Joann K. Beck
, for petitioners.
Kathey I. Shaw
, for respondent.
MEMORANDUM OPINION
HAMBLEN, Judge
: By four separate notices of deficiency, respondent determined deficiencies, additions to tax, and penalties in regard to petitioners' Federal income tax as follows:
Milo G. and Sarah E. Chapman--docket No. 20342-94
Addition to Tax and Penalties
Year
Deficiency
1988 $25,424 $1,237 ---1989 12,429 --- $2,357 1990 1,574 --- 315 David E. and Gladys A. Christie--docket No. 20363-94 Addition to Tax and Penalties Year Deficiency Sec. 6653(a)(1)
1988 $19,469 $973 ---1989 10,846 --- $2,040 1990 962 --- 192 Dura-Craft, Inc.--docket No. 20560-94 Taxable Year Addition to Tax and Penalty Ending Deficiency Sec. 6653(a)(1)
10/31/88 $15,968 $798 ---10/31/89 93,410 --- $3,591 Unless otherwise indicated, all section references are to the Internal Revenue Code as in effect for the years at issue, and Rule references are to the Tax Court Rules of Practice and Procedure.
After concessions, the issues for decision are:
(1) Whether petitioners Milo and Sarah Chapman and David and Gladys Christie received distributions from the Dura-Craft profit-sharing plan (Plan) in 1988 and 1989 pursuant to section 72(p);
(2) whether petitioners Milo and Sarah Chapman and David and Gladys Christie received early distributions from the Plan in 1988 and 1989 and therefore are liable under section 72(t) for the 10-percent additional tax for early distributions; (3) whether petitioners Milo and Sarah Chapman and David and Gladys Christie constructively received interest income in 1989 from the payments by Dura-Craft, Inc. (Dura-Craft), and Springbrook Marketing (Springbrook) to the Plan;
(4) whether petitioners David and Gladys Christie received constructive dividends in 1989 from the loan repayments by both Dura-Craft and Springbrook to the Plan in amounts greater than those actually owed to the individual petitioners; and (5) whether the 5-percent processing fees charged by Northwest Purchasing, Inc., were allowable as a part of DuraCraft's cost of goods sold for fiscal years ending October 31, 1988 and 1989.
Background
These consolidated cases were submitted without a trial pursuant to Rule 122. The stipulation of facts and the attached exhibits are incorporated by this reference, and the facts contained therein are found accordingly. Petitioners Milo Chapman and Sarah Chapman (collectively hereinafter referred to as the Chapmans) resided in Newberg, Oregon, at the time the petition was filed in docket No. 20342-94, and petitioners David Christie and Gladys Christie (collectively hereinafter referred to as the Christies) resided in Aurora, Oregon, at the time the petition was filed in docket No. 20363-94. Dura-Craft, Inc., is a C corporation which maintained its principal place of business in Newberg, Oregon, at the time the petition was filed in docket No. 20560-94. During the years at issue, the Chapmans and the Christies prepared their respective joint Federal individual income tax returns using the cash receipts and disbursements method of accounting, and Dura-Craft prepared its Federal corporate income tax returns using an accrual method of accounting.
This case involves three closely held corporations and their shareholders. Northwest Purchasing, Inc. (Northwest), is a subchapter S corporation which is owned equally by David Christie and Milo Chapman. Northwest sells raw materials to Dura-Craft at Northwest's cost, plus a 5-percent processing fee. During the years at issue, Dura-Craft was owned by Milo Chapman (25 percent) and David Christie (75 percent). Dura-Craft manufactures doll house kits and sells these kits exclusively to Springbrook. During the years at issue, Springbrook was owned by Milo Chapman (75 percent) and David Christie (25 percent). Springbrook markets the doll house kits to various outside retailers such as Fred Meyer and Payless.
During the years at issue, Milo Chapman was an employee of
Springbrook, and David Christie was both an officer and an employee of Dura-Craft. Milo Chapman controlled all of the Although the Plan agreed to these loans, the Plan instead paid $50,000 to Dura-Craft on February 22, 1983, and $25,000 to Springbrook on April 27, 1983. On February 22, 1983, Dura-Craft signed a note agreeing to pay David Christie and Milo Chapman a total of $50,000 plus 12 percent interest, and, on April 27, 1983, Springbrook signed a note agreeing to pay David Christie and Milo Chapman $25,000 plus 12 percent interest (collectively referred to as corporate loans).
