Richard M. Kates
, for petitioners.
James S. Stanis
, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge
: Respondent determined deficiencies in and additions to petitioners' Federal income tax as follows:
Douglas R. and Jane E. Prince, docket No. 22467-93
Additions to Tax
Sec. Sec. Sec. Sec.
Year
Deficiency
6651(a)(1)
6653(a)(1)(A)
6653(a)(1)(B)
6661(a)
1987 $76,684 19,360 4,2131 19,1711 50 percent of the interest due on the deficiency. Douglas R. Prince, D.D.S., M.S., P.C., docket No. 8457-94 Additions to Tax Taxable Secs. Secs.
Year Ending Sec. 6653(a)(1)/ 6653(a)(2)/ Sec.
June 30
Deficiency
6651(a)(1)
6653(a)(1)(A)
6653(a)(1)(B)
6661(a)
1986 $24,683-1,2341 6,171 1987 40,087 2,067 2,0671 10,022 Additions to Tax Taxable Secs. Secs.
Year Ending Increase Sec. 6653(a)(1)/ 6653(a)(2)/ Sec. Dec. 31 in Tax 6651(a)(1)
6653(a)(1)(A)
6653(a)(1)(B)
6661(a)
1987 $7,348-3671 -1988 29,345 2,935 1,467-7,3361 50 percent of the interest due on the deficiency. Unless otherwise indicated, all section and Code references are to the Internal Revenue Code as in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
3. whether they are liable for additions to tax pursuant to sections 6651, 6653, and 6661 for their 1987 taxable year. B. Issues With Respect to Petitioner Douglas R. Prince, D.D.S., M.S., P.C.
1. Whether certain payments made by petitioner Douglas R. Prince, D.D.S., M.S., P.C. to petitioner Douglas R. Prince are deductible as compensation expenses pursuant to section 162; and 2. whether petitioner Douglas R. Prince D.D.S., M.S., P.C. is liable for additions to tax pursuant to sections 6651, 6653, and 6661.
FINDINGS OF FACT
Some of the facts have been stipulated for trial pursuant to
Rule 91. The parties' stipulations of facts are incorporated herein by reference and are found as facts in the instant case. During the relevant taxable years, petitioner Douglas R. Prince (hereinafter individually referred to as petitioner) owned all of the stock of petitioner Douglas R. Prince, D.D.S., M.S., P.C., a professional corporation (hereinafter referred to as the corporation) that was organized pursuant to the laws of the State of North Dakota.
At the time the petition in docket No. 22467-93 was filed, petitioners Douglas R. Prince and Jane E. Prince (hereinafter jointly referred to as petitioners) resided in DuPage County, Illinois. At the time the petition in docket No. 8457-94 was filed, the corporation's principal office was at 358 East First Street, Dickinson, North Dakota. The corporation's taxable year was a fiscal year ending June 30 for taxable years ending June 30, 1986 and 1987. During 1987, however, the corporation changed its taxable year to a calendar year.
During the relevant taxable years, petitioner was an orthodontist who maintained, through the corporation, an orthodontic practice with locations in Dickinson, North Dakota; Williston, North Dakota; Sidney, Montana; Glendive, Montana; and Miles City, Montana. Petitioner was the only orthodontist in the corporation's orthodontic practice, for which he was paid a salary by the corporation.
In its books and records, the corporation maintained a "Loan and Exchange" account receivable from petitioner (the loan and exchange account). The corporation made payments to and for the benefit of petitioner for both corporate and personal expenses and increased the amount in the loan and exchange account to reflect the amounts of such payments. Additionally, the corporation made certain payments to and for the benefit of petitioner that were not from the loan and exchange account. At the end of the corporation's taxable year, the corporation's accountant classified payments from the loan and exchange account as either corporate expenses or personal expenses. Generally, amounts that were classified as personal expenses were treated as compensation to petitioner and were reported on petitioner's Form W-2.
