 1993. Check No.
23661 payable to Elizabeth was deposited into Esther’s account,
and the director’s fee check for Esther was deposited into
Elizabeth’s account.
33
There is an inconsistency in the parties’ stipulation.
The parties stipulated that Esther was issued eleven $1,000
checks in 1993, one of which was deposited into an account owned
by Elizabeth and Burton. The parties also stipulated that eleven
(continued...)
- 27 1994 ERG issued eight $1,000 checks payable to Esther.34
Esther
did not file Federal income tax returns for 1988 through and
including 1993.
Check to Esther V. Benson
In 1994, Burton took an uncashed check for $12,000 that ERG
had issued to Esther prior to May 1988, altered the date on the
check to indicate a date in August 1994, and deposited the check
into a bank account in September 1994 shortly after his mother’s
death.35
The bank account into which the check was deposited was
held in the names of Burton and his mother as joint tenants.
33
(...continued)
$1,000 checks were deposited into an account owned by Esther and
Burton. Indeed, the documentary evidence in the record contains
a bank statement for the Esther/Burton account which shows eleven
$1,000 deposits made in 1993. Additionally, the record contains
copies of eleven $1,000 checks, one of which was apparently,
erroneously deposited into an account owned by Elizabeth and
Burton. Arguably, then, there must have been twelve $1,000
checks issued to Esther, eleven of which were deposited into the
Esther/Burton account and one of which was deposited into the
Elizabeth/Burton account.
34
The parties stipulated that ERG issued eight $1,000 checks
to Esther, but the issuing bank was unable to locate a copy of
one check. However, the parties also stipulated that ERG did not
file Form 1099 with respect to the $9,000 paid to Esther. We are
unable to resolve the seeming inconsistency and ascribe a
scrivener’s error to the latter stipulation.
35
Burton testified that the check represented director’s
fees, and after his mother died he found the check uncashed among
her papers. He changed the date on the check because he believed
it would be rejected due to its age if negotiated.
- 28 (iii) Eric B. Benson
ERG issued check No. 23548 for $6,000 to Eric, dated
December 30, 1992, on which “Directors Fee - 6 months” is written
on the memo line.36
On or about February 26, 1993, Burton and
Eric submitted an application to open an account with USAA
Investment Management Co. as joint tenants (the USAA account).
The initial investment into the USAA account was the
aforementioned $6,000 check.
In 1993, ERG issued twelve $1,000
checks to Eric, of which eleven were deposited into the USAA
account in 1993 and one in 1994.
(k) Townsend & Townsend Check
Townsend & Townsend, patent attorneys, issued a retainer fee
refund check for $15,000 dated January 14, 1994, payable to ERG.
Burton endorsed the check on behalf of ERG to the order of
Massachusetts Mutual Life Insurance Co.
The $15,000 was credited
on January 27, 1994, as a partial repayment of loans from the
insurance company to Burton relating to insurance policy No.
4506416.37
The parties stipulated that during the years at issue
the primary beneficiary of the insurance policy was Elizabeth.
36
Eric turned 19 years old on July 24, 1993.
See supra note
6.
37
Burton testified that loans totaling $15,000 were taken
out in 1975 and 1984 against the insurance policy and that the
funds were “borrowed from the * * * policy to be put into ERG to
meet the payroll.” He testified that none of the loan proceeds
were used for his personal benefit.
- 29 (l) Travel Expenses
On or about February 9, 1994, Burton signed an ERG travel
expense report indicating that he spent $616.47 on behalf of ERG.
Additionally, the following charges were made on the dates
indicated to an ERG BankAmericard credit card, account No. 0109733-620:
Date
Description of Charge
Amount
2/5/94
Grand Manor Inn #35
Corvallis, OR
Hertz Rent-A-Car
St. Paul, MN
Radisson Hotels
Minneapolis, MN
Ramada Inns
Falls Church, VA
Hertz Rent-A-Car
Washington, D.C.
Karim Cyclery
Berkeley, CA
Surf Berkeley
Berkeley, CA
Lowell Inn
Lake Elmo, MN
SuperAmerica 4454
Bloomington, MN
Hertz Rent-A-Car
St. Paul, MN
The Claremont Resort
$223.82
5/10/94
5/10/94
5/13/94
5/13/94
9/7/94
9/7/94
9/10/94
9/11/94
9/11/94
12/18/94
Total
91.61
227.32
342.17
137.46
16.24
56.40
1,542.79
9.23
89.90
2,504.30
5,241.24
ERG paid all these expenses.
Esther passed away sometime in early September 1994, and
funeral services were held in Still Water, Minnesota.
On or
about October 4, 1994, ERG paid $833.06 for travel expenses
incurred on behalf of Pastor Leroy M. Nelson, Burton and
- 30 Glendon’s cousin.
Pastor Nelson presided over Esther’s funeral
services.
(m) Legal Expenses
The stipulated documentary evidence shows that in 1994 ERG
paid legal expenses of $4,660.19.
The invoices detail the
services provided as, inter alia, “Review: information from Burt
Benson respecting property line dispute”, an appeal to the
unemployment office, “Burton O. Benson v. Westinghouse Electric,”
review of proposed loan agreement, probate questions re: mother’s
estate, etc.
(n) Employee Relations Expenses
ERG purchased Oakland baseball tickets for $2,119.50, the
invoice for which was paid on or about February 11, 1994.
Additionally, respondent submitted copies of monthly invoices for
the Lakeview Club for the period December 25, 1993, through
September 25, 1994.
These invoices are addressed to “RADM Burton
O. Benson” and bear his home address.
The total amount shown as
being paid on these invoices is $915.66.
3.
Nonconstructive Dividend Issues
(a) Dividend Franklin Accounts
On or about May 1, 1983, Burton submitted an application to
open a joint investment account with the Franklin Money Fund
(Franklin).
The application bears the name “Benson Properties
Unlimited” as owner, Eric or Burton as co-owner, and Eric’s
- 31 Social Security number.
Franklin opened the account and assigned
it account No. 11102309431 (Franklin account #1).
On or about
December 28, 1983, Burton and Elizabeth submitted an account
revision form to Franklin, changing the signatories to “Burton O
Benson/Elizabeth C. Benson and no others.”
Throughout 1988, 1989, 1990, 1993, and 1994, rent payments
received from tenants occupying residential real properties owned
by the Bensons were deposited into the Franklin account #1.
Expenses incurred with respect to those properties were also paid
from this account.
During the years 1988, 1989, 1990, 1993, and
1994, dividends were credited to this account in the amounts of
$204, $193, $229, $360, and $1,072.03, respectively.38
For the
years at issue, the Bensons did not report interest or dividend
income from Franklin account #1.
However, on his 1994 return
Eric reported dividend income from Franklin account #1 of $1,072.
(b)
Forgiveness of Debt Income
ERG’s 1987 Form 1120, Schedule L, Balance Sheet, reported
under the category assets “Loans to stockholders/officers” of
$88,291 as the balance at the beginning and end of that tax year.
For 1988, ERG’s Form 1120, Schedule L, filed August 1, 1994,
reported no amount for “Loans to stockholders/officers”.
38
On or
The parties stipulated that in 1994 $1,072 in dividends
was credited to this account. In fact, the amount credited was
$1,072.03.
- 32 about July 29, 1994, accountant Bradac sent Burton a letter which
stated in part:
Loans to Stockholders cannot be identified from
our workpapers. If it could be identified, any
amounts due from stockholders should be shown
here, and the Corporation should make sincere
efforts to collect. Any stockholder who has not
repaid a corporate loan has personal income to
report if the loan is forgiven by the Corporation.
On October 25, 1995, the Bensons filed their 1994 return.
4.
Transfers From NPI
In 1993, Burton caused NPI to issue:
(1) Check Nos. 424,
439, and 444, totaling $129,480 from NPI’s bank account made
payable to the California Franchise Tax Board to pay his personal
tax liabilities; and (2) check Nos. 423, 425, 432, and 438 from
NPI’s bank account made payable to the Internal Revenue Service
(IRS) to pay his personal tax liabilities, the aggregate amount
of which was $378,000.39
In 1994, Burton caused NPI to:
(1) Issue check Nos. 452,
462, and 468 totaling $28,745 from NPI’s bank account made
payable to the California Franchise Tax Board to pay his personal
tax liabilities;
39
(2) issue check Nos. 446, 451, 455, and 461
The parties stipulated that check No. 424 for $81,000 and
check No. 444 for $28,480 totaled $129,480, which was obviously
an error since these two sums equal $109,480. It is clear from
the documentary evidence in the record that three checks, Nos.
424, 439, and 444 were written from NPI’s bank account to the
California Franchise Tax Board in the total amount of $129,480.
Additionally, it is clear from the evidence that NPI issued
checks, Nos. 423, 425, 432, and 438 to the IRS in the total
amount of $378,000.
- 33 totaling $135,869 to the IRS to pay his personal tax liabilities;
(3) issue check Nos. 453 and 457 to himself in the total amount
of $200,000; and (4) wire transfer $1 million to First American
Title Guaranty Co. for the purpose of funding a $2,213,000
secured promissory note with respect to which Burton and
Elizabeth held a 45.188-percent interest as joint tenants.
In 1995, Burton caused NPI to issue:
(1) Check No. 469 for
$23,331 payable to the IRS to pay his personal tax liabilities;
(2) check Nos. 474, 475, 486 in the aggregate amount of $400,000
to himself and/or his wife; (3) check No. 477 for $1 million
payable to Jack White & Co. to establish an investment account in
the name “Burton O. Benson”; (4) check No. 478 for $1 million
payable to USAA Mutual Fund to establish an investment account in
the Bensons’ names; (5) check Nos. 482 and 485 in the respective
amounts of $5,441.55 and $4,860.81 payable to Insight Capital
Research & Management, Inc., to establish an investment account;
and (6) check Nos. 487, 488, and 489 for $100,000 each to Eric,
Brad, and Mark.
5.
Baden Spiel Haus Partnership
During the years 1989, 1990, 1993, and 1994, Burton was a
partner owning a 25-percent interest in the Baden Spiel Haus
partnership.
Baden Spiel Haus owned and operated a ski cabin in
California.
The Bensons claimed partner deductions of $1,281,
$1,182, $1,473, and $2,635, for 1989, 1990, 1993, and 1994,
- 34 respectively, which respondent denied for lack of substantiation.
The Bensons conceded respondent’s determination for all years
except 1994.
See appendix, par. 13.
6. Evelyn Hermsmeier Partnership
During the years 1988, 1989, 1990, and 1993, Elizabeth was a
partner holding a 50-percent interest in the Evelyn C. Hermsmeier
et al. partnership.
Evelyn C. Hermsmeier, f.k.a. E.C. Ford, is
the sister of Elizabeth.
For the years listed, gross income of
the partnership was as follows:40
7.