In 1985, Dura-Craft paid David Christie $10,000 on its
$50,000 corporate loan, and Springbrook paid Milo Chapman $10,000 on its $25,000 corporate loan. At that time, Dura-Craft reduced its loan payable balance reflected in its accounting records by the $10,000 it paid to David Christie. Springbrook also reduced its loan payable balance reflected in its accounting records by the $10,000 it paid to Milo Chapman. Due to an error, Springbrook included the 1985 $10,000 loan repayment to Milo Chapman on his 1985 Form W-2. Neither David Christie nor Milo Chapman reduced his loan balance with the Plan in 1985. As of January 1, 1986, the accounting records of Dura-Craft had a loan payable balance to David Christie and Milo Chapman of $40,000, and the accounting records of Springbrook had a loan payable balance of $15,000.
On April 25, 1989, Springbrook paid the balance of its corporate loan by issuing a check to the Plan in the amount of $43,315 with the notation "princ $25,000-int $18,315". On the same day, Dura-Craft also paid the balance of its corporate loan by issuing a check to the Plan for $87,185 with the notation "princ $50,000, int $37,185". Dura-Craft's check register for the $87,185 check to the Plan bears the notation "Loan Payback from Milo-Dave-pd directly to Dura-Craft profit Share Trust." Springbrook recorded the payment on its accounting records as follows:
Wage expense $10,000
Interest expense 18,315
Loan payment 15,000
Paid to profit-sharing plan 43,315
At the time of the payment, Springbrook's accounting records reflected a loan payable balance of $33,315. Springbrook computed and paid interest to the Plan on the full amount of its corporate loan despite the $10,000 loan payment which Springbrook made to Milo Chapman in 1985. Accordingly, as of the date of its payment, Springbrook owed to Milo Chapman and David Christie a total of $14,000 in interest rather than the $18,315 which was paid.
Dura-Craft recorded the $87,185 repayment on the same date in its accounting records as follows:
Wage expense $10,000
Interest expense 37,185
Loan payment 40,000
Paid to profit-sharing trust 87,185
At the time of the payment, Dura-Craft's accounting records reflected a remaining loan payable balance of $40,000. Nonetheless, Dura-Craft computed the interest owed based upon an outstanding loan balance of $50,000 despite the $10,000 loan payment which Dura-Craft made to David Christie in 1985. Accordingly, as of the date of its payment, Dura-Craft owed interest to Milo Chapman and David Christie in the amount of $33,000 rather than the $37,185 which was paid.
On February 22, 1986, the loan principal and interest due to the Plan for each of the plan loans exceeded the statutory limit of $50,000, pursuant to section 72(p)(2)(A)(i). Total interest of $9,000 and $3,000 accrued on the plan loans during 1988 and 1989, respectively.
The Chapmans and the Christies did not report any income with respect to the corporate or plan loans. Respondent determined that the Chapmans and the Christies each received two plan distributions from the Plan pursuant to section 72(p): (1) In 1988, in the amount of the principal balance of $37,500 and one-half of the accrued interest ($4,500), and (2) in 1989, in an amount of one-half of the interest accruing during that year ($1,500). In addition, respondent determined that petitioners were liable for an additional 10-percent tax pursuant to section 72(t) on each distribution.
Respondent also determined that the Chapmans and the
Christies each received the following amounts of income in 1989: (1) Dividends from Springbrook equal to one-half of the difference between interest of $14,000 owed by Springbrook on its corporate loan and the $18,315 actually paid by Springbrook to the Plan ($2,158); (2) dividends from Dura-Craft equal to onehalf of the difference between the $33,000 of interest owed by Dura-Craft on its corporate loan and the $37,185 actually paid by Dura-Craft to the Plan ($2,092); (3) interest income equal to one-half of the interest owed by Dura-Craft ($16,500) and by Springbrook ($7,000) on the respective corporate loans but paid to the Plan.
