Frederick Todd, II v. CIR

Case: 11-60845 Document: 00511958820 Page: 1 Date Filed: 08/16/2012
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
August 16, 2012
No. 11-60845 Lyle W. Cayce
Summary Calendar Clerk
FREDERICK D. TODD, II; LINDA D. TODD,
Petitioners–Appellants
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent–Appellee
Appeal from the United States Tax Court
USTC No. 26378-06
Before SMITH, STEWART, and PRADO, Circuit Judges.
PER CURIAM:*
Petitioners–Appellants Frederick and Linda Todd appeal the decision of
the United States Tax Court that a purported $400,000 loan to Frederick was
taxable income (and not a loan) and therefore found the Todds liable for both
income tax deficiency and a penalty under I.R.C. § 6662(a). Because the Tax
Court did not clearly error in finding that the purported $400,000 loan was
income nor in finding that the Todds had failed to prove their affirmative
defense to the penalty, we AFFIRM.
*
Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH CIR.
R. 47.5.4.
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No. 11-60845
I. FACTUAL AND PROCEDURAL BACKGROUND
Frederick Todd is the sole shareholder, director, and president of Frederick
D. Todd II, M.D., P.A. (the “Corporation”), a Texas professional association for
Frederick’s neurosurgery practice. In August 1995, the Corporation became a
member of a union, which allowed the Corporation to participate in a death-
benefits-only plan through the American Workers Benefit Fund Trust (“AWBF”).
The death-benefits-only plan provided death benefits of up to eight times an
employee’s annual salary with a cap at $6 million. To fund these obligations,
AWBF took out life insurance policies in the same amount of the death benefit
for each of the Corporation’s employees from Southland Life Insurance Company
(“Southland”). Finally, to continue the eligibility for the death benefits, the
Corporation had to make annual payments to AWBF roughly equal to the
amount AWBF owed to Southland in combined premiums for the Corporation’s
employees. Frederick had a $6 million death benefit with his wife Linda named
as the beneficiary. In December 2000, the Corporation changed local union
affiliation and resultantly transferred its AWBF plan to United Employee
Benefit Fund Trust (“UEBF”) on the same terms and with the same relationship
with Southland.
Under the terms of the UEBF plan, UEBF trustees could, upon a showing
of serous financial hardship, make loans to a plan participant up to the accrued
equity in his plan. After Frederick inquired to UEBF and after UEBF consulted
with Southland, UEBF informed Frederick that his maximum available
distribution from the plan was $400,000. In July 2002, Frederick formally
applied to UEBF for a $400,000 loan/distribution from his plan due to
“unexpected housing costs.” UEBF approved Frederick and secured a $400,000
loan from Southland, but after realizing that Southland was going to charge
UEBF nearly 5% interest on the loan, UEBF decided that such an arrangement
was unacceptable. Instead, UEBF with Frederick’s consent decided to reduce
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the value of the life insurance on Frederick by $400,000 (i.e., a partial
surrender), which left UEBF’s policy on Frederick’s life with a $5.6 million face
value. In September 2002, UEBF issued Frederick a check for $400,000 with
“participant loan” noted on the memo line. The issuance of the $400,000 check
coincided with the last payment to UEBF that the Corporation would make.
Under the terms of the UEBF’s trust agreement with the Corporation,
UEBF was supposed to secure any loan to a plan participant before making any
distribution. Such a note was also required to establish a quarterly payment
schedule and bear a reasonable rate of interest. In February 2003, UEBF
decided that it needed a promissory note from Frederick. In March 2003,
Frederick signed a note for $400,000 to UEBF. That note bore a 1% interest rate
and provided for quarterly payments by Frederick of approximately $20,500
until the note was paid off. The note also provided a “dual repayment
mechanism,” which allowed UEBF to deduct any outstanding balance on the
note from any later distribution to Frederick. In practice, that mechanism
allowed UEBF to deduct any remaining balance owed on the note from any
death benefits owed to Linda upon Frederick’s death. As noted above, the
Corporation ceased its payments to UEBF in late 2002; similarly, Frederick
never made any payments on the note.