Tax Year
Gross Income
1988
1989
1990
1991
1992
1993
1994
$263,448
274,683
242,700
282,059
202,192
185,770
201,239
The Income Tax Returns
(a) The Bensons
On July 25, 1994, the Bensons filed their 1988 Federal
income tax return through respondent’s revenue agent.
The 1988
return was filed after the October 15, 1989, due date, as
extended.
On September 16, 1994, the Bensons filed their 1989
Federal income tax return through respondent’s revenue agent.
40
On brief, respondent indicated that facts pertaining to
the Evelyn Hermsmeier Partnership relate “solely to the issue of
substantial omission of income pursuant to” sec. 6501(e). Income
or loss from the partnership was reported on the Bensons’ 1989,
1990, 1993, and 1994 Schs. E as Elizabeth’s distributive share.
- 35 The 1989 Federal income tax return was filed after the October
15, 1990, due date, as extended.
On October 21, 1994, the
Bensons filed their 1993 Federal income tax return.
On February
14, 1995, the Bensons filed their 1990 Federal income tax return
through respondent’s agent.
The 1990 Federal income return was
filed after the October 15, 1991, due date, as extended.
On June 29, 1995, respondent issued Burton a notice of
deficiency for the tax years 1991 and 1992.
On October 25, 1995,
the Bensons filed their 1994 Federal income tax return.
On
November 27, 1995, respondent assessed a deficiency against
Burton for the 1992 tax year on the basis of a notice of
deficiency dated June 29, 1995.
On December 13, 1995, the
Bensons filed their 1991 Federal income tax return.
On January
1, 1996, respondent assessed a deficiency against Burton for the
1991 tax year on the basis of a notice of deficiency dated June
25, 1995.
On March 5, 1997, the Bensons filed their 1992 Federal
income tax return.
(b) Eric B. Benson
On or about April 15, 1994, Eric requested an extension of
time to file his 1993 Federal income tax return.
On October 17,
1994, Eric filed his 1993 Federal income tax return.
On October
23, 1995, Eric filed his 1994 Federal income tax return.
- 36 (c)
Mark D. and Brad D. Benson
Neither Mark nor Brad filed a Federal income tax return for
1993.
On October 25, 1995, Mark and Brad each filed their 1994
Federal income tax return.
(d) ERG
ERG filed its Forms 1120 Federal income tax returns on the
dates and for the years listed:
Date
5/23/89
8/1/94
8/28/94
9/18/94
11/20/94
7/16/95
Tax Year
1987
1988
1989
1993
1990
1991 & 1992
There is a dispute between the parties whether ERG filed a 1994
return.
(e)
NPI
NPI filed its Forms 1120S on the dates and for the years
listed:
Date
1/14/91
1/21/92
5/22/92
7/14/92
9/17/92
9/20/94
9/20/94
12/15/94
7/19/95
9/20/95
9/18/95
Tax Year
1987
1988
1989
1990
1991
1993
Amended 1989
Amended 1990
1992
1994
Amended 1991
- 37 8.
The Return Preparers
G.A. “Al” Piepho prepared ERG’s and NPI’s 1987 returns.
Piepho died on or about October 1, 1989.
After Piepho died,
Bradac purchased Piepho’s accounting practice.
For the tax years
beginning in or after 1988 through 1994, Bradac generally
prepared the tax returns for ERG, NPI, and each of the
petitioners.
However, Jill Toibin, C.P.A. (Toibin), prepared the
Bensons’ 1992 Form 1040.
9.
Notices of Deficiency
On October 15, 1997, respondent issued Eric a notice of
deficiency for his tax year 1993.
On September 10, 1998,
respondent issued notices of deficiency to Eric, Mark, and Brad
for the 1994 tax year.
On September 13, 2000, respondent issued
to the Bensons notices of deficiency for the tax years 1988,
1989, 1990, and 1993.
On September 24, 2001, respondent issued
to the Bensons a notice of deficiency for their 1994 tax year.
(a)
Examinations
On November 19, 1996, respondent opened an examination of
the Benson’s 1993 return.
The examination of the Bensons’ 1993
return related to an ongoing examination of ERG, which
examination commenced on August 23, 1995.
On March 11, 1997,
respondent opened an examination of the 1988, 1989, 1990, and
1994 returns of the Bensons.
- 38 OPINION
The gravamen of respondent’s argument is that due to a
bitter family feud over the control and ownership of ERG, Burton
“formed a fraudulent scheme to divert the earnings and profits of
ERG to himself (either through NPI or directly) and to thereby
lower the reportable profits of ERG.”
Respondent alleges that
Burton labored to reduce ERG’s profits because the unbundling
agreement required him to pay his brother a multiple of ERG’s
profits.
The alleged scheme, respondent argues, was perpetrated
in three ways:
(1) Various transactions to divert cash from ERG
to NPI; (2) ERG’s payment for 143 Alice Lane for the Bensons’
benefit; and (3) ERG’s direct payment of the Benson family
personal expenses.
Respondent alleges Burton’s scheme was also
intended to defraud the Government of income tax due and owing.
The Bensons seek solace in the circumstances surrounding the
preparation and filing of their income tax returns.
The Bensons
allege that the uncertainties associated with the brothers’ legal
and personal struggle to control the closely held entities, the
pressures of running successful and profitable businesses, and
the death of their longtime accountant and tax preparer caused
their failure to prepare timely and accurate tax returns, not
intentional malfeasance.
As discussed in detail below, the voluminous record in this
case does not sustain respondent’s burden of proving by clear and
- 39 convincing evidence that the Bensons fraudulently intended to
evade the payment of their income taxes.
However, respondent has
persuaded us that the Bensons substantially understated their
income.
A.
The Burden of Proof and the Statute of Limitations
A determination made by the Commissioner in a notice of
deficiency is presumed correct, and the taxpayer bears the burden
of proving that determination incorrect.41
Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933).
Generally, the Commissioner must assess the amount of tax
within 3 years after a return is filed.
See sec. 6501(a).
Code provides exceptions to this period of limitations.
One
exception, of course, is for fraud.
In
The
See sec. 6501(c).
pertinent part, section 6501(c) provides:
SEC. 6501(c).
Exceptions.--
(1) False return.–-In the case of a false or
fraudulent return with the intent to evade tax, the tax
may be assessed, or a proceeding in court for
collection of such tax may be begun without assessment,
at any time.
41
Sec. 7491(a)(1) provides that the burden of proof shifts
to the Commissioner if the taxpayer introduces credible evidence
with respect to any factual issue relevant to ascertaining the
tax liability of the taxpayer. Sec. 7491(a)(1) applies to court
proceedings arising in connection with examinations commencing
after July 22, 1998. See Internal Revenue Service Restructuring
and Reform Act of 1998, Pub. L. 105-206, sec. 3001(c), 112 Stat.
726. The record indicates that the examinations of petitioners’
returns began prior to the effective date of sec. 7491. Thus,
sec. 7491 is inapplicable to this case. See Seawright v.
Commissioner, 117 T.C. 294 (2001).
- 40 There is an exception for the substantial understatement of
income.
Section 6501(e) provides in pertinent part:
SEC. 6501(e). Substantial Omission of Items.–Except as otherwise provided in subsection (c)-(1) Income taxes.–-In the case of any tax
imposed by subtitle A–
(A) General rule.–-If the taxpayer omits
from gross income an amount properly
includible therein which is in excess of 25
percent of the amount of gross income stated
in the return, the tax may be assessed, or a
proceeding in court for the collection of
such tax may be begun without assessment, at
any time within 6 years after the return was
filed. For purposes of this subparagraph–
(i) In the case of a trade or
business, the term “gross income” means
the total of the amounts received or
accrued from the sale of goods or
services (if such amounts are required
to be shown on the return) prior to
diminution by the cost of such sales or
services; and
(ii) In determining the amount
omitted from gross income, there shall
not be taken into account any amount
which is omitted from gross income
stated in the return if such amount is
disclosed in the return, or in a
statement attached to the return, in a
manner adequate to apprise the Secretary
of the nature and amount of such item.
Respondent bears the burden of proving by a preponderance of the
evidence that:
(1) The Bensons omitted from gross income an
amount in excess of 25 percent of the amount of gross income
reported on their return, and (2) that the omitted income was
properly includable in gross income.
Burbage v. Commissioner, 82
- 41 T.C. 546, 553 (1984), affd. 774 F.2d 644 (4th Cir. 1985); Ghadiri
v. Commissioner, T.C. Memo. 1996-528; Hittleman v. Commissioner,
T.C. Memo. 1990-325, affd. without published opinion 945 F.2d 409
(9th Cir. 1991).
Accordingly, respondent must introduce
affirmative evidence to meet his burden.
Commissioner, supra.
Ghadiri v.
On brief, the parties agree that our
opinion on the merits will determine whether the period of
limitations bars respondent’s assessment for 1989, 1990, 1993,
and 1994.
For respondent to prevail with respect to the 1988 taxable
year, we must find fraud, which we do not.
However, as discussed
infra, we do find that respondent has proved substantial
omissions of income in 1989, 1990, 1993, and 1994.
The Bensons
argue on brief that the only way respondent can show a 25-percent
omission is by proving that they had constructive dividends.
We
have found that substantial constructive dividends were received.
On brief, respondent refers to this matter as a computational
issue.
A recomputation of the Bensons’ income under Rule 155
pursuant to our findings and holdings herein will control whether
the Bensons omitted from gross income an amount which is in
excess of 25 percent of the amount of gross income stated in the
returns.
If there was such an omission the period of limitations
in section 6501(a) will not bar assessment for those years.
See
- 42 Garden State Dev., Inc. v. Commissioner, 30 T.C. 135, 142 (1958);
Hulshart v. Commissioner, T.C. Memo. 1955-231.
B.
Constructive Dividends
The heart of respondent’s imputation of income is that
numerous ERG expenditures and transfers constitute constructive
dividends to the Bensons.
On the contrary, petitioners argue
that if the percentage of NPI’s ownership declared in the final
arbitration decision is considered, petitioners overpaid their
income tax liability.
The Commissioner is authorized and has great latitude in
reconstructing income in accordance with any reasonable method
that accurately reflects actual income.
Secs. 446(b), 6001;
Petzoldt v. Commissioner, 92 T.C. 661, 687 (1989); Meneguzzo v.
Commissioner, 43 T.C. 824, 831 (1965); see Taglianetti v. United
States, 398 F.2d 558, 562 (1st Cir. 1968), affd. on other grounds
394 U.S. 316 (1969); Ramsey v. Commissioner, T.C. Memo. 1980-59;
Bolton v. Commissioner, T.C. Memo. 1975-373.
The reconstruction
of a taxpayer’s income need only be reasonable in light of the
surrounding facts and circumstances.
Giddio v. Commissioner, 54
T.C. 1530, 1533 (1970); Schroeder v. Commissioner, 40 T.C. 30, 33
(1963).