B. Northwest
Northwest was incorporated in 1978 as a corporation electing small business status under subchapter S and is equally owned by David Christie and Milo Chapman. During 1988, 1989, and 1990, Northwest had no employees and had the same telephone number, business address, and office space as Dura-Craft. For its taxable years ending October 31, 1988 and 1989, Dura-Craft purchased all of its raw materials from Northwest. Northwest sold Dura-Craft these raw materials at Northwest's cost, plus a 5-percent processing fee. For the years ending October 31, 1988 and 1989, Dura-Craft paid Northwest processing fees of $39,840.83 and $55,572, respectively. As Northwest had no employees, all of Northwest's orders were placed by Dura-Craft employees and delivered directly to the Dura-Craft plant. Northwest maintained its own set of accounting records and filed its own tax returns for the taxable years ending July 31, 1989 and 1990. Respondent disallowed the payments Dura-Craft claimed as cost of goods sold for taxable years ending October 31, 1988 and 1989.
(1) [Northwest] was formed * * * by the Chapman and Chritie [sic] families for the purpose of locating and brokering wood products for sale to others; (2) David Christie oversees the administrative and accounting portions of Northwest Purchasing while Milo Chapman locates, evaluates and secures the raw materials purchased by [Northwest] for sale; (3) the services of Northwest's principals are not performed by anyone else.
Discussion
Petitioners bear the burden of establishing that respondent's determinations of deficiencies, as contained in the statutory notices of deficiency, are incorrect. Rule 142(a); Welch v. Helvering , 290 U.S. 111 (1933). Petitioners' briefs refer to several facts which were not included in the parties' stipulation of facts. Statements in briefs do not constitute evidence and will not be considered by the Court.3
Rule 143(b);
Evans v. Commissioner
, 48 T.C. 704, 709 (1967), affd. per curiam 413 F.2d 1047 (9th Cir. 1969). The record of this case was closed prior to the submission of the parties' briefs. Accordingly, we hold that the additional facts contained in petitioners' briefs that were not part of the stipulation of facts or offered at trial are not a part of the record.
the general rule of section 72(p)(1) if the following requirements are satisfied: (1) The balance of all outstanding plan loans does not exceed the lesser of: (i) $50,000, or (ii) the greater of $10,000 or half of the participant's vested accrued benefit under the plan; and (2) the loan, by its terms, requires repayment within 5 years. Sec. 72(p)(2)(A) and (B). Section 72(p)(2)(C) was added by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1134(b), 100 Stat. 2085, 2484, and limits the exception in section 72(p)(2) to those loans that are required to be amortized in substantially level installments paid at least quarterly. This provision applies to loans made, renewed, renegotiated, modified, or extended after December 31, 1986. Id.
Section 72(t)(1) imposes an additional tax on an amount received from a qualified retirement plan equal to 10 percent of the portion of such amount that is includable in gross income. Section 72(t)(2) exempts distributions from the additional tax if the distributions are made, inter alia: (1) To an employee age 59½ or older; (2) to a beneficiary (or the estate of the employee) on or after the death of the employee; (3) on account of disability; (4) as part of a series of substantially equal periodic payments made for life; (5) to an employee after separation from service after attainment of age 55; or (6) as dividends paid with respect to corporate stock described in section 404(k).
Respondent does not dispute the form in which petitioners have cast the loans in question. Instead, respondent argues that the Chapmans and the Christies have failed to recognize the income tax consequences flowing from the corporate and plan loans. Accordingly, we must decide whether petitioners should be permitted to repudiate the loans from the Plan to the Chapmans and the Christies and the loans from Milo Chapman and David Christie to the corporations.
A taxpayer's ability to disavow the form it has chosen for a transaction is circumscribed. Illinois Power Co. v. Commissioner , 87 T.C. 1417, 1430 (1986); Bolger v. Commissioner , 59 T.C. 760, 767 n.4 (1973). The Supreme Court has observed repeatedly that "while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not * * * and may not enjoy the benefit of some other route he might have chosen to follow but did not." Central Tablet Manufacturing Co. v. United States , 417 U.S. 673, 690 (1974); Commissioner v.
National Alfalfa Dehydrating & Milling Co.