The Todds filed their 2002 and 2003 tax returns with the IRS in July 2005.
The IRS noted unrelated deficiencies in the Todds’ returns for 2002 and 2003,
which the Todds challenged in the Tax Court. During the course of its
investigation, the IRS discovered the $400,000 distribution from UEBF to
Frederick and amended its deficiency charges to include deficiencies caused by
the non-reporting of the $400,000 as income. The Tax Court applied a multi-
factored approach to the determination of whether the $400,000 constituted a
loan and determined that it did not. It therefore concluded that the Todds were
deficient in 2002 and found a penalty applicable for the same year.
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II. STANDARD OF REVIEW
We review decisions of the Tax Court under the same standard as district
court decisions: legal conclusions are reviewed de novo; factual findings are
reviewed for clear error. Terrell v. Comm’r, 625 F.3d 254, 258 (5th Cir. 2010).
Both “whether a certain transaction constitutes a loan for income tax purposes”
and whether taxpayers “acted with reasonable cause and in good faith in making
a substantial understatement of tax liability” are factual issues reviewed for
clear error. Green v. Comm’r, 507 F.3d 857, 871 (5th Cir. 2007) (reasonable
cause); Moore v. United States, 412 F.2d 974, 978 (5th Cir. 1969) (loan). Clear
error only exists where we are “left with the definite and firm conviction that a
mistake has been made.” Terrell, 625 F.3d at 258 (internal quotation marks
omitted).
III. DISCUSSION
A. The $400,000 “Loan”
A loan does not “constitute income [under the Internal Revenue Code]
because whatever temporary economic benefit the borrower derives from the use
of the funds is offset by the corresponding obligation to repay them.” Moore, 412
F.2d at 978. The central inquiry for determining if a transaction is a bona fide
loan for tax purposes is whether it is “the intention of the parties that the money
advanced be repaid.” Id. As we noted in Moore, this inquiry is one that
“involv[es] several considerations.” Id. Moore, however, failed to delineate what
those considerations were.
The Tax Court below looked to seven factors laid out by the Ninth Circuit
in Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000):
(1) whether the promise to repay is evidenced by a note or other
instrument; (2) whether interest was charged; (3) whether a fixed
schedule for repayments was established; (4) whether collateral was
given to secure payment; (5) whether repayments were made; (6)
whether the borrower had a reasonable prospect of repaying the
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loan and whether the lender had sufficient funds to advance the
loan; and (7) whether the parties conducted themselves as if the
transaction were a loan.
Id. at 1230 (citing Crowley v. Comm’r, 962 F.2d 1077, 1079 (1st Cir. 1992);
Frierdich v. Comm’r, 925 F.2d 180, 182 (7th Cir. 1991); Piedmont Minerals Co.
v. United States, 429 F.2d 560, 563 (4th Cir. 1970)). The Welsh Court noted that
these factors were “non-exhaustive” and merely provided a “ general basis upon
which courts may analyze a transaction.” Welch, 204 at 1230. The Tax Court
found that:
1. Although there was a promissory note executed, the process through
which it was executed did not conform with UEBF’s policies and
“fail[ed] to correspond with the substance of the transaction.” It
therefore afforded the existence of the note “little weight.”
2. Although UEBF charged 1% interest, the significantly-below-
market-rate interest demonstrated that the transaction was not
intended as a loan.
3. Although a payment schedule was established, Frederick’s non-
payment and UEBF’s non-enforcement demonstrated that the
transaction was not intended as a loan.
4. The “dual repayment mechanism” could serve as collateral and
therefore the fourth factor cut in favor of the Todds.
5. The “dual repayment mechanism” was too contingent upon future
events to evince an unconditional obligation to repay, citing Midkiff
v. Commissioner, 96 T.C. 724, 734–35 (1991), and therefore lack of
any repayment by Frederick was controlling to demonstrate that the
transaction was not intended as a loan.