Furthermore, it is axiomatic that “The Commissioner and
the reviewing courts are permitted to fully examine any
transaction to determine its economic and financial reality.”
Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966), affg.
- 43 T.C. Memo. 1965-84.
Those transactions which lack economic
substance may be ignored.
Gregory v. Helvering, 293 U.S. 465,
467 (1935); Muhich v. Commissioner, 238 F.3d 860, 864 (7th Cir.
2001), affg. T.C. Memo. 1999-192.
Section 61(a) defines gross income as “all income from
whatever source derived”.
definition’s expanse:
The regulations demonstrate the
“Gross income includes income realized in
any form, whether in money, property, or services.”
Sec. 1.61-
1(a), Income Tax Regs. (emphasis added); see Han v. Commissioner,
T.C. Memo. 2002-148 (citing Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 431 (1955)).
As the Supreme Court explained, a
gain “constitutes taxable income when its recipient has such
control over it that, as a practical matter, he derives readily
realizable economic value from it.”
Rutkin v. United States, 343
U.S. 130, 137 (1952).
Section 301, however, qualifies the definition of gross
income.
Barnard v. Commissioner, T.C. Memo. 2001-242.
Generally, that section provides that funds distributed by a
corporation over which the taxpayer/shareholder has dominion and
control are taxed under the auspices of section 301(c).
Id.
Pursuant to section 301(c), a dividend is taxed as ordinary
income only to the extent of the distributing corporation’s
- 44 earnings and profits;42 any excess is nontaxable return of
capital to the extent of the taxpayer’s basis; and any remaining
amount received is taxable as capital gain from the sale or
exchange of a capital asset.
Sec. 301(c)(1),(2), and (3);
Truesdell v. Commissioner, 89 T.C. 1280, 1295-1298 (1987);
Barnard v. Commissioner, supra.
The parties have stipulated
that, to the extent we find constructive dividends, ERG had
sufficient earnings and profits to deem any distributions as
ordinary income.
“It is well established that transfers between related
corporations may result in constructive dividends to a common
shareholder.”
Speer v. Commissioner, T.C. Memo. 1996-323 (citing
Joseph Lupowitz Sons, Inc. v. Commissioner, 497 F.2d 862, 868 (3d
Cir. 1974), affg. in part, revg. in part on another ground, and
remanding T.C. Memo. 1972-238); see DiLeo v. Commissioner, 96
T.C. 858, 883 (1991), affd. 959 F.2d 16 (2d Cir. 1992).
“A
greater potential for constructive dividends * * * exists in
closely held corporations where dealing between stockholders and
the corporation are commonly characterized by informality.”
Zhadanov v. Commissioner, T.C. Memo. 2002-104.
However, common
ownership alone will not support a finding of constructive
dividends.
42
Sammons v. Commissioner, 472 F.2d 449, 451 (5th Cir.
The determination and calculation of earnings and profits
is governed by sec. 316 and the regulations promulgated
thereunder.
- 45 1972), affg. in part and revg. in part on another ground T.C.
Memo. 1971-145.
“Corporate expenditures constitute constructive dividends
only if 1) the expenditures do not give rise to a deduction on
behalf of the corporation, and 2) the expenditures create
‘economic gain, benefit, or income to the owner-taxpayer.’”
P.R.
Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088 (9th Cir. 1987)
(quoting Meridian Wood Prods. Co. v. United States, 725 F.2d
1183, 1191 (9th Cir. 1984)), affg. T.C. Memo. 1984-549.
“The
crucial concept in a finding that there is a constructive
dividend is that the corporation has conferred a benefit on the
shareholder in order to distribute available earnings and profits
without expectation of repayment.”43
Truesdell v. Commissioner,
supra at 1295 (citing Noble v. Commissioner, supra at 443).
A
“constructive dividend” is “simply a corporate disbursement that
is a dividend in the contemplation of law though not called such
43
“To constitute a distribution taxable as
a dividend, the benefit received by the
shareholder need not be considered as a
dividend either by the corporation or its
shareholders, declared by the board of
directors, nor other formalities of a
dividend declaration need be observed, if on
all the evidence there is a distribution of
available earnings or profits under a claim
of right or without any expectation of
repayment.” * * *
Noble v. Commissioner, 368 F.2d 439, 443 (9th Cir. 1966), affg.
T.C. Memo. 1965-84 (quoting Clark v. Commissioner, 266 F.2d 698,
711 (9th Cir. 1959)).
- 46 by the corporation making the disbursement.”
Mews, 923 F.2d 67, 68 (7th Cir. 1991).
United States v.
Furthermore, to be a
constructive dividend to a shareholder, the corporation need not
pay it directly to the shareholder.
Id.
It is clear that when a corporation confers an economic
benefit upon a shareholder without expectation of reimbursement,
that economic benefit becomes a constructive dividend.
Loftin &
Woodard, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir.
1978); Thorpe v. Commissioner, T.C. Memo. 1998-115.
For example,
the amount of taxes paid by a corporation on behalf of and for
the benefit of a shareholder was held to be a constructive
dividend.
Inland Asphalt Co. v. Commissioner, 756 F.2d 1425 (9th
Cir. 1985), affg. T.C. Memo. 1982-463.
Corporate payment of a
shareholder’s personal expenses constituted a constructive
dividend.
Dobbe v. Commissioner, 61 Fed. Appx. 348 (9th Cir.
2003), affg. T.C. Memo. 2000-330.
Payments by a corporation for
painting and repairs made to a shareholder’s family residence and
travel expenses incurred for personal purposes were deemed to be
constructive dividends.
Grossman v. Commissioner, 182 F.3d 275
(4th Cir. 1999), affg. T.C. Memo. 1996-452; Noble v.
Commissioner, 368 F.2d 439 (9th Cir. 1966).
And use of a
corporate-owned luxury automobile for personal purposes
constituted a constructive dividend.
Mohan Roy, M.D., Inc. v.
Commissioner, T.C. Memo. 1997-562, affd. 182 F.3d 927 (9th Cir.
1999).
- 47 “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.”
Gow v. Commissioner, T.C. Memo.
2000-93 (citing T.J. Enters., Inc. v. Commissioner, 101 T.C. 581
(1993)), affd. 19 Fed. Appx. 90 (4th Cir. 2001).
“An expenditure
generally does not have independent and substantial importance to
the distributing corporation if it is not deductible under
section 162.”
Id. (citing P.R. Farms, Inc. v. Commissioner,
supra.)
Respondent determined that numerous transactions constituted
constructive dividends to the Bensons.
For ease of discussion,
we shall separately detail each item and then describe the
economic benefit the Bensons received from those items.
1.
ERG Transfers to NPI
Transfers made by ERG to NPI and the amounts reported for
the years 1988 through 1994 are listed as follows:
Year
ERG Transfer
to NPI
1
Amount Reported
by NPI
Amt. Reported on
Shareholder Return
-$165,481
129,070
757,025
365,754
146,667
24,444
80,032
26,677
26,677
26,677
1,748,504
1988
1989
1990
1991
1992
1993
$180,000
483,098
–––3,600,000
–$248,097
193,508
1,764,049
907,443
220,000
1994
160,063
160,063
4,423,161
3,493,160
Total
1
Petitioners offered no evidence as to this transfer.
could not recall the purpose of the transfer.
Reporting
Shareholder
n/a
The Bensons
The Bensons
The Bensons
The Bensons
The Bensons
Eric Benson
The Bensons
Eric Benson
Brad Benson
Mark Benson
Furthermore, Burton
- 48 As found above, in 1989 ERG transferred $483,098 to NPI with
respect to the MOA.
Although there was conflicting testimony
concerning what was contemplated by the MOA,44 petitioners
offered no evidence of what specific services, if any, were
performed and/or what equipment, if any, was purchased.
Mr.
Bradac, Burton’s accountant and return preparer, testified that
Burton informed him that no equipment was purchased, and he
instead booked the payment as a security deposit.
Generally, money was transferred from ERG to NPI ostensibly
for two reasons.
First, in accordance with the exclusive license
agreement between ERG and NPI, 10 percent of ERG’s profits flowed
to NPI in the form of royalties.45
Second, to achieve Burton’s
goal of having ERG show a paper profit of approximately $75,000
per year, the difference between the purported royalty payments
and ERG’s actual annual profit (less approximately $75,000) was
transferred as payment to NPI for purported engineering services
performed by NPI.
44
Warren Timothy, a former employee of Hercules, testified
that the MOA was a purchase contract, and it did not contemplate
reengineering. Similarly, William Morton, also a former employee
of Hercules, testified that the MOA was an equipment purchase
contract. However, Bryan Leyda, an ERG employee, testified that
the schedule attached to the MOA was his “personal best estimate”
for time and engineering to design the assembly, the
modifications, and the installation, and any debugging processes.
45
The payments were labeled “royalties” on the basis of
information that Burton provided. Bradac did not see a copy of
the royalty agreement until after he prepared the returns.
- 49 The realization of the “plan” is demonstrated in a
stipulated exhibit.
For example, in 1992 ERG had $2,704,096 in
total sales and allocated $275,867 in royalties to NPI.46
Similarly, in 1993 ERG had total sales of $2,440,139 and
allocated $244,023 in royalties to NPI.47
ERG reported a profit
in 1989, 1990, and 1993 of $77,930, $79,576, and $76,941,
respectively.
Because many of ERG’s payments to NPI were made after the
purported royalties and engineering services were supposedly
earned, there had to be a plan or basis upon which the funds were
attributed to the tax years at issue.48
At trial, Mr. Bradac
46
NPI’s original 1992 return reported royalty income of
$907,443.
47
NPI’s original 1993 return reported royalty income as
$220,000.
48
Jill Toibin, C.P.A., prepared the Bensons’ 1992 Form 1040.
On or about Oct. 3, 1996, Toibin wrote a memorandum to her file
which states in pertinent part:
I asked Burt if all disbursements from ERG were
ordinary and necessary business expenses of the
corporation and he confirmed in the positive. He
indicated that the corporation has a royalty agreement
with New Process Industries (a related corporation).
In addition, New Process provides services to ERG
through the action of the employee owner (himself) that
are not covered by the rent agreement, so that
engineering services are paid to compensate the
corporation for these services.
At trial, Toibin testified that the classification of
engineering services was on the basis of Burton’s representations
that he provided “know-how, show-how, something of value to NPI”.
- 50 explained the “plan”:
“And not having exact numbers to work
with, I suggested that we allocate the numbers based upon the
income of the corporation.
When we get down to the end, we’ll
take whatever difference there is and put it into the middle
years.”
The theory of allocating ERG payments for tax years
prior to payment was further refined in Jill Toibin’s letter to
the California Franchise Tax Board:
The corporation [NPI] receives royalties and performs
engineering services for a related entity * * * [ERG].
The corporation is a cash basis taxpayer. However, the
corporation was required to report as current income
any amounts constructively received, even though such
amounts were not actually paid in the current year.
