Hannon v. Dept. of Rev. ( 2017 )

IN THE OREGON TAX COURT
MAGISTRATE DIVISION
Income Tax
PATRICK L. HANNON )
and KARA D. HANNON, )
)
Plaintiffs, ) TC-MD 160324R
)
v. )
)
DEPARTMENT OF REVENUE, )
State of Oregon, )
)
Defendant. ) FINAL DECISION1
Plaintiffs appealed Defendant’s Notice of Assessment, dated August 29, 2016, for the
2013 tax year. A telephonic trial was held on January 11, 2017. Lance Brant, CPA, appeared on
behalf of Plaintiffs. Dixie Hannon (Dixie)2, Patrick Hannon (Patrick), and Mark Bonnett
(Bonnett), attorney-at-law, testified on behalf of Plaintiffs. David Lenhart appeared on behalf of
Defendant. Plaintiffs’ Exhibits 1 to 8 were admitted into evidence without objection.
Defendant’s Exhibits A to R were admitted into evidence without objection.
I. STATEMENT OF FACTS
Patrick persuaded his mother, Dixie, to jointly purchase an ambulance company known
as Cascade Medical Transport of Oregon (Cascade), an S corporation, in 2012. Dixie had better
access to credit and she borrowed money under an equity line of credit from Bank of the West,
for the benefit of Cascade. (Ptfs’ Ex 7.)3 On or about September 10, 2012, Cascade executed a
1
This Final Decision incorporates without change the court’s Decision, entered June 30, 2017. The court
did not receive a statement of costs and disbursements within 14 days after its Decision was entered. See Tax Court
Rule–Magistrate Division (TCR–MD) 16 C(1).
2
It is the court’s practice to identify individuals by their last name, however, in this case there are two
individuals with the same last name.
3
Plaintiffs submitted as an exhibit a document showing a renewal of Dixie’s line of credit dated April 8,
2013.
FINAL DECISION TC-MD 160324R 1
document entitled “Revolving Line of Credit Note” up to the principal sum of $200,000 in favor
of Dixie. (Ptfs’ Ex 3.) The loan rate was set at two percent above the line of credit owed by
Dixie to Bank of the West. (Id.) The loan to Cascade was executed by “Patrick Hannon,
Member” and “Dixie Hannon, Member” and the document identified the “Lender” as “Dixie L.
Hannon.” (Ptfs’ Ex 3 at 2.) Patrick signed a second document, dated September 10, 2012,
entitled “Guarantee of Revolving Line of Credit Note” in which he as “Guarantor” personally
guaranteed the debt “due to the Lender [Dixie] by the Debtor [Cascade], up to a limit of 49% of
$200,000, under the terms of the September 10, 2012 Revolving Line of Credit Note.” (Ptfs’ Ex
3 at 3.) Dixie and Patrick testified that it was their intent that Patrick would be considered a
lender up to his 49 percent of his guarantee. Dixie testified that Patrick has not paid her any
money based on the 2012 guarantee. Plaintiffs claimed a pass-through loss of $52,615 from
Cascade on their 2013 income tax return. (Def’s Ex D at 3.)
Defendant audited Plaintiffs’ 2013 income tax return with respect to the pass-through
loss. During the audit, Plaintiffs’ representative submitted a 2013 profit and loss statement and
balance sheet for Cascade. (Def’s Ex I.) Under the category of “liabilities” the statement lists
“Dixie LOC Loan” next to the figure of $179,160.52. (Id. at 3.) On June 15, 2016, the auditor
mailed Plaintiffs a notice that their 2013 income taxes had been adjusted to “[d]isallow losses
claimed in excess of basis in S Corporation.” (Def’s Ex J at 3). Plaintiffs’ representative
requested a conference and wrote in a letter to Defendant as follows:
“Dixie Hannon, the mother of Patrick Hannon, has funded, outside the company,
a loan in her own name with a bank. Patrick Hannon has entered into a
subordination agreement drafted by corporate attorney for this outside loan in
their personal names and Patrick Hannon now owes Dixie Hannon 50% of the
loan taken out. Both parties then contributed their money from the outside loan
proceeds to the company as a shareholder note.”
(Def’s Ex K.)