On its Federal income tax returns and amended returns, the corporation claimed deductions for compensation payments to petitioner as follows:
Taxable Year Ending
Original Return
Amended Return
June 30, 1986 $446,781 no change
June 30, 1987 379,694 $364,694
Dec. 31, 1987 49,782 181,718
Dec. 31, 1988 430,002 no amended return filed
On their Federal income tax returns and amended return, petitioners included in their gross income compensation payments from the corporation as follows:
Taxable Year
Original Return
Amended Return
1986 $446,781 $253,167 1987 344,316 no amended return filed 1988 430,002 no amended return filed During 1988, petitioner sold a rental building in Yorkville, Illinois (the Yorkville building). Petitioner was personally liable for a loan secured by the Yorkville building (the Yorkville loan). At the time of the sale, the interest on the Yorkville loan was in arrears. On their 1988 Federal income tax return, petitioners reported gain on the sale of the Yorkville building and claimed on their Schedule E an interest expense on the Yorkville loan in the amount of $74,723. In the notice of deficiency, respondent determined a loss on the sale of the Yorkville building but disallowed the interest expense claimed by petitioners.
Prior to and continuing through the relevant taxable years, the corporation maintained the Douglas R. Prince, D.D.S., M.S., P.C. Pension Plan and Trust (the pension plan), in which petitioner was a participant. The pension plan was a qualified trust within the meaning of section 401(a).
On or about March 14, 1986, the pension plan made a loan in the amount of $50,000 to petitioner (the original loan). The original loan, which was secured by petitioner's vested benefit in the pension plan, was to be repaid on April 1, 1988, with interest at the rate of 13.75 percent per annum. On the due date of the original loan, the principal and interest on the original loan were not paid but were instead rolled over into a new loan (the renewed loan). Neither the original loan nor the renewed loan contained a provision for "level amortization" of the principal. At all relevant times, the present value of one-half of petitioner's "accrued benefit" under the pension plan exceeded $100,000.
Petitioners did not include the original loan or the renewed loan in their gross income on their Federal income tax returns for the years in issue. Respondent determined that the renewed loan did not provide for "level amortization" as required by section 72(p)(2)(C) and concluded that the renewed loan did not qualify for the section 72(p)(2)(A) exception. Consequently, to section 162. The corporation bears the burden of proof. Rule 142(a).
Section 162(a)(1) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including "a reasonable allowance for salaries or other compensation for personal services actually rendered". To deduct payments as compensation expenses pursuant to section 162, the taxpayer must establish that the payments are: (1) Reasonable, and (2) intended to be payments purely for services. Elliotts, Inc. v. Commissioner , 716 F.2d 1241, 1243 (9th Cir. 1983), revg. and remanding on another issue T.C. Memo. 1980-282; Paula Constr. Co. v. Commissioner , 58 T.C. 1055, 1058 (1972), affd. without published opinion 474 F.2d 1345 (5th Cir. 1973); Electric & Neon, Inc. v. Commissioner , 56 T.C. 1324, 1340 (1971), affd. without published opinion 496 F.2d 876 (5th Cir. 1974); sec. 1.162-7(a), Income Tax Regs. Whether the taxpayer has shown the requisite intent to treat the payments as compensation is a factual question to be decided on the basis of the particular facts and circumstances. Electric & Neon, Inc. v. Commissioner , supra . "Where officershareholders, who are in control of a corporation, set their own compensation, careful scrutiny is required to determine whether the alleged compensation is in fact a distribution of profits." Home Interiors & Gifts, Inc. v. Commissioner , 73 T.C. 1142, 1156 (1980).
Applying the foregoing requirements, we must decide whether the corporation has established that it intended to treat the disallowed corporate payments as compensation for petitioner's services. The corporation contends that it mistakenly treated the disallowed corporate payments that were made from the loan and exchange account as corporate expenses instead of personal expense payments. It argues that, consistent with its established practice of treating personal expenses as compensation to petitioner, the disallowed corporate payments should be treated as compensation to petitioner. The corporation argues that its intent is not altered by the fact that the accountant made a mistake in characterizing the payments. Additionally, the corporation contends that petitioner generated all of the income of the corporation and that all of the disallowed corporate payments therefore should be treated as compensation to petitioner.
Based on our review of the record before us, we conclude that the corporation has not established that it intended to treat the disallowed corporate payments as compensation for petitioner's services when the payments were made. The corporation's arguments on brief that the disallowed corporate payments were characterized incorrectly and that petitioner generated all of the corporation's income do not establish the requisite intent to treat the corporate payments as compensation for petitioner's services. The question is whether the corporation intended the disallowed corporate payments to be compensation to petitioner when they were made. Paula Constr. Co. v. Commissioner , supra at 1059. Moreover, we decide the case in light of what was done, not what might have been done. Id. at 1060 (and cases cited therein).