* * *
During trial, Bradac was asked and answered as follows:
Q:
Okay. Now was there a discussion at some point
between you and Admiral Benson of a desire to flow
profits from ERG to NPI?
A:
I mean I don’t think of it in those terms, but
yes, I guess there would be discussion which entailed
that.
*
*
*
*
*
*
*
Q:
Did you specifically recall, do you recall having
conversations with Admiral Benson about trying to keep
the profits of ERG down?
A:
Yes.
*
*
*
*
*
*
*
Q:
Did you have an understanding from Admiral Benson
that more of the profits of ERG could be passed, or
flowed to New Process through increasing deductions on
ERG’s returns?
- 51 A:
I vaguely recall having some discussions like
increasing the rents, and along those lines, yes.
Q:
And in those discussions, do you recall discussing
performing services as another way that ERG’s profits
might flow to NPI?
A:
Probably.
Q:
And if those profits flowed from ERG to NPI, then
would ERG appear less profitable?
A:
Yes.
Q:
At least on paper?
A:
Yes.
Q:
Do you recall a discussion or discussions with
Admiral Benson in which Admiral Benson expressed a
desire to keep the profits of ERG for any given year,
to a level of about $75,000 – excuse me, did I say
profits? I meant taxable income.
A:
We have [sic] a conversation along those lines.
Similarly, on or about April 13, 1993, Burton sent Bradac a
memorandum which states in pertinent part:
ERG
1) ERG had an estimated profit of $757,000 for yrend 1992.
2) Assume ERG pay [sic] royalties to NPI of $750K
for this period.
3) Then ERG has minimal to no tax for Fed & state
in 92.
NPI
1) NPI has a est. profit of $750K from ERG plus
$68K self made profit equals $818K for 1992.
2) Assume $818K flows to BOB somehow royalty,
profit, salary, this yet to be determined.
3) Then NPI has no Fed tax but has CA State
of 2 1/2% of profit * * *
- 52 Burton testified that this memorandum was “a tax planning
document”.
Similarly, on or about March 7, 1996, Burton sent a
memorandum to Bradac stating:
“Considering that we desire to
keep ERG at a profit of about $75K, we would then pull about
$260K out of ERG and allocate it to NPI.”
(Emphasis added.)
Petitioners produced purported “invoices” for the royalties
paid only with respect to 1993.
The invoices are printed on
NPI’s letterhead, addressed to ERG, and show an amount “due”.
Each document is stamped “RECEIVED” by ERG on a specific date and
bears a “paid” stamp showing an amount, date, and check number.
However, these invoices were not created contemporaneously with
payment and/or the receipt of services, but they were prepared in
response to a meeting Burton had with a revenue agent.
Burton testified that the “engineering services” for which
ERG compensated NPI were consulting design services that he
performed to make the Hercules contract “work”.
He stated:
“The
engineering services I’m referring to was the understanding
between ERG and NPI in light of the agreement that ERG had with
NPI to do the design services, to change the D-5 process, and
scale up to the delivery rate that the customer wanted.”
He
stated that the payments were for his “engineering know-how”.
However, there was no written agreement between ERG and NPI
concerning the provision of engineering services.
- 53 The record also includes purported invoices for engineering
and design services for only 1993.
The documents state in
pertinent part:
Engineering and Design Services for Hercules Aerospace,
as Prime Contractor to the Department of Defense
authorization to ERG for the investment in the
Facilitization and Plant Equipment required to obtain
the contract delivery rate requirements under Hercules
Classified Contract No. 2257-003136 as line item 1 and
under Hercules Classified Contract No. 2295-03020 as
line item 2, for the Fleet Ballistic Missile Program
“Special” D-5 tooling requirements.
The documents are written on NPI’s letterhead, addressed to ERG,
and bear the last day of each month in 1993 as the date.
Additionally, the documents are stamped “RECEIVED” on a certain
date by “ERG, Inc.” and are also stamped “paid” showing an
amount, date, and check number.
Burton admitted, however, that
these invoices were created shortly before an audit meeting with
a revenue agent.
Burton testified that he kept track of the hours he spent
performing the purported design and engineering services on his
desk calendar.49
In answering a question concerning how much NPI
charged ERG for his alleged services, he testified:
“I’d be
guessing, 200, 300 dollars an hour, something like that.”
was asked and answered as follows:
Q:
And how would you make that calculation, if you
didn’t keep specific hours on your desk calendar?
49
The desk calendar was not proffered as evidence.
Burton
- 54 A:
You know I really don’t know. They seem like very
round numbers. They could be just what we in the
business call engineering estimates.
However, Burton presented no evidence detailing precisely what
services he provided, the number of hours he spent performing
those services, and whether the compensation charged was ordinary
and reasonable in the industry.
Clearly, Burton controlled both
sides of the “table” with respect to ERG and NPI.
Transactions
between related corporations are inherently suspect.
Tulia
Feedlot, Inc. v. United States, 513 F.2d 800, 805 (5th Cir. 1975)
(“Transactions between related taxpayers or between a close
corporation and its principals * * * must be subject to close
scrutiny.” (citing United States v. Ragen, 314 U.S. 513 (1942)));
Ludwig Baumann & Co. v. Commissioner, T.C. Memo. 1961-271
(“common ownership factor requires a close scrutiny to determine
the substance of the transaction and whether it reasonably would
have been made between parties dealing at arm’s length.”), affd.
312 F.2d 557 (2d Cir. 1963).
Furthermore, we infer from the evidence that the exclusive
licensing agreement was merely a tax planning tool, completely
lacking in economic substance.
Although taxpayers are entitled
to structure their transactions in such a way to achieve the most
advantageous tax ramifications, nonetheless, those transactions
must be real and have economic substance.
293 U.S. at 469.
Gregory v. Helvering,
For example, the exclusive licensing agreement
- 55 was entered into in 1990 but had retroactive application to 1987,
the year during which Burton took sole control of ERG.
The
amounts that ERG transferred to NPI were not regular.
As the
arbitrators found, the pattern of payment demonstrates that
Burton was merely funneling ERG’s profits to NPI.
There is no
evidence of a business purpose why ERG would “sell” its valuable
patent rights to NPI and simultaneously license them back.
Furthermore, there is no evidence whether ERG received the
consideration contemplated by the agreement for “selling” those
rights.
The agreement states that ERG is entitled to, inter
alia, 50 percent of the moneys NPI receives from licensing the
patent rights.
ERG ostensibly was “licensing” those patent
rights under the agreement and paying NPI hundreds of thousands
of dollars for such rights.
However, the record shows only the
unidirectional flow of money from ERG to NPI.
ERG transferred millions of dollars to NPI for payment of
supposed “engineering services”.
However, there is no evidence
of what services Burton performed on behalf of NPI other than his
testimony that he provided ERG with engineering “know how”.
third party testified as to what Burton specifically did.
No
There
is no evidence of how much time he devoted to this endeavor and
whether the amounts charged were reasonable and customary.
In
fact, we infer from the evidence that in conjunction with the
exclusive licensing agreement, the label “engineering services”
- 56 was created to achieve Burton’s goal of having ERG show a
consistent paper profit of approximately $75,000.50
For example,
ERG’s records show that in 1991 ERG incurred $1,539,463 for
“engineering services” provided by NPI.
Assuming, as Burton
testified, that NPI charged ERG $300 per hour, Burton would have
had to spend 5,131.5 hours or 213.8 twenty-four hour periods
performing so-called engineering services.
On brief, petitioners argue that the percentage of ownership
determined in the arbitration decisions affects the issue of what
amount, if any, constitutes taxable income to the Bensons.
Petitioners direct the Court’s attention to the arbitrators’
finding that Burton owned one-third of NPI’s stock during the
years at issue.
Thus, petitioners conclude, if one-third of the
distributive share rights in NPI is considered, the Bensons
overpaid their income tax liability.
We disagree.
The fact that Burton did not actually own 100 percent of NPI
during the years at issue does not affect our holding that those
ERG funds transferred to NPI constituted constructive dividends
to Burton.
The arbitrators found and the parties agree that
during the years at issue, Burton maintained sole operating
50
On brief, petitioners argue: “The allocations of income
to NPI for the engineering services that Burton performed for ERG
respecting the Hercules contract were legitimate business
accounting decisions.” (Emphasis added.)
- 57 control of ERG and NPI.51
The record clearly demonstrates that
ERG funds transferred to NPI were used for Burton’s family’s
economic benefit and otherwise lacked a business purpose.
Furthermore, petitioners argue:
“Respondent has not
presented compelling evidence that Burton appropriated NPI’s bank
accounts to his own benefit.”
Again, we disagree.
The record
demonstrates, and indeed as the arbitrators also found, that
Burton transferred ERG money to NPI and then used this money for
the sole and exclusive benefit of himself and his family.
Glendon received no benefit from his determined ownership rights
in NPI or ERG until after the final arbitration decision.
As he
testified, after June 1987 neither he nor Aker had any
involvement with ERG.
That issue was at the very heart of the
brothers’ dispute during the arbitration proceedings.
As we discuss infra, the Bensons received a substantial
economic benefit from the ERG funds transferred to NPI.
Accordingly, we find and hold52 that the ERG transfers to NPI
51
Petitioners asked us to find as fact that:
All of the funds at issue that were transferred from
ERG to NPI were deposited in an NPI bank account * * *
over which Burton exercised sole authority and control
as president of NPI responsible to its shareholders.
[Emphasis added.]
52
Our use of the term “find and hold” in this opinion means
that we have determined that a preponderance of evidence supports
our conclusion.
- 58 constituted constructive dividends to Burton in the year of
transfer.
2.
ERG-Recreation Fund Account
Respondent submitted copies of canceled checks and bank
statements for the ERG-Recreation fund account.
Petitioners
conceded that many of the ERG-Recreation fund account items
constituted constructive dividends to Burton.
7.
See appendix, par.
Melody Carter, ERG’s administrative assistant, testified that
this account was funded with moneys that ERG received “from
recycling cans, recycling cardboard, refunds”, etc.
She stated:
“I’ll apply for the refund; the refund will go into that fund.”
She also testified that this account was used to “purchase
baseball tickets, to purchase Christmas parties, company picnic,
weight room equipment, things of that nature.”53
Respondent demonstrated that Burton was the sole signatory
for this account and withdrew funds from this account.
In
addition to the canceled checks proffered by respondent and
Burton’s concessions, the Court notes that the Bensons failed to
provide evidence that any specific amounts withdrawn were used
for ERG’s business purposes.
In fact, the checks at issue
provide a contrary inference that the ERG-Recreation fund was
53
Burton testified that at least one ERG Christmas party was
not paid from this account but was instead charged to a corporate
credit card. See discussion infra. There is no indication that
funds from this account were used to pay this bill.
- 59 used for personal expenses.