FINAL DECISION TC-MD 160324R 2
On June 29, 2016, Defendant’s conference officer upheld the audit decision. (Def’s Ex
L.) Plaintiffs consulted Bonnett. Bonnett testified that he reviewed the documents Plaintiffs
presented during the audit and concluded that they did not effectuate the stated intent of Dixie
and Patrick to make Patrick a co-lender on the loan to Cascade. Bonnett testified that in 2016 he
drafted a document entitled “Partial Assignment of Revolving Line of Credit Note” (Partial
Assignment Note) to effectuate his client’s stated intent to make Patrick a co-lender for the 2012
loan. Bonnett testified on cross-examination that he did not date the document and “told the
clients that here is a document that accomplishes what you said your intent was and you fill it out
as you deem appropriate.” The document as completed by or on behalf of the client states “THIS
PARTIAL ASSIGNMENT is entered into as of this 28 day of September, 2012.” (Def’s Ex M at
2.) On July 21, 2016, Plaintiffs’ CPA mailed a request to reconsider the conference decision and
attached a copy of the Partial Assignment Note. (Def’s Ex M at 1.) On or about August 23,
2016, Defendant denied Plaintiffs’ request stating “I do not accept the attempt to recharacterize
the guarantee originally presented during the audit.” (Def’s Ex N at 1.) On or about September
7, 2016, Bonnett wrote Defendant a letter indicating that he was representing Plaintiffs for the
2013 tax year. (Def’s Ex O at 2.) The letter states that Plaintiffs “haven’t attempted to
recharacterize anything.” (Id). The letter also states “the partial assignment of note provides for
Mr. Hannon’s purchase of a 49 percent interest in the loan and associated note.” (Id. at 3.)
Plaintiffs submitted at trial a revised 2013 balance sheet for Cascade, dated December 20, 2016,
stating long-term liabilities were “N/P Dixie—51%” and “N/P Patrick—49%.” (Ptfs’ Ex. 4 at 1.)
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FINAL DECISION TC-MD 160324R 3
II. ANALYSIS
The issue in this case is whether Plaintiffs had sufficient basis in indebtedness, based on a
loan to an S corporation, under Internal Revenue Code (IRC) §1366 from which to deduct a
percentage of losses the corporation sustained in the 2013 tax year. In analyzing Oregon income
tax cases, the court starts with several general guidelines. First, the court is guided by the intent
of the legislature to make Oregon’s “personal income tax law identical in effect” to the IRC for
the purpose of determining taxable income of individuals, where possible. ORS 316.007.4
Second, in cases before the Tax Court, the party seeking affirmative relief bears the burden of
proof and must establish his or her case by a “preponderance of the evidence.” ORS 305.427.
The IRC provides that a shareholder of an S corporation is liable for tax on their pro rata
share of the corporation’s income and conversely may be entitled to deduct their pro rata share of
the losses. IRC §1366. The loss deduction is limited by the shareholder’s basis in the S
corporation. IRC §1366(d)(1). “Any genuine indebtedness of the corporation to the shareholder
increases basis under §1366. Thus, where a shareholder loans money to the corporation, the
shareholder’s basis in the corporation increases and so does the amount of loss he or she can
deduct.” Oren v. Comm’r, 357 F3d 854, 857 (11th Cir 2004). The tax courts have issued a
number of decisions defining genuine indebtedness: The transaction must leave the taxpayer
“poorer in a material sense” (Oren, at 857-58); the “S corporation’s indebtedness must run
directly to the shareholder; an indebtedness to a pass-through entity that advanced the funds and
is closely related to the taxpayer does not satisfy the statutory requirements.” Miller v. Comm’r,
TCM 2006-125 (2006) (citations omitted). “When an S corporation shareholder guarantees a
loan by a bank to the S corporation, no debt has been created between the S corporation and the
4
The court’s references to the Oregon Revised Statutes (ORS) are to the 2011 edition.
FINAL DECISION TC-MD 160324R 4
shareholder.” Montgomery v. Comm’r, TCM 2013-151 (2013) (citations omitted).
A. Pre-Notice of Assessment Facts
The court will first consider the documents as they were submitted at audit and then
review the documents supplied after the Notice of Assessment. In the documents originally
submitted to Defendant, the court finds that there is no economic substance to the assertion that
Patrick loaned Cascade money. Dixie obtained the money for the loan through a bank loan
which she alone was the signatory and obligor. The Revolving Line of Credit Note identified
Dixie as “lender” and Cascade as “borrower.” As of 2013, Patrick’s only written obligation in
the transaction was a guarantee to Dixie of up to 49 percent of $200,000. He had no obligation
to Bank of the West on the loan on one side, and was not entitled to payment from Cascade on
the loan on the other side. Treasury Regulations specifically states that:
“A shareholder does not obtain basis of indebtedness in the S corporation merely
by guaranteeing a loan or acting as a surety, accommodation party, or in any
similar capacity relating to a loan. When a shareholder makes a payment on
bona fide indebtedness of the S corporation for which the shareholder has acted
as guarantor or in a similar capacity, then the shareholder may increase the
shareholder’s basis of indebtedness to the extent of that payment.”
Treas Reg §1.1366-2(a)(ii).