The record in the instant case lacks any credible evidence of the corporation's intent to treat the disallowed corporate payments as compensation for petitioner's services when the payments were made. For the taxable years in issue, the corporation characterized certain amounts other than the disallowed corporate payments on its Federal income tax returns and petitioner's Forms W-2 as compensation to petitioner, which compensation was included as compensation income on petitioners' Federal income tax returns. However, neither books or records of the corporation nor testimony were offered to establish that the corporation intended to treat the disallowed corporate payments as compensation for petitioner's services. Moreover, the disallowed corporate payments were not characterized as payments of compensation to petitioner on the corporation's Federal income tax returns or on the Forms W-2 that it furnished to petitioner. Finally, the disallowed corporate payments were not reported as income on petitioners' Federal income tax returns. Based on the record in the instant case, we are not persuaded that the corporation intended to treat the disallowed corporate payments as compensation for petitioner's services when the payments were proceeds of the sale of the Yorkville building. Petitioners argue that they have substantiated their interest expense. To substantiate their interest payment on the Yorkville loan petitioners rely on petitioner's testimony and an interest statement. At trial, petitioner testified that, at the closing of the sale on the Yorkville building, the interest on the loan, which was in arrears, was paid from the proceeds from the sale. Additionally, the record contains a copy of a statement from First Midwest Bank/Illinois that states, in part: "the interest paid on your loan account in 1988 was $74,722.55." Respondent concedes that the loan account related to the Yorkville loan. Based on the foregoing, we are satisfied that the interest on the Yorkville loan was paid.
Respondent's contention that petitioners did not prove that the proceeds from the sale of the Yorkville building were used to make the interest payment is misplaced. Where there is no allegation that the funds to pay the interest were borrowed from the creditor, there is no requirement that the source of the funds used to make the interest payment be traced. Respondent has not cited, and we are unable to find, any authority to the contrary. Consequently, the failure of petitioners to establish that the sale of the Yorkville building produced sufficient proceeds to pay off the Yorkville loan is immaterial. The only fact petitioners must establish is that the interest on the Yorkville loan was paid, and that fact is shown by petitioner's loan (with payments not less frequently than quarterly) is required over the term of the loan", sec. 72(p)(2)(C). The requirement of section 72(p)(2)(C) applies to loans made, renewed, renegotiated, modified, or extended after December 31, 1986. Tax Reform Act of 1986, Pub. L. 99-514, sec. 1134(b), 100 Stat. 2085, 2484.
Respondent, citing petitioners' concession that the renewed loan does not provide for "level amortization", argues that the renewed loan does not qualify for the section 72(p)(2)(A) exception because it does not meet the section 72(p)(2)(C) requirement of "level amortization". Consequently, respondent contends that the renewed loan is a taxable distribution to petitioners pursuant to section 72(p)(1)(A). Petitioners, however, merely argue that "There is not enough in the record to cause the $50,000 loan to constitute taxable income to the petitioners under Section 72(p)."
Contrary to respondent's argument, section 72(p)(2)(C) provides that the exception pursuant to section 72(p)(2)(A) does not apply unless the loan requires substantially level amortization. The phrase "substantially level amortization" is less stringent than the phrase "level amortization". Although petitioners conceded that the renewed loan did not provide for "level amortization", respondent must still establish that the renewed loan did not have "substantially level amortization" in order to prevent the application of the exception contained in the corporation bear the burden of proving that respondent's determinations of additions to tax are erroneous. Rule 142(a). Neither petitioners nor the corporation objected to respondent's requested ultimate findings of fact that the underpayments of tax by petitioners and by the corporation "were due to negligence and/or intentional disregard of rules and regulations." Additionally, they make no argument on brief concerning the additions to tax pursuant to section 6653. Accordingly, we consider petitioners and the corporation to have conceded the additions to tax pursuant to section 6653. Petitioners and the corporation argue that, to the extent that the threshold requirements of section 6661 are not met, the section 6661 addition to tax does not apply. Neither petitioners nor the corporation makes any argument concerning the additions to tax pursuant to section 6651. Consequently, we consider the additions to tax pursuant to sections 6651 and 6661 (to the extent that the threshold requirements are met) to have been conceded. Rybak v. Commissioner , 91 T.C. 524, 566 (1988).