For example, in 1993, check No. 31
is made payable to ERG Retirement Trust for $8,000; similarly, in
1994 Burton issued two checks for expenses relating to his
sailboat, Risktaker, a check to Berkeley Yamaha, and checks to
various individuals.
In the face of the above facts and
concessions, the Bensons failed to substantiate any of the
expenses for which checks were written from this account and
otherwise failed to demonstrate a business purpose for any of the
expenditures.
Accordingly, we find and hold that, in addition to
the amounts conceded, Burton received and failed to report
constructive dividends in 1993 and 1994 of $8,000 and $2,698,
respectively.
3.
Payment for 143 Alice Lane
The parties do not dispute that in 1990 ERG paid $336,500
for the real property described as 143 Alice Lane and held that
property in the name “ERG Retirement Trust”.
Petitioners did not
object to respondent’s requested finding of fact that the
purchase of 143 Alice Lane gave the Bensons “a large,
uninterrupted piece of land behind and abutting their personal
residence.”
The Bensons’ only argument is that they did not receive a
personal benefit until 1997, a year not before the Court, when
the ERG Retirement Trust deeded the property to the Bensons in
their individual capacities for no consideration.
We disagree.
- 60 The facts indicate that the property was purchased to enhance the
Bensons’ personal residence.
The fact that it was finally deeded
to the Bensons merely confirms this.
Clearly, the Bensons received a personal and economic
benefit when ERG purchased 143 Alice Lane.
They had the
exclusive use of real property, and eventually the title, for
which they paid no consideration.
We find and hold that ERG’s
payment in 1990 for 143 Alice Lane was a constructive dividend to
Burton.
We also find and hold, under the same reasoning, that
ERG’s payment of property taxes, $3,879 in 1993 and $8,196 in
1994, also constituted constructive dividends to the Bensons.
4.
ERG Check to Burton (Ref. Carroll)
According to a 1989 petition for confirmation of an
arbitration award, Burton owed Mr. Carroll $96,748.98, plus
interest thereon.
In 1989, ERG issued a check payable to Burton
for $96,748.98, on which is written “for Michael B. Carroll”.
With these funds, Burton purchased a cashier’s check in the
amount of $97,467.21 made payable to Mr. Carroll.
The Bensons
offered no evidence or explanation concerning this check other
than stating that ERG was also named as a defendant in that suit.
However, the fee arbitration award names only Burton as a
defendant.
Indeed, we infer from the recitation of the facts
that the representation involved a personal and noncorporate
matter between the brothers.
The petition for confirmation of
- 61 arbitration award and entry of judgment states:
“Carroll
provided * * * advice and services as an advocate for Benson.”
In fact, ownership and control of ERG and NPI was the issue for
which Mr. Carroll provided legal services.
The payment by a corporation of personal expenses of a
shareholder constitutes a constructive dividend.
See Inland
Asphalt Co. v. Commissioner, 756 F.2d 1425 (9th Cir. 1985); Noble
v. Commissioner, 368 F.2d 439 (9th Cir. 1966).
Accordingly, we
find and hold that Burton received a constructive dividend in
1989 of $96,748.98.
5.
Automobile Expenses
ERG claimed the following amounts as deductions for
automobile and truck expenses for the years as stated:
Tax Year
Amount of Deduction
1989
1990
1993
1994
$10,624
23,676
28,308
14,723
The parties stipulated that the $15,000 and the $13,500 that ERG
paid in 1990 and 1993, respectively, to purchase vehicles for
Eric and Mark were constructive dividend income to Burton.
appendix, par. 4.
See
Respondent argues that the balance constitutes
constructive dividend income to Burton.
Petitioners failed to substantiate any of the expenses
claimed and offered no evidence detailing the percentage that the
automobiles and trucks were used for business purposes.
See
- 62 Mohan Roy, M.D., Inc. v. Commissioner, T.C. Memo. 1997-562.
Indeed, Burton admitted that possibly some of the automobile
expenses were spent on his family’s cars.
The Bensons have
failed to meet their burden of proving error in respondent’s
determination with respect to the amounts still in issue.54
We
hold that, in addition to the amounts conceded, Burton had
constructive dividend income in 1989, 1990, 1993, and 1994 of
$10,624, $8,676, $14,808, and $14,723, respectively.
6.
Charitable Contributions
Because respondent has conceded that ERG’s payments of
$6,000, $6,000, $6,000, and $13,500 in 1989, 1990, 1993, and 1994
to Moraga Valley Presbyterian Church (MVPC) are not constructive
dividends, the Bensons are not entitled to deduct these amounts
on their personal returns.
Income Tax Regs.
See sec. 170(a)(1); sec. 1.170A-1(a),
Additionally, respondent conceded that a $2,000
ERG check to Camp Timberwolf in 1994 was not a constructive
dividend to the Bensons.
deduct this donation.55
Thus, the Bensons are not entitled to
See sec. 170(a)(1); sec. 1.170A-1(a),
54
We do not find that respondent has affirmatively proven
that the amounts in issue are constructive dividends.
55
There appears to be a scrivener’s error in respondent’s
opening brief. Respondent argues: “Finally, with respect to the
1994 check for $2,000 paid to Camp Timberwolf * * * respondent
has conceded that this amount was not a constructive dividend to
* * * [the Bensons]. Therefore, ERG’s charitable contribution to
Camp Timberwolf should be allowed as an itemized deduction on the
Bensons’ 1994 return.” Given respondent’s first argument that to
(continued...)
- 63 Income Tax Regs.
Petitioners appear to concede the deductibility
issue as they advance no argument.
The only remaining matter of contention is whether an ERG
check issued on December 31, 1992, for $50,000 made payable to
the Bank of America constituted a constructive dividend to the
Bensons.
Burton used these funds to purchase a $50,000 cashier’s
check from the Bank of America made payable to MVPC.
lists Burton as its purchaser.
The check
The Bensons, and not ERG, claimed
a $50,000 deduction on their 1993 return.
the donation was from him and not ERG.
Burton testified that
At trial, Burton
explained that MVPC “put on both the non-negotiable receipt, they
put B.O. Benson and on the face of the [cashier’s] check they put
B.O. Benson.
The reason, Your Honor, I put it on, I wanted to
ensure they knew where it came from.”
Accordingly, we find and
hold that the Bensons received a $50,000 constructive dividend in
1993 and hold that they are entitled to a charitable deduction
for the amount of the donation.
See sec. 170(a)(1); sec. 1.170A-
1(a), Income Tax Regs.
7.
Excess Rent Paid by ERG Re: Stanford Plant
Throughout the years 1988 to 1994, ERG occupied the Stanford
plant and paid rent to NPI for its use.
55
The unbundling agreement
(...continued)
the extent that amounts paid by ERG are not constructive
dividends to the Bensons they should not also receive the benefit
of the deduction, we presume that respondent inadvertently
omitted the word “not” between “should” and “be”.
- 64 contemplated that the parties would enter into a lease on the
Stanford plant for 8 years for “$5,000 (or $5,500 per month)”.
A
commercial lease for this property was prepared but never
executed.
According to this unexecuted document, for a period of
8 years commencing March 1988, ERG was to pay NPI $5,000 per
month for the use of the Stanford plant.
For 1988 and 1989, ERG paid NPI $5,159 per month for the use
of the Stanford plant.
This monthly amount paid remained
unchanged until August 15, 1990, when ERG paid NPI $26,159 that
month.
For the last 4 months of 1990 the monthly amounts paid
were $8,159, $8,159, $14,159, and $8,159, respectively.
In 1993
and 1994, ERG paid NPI $9,380 and $10,787 per month,
respectively.
Respondent determined that part of the money, $40,067,
$46,560, and $63,444, ERG paid to NPI as rent for the Stanford
plant in 1990, 1993, and 1994, respectively, constituted
constructive dividends to the Bensons.56
Thus, it appears that
respondent is arguing that the amount of rent paid in excess of
$5,500 per month constitutes constructive dividends.
The maximum monthly lease amount listed in the unbundling
agreement apparently reflected the product of an arm’s-length
56
See supra p. 5, table, note 2.
- 65 negotiation between the two warring brothers.57
Under these
circumstances, this is the best indication of the intent of the
parties and the value of the use of the property at that time.
Helba v. Commissioner, 87 T.C. 983 (1986), affd. without
published opinion 860 F.2d 1075 (3d Cir. 1988); see Zirker v.
Commissioner, 87 T.C. 970 (1986).
Furthermore, the “excess rent”
ERG paid pooled money in NPI, which as we later discuss, was used
for the Benson family’s economic benefit.
Accordingly, we find
and hold that Burton had constructive dividend income of $40,067,
$46,560, and $63,444 in 1990, 1993, and 1994, respectively.
8.
ERG Payments to NPI for Rent on Lowell Plant
In the unbundling agreement the brothers agreed to enter
into an 8-year lease with respect to the Lowell plant, which was
to provide that Glendon would pay NPI $2,000 per month.
In 1988,
a confirming commercial lease was prepared but not executed.
This lease agreement was for a term of 8 years to commence in
March 1988 and provided for a rental payment by “Acker [sic]
Industries, Inc.” of $2,000 per month.
During the years at issue, neither Glendon nor Aker paid
rent to NPI for use of the Lowell plant.58
Instead, ERG paid
57
Respondent requested the Court to find that the unbundling
agreement was “the result of intense arm’s-length bargaining”.
Petitioners failed to object to this requested finding.
58
Glendon explained why he failed to pay rent:
(continued...)
- 66 rent to NPI on behalf of Glendon/Aker.
Burton testified that
during the arbitration proceedings, it was ERG’s responsibility
to pay Aker’s rent obligation since it was still, at least until
a final resolution was achieved, ERG’s research and development
division.
The arbitrators in their final decision found that “the rent
that should be paid by GMB [Glendon]/Aker to NPI is $2,000 per
month from July 1, 1987 to December 31, 1994 and $2,500 per
month” thereafter.
And in fact, Glendon did pay such rent via a
credit to the amount the arbitrators decided Burton owed him.
Respondent argues that ERG had no duty to pay NPI $31,850,
$29,400, $29,400, $31,020, and $41,736 in 1988, 1989, 1990, 1993,
and 1994, respectively, for Aker’s use of the Lowell plant and
that those payments constituted constructive dividends to the
Bensons.59
We agree with respondent that ERG had no contractual
58
(...continued)
I knew that the performance on the [unbundling]
agreement required payment of rent. * * * [But it] also
required my brother to advance money to satisfy the
terms of that agreement. I was not going to pay rent
until my brother satisfied his monetary agreement, or
commitments.
59
Respondent determined these amounts in the notices of
deficiency. However, in a stipulated exhibit, the parties agreed
that ERG paid NPI $31,850, $26,950, $31,850, $33,840, and $38,296
during the years at issue, respectively, as rent for the Lowell
plant. But see supra p. 25, table, note 1. From the evidence
and argument presented, we cannot determine why there is a
discrepancy between the amounts that respondent determined and
the amounts the parties stipulated. Thus, we assume the parties
(continued...)