Plaintiffs argue that the source of the funding to Cascade was a “back-to-back” loan and
that the “‘Actual Economic Outlay’ standard no longer applies.” (Ptfs’ Ex 2 at 2.) However, the
court believes that Plaintiffs misread case law and IRS directives. See, Basis of Indebtedness of
S Corporations to Their Shareholders, 79 FR 42675-01 (2014). Courts still look to transactions
as a whole for their economic substance. Id. Dixie’s loan to the corporation, immediately after
she obtained a loan from Bank of the West, appears to be a back-to-back loan. Dixie’s loan
involved a real economic outlay, involving an unrelated third party, and her funds were at risk.
Her loan to Cascade confers an increased basis. Patrick never borrowed money from any source.
FINAL DECISION TC-MD 160324R 5
Patrick’s “loan” did not involve a real economic outlay from him, involved only a related party,
and the risk to his funds remained theoretical as he was not the primary obligor on the loan.
With respect to Patrick, the loan to Cascade was not a back-to- back loan and the economic
outlay standards apply.
The court then turns to an examination of the economic outlays involved. The 2013
Cascade profit and loss statement originally submitted to Defendant unambiguously identifies
the loan obligation as belonging to Dixie. Patrick was not made any poorer in a material sense in
the loan transaction to Cascade. Plaintiffs have offered no evidence that they personally
borrowed funds from any source and then advanced those funds to Cascade. Further, Patrick
was never forced to make payments under his guarantee; this obligation remained purely
theoretical in 2013. Based on a totality of the circumstances the court finds that Patrick’s “loan”
to Cascade had no economic substance. Therefore, Plaintiffs did not acquire a basis from the
2012 loan to Cascade based on the evidence submitted to Defendant prior to the Notice of
Assessment.
B. Post-Assessment Document
The court considers documents submitted to Defendant and the court subsequent the
Notice of Assessment separately because there are additional factors to consider. Plaintiff argues
that the Partial Assignment Note gives economic substance for Patrick’s loan to Cascade.
Plaintiff argues that the Partial Assignment Note, created by Bonnett in 2016, which states that it
is entered into as of September 28, 2012, is not a backdated document, but rather a document
which memorializes the intent of the parties as of that date. Backdate means “to put a date
earlier than the actual date on (something, as an instrument.)” Black’s Law Dictionary 148 (8th
ed 2004). The Dictionary notes that backdating does not alter the negotiability of the instrument
FINAL DECISION TC-MD 160324R 6
under the Uniform Commercial Code. The Partial Assignment Note contains a date earlier than
its creation. Thus, the court finds the Partial Assignment Note is a backdated document. As
between Patrick and Dixie, the agreement, which they both agree represented their intent at the
time the loan to Cascade, appears enforceable. But it is a different result as it applies to the tax
consequences. The contemporaneously signed agreements—loans, guarantees, and accounting
documents—belie the assertion that the backdated document memorializes the actual agreement
between the parties. “The determinative fact is the intention as it existed at the time of the
transaction. That intention cannot be vitiated by changed circumstances or subsequent actions
bred in the cold light of tax consequences.” Saigh v. Comm’r, 36 TC 395, 420 (1961).
Additionally, the fact that Plaintiffs’ CPA and attorney both attempted to persuade Defendant to
change the results of its audit and conference decision based in part on the Partial Assignment
Note, without disclosing that it was backdated, and did not candidly present that information to
the court during Bonnett’s direct testimony, renders the document of little weight on the issues
before the court.5 The Partial Assignment Note, which contradicts documents which were
created contemporaneous with the loan at issue, does not confer economic substance to the
assertion that Patrick loaned Cascade money in 2012. Plaintiffs may not use the loan to establish
their basis pursuant to IRC §1366.
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5
It is beyond the jurisdiction of this court to decide whether CPA Brant or Attorney Bonnett violated their
respective rules of Professional Conduct for failing to disclosure to Defendant that the Partial Assignment Note was
backdated. The court did consider whether its duty to report ethics violations under Rule 3.11(B) of the Code of
Judicial Conduct was triggered by the parties conduct. The court ultimately found that it could not conclude that a
clear ethical violation had occurred.
FINAL DECISION TC-MD 160324R 7
III. CONCLUSION
After careful consideration of the evidence, the court concludes that Plaintiffs failed to
carry their burden of proof that they had sufficient basis in indebtedness, based on a loan to
Cascade, from which to deduct a percentage of losses the corporation sustained in the 2013 tax
year. Now, therefore,
IT IS THE DECISION OF THIS COURT that Plaintiffs’ appeal is denied.
Dated this day of July 2017.
RICHARD DAVIS
MAGISTRATE
If you want to appeal this Final Decision, file a complaint in the Regular
Division of the Oregon Tax Court, by mailing to: 1163 State Street, Salem, OR
97301-2563; or by hand delivery to: Fourth Floor, 1241 State Street, Salem, OR.
Your complaint must be submitted within 60 days after the date of the Final
Decision or this Final Decision cannot be changed. TCR-MD 19 B.
This document was filed and entered on July 18, 2017.
FINAL DECISION TC-MD 160324R 8