6. Frederick had the means to repay the loan and therefore this factor
cut in favor of the Todds.
7. Overall, the parties did not conduct themselves in manner evincing
an intention to establish a debtor-creditor relationship.
The Todds contend that the Tax Court clearly erred because they formally
satisfied the first three categories, which were three of the central pieces of
evidence that the Tax Court used to conclude that the $400,000 was not a loan.
While we recognize that Frederick and UEBF executed a note and payment
schedule, the fact that the note and schedule were only adopted after the fact,
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in contravention of UEBF policies, suggests the possibility that doing so was
merely “a formalized attempt to achieve the desired tax result while lacking in
necessary substance, . . . merely parad[ing] under the false colors” of a bona fide
loan. Tomilinson v. 1661 Corp., 377 F.2d 291, 295 (5th Cir. 1967). When the
post hoc note execution is coupled with the fact that Frederick never repaid any
of the so-called loan despite his clear means to do so, we cannot say that the Tax
Court clearly erred in concluding that the $400,000 payment was not a bona fide
loan and therefore should have been included in the Todds’ 2002 income.1
B. Reasonable Cause Defense
Where there is an underpayment that results from negligence or disregard
of the rules or that was substantial, the Internal Revenue Code imposes a
penalty equal to 20% of the underpayment. 26 U.S.C. § 6662(a)–(b). However,
the penalty shall not be imposed “if it is shown that there was a reasonable
cause for [any portion of an underpayment] and that the taxpayer acted in good
faith with respect to such portion.” Id. at § 6664(c)(1). The Todds argue that the
penalty should not apply because they had a certified public accountant prepare
their 2002 return. Our precedent mandates that the taxpayers show that they
“[r]eli[ed] on the advice of a professional tax adviser” and additionally that such
reliance was valid due to “the quality and objectivity of the professional advice
which they obtained.” Bemont Invs., L.L.C. ex. rel. Tax Matters Partner v.
1
The Todds also contend that the stipulations of fact entered into by the parties
establish that the $400,000 payment was a loan. The parties stipulated: “Dr. Todd’s unpaid
principal balance on the note was $400,000 on December 31, 2002” and “As of December 31,
2003, Todd owed a principal balance of $400,000 to UEBF.” From these stipulations, the
Todds posit that by acknowledging that $400,000 was “owed,” the Commissioner was
acknowledging genuine indebtedness. Our inquiry under Moore is whether it is “the intention
of the parties that the money advanced be repaid.” 412 F.2d at 978. Neither of these
stipulations resolves this question. See also Saviano v. Comm’r, 765 F.2d 643, 645 (7th Cir.
1985) (Commissioner’s stipulation that taxpayer executed a “Loan Agreement” did not bind
court as to appropriate characterization of the transaction for tax purposes); cf. Estate of
Maceo, 23 T.C.M. (CCH) 258, 356 (1964) (“[A] stipulation presupposes a meeting of the minds
covering the facts which are the subject of consideration.”)
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United States, 679 F.3d 339, 349 (5th Cir. 2012) (internal quotation marks
omitted). The Todds have put forth no evidence, other than the fact that a
C.P.A. prepared their taxes, that they validly relied on the C.P.A.’s advice.
Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 548 (5th Cir. 2009)
(The taxpayer bears the burden of proof on a “reasonable cause” defense.); see
also Neonatology Assocs. P.A. v. Comm’r, 115 T.C. 43, 100 (2000) (“The mere fact
that a certified public accountant has prepared a tax return does not mean that
he or she has opined on any or all of the items reported therein.”), aff’d, 299 F.3d
221 (3d Cir. 2002). Therefore, we find no clear error in the Tax Court’s
imposition of the § 6662 penalty.
IV. CONCLUSION
For the foregoing reasons, we AFFIRM the decision of the Tax Court.
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