- 67 obligation to pay Aker’s rent obligations.
Indeed, it was, as
the arbitrators concluded, Aker’s responsibility to pay NPI for
the use of the Lowell plant, which Glendon ultimately paid by
virtue of the final arbitration decision.
This, of course, is in
accord with what the brothers agreed in the unbundling agreement.
Given that these funds were transferred to NPI, which the Bensons
used for their personal benefit, see infra, we find and hold that
the Bensons received constructive dividends in the amounts of the
excess rents that ERG paid.
9.
Director’s Fees
During the years at issue, ERG paid moneys to Esther,
Elizabeth, Mark, Brad, and Eric as purported director’s fees.
Additionally, in 1994, Burton altered the date on a $12,000 check
previously issued to his mother and negotiated it shortly after
her death.
Burton testified that this check also represented
director’s fees paid to his mother.
Respondent argues that all
these payments represent constructive dividends to Burton.
We
agree with respondent.
At trial, Burton generally testified that his family members
were directors of ERG, that ERG held meetings from time to time,
and that the purported directors performed services for ERG.
However, he did not testify what services the purported directors
59
(...continued)
will resolve the difference in their Rule 155 computation.
- 68 performed, and there is no evidence when and how often board
meetings were held.
No minutes of these alleged board meetings
were proffered as evidence.
Furthermore, ERG did not issue Forms
1099, and generally, none of the purported directors reported the
income on their individual returns.60
The “Transfer of income within the family presumably
benefits both transferor and transferee.”
P.R. Farms, Inc. v.
Commissioner, 820 F.2d at 1089-1089 (citing Helvering v.
Clifford, 309 U.S. 331, 335 (1940)).
In P.R. Farms, Inc. v.
Commissioner, supra, the majority shareholder of a corporate
taxpayer structured his business affairs to, inter alia, shuttle
money to his children.61
The court found the business
arrangement gratuitous and held that the corporation could not
deduct the transfers as ordinary and necessary business expenses,
and the amounts transferred were constructive dividends to the
shareholder.
Id. at 1088.
A similar result is appropriate here.
There is no evidence what services the purported directors
performed on behalf of ERG, when the meetings were held, and
60
However, Eric did report the fees received in 1994 on his
1994 return.
61
In P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084 (9th
Cir. 1987), affg. T.C. Memo. 1984-549, the taxpayer owned and
operated fruit orchards (orchards company). The 91-percent
shareholder, president, and director of the orchards company
incorporated a fruit packing corporation (packing company) owned
by the shareholder’s four children. The packing company was
formed to assume responsibility for packing the orchards
company’s fruit in exchange for fees.
- 69 whether the amounts paid to the purported directors were
reasonable and customary in the industry.
This appears to be
just another instance where Burton channeled funds from ERG for
personal reasons.
Accordingly, we find and hold that Burton had
constructive dividend income of $6,000, $23,000, $42,000, and
$49,000 in 1989, 1990, 1993, and 1994, respectively.
10.
Townsend & Townsend Check
The parties stipulated that the law firm Townsend & Townsend
issued ERG a check for $15,000 dated January 14, 1994, which
Burton negotiated in favor of an insurance company.
The funds
were credited to an insurance policy against which Burton had
previously taken loans.
Additionally, the parties stipulated
that during the years at issue, Elizabeth was the primary
beneficiary of the insurance policy.
The beneficiary was not
changed to ERG until sometime in 1996.
At trial, Burton
testified that when the insurance policy was purchased, it was a
mistake to designate his wife as the primary beneficiary; he
thought the policy was a “key man” policy owned by ERG.
Burton
testified that the loan proceeds originally taken against the
policy were used to meet ERG’s payroll.
There is no evidence, save Burton’s self-serving testimony,
that the funds were used for the benefit of ERG.
The record,
instead, demonstrates that two loans were taken against the
insurance policy in 1975 and 1984 which totaled approximately
- 70 $15,000.
Indeed, the policy was not for the benefit of ERG but
for the Bensons.
If Burton had died after repayment, Elizabeth
would have received $15,000 more as a death benefit than if the
loans had not been repaid.
Accordingly, we find and hold that
the $15,000 was a constructive dividend.
11.
Travel Expenses
On brief, respondent concedes that the Bensons did not have
constructive dividend income with respect to items of expense
Burton substantiated.
Respondent concedes the following items on
the basis of Burton’s explanation at trial:
Karim Cycling
$16.24, Surf Berkeley $56.40, and Claremont Resort $2,504.30.
The balance is still at issue.
Burton testified that a $9.23 expense was “Probably * * * a
tank of gas that went into a rental car.”
(Emphasis added.)
Some of the charges were incurred in Corvallis, Oregon, where
Burton’s son was attending college.62
Finally, expenses were
incurred by Pastor Nelson with respect to the performance of
memorial services on behalf of Esther.
Burton testified that
these expenses were allocated to ERG because his mother was a
director of ERG.
After respondent presented evidence supporting
his contention that these items constituted constructive
dividends, with the exception of Burton’s self-serving testimony,
62
Burton testified that these expenses were incurred on a
visit to a Hewlett Packard laser and jet ink printer division.
He did not explain what that visit had to do with ERG’s business.
- 71 petitioners fail to demonstrate a business purpose for any of
these expenditures and otherwise fail to substantiate any of the
items.
Furthermore, expenses for Esther’s memorial services are
clearly personal and noncorporate expenses.
Accordingly, we find
and hold that Burton had constructive dividend income of
$3,889.63
12.
Legal Expenses
In 1994, ERG paid legal expenses of $4,660.19.
Respondent
determined that $4,159 constituted a constructive dividend to
Burton.64
The stipulated invoices provide some explanation of
the nature of the charges incurred.
Although we generally agree with respondent, the face of the
invoices grant the Bensons some relief.
For example, $126 in
63
Respondent appears to have double-counted a charge of
$223.82. In his opening brief, respondent lists the amount still
at issue as $6,690. Apparently, this amount is the aggregate of
those items listed on the ERG travel expense report dated Feb. 9,
1994, $616.47, the expense report dated Oct. 4, 1994, $833.06,
and the amounts the parties stipulated totaling $5,241.24.
However, the amount $223.82 concerning a charge at a hotel in
Corvallis, Oregon, is listed twice. Thus, an amount equal to
$223.82 should be backed out of respondent’s determination.
Thus, we calculate Burton’s constructive dividend as follows:
$6,690 less $2,576.94 of substantiated expenses less $223.82.
64
We are unable to resolve the apparent discrepancy between
the amount listed in the notice of deficiency and the amount
shown on the documentary evidence. Similarly, respondent asked
us to find as fact that in 1994 ERG paid legal bills of $4,159.
Without an explanation to the contrary, we assume that respondent
has conceded the difference.
- 72 legal fees65 was incurred concerning unemployment issues.
Presumably, these were not personal expenses.
However, for the
majority of the charges detailed, it is either impossible to
determine the purpose of the charges or those charges do not
appear to be deductible expenses of ERG.
For example, there are
charges concerning a property line dispute and loan agreement and
“MVPC documents”.
These could be either personal or business
expenses since both ERG and the Bensons donated money to MVPC for
which charitable deductions were claimed.
Additionally, there
are charges relating to probating Esther’s estate, which would
not appear to be ERG’s deductible expense.
Petitioners have
failed to meet their burden of proof as to these items except for
$126.
Accordingly, we hold that Burton has constructive dividend
income of $4,033.66
13.
Employee Relations Expenses
Respondent determined that the Bensons received certain
amounts paid by ERG designated as business relations expenses.
On brief, respondent’s only argument is that the Bensons failed
to overcome the presumption of correctness in the notice of
deficiency as to this issue.
The amount of income determined by
respondent is $4,027, but the invoices in evidence total
$3,035.16.
See supra p. 30.
The Bensons failed to overcome the
65
That is $210 per hour multiplied by .6 of an hour.
66
That is $4,159 less $126.
- 73 presumption of correctness with respect to $3,035.16.
We hold
that $3,035 was a constructive dividend.
Use of Funds From NPI
The Bensons used proceeds from the above-listed transfers
for their personal benefit.
For example, from 1993 through 1995,
Burton caused NPI to expend more than $4.6 million for his
family’s personal benefit.67
These funds were used for, inter
alia, the Bensons’ personal State and Federal income tax
liabilities, personal investments, and transfers to their three
sons.
There is no indication in the record that the Bensons
intended to repay any part of these expenditures and/or transfers
67
NPI made the following transfers on behalf of the Bensons:
Transfer Year
1993
1993
1994
1994
1994
1994
1995
1995
1995
1995
1995
1995
1995
Total
Description
Amount
California Franchise
Tax Board
$129,480.00
IRS
378,000.00
California Franchise
Tax Board
28,745.00
IRS
135,869.00
Checks payable
to Burton
200,000.00
Wire transfer re secured
promissory note
1,000,000.00
IRS
23,331.00
Checks payable to
Burton and Elizabeth
400,000.00
Burton’s Jack White & Co.
investment account
1,000,000.00
Bensons’ USAA Mutual
Fund
1,000,000.00
Bensons’ Insight Capital
Research & Management, Inc.
account
5,441.55
Bensons’ Insight Capital
Research & Management, Inc.
account
4,860.81
Checks payable to Eric, Brad,
and Mark
300,000.00
4,605,727.36
- 74 to NPI.
See Noble v. Commissioner, 368 F.2d at 443; Truesdell v.
Commissioner, 89 T.C. 1280 (1987).
Nor is there any indication
that any of the transfers served NPI’s business purpose.
Additionally, as detailed above, ERG made significant payments to
third parties, family members, and the Bensons themselves.
ERG
paid the Benson family’s personal expenses and purchased real
property for their sole use and enjoyment.
We disagree with the Bensons that a finding of constructive
dividends necessitates a declaration that NPI is a sham entity.
We do not find that NPI was a sham; however, we do find that
there is competent evidence that transfers by ERG to NPI for
purported royalties and engineering services during the years at
issue were made by Burton for his personal benefit and lacked a
business purpose.
Indeed, the record discloses that NPI was a
receptacle to which ERG transferred and pooled its operational
profits.
The exclusive licensing agreement and the payment of
engineering services were the articulated justification for these
payments.
As the testimony and evidence demonstrates, there was
a “plan” to keep ERG profits static, shuttling amounts in excess
thereof to NPI, clothed as business payments.
The profit level
of ERG was not a function of economic realities but instead of
tax planning and tinkering.
The record demonstrates that Burton controlled both sides of
the equation; there were no arm’s-length transactions between the
- 75 two entities.
There is no evidence upon which we can find that
the transfers of funds by ERG to NPI served any business purpose.
The Bensons substantially benefited economically from those
transfers through NPI’s disbursement of millions of dollars for
the Benson family’s personal use and enjoyment.