, 417 U.S. 134, 148-149 (1974). It would be quite intolerable to pyramid the existing complexities of tax law by a rule that the tax shall be that resulting from the form of transaction taxpayers have chosen or from any other form they might have chosen, whichever is less. Television Indus., Inc. v. Commissioner , 284 F.2d 322, 325 (2d Cir. 1960), affg. 32 T.C. 1297 (1959).
Petitioners' assertion that they used Milo Chapman and David
Christie as intermediaries to avoid the excise tax of section 4975 is untenable. Petitioners now are bound by the form of the loans that they have chosen and may not in hindsight recast the transaction in another form. Don E. Williams Co. v. Commissioner , 429 U.S. 569 (1977); Commissioner v. National Alfalfa Dehydrating & Milling Co.
, supra ; Lomas Santa Fe, Inc. v.
Commissioner
, 693 F.2d 71, 73 (9th Cir. 1982), affg. 74 T.C. 662 (1980).
Petitioners seek to circumvent the above outcome by relying upon examples 3, 5, and 6 found in 29 C.F.R. sec. 2550.408b1(a)(4) (1989), which they contend support treating the plan loans as prohibited transactions rather than as participant loans. These examples provide in pertinent part:
Example (2): P is a plan covering all the employees of
E, the employer who established and maintained [the plan] P. F is a fiduciary with respect to P and an officer of E. The plan documents governing P give F the authority to establish a participant loan program in accordance with section 408(b)(1) of the [Employer Retirement Income Security Act of 1974] Act. Pursuant to an arrangement with E, F establishes such a program but limits the use of loan funds to investments in a limited partnership which is established and maintained by E as general partner. Under these facts, the loan program and any loans made pursuant to this program are outside the scope of relief provided by section 408(b)(1) because the loan program is designed to operate for the benefit of E. Under the circumstances described, the diversion of plan assets for E's benefit would also violate sections 403(c)(1) and 404(a) of the Act.
Example (3): Assume the same facts as in Example 2, above, except that F does not limit the use of loan funds. However, E pressures his employees to borrow funds under P's participant loan program and then reloan the loan proceeds to E. F, unaware of E's activities, arranges and approves the loans. If the loans meet all the conditions of section 408(b)(1), such loans will be exempt under that section. However, E's activities would cause the entire transaction to be viewed as an indirect transfer of plan assets between P and E, who is a party in interest with respect to P, but not the participant borrowing from P . By coercing the employees to engage in loan transactions for its benefit, E has engaged in separate transactions that are not exempt under section 408(b)(1). Accordingly, E would be liable for the payment of excise taxes under section 4975 of the Code.
* * * * * * * Example (5): F is a fiduciary with respect to plan P. D is a party in interest with respect to plan P .
Section 406(a)(1)(B) of the Act would prohibit F from causing P to lend money to D. However, F enters into an agreement with Z, a plan participant, whereby F will cause P to make a participant loan to Z with the express understanding that Z will subsequently lend the loan proceeds to D . An examination of Z's credit standing indicates that he is not creditworthy and would not, under normal circumstances, receive a loan under the conditions established by the participant loan program. F's decision to approve the participant loan to Z on the basis of Z's prior agreement to lend the money to D violates the exclusive purpose requirements of sections 403© and 404(a). In effect, the entire transaction is viewed as an indirect transfer of plan assets between P and D, and not a loan to a participant exempt under section 408(b)(1)
. Z's lack of credit standing would also cause the transaction to fail under section 408(b)(1)(A) of the Act.
Example (6): F is a fiduciary with respect to Plan P. Z is a plan participant. Z and D are both parties in interest with respect to P. F approves a participant loan to Z in accordance with the conditions established under the participant loan program. Upon receipt of the loan, Z intends to lend the money to D. If F has approved this loan solely upon consideration of those factors which would be considered in a normal commercial setting by an entity in the business of from their loan agreements on the ground that the loans reflected therein were not as documented. Petitioners have not acted in accordance with what they argue is the substance of the loans. Rather, petitioners freely admit the purpose of the corporate and plan loans was to permit Dura-Craft and Springbrook to escape the imposition of the excise tax pursuant to section 4975. Petitioners now seek relief from the unforeseen tax consequences arising from the misrepresentation they deliberately perpetrated. Petitioners may not disavow their chosen form of the loans on the belated assertion that the entire loan transaction was fictitious and was designed to avoid the prohibited transaction provisions of section 4975. "One should not be garroted by the tax collector for calling one's agreement by the wrong name", Pacific Rock & Gravel Co. v. United States , 297 F.2d 122, 125 (9th Cir. 1961), but to allow petitioners "to disavow their prior representations, under such circumstances would invite similar intentional deceit on the part of other taxpayers seeking to gain a tax benefit", Cluck v. Commissioner , 105 T.C. 324, 332 (1995);
Lefever v. Commissioner
, 103 T.C. 525, 544 (1994), affd. 100 F.3d 778 (10th Cir. 1996). Having determined that petitioners may not disavow the form of their loans, we turn to consider the tax consequences flowing from that form.