Accordingly, we sustain respondent's determination of additions to tax for petitioners and the corporation.
To reflect the foregoing, Decisions will be entered under Rule 155 .
APPENDIX
Taxable Year Ending June 30, 1986
Amount of Purpose of deduction claimed deduction claimed by the corporation by the corporation Concessions and Arguments $17,695 other deduction The corporation conceded entire amount to be the cost of acquiring paintings and not a deductible business expense to the corporation; respondent allowed additional depreciation expenses.
5,497 other deduction The corporation conceded entire amount to be petitioner's personal real estate expense and contends that entire amount is deductible as compensation to petitioner.
1,728 other deduction The corporation conceded entire amount to be petitioner's personal educational expense and contends that entire amount is deductible as compensation to petitioner.
8,775 other deduction The corporation conceded 4387.00 [sic] to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner;
respondent conceded 4387.50.
4,500 legal and The corporation conceded 1,000 professional fees to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner;
respondent conceded 3,500.
894 repairs/supplies The corporation conceded 594 to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner;
respondent conceded 300.
600 professional The corporation conceded 600 education expenses to be petitioner's personal business expense and contends that such amount is deductible as compensation to petitioner.
800 consulting fees The corporation conceded 400 to be petitioner's personal business expense and contends that such amount is deductible as compensation to petitioner;
respondent conceded 400.
Taxable Year Ending June 30, 1987
Amount of Purpose of deduction claimed deduction claimed by the corporation by the corporation Concessions and Arguments $22,622 other deduction The corporation conceded entire amount to be petitioner's personal real estate expense and contends that entire amount is deductible as compensation to petitioner.
38,979 other deduction The corporation conceded 19,489 to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner; respondent conceded 19,489. [1-dollar mathematical error by the parties]
823 real estate taxes Respondent conceded entire amount.
3,500 legal and The corporation conceded professional fees entire amount to be petitioner's personal expense and contends that entire amount is deductible as compensation to petitioner.
4,600 consulting fees The corporation conceded 1,400 to be petitioner's personal expense and contends that such amount is compensation to petitioner; respondent conceded 3,200.
5,000 furniture and The corporation conceded fixtures entire amount to be not deductible; respondent allowed additional ACRS deductions pursuant to section 168.
Taxable Year Ending December 31, 1987
Amount of Purpose of deduction claimed deduction claimed by the corporation by the corporation Concessions and Arguments $8,075 other deduction The corporation conceded entire amount to be petitioner's personal real estate expense and contends that all is deductible as compensation to petitioner.
8,078 other deduction The corporation conceded 4,039 to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner;
respondent conceded 4,039.50 [sic].
9,098 real estate taxes The corporation conceded 3,359 to be petitioner's personal real estate taxes and contends that such amount is deductible as compensation to petitioner;
respondent conceded 5,739.
Taxable Year Ending December 31, 1988
Amount of Purpose of deduction claimed deduction claimed by the corporation by the corporation Concessions and Arguments $3,292 other deduction The corporation conceded entire amount to be petitioner's personal real estate expense and contends that all is deductible as compensation to petitioner.
8,512.93 other deduction The corporation conceded entire amount to be the cost of acquiring paintings;
respondent allowed additional depreciation expenses.
68,713.07 other deduction The corporation conceded 50,361 to be not deductible for the purpose claimed and contends that such amount is deductible as compensation to petitioner; respondent conceded 18,352.
9,961 legal and The corporation conceded professional fees 6,161.35 to be an amount that was wire transferred to petitioner and 3,800 to be petitioner's personal business and investment expense. The corporation contends that entire amount is deductible as compensation to petitioner.
5,064 repairs/supplies The corporation conceded entire amount to be payments by the corporation to Western Savings Credit Union and contends that entire amount is deductible as compensation to petitioner.
1,861 insurance The corporation conceded entire amount to be petitioner's personal real estate insurance expense and contends that entire amount is deductible as compensation to petitioner.