Accordingly, we
find the Bensons enjoyed considerable economic benefits from the
ERG transfers and expenditures.
Nonconstructive Dividend Issues
1.
Franklin Dividends
The Bensons conceded that they had additional, unreported
dividend income from their Franklin account #1 for all the years
at issue except 1994.
to this account.
In 1994, $1,072 was credited as dividends
The stipulated evidence demonstrates that the
account was held in the Bensons’ name, although the account bore
the Social Security number of Eric.
All the funds deposited into
this account are attributable to the Bensons.
Despite the fact
that Eric reported the amount credited on his 1994 return, the
dividends are clearly attributable to the Bensons and should have
been reported by them.
Thus, we find and hold that the Bensons
had additional dividend income in 1994 of $1,072.
2.
Forgiveness of Debt Income
On its returns, ERG’s “loans to stockholders/officers” were
reduced from $88,291 in 1987 to $0 in 1988.
Respondent argues
that the forgiveness of the debt was income to the Bensons in
- 76 1994, or, alternatively, in 1988.
We agree and sustain
respondent’s determination that the Bensons’ debt was forgiven in
1994.
“Income from discharge of indebtedness" is included within
the broad definition of income.
See sec. 61(a)(12).
“The
underlying rationale for such inclusion is that to the extent a
taxpayer is released from indebtedness, he or she realizes an
accession to income due to the freeing of assets previously
offset by the liability.”
Jelle v. Commissioner, 116 T.C. 63, 67
(2001) (citing United States v. Kirby Lumber Co., 284 U.S. 1, 3
(1931)).
In July 1994, Bradac stated to Burton that without an
explanation such unpaid loans constituted income in the year the
indebtedness was discharged.
August 1, 1994.
ERG filed its 1988 tax return on
Burton’s indebtedness was discharged in 1994
when it was eliminated from ERG’s return.
It was at that
“‘moment it * * * [became] clear that a debt will never have to
be paid, such debt must be viewed as having been discharged.’”
Rinehart v. Commissioner, T.C. Memo. 2002-71 (quoting Cozzi v.
Commissioner, 88 T.C. 435, 445 (1987)).
Accordingly, we find and
hold that Burton had cancellation of indebtedness income of
$88,291 in 1994.
3.
Partner Expenses--Baden Spiel Haus Partnership
Burton was a 25-percent partner in the Baden Spiel Haus
partnership, which owned and operated a ski cabin in California.
Respondent determined that the Bensons were not entitled to
- 77 deductions for partner expenses claimed on their returns.
The
Bensons conceded the issue for the years 1989, 1990, and 1993,
but not for 1994.
expense.
The Bensons failed to substantiate any item of
Accordingly, we sustain respondent’s determination as
to 1994.
4.
Rental Income/Loss--Residential Rental Expenses:
Respondent determined that the Bensons were not entitled to
unsubstantiated residential rental expenses of $23,599, $22,951,
$28,621, $23,737, and $23,599 for 1988, 1989, 1990, 1993, and
1994, respectively.
The deductions were claimed by NPI and
passed through to its shareholders.
The Bensons did not provide
the Court with evidence to substantiate the deductions claimed.
Accordingly, we sustain respondent’s determination on this issue.
5.
Passive Loss Limitation
Respondent determined that rental losses reported on Eric’s,
Brad’s, and Mark’s returns are subject to the passive loss
limitations contained in section 469.
Petitioners offer no
evidence with which we can find that they fall within the
auspices of any of the exceptions articulated in the
regulations.68
See Kessler v. Commissioner, T.C. Memo. 2003-185;
sec. 1.469-1T(e)(3)(ii)(A) through (F), Temporary Income Tax
Regs., 53 Fed. Reg. 5702 (Feb. 25, 1988).
68
Without a finding that
On brief, petitioners state: “Petitioners do not dispute
respondent’s argument on the applicable Subchapter S rules at
page 136-38 of his brief.”
- 78 petitioners fall within one of those enunciated exceptions,
“material participation” is irrelevant.
See sec. 469(c)(1);
Tarakci v. Commissioner, T.C. Memo. 2000-358; Welch v.
Commissioner, T.C. Memo. 1998-310 (“If * * * [taxpayer]
establishes that the activity was not a rental activity, he then
must establish that he materially participated in the activity to
avoid the proscription of section 469.").
Accordingly, we
sustain respondent’s determination on this issue.
6.
NPI Distributions
On its 1994 return, NPI reported total property
distributions other than dividends of $1,017,373.
Eric’s,
Brad’s, and Mark’s shares thereof were $169,562 each.
In the
notice of deficiency, respondent determined that Eric had
substantiated a basis in his NPI stock of $105,224 and that he
had distributions in excess of basis of $64,338.
In the notices
of deficiency for Brad and Mark, respondent determined that they
had substantiated bases in their NPI stock of $76,926 each and,
thus, had distributions in excess of basis of $92,636.
The parties indicate on brief that the issue concerning what
amounts are properly reportable on Eric’s, Brad’s, and Mark’s
returns can be resolved by the parties under their Rule 155
computation.
- 79 Fraud Penalty
In his determinations, respondent asserted fraud penalties.
Although the record discloses what could be construed as “badges
of fraud,” see Bradford v. Commissioner, 796 F.2d 303, 307 (9th
Cir. 1986), affg. T.C. Memo. 1984-601, we are not convinced that
respondent has carried his heavy burden of proving fraud by clear
and convincing evidence, Gow v. Commissioner, T.C. Memo. 2000-93
(“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”).
The record contains evidence that the
inaccuracies and the inconsistencies in petitioners’ returns may
have been a result of extraordinary circumstances, albeit many
times at the hands of Burton himself.
For example, petitioners’
long-time accountant and return preparer died just prior to the
years at issue.
A new accountant/return preparer was engaged
years later and inherited a poorly administered accounting
system.
There were few records from which the financial history
of the entities could be reconstructed.
Apparently, a
significant amount of work was performed to get the books and
records of the entities in a position from which returns could be
filed.
Some of the returns were filed out of order, and amended
returns were filed as additional information was discovered.
- 80 Clearly, ERG transferred millions of dollars to NPI.
In
reviewing and reconstructing the books and records of the
entities, the accountants inquired as to these transfers.
Burton
and the accountants labeled these transfers as payments of
royalties and for engineering services.
The royalties were paid
on the basis of an exclusive licensing agreement suggested by
Miller, the mediator of the brothers’ dispute.
The balances were
designated “engineering services” by Burton and his accountants.
When asked at trial who came up with the idea of how to
allocate income between NPI and ERG, Bradac testified “Probably
through my suggestion in the early years we were trying to base
it on the income of ERG and we started with a number, somewhere
an average of fifty to seventy-five thousand dollars of profits
for the corporation.”
That number was based upon Bradac’s
suggestion because “the tax rates for a corporation * * *
[become] rather prohibitive after 75,000, and also looking at
perhaps the balance sheets and estimating the growth of the
company over those years.”
Bradac admitted at trial that “any
plan developed by * * * [Burton], was developed with my
consultation.”
For example, Bradac knew that the $483,098 that
ERG transferred to NPI was not for equipment purchased and,
instead, he claimed a royalty deduction in preparing the ERG
returns for 1989 of $252,679 explaining:
“I believe it was an
unfortunate tag, meaning the royalty name”.
He stated:
“And I
- 81 was focused on royalties as a possible deduction from ERG to * *
* NPI and we put the amount in there when it probably should have
been better labeled services * * * so we deducted the amount as
royalties when perhaps a better label even then would have been
engineering services.”
According to Bradac’s testimony, there
was no real formula to allocate royalties to the years at issue.
The Court asked and Bradac answered as follows:
Q: How were the specific amounts arrived at for
the individual years?
A: We would–-we initially, one based it on the
profits of ERG. And when I say that, we anticipated
that ERG would still be profitable during the period.
So we estimated their profits in the range of fifty to
seventy-five thousand dollars. And calculated the
royalties that were necessary to bring the income down
to that level.
Additionally, Bradac testified that he suggested the concept of
constructive receipt as a basis to allocate payments to tax years
prior to receipt.
Bradac, Toibin, and Burton discussed the
characterization of other ERG payments to NPI as “engineering
services”.
Finally, Bradac testified that Burton did not order
him to make any particular entry that appeared on the returns and
that he made discretionary decisions with respect to classifying
income and expense.
Given this record, we are unable to sustain respondent’s
determination of fraud.
- 82 Accuracy-Related Penalties
With respect to the Bensons,69 respondent determined that to
the extent we do not find fraud, we should impose accuracyrelated penalties.70
Additionally, respondent determined
accuracy-related penalties for Eric, Brad, and Mark for 1994.
Respondent based his determinations on negligence or disregard of
the tax rules and regulations and/or a substantial understatement
of income tax.
Respondent’s determinations are presumed correct,
and the burden lies with petitioners to demonstrate that
respondent’s penalty determinations were in error.71
Rule
142(a).
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment of tax attributable to, inter alia, negligence
and/or a substantial understatement of income tax.
and (b).
Sec. 6662(a)
“Underpayment” is defined as the amount by which any
tax imposed exceeds the excess of the sum of the amount shown by
the taxpayer on his return plus the amounts not so shown
69
Respondent also determined, as an alternate to the fraud
penalty which he conceded shall not apply to Eric, an accuracyrelated penalty for Eric’s 1993 tax year. See docket No. 585-98.
However, on brief, respondent explains that the penalty is
affected by our holding on the issue of constructive dividends.
70
In fact, respondent’s alternative position for 1989, 1990,
1993, and 1994 is based upon sec. 6662(a).
71
41.
Sec. 7491(c) does not apply in this case.
See supra note
- 83 previously assessed (or collected without assessment) over the
amount of rebates made.
Sec. 6664(a).
“Negligence” is defined as “any failure to make a reasonable
attempt to comply with the provisions of this title” and
“disregard” means “any careless, reckless, or intentional
disregard.”
Sec. 6662(c).
Similarly, caselaw defines negligence
as a lack of due care or “‘the failure to do what a reasonable
and ordinarily prudent person would do under the circumstances.’”
Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting
Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967),
affg. on this issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299)),
affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).
Pursuant to the regulations, “‘Negligence’ also includes any
failure by the taxpayer to keep adequate books and records or to
substantiate items properly.”
Sec. 1.6662-3(b)(1), Income Tax
Regs.
Section 6664(c) provides an exception to the penalty imposed
under section 6662(a).
“No penalty shall be imposed under this
part with respect to any portion of an underpayment if it is
shown that there was a reasonable cause for such portion and that
the taxpayer acted in good faith with respect to such portion.”
Sec. 6664(c)(1).
The determination of whether the taxpayer acted
with reasonable cause and in good faith is made on a case-by-case
- 84 basis, contemplating all the relevant facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs.
“Reasonable cause requires that the taxpayer exercise
ordinary business care and prudence”.