B. Tax Consequences of Loans
1. Plan Loans
First, we direct our attention to the income tax consequences of the plan loans. Section 72(p)(1)(A) provides in pertinent part that "If during any taxable year a participant * * * receives (directly or indirectly) any amount as a loan * * *, such amount shall be treated as having been received * * * as a distribution under such plan." (Emphasis added.) Section 72(p)(2) carves out an exception permitting the tax-free withdrawal of funds from a qualified plan by a plan participant, in the form of a loan, if, inter alia, the terms of the loan prescribe a repayment period of 5 years or less.
Respondent contends that the legislative history of section
72(p)(2) interprets the statute to provide that any unpaid principal or interest is treated as distributed at the end of the 5-year period. The legislative history of section 72(p) states in pertinent part: "if payments under a loan with a repayment period of less than 5 years are not in fact made , so that an amount remains payable at the end of 5 years, the amount remaining payable is treated as if distributed at the end of the 5-year period." H. Conf. Rept. 97-760, at 619 (1982), 1982-2 C.B. 600, 672 (emphasis added). Respondent further argues that any interest accruing after the 5-year period but before the indirectly by the participant or beneficiary. The accrued interest does not satisfy the requirement that the loan must be received to be a distribution. Accordingly, we find that for purposes of section 72(p)(1) neither Milo Chapman nor David Christie received distributions in 1988 or 1989 equal to the interest in the amounts of $4,500 and $1,500 which accrued on the plan loans.
Section 72(t)(1) imposes an additional 10-percent income tax on amounts received from a qualified retirement plan. Petitioners do not claim to come within one of the enumerated exceptions of section 72(t)(2). We sustain respondent's determination that the distributions of $37,500 are subject to the 10-percent additional income tax of section 72(t)(1). Having decided, however, that the accrued interest amounts of $4,500 and $1,500 are not plan distributions, we find that section 72(t) does not apply to these amounts.
2. Corporate Loans
We first consider whether the Chapmans and the Christies earned interest income in 1989 from the corporate loans to them. It is well settled that if a taxpayer's obligation is paid by a third party, the effect is the same as if the third party had paid the taxpayer who in turn paid his creditor. Douglas v. Willcuts , 296 U.S. 1 (1935); United States v. Boston & M.R.R. , 279 U.S. 732 (1929); Old Colony Trust Co. v. Commissioner , 279 U.S. 716 (1929); Wall v. United States , 164 F.2d 462 (4th Cir.
Petitioners contend that the excess loan payments should not be treated as dividends because those payments were bookkeeping errors, which should be corrected pursuant to section 4975(f)(5). Section 4975(f)(5) defines the terms "correction" and "correct" to mean " with respect to a prohibited transaction , undoing the transaction to the extent possible, but in any case placing the plan in a financial position not worse than that in which it would be if the disqualified person were acting under the highest fiduciary standards." (Emphasis added.)
Petitioners' reliance on section 4975(f)(5) is misplaced. It is evident from the above language that section 4975(f)(5) has no relevance to the income tax imposed upon dividend income arising from a corporation's conferring a benefit upon its shareholders. This is apparent from the structure of the Code. Section 4975(f)(5) is contained in subtitle D, chapter 43, whereas the provisions governing taxation of dividends are found in subtitle A, chapter 1. There is no cross-reference between section 4975(f)(5) and those provisions.