Bitker v. Commissioner,
T.C. Memo. 2003-209 (citing United States v. Boyle, 469 U.S. 241
(1985)).
With respect to the tax treatment of an item, the good
faith reliance on the advice of a competent and independent
professional may constitute “reasonable cause”.
1.6664-4(b), Income Tax Regs.
Id.; sec.
However, whether a taxpayer
reasonably relies on the advice of a professional depends upon
the facts and circumstances of the case and the applicable law.
Sec. 1.6664-4(c)(1)(i), Income Tax Regs.
“[T]he ultimate
responsibility for a correct return lies with the taxpayer who
must furnish the necessary information to his agent who prepared
his return.”
Pessin v. Commissioner, 59 T.C. 473, 489 (1972);
sec. 1.6664-4(c)(1)(i), Income Tax Regs.
The taxpayer “has the
burden of establishing that he at least supplied the correct
information to his accountant * * * and that the incorrect
returns were a result of the accountant’s mistakes.”
Pessin v.
Commissioner, supra at 489.
In this case, the understatement and underpayment of tax is
a direct result of the misapplication and mislabeling of
transactions in derogation of the tax laws.
Furthermore,
Burton’s failure to keep accurate and complete corporate books
- 85 significantly contributed to his failure to accurately and
completely report income and file returns.72
The record is replete with indications that Burton did not
supply complete and/or correct information to his return
preparers.
He cannot hide behind the shield of ignorance or
reliance.
Indeed, both Bradac and Toibin testified repeatedly
that they relied in large part on Burton’s representations and
characterizations.
For example, Bradac testified that with
respect to the automobile and truck deductions, he relied
completely on Burton’s representations that the correct
allocation between personal and business use was made.
Additionally, Bradac testified that he had not seen a copy of the
royalty agreement before he commenced preparation of ERG’s and
NPI’s returns.
We sustain respondent’s determination of
negligence penalties in this case against the Bensons.
Likewise, petitioners argue on brief that “Burton testified
he was responsible for getting his son’s returns completed and
filed for 1993 and 1994, and * * * accuracy related penalties
should not inure to the sons for what the father undertook to
do.”
We disagree.
“[T]he taxpayer must bear the consequences of
any negligent errors committed by its agent.”
Ellwest Stereo
Theater v. Commissioner, T.C. Memo. 1995-610 (citing Logan Lumber
72
On brief, petitioners argue: “there is no question that
Burton neglected his responsibilities to enlist new accounting
help and to keep up with required tax return filings.”
- 86 Co. v. Commissioner, 365 F.2d 846, 854 (5th Cir. 1966), affg.
T.C. Memo. 1964-126).
Thus, we sustain respondent’s
determinations of accuracy-related penalties as to Eric, Brad,
and Mark.
Additions to Tax--Failure To File Timely Return
Pursuant to section 6651(a)(1), respondent determined that
the Bensons are liable for additions to tax for 1989 and 1990 and
that Eric is liable for additions to tax for 1993.73
An addition
to tax is imposed under section 6651 for the failure to file a
return within the period prescribed, unless the taxpayer shows
that such failure was due to reasonable cause and not due to
willful neglect.
Sec. 6651(a)(1).
The amount of the addition is
5 percent of the amount required to be shown as tax for each
month that the delinquency persists, up to a maximum of 25
percent.
Id.
The delinquency is due to reasonable cause if the taxpayer
exercised ordinary business care and prudence but was
nevertheless unable to perform his tax obligations in a timely
manner.
Brewery, Inc. v. United States, 33 F.3d 589, 592 (6th
Cir. 1994); Housden v. Commissioner, T.C. Memo. 1992-91.
73
According to the notice of deficiency, Eric’s delinquency
addition to tax is a result of an invalid extension. Since he
did not properly estimate his tax liabilities on his extension
application and since he failed to show a reasonable attempt to
secure the information necessary to make the estimate, his
extension was considered invalid.
- 87 However, “The delinquency is due to willful neglect if it
resulted from a conscious decision or from reckless
indifference.”
Ellwest Stereo Theater v. Commissioner, supra
(citing United States v. Boyle, supra at 245).
The Bensons offered no evidence or excuse for their failure
to file timely returns, and we conclude that they have not shown
that their failure to file returns for the years at issue was due
to reasonable cause and not due to willful neglect.
Accordingly,
we sustain respondent’s determinations.
Furthermore, petitioners argue on brief that since Burton
testified that he was responsible for filing his son’s returns,
the additions to tax “should not inure to the sons for what the
father undertook to do.”
Petitioners cite no authority upon
which we can look to relieve Eric from his duty to file his tax
return timely.
They rely solely upon Burton’s testimony that he
undertook the responsibility to file his children’s returns.
Where the duty to file the return is imposed on the
guardian charged with the care of the taxpayer's
property, and not on the taxpayer, the inability of the
taxpayer is not controlling, and the applicability of
additions to tax depends on whether or not there was a
lack of good cause and due care on the part of the
guardian.
Bassett v. Commissioner, 67 F.3d 29, 32 (2d Cir. 1995), affg. 100
T.C. 650 (1993).
We are not convinced that the failure to file
was attributable to reasonable cause and not to willful neglect.
- 88 Thus, we sustain respondent’s imposition of delinquency additions
to tax as to Eric’s 1993 tax year.
Decisions will be entered
under Rule 155.
- 89 Appendix
Concessions of the Parties
1.
Respondent concedes that payments of $6,000 made in
1989, 1990, and 1993, and $13,500 in 1994, by Energy Research &
Generation, Inc. (ERG), to Moraga Valley Presbyterian Church
(MVPC) are not constructive dividends to Burton Benson
(Burton).74
2.
Respondent concedes that the following payments that ERG
made for the years listed are not constructive dividends to
Burton:
Year
Check No.
Amount
1988
1988
1989
1990
19378
18617
20021
21166
$10,000
10,000
33,328
2,610
Respondent concedes that Burton O. and Elizabeth C. Benson (the
Bensons) are not liable for constructive dividends with respect
to the category “other payments” that ERG made of $5,700 for
1990.
3.
Respondent concedes that a payment that ERG made in 1993
for medical expense of $4,000 is not a constructive dividend to
Burton.
74
In the text of respondent’s opening brief, he states the
amount conceded as $13,500. However, he also states the amount
as $15,500. We assume from the parties concessions and the
record that respondent conceded $13,500 paid to MVPC and $2,000
to Camp Timberlake.
- 90 4.
Burton concedes that he had constructive dividend income
with respect to payments that ERG made for automobile expenses in
the following amounts:
5.
Year
Amount
1990
1993
$15,000
13,500
Burton concedes that he had constructive dividend income
with respect to payments that ERG made for life insurance for the
years and in the amounts listed:
Year
Amount
1988
1989
1990
1994
$2,425
2,404
2,480
4,781
Respondent concedes the adjustment of $2,646 for 1993.
6.
Burton concedes that he had constructive dividend income
with respect to payments that ERG made in 1993 and 1994 for Eric
Benson’s (Eric) education of $2,599 and $9,166, respectively.
7.
Burton concedes that he had constructive dividend income
with respect to funds withdrawn from the ERG-Recreation fund bank
account(s) for the years and in the amounts listed:
Year
Amount
1988
1990
1993
$3,000
686
18,556
The amount conceded for 1993 includes $9,000 from cashing check
No. 27 dated March 8, 1993, payable to ERG.
It also includes
- 91 check No. 30 drawn on the ERG-Recreation fund account payable to
Mark Benson (Mark) for $9,000.
However, the balance for 1993,
$8,000, remains at issue as well as the entire amount for 1994.
8.
Respondent concedes that a payment made from the ERG-
Ford Retirement Fund in 1990 of $26,000 is not income to the
Bensons.
Respondent also concedes that the Bensons are not
liable for the 10-percent penalty pursuant to section 72 of
$2,600 for 1990.
9.
The Bensons concede that they had additional royalty
income from Form 1099 sources in the years and amounts listed:
10.
Year
Amount
1988
1989
1993
1994
$883
709
570
586
The Bensons concede that they had additional dividend
income from Franklin Money Fund accounts for the years, for the
accounts, and in the amounts listed:
Account No.
1988
1989
1990
1993
11102309431
11100025476
$204.36
-0-
$192.66
-0-
$229.39
461.69
$360.04
627.07
11.
The Bensons are not entitled to the dependency
exemptions claimed for Esther Benson (Esther) for 1988, 1989, and
1990.
12.
The Bensons are not entitled to itemized deductions for
mortgage interest in excess of the amounts allowed by respondent
- 92 in the notices of deficiency for tax years 1988, 1989, 1990, and
1993.
13.
The Bensons are not entitled to deductions for partner
expenses with respect to the Baden Spiel Haus partnership for the
years and in the amounts listed:
14.
Year
Amount
1989
1990
1993
$1,281
1,182
1,473
For 1993, Eric had additional:
(1) Capital gain income
of $1,957; (2) dividend income of $565; and (3) interest income
of $121.
15.
Respondent concedes that Eric and Elizabeth Benson
(Elizabeth) are not liable for civil fraud penalties for the
years at issue.
16.
For 1994, Brad Benson (Brad) had additional:
(1)
Capital gain income of $2,444; (2) dividend income of $2,779; and
(3) interest income of $65.
17.
For 1994, Mark had additional:
(1) Capital gain income
of $2,542; (2) dividend income of $11,674; (3) income from ERG of
$5,000; and (4) self-employment income with respect to the
amounts received from ERG.
18.
For 1994, Eric had additional:
(1) Capital gain income
of $2,443; (2) dividend income of $2,822; (3) interest income of
$112; (3) gross wage income of $232; and (4) self-employment
- 93 income with respect to the amounts received from ERG and reported
on his 1994 return as “other income”.
19.
Respondent concedes that the Bensons did not have
constructive dividend income in 1994 with respect to payments
that ERG made for travel expense for $536.
20.
Respondent concedes his alternative position that the
fair market value of rent on the Stanford plant was as determined
by an expert appraiser whose report respondent submitted to the
Court.
21.
Respondent concedes ERG’s computer purchase in the
amount of $3,847 did not constitute a constructive dividend to
the Bensons in 1993.
22.
Respondent concedes that ERG’s payment of $692 for
health insurance coverage for Esther did not constitute a
constructive dividend to the Bensons in 1994.
23.
Respondent concedes that if the Court determines that
the Bensons received constructive dividends of $96,749 from ERG’s
payment of legal expenses, the Bensons are entitled to deduct
legal expenses (subject to the limitations in section 67) of
$77,973 for 1989.
24.
For the years 1988, 1989, 1990, 1993, and 1994 to the
extent that the Court determines constructive dividends, these
amounts are taxed as dividends to the Bensons.
- 94 25.
The parties agree that if respondent prevails on the
constructive dividend issue, then the income reported by the
other shareholders of New Process Industries, Inc., will have to
be accordingly adjusted.
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.