Petitioners further contend that bookkeeping errors do not give rise to a penalty tax, relying upon Ahlberg v. United States , 780 F. Supp. 625 (D. Minn. 1991). In Ahlberg , the sole beneficiary and administrator misallocated contributions between a pension plan and profit-sharing plan, the funds of which were maintained in a commingled mutual fund. The District Court granted summary judgment sua sponte, holding that the taxpayer was not subject to the excise tax of 5 percent for maintaining a plan with an accumulated funding deficiency. The court concluded that the misallocations were bookkeeping errors, from which the taxpayer did not receive any extra benefit, and that no harm came to the plans.
Ahlberg is distinguishable from the instant case. Unlike the taxpayer in Ahlberg , Milo Chapman and David Christie did receive a benefit from the bookkeeping errors. Corporate payments to third parties at the direction of shareholders, or in discharge of the shareholders' debts and liabilities, may constitute a constructive dividend. Tennessee Sec. Inc. v. Commissioner , 674 F.2d 570, 573 (6th Cir. 1982), affg. T.C. Memo. 1978-434; Gardner v. Commissioner , 613 F.2d 160 (6th Cir. 1980), affg. T.C. Memo. 1976-349; Wortham Mach. Co. v. United States , 521 F.2d 160, 164 (10th Cir. 1975); Noble v. Commissioner , 368 F.2d at 442; Sachs v. Commissioner , 277 F.2d 879, 882 (8th Cir.
1960), affg. 32 T.C. 815 (1959); Yelencsics v. Commissioner , 74 T.C. 1513, 1529 (1980); Magnon v. Commissioner , 73 T.C. 980, 997 (1980). Petitioners seek to distinguish the facts in many of the above cases from those in the instant case on grounds that are immaterial to the outcome. The basic issue is whether the corporate expenditures were incurred primarily to benefit the corporations' trade or business or primarily for the benefit of the shareholders. Ireland v. United States , 621 F.2d 731, 735 (5th Cir. 1980); Loftin & Woodard, Inc. v. United States , 577 F.2d 1206, 1215 (5th Cir. 1978); Noble v. Commissioner , supra at 443; Magnon v. Commissioner , supra at 993-994. When a corporation confers an economic benefit upon a shareholder in his capacity as such, without an expectation of repayment, that economic benefit becomes a constructive dividend, taxable to the shareholder whether or not the corporation intended to confer a I. Issue 5. Processing Fee Finally, we must consider whether the 5-percent processing fees paid to Northwest and included as a part of Dura-Craft's cost of goods sold are allowable. Section 61(a) includes "gross income derived from business" in its general definition of gross income. Sec. 61(a)(2). Gross income from business means total sales, less cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Sec. 1.61-3(a), Income Tax Regs.
Respondent disallowed the processing fees on the grounds that the transactions were shams lacking a business purpose and economic substance. Petitioners, however, argue that the separate corporate entity status of Northwest should be recognized, citing the test in Moline Properties, Inc. v. Commissioner , 319 U.S. 436 (1943), and the line of cases resting thereon.
We are not required to find Northwest was a sham in order to uphold respondent's determinations. The notice of deficiency focuses on the sham nature of the transactions rather than the sham nature of the corporation.
A "sham" transaction is one that lacks economic substance beyond the creation of tax benefits. Knetsch v. United States , 364 U.S. 361, 365-366 (1960); Karr v. Commissioner , 924 F.2d 1018, 1022-1023 (11th Cir. 1991), affg. Smith v. Commissioner , 91 T.C. 733 (1988). Petitioners bear the burden of proving that the challenged transactions were not shams. Rule 142(a); Sheldon v. Commissioner , 94 T.C. 738, 753 (1990).
Alternatively, petitioners appear to argue that the proper test for sustaining the deduction of the processing fee is the test in Grodt & McKay Realty, Inc. v. Commissioner , 77 T.C. 1221, 1237-1238 (1981). In Grodt , we set forth eight factors by which to determine whether the benefits and burdens of ownership have (1) Whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the sale of the property. [ Grodt & McKay Realty, Inc. v. Commissioner , 77 T.C.
1221, 1237-1238 (1981); citations omitted.]
passed and a sale has occurred between contracting parties.13 While the shifting of benefits and burdens of ownership is a key indicator of the presence or a lack of economic substance, it is only one of several considerations. Rose v. Commissioner , 88 T.C. 386, 410 (1987), affd. 868 F.2d 851 (6th Cir. 1989). The U.S. Court of Appeals for the Ninth Circuit, the circuit in which this case is appealable, Golsen v. Commissioner , 54 T.C.
742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), determines whether a transaction is a sham by the following two-part test: (1) Has the taxpayer shown a business purpose for engaging in the transaction other than tax avoidance? (a subjective test) and (2) has the taxpayer shown that the transaction had economic substance beyond the creation of tax benefits? (an objective test), Casebeer v. Commissioner , 909 F.2d 1360, 1363 (9th Cir.
1990) (citing Bail Bonds By Marvin Nelson, Inc. v. Commissioner , 820 F.2d 1543, 1549 (9th Cir. 1987), affg. T.C. Memo. 1986-23), affg. T.C. Memo. 1987-628. This two-part test, however, is not to be used as a "rigid two-step analysis." Id.
at 1363.
Instead, business purpose and economic substance are simply more precise factors to be considered in the application of the traditional sham analysis; that is, whether the transaction had any practical economic effects other than the creation of income tax losses. Sochin v. Commissioner , 843 F.2d 351, 354 (9th Cir.
1988).
The business purpose factor often involves an examination of the subjective factors which motivated a taxpayer to enter into the transaction at issue. Bail Bonds By Marvin Nelson, Inc. v. Commissioner , supra at 1549. The economic-substance factor involves a broader examination of whether the substance of a transaction reflects its form, and whether from an objective standpoint the transaction was likely to produce economic benefits aside from a tax deduction. Id.
Dura-Craft and Northwest, both of which acted under the effective control or direction of Milo Chapman and David Christie, were related parties. In determining whether the form of a transaction between related parties has substance, we compare their actions with what would have occurred if the transaction had occurred between parties who were dealing at arm's length. Maxwell v. Commissioner , 95 T.C. 107, 117 (1990).
The question of whether an expense is lacking in economic substance is essentially a factual determination. Commissioner v. Heininger , 320 U.S. 467, 475 (1943); Thompson v. Commissioner , 631 F.2d 642, 646 (9th Cir. 1980), affg. 66 T.C. 1024 (1976). Tax laws affect the shape of many business transactions. The parties to a transaction are entitled to take into account and to maximize favorable tax results so long as the transaction is compelled or encouraged by nontax business reasons. Frank Lyon Co. v. United States , 435 U.S. 561, 580 (1978); James v.
Commissioner
, 87 T.C. 905, 918 (1986), affd. 899 F.2d 905 (10th Cir. 1990). We agree with respondent, however, that the payments of the processing fees by Dura-Craft to Northwest were shams. Dura-Craft is a subchapter C corporation, and Northwest is a subchapter S corporation as defined in section 1361. The profits of a C corporation are subject to corporate income tax, sec. 11, and any distributions to shareholders are then subject to the shareholders' personal income tax, secs. 61(a), 316. The profits of a subchapter S corporation, however, are generally not subject to a corporate tax, sec. 1371(a), but pass through to be taxed on the individual shareholders' returns, sec. 1366, thereby eliminating the double taxation of distributions to the shareholders of C corporations. Moreover, petitioners have failed to show that Dura-Craft had a business purpose in making the payments. Furthermore, the payments served no purpose other than the generation of tax benefits by shifting money and income between Dura-Craft and Northwest. The record is devoid of evidence that services were provided or value was added by Northwest, while the tax benefits are quite apparent. Northwest had no employees during the years at issue. Moreover, Dura-Craft employees placed all of the orders in Dura-Craft office space and received all of the raw materials directly at the Dura-Craft plant. Simply, there was no "arm's-length" reason beyond these tax benefits for Dura-Craft to compensate Northwest. Based upon the entire record in this case, we conclude that Dura-Craft is not entitled to include the 5-percent processing fees paid to Northwest as part of its cost of goods sold for its taxable years ending October 31, 1988 and 1989. We have considered all of the other arguments made by petitioners and, to the extent we have not addressed them, find them to be without merit.
To reflect the foregoing and concessions by the parties, Decisions will be entered under Rule 155 .