Gideon L. and Corazon P. Medina v. Commissioner

112 T.C. No. 6
UNITED STATES TAX COURT
GIDEON L. MEDINA AND CORAZON P. MEDINA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18999-97. Filed February 22, 1999.
H and W, who were both disqualified persons within
the meaning of sec. 4975, I.R.C., borrowed $340,000
from the qualified pension plan of H's wholly owned
corporation. H and W did not make any payments of
interest or principal relating to the loan and did not
file excise tax returns.
1. Held: Sec. 4975, I.R.C., applies to a loan,
even though such loan, pursuant to sec. 72(p), I.R.C.,
was treated as a distribution.
2. Held, further, H and W did not correct, within
the meaning of sec. 4975, I.R.C., the prohibited
transaction and, pursuant to sec. 4975(a) and (b),
I.R.C., are liable for both tiers of excise taxes.
3. Held, further, the "amount involved", on which
the sec. 4975 excise taxes are based, is equal to the
greater of interest paid or fair market interest
relating to the loan. Because H and W did not make any
payments of interest, the amount involved is the fair
market interest.
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4. Held, further, in determining the amount
involved, the fair market interest rate is 10.5
percent.
5. Held, further, H and W, pursuant to sec.
6651(a)(1), I.R.C., are liable for additions to tax for
failing to file excise tax returns.
Michael E. Dumke, for petitioners.
Mark L. Hulse and Roberta M. Amos, for respondent.
OPINION
FOLEY, Judge: By notices dated June 25, 1997, respondent
determined deficiencies in, and an addition to, petitioners'
Federal excise taxes as follows:
Gideon L. Medina
Excise Taxes Addition to Tax
Year Sec. 4975(a) Sec. 4975(b) Sec. 6651(a)(1)
1991 $2,685 -- $671
1992 5,652 -- 1,413
1993 8,930 -- 2,233
1994 12,553 -- 3,138
1995 16,556 -- 4,139
1996 20,979 -- --
19971 -- $468,469 --
1
For the taxable period ending June 30, 1997.
Corazon P. Medina
Excise Taxes Addition to Tax
Year Sec. 4975(a) Sec. 4975(b) Sec. 6651(a)(1)
1992 $2,967 -- $742
1993 6,245 -- 1,561
1994 9,868 -- 2,467
1995 13,871 -- 3,468
1996 18,294 -- --
19971 -- $414,769 --
1
For the taxable period ending June 30, 1997.
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Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure. The issues for decision are as follows:
1. Does section 4975 apply to a loan even though such loan,
pursuant to section 72(p), was treated as a distribution? We
hold that it does.
2. Did petitioners, within the meaning of section
4975(f)(5), correct the prohibited transaction? We hold that
they did not.
3. What is the "amount involved" relating to a loan that is
subject to section 4975 excise taxes? We hold that the "amount
involved" is the greater of the interest paid or the fair market
interest.
4. In determining the "amount involved" relating to
petitioners' loan, what is the fair market interest rate? We
hold that the fair market interest rate is 10.5 percent.
5. Are petitioners, pursuant to section 6651(a), liable for
additions to tax for failing to file excise tax returns? We hold
that they are.
Background
The parties submitted this case fully stipulated pursuant to
Rule 122. At the time the petition was filed, petitioners
resided in Niles, Michigan.
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Gideon Medina was an employee, the sole shareholder, and
president of Gideon L. Medina, M.D., P.C., a Michigan
professional corporation (corporation). Corazon Medina was
secretary of the corporation. The corporation established a
qualified employees' pension plan and trust (plan), which met the
requirements of section 401. During the years in issue,
petitioners were participants in the plan.
On December 1, 1986, petitioners borrowed $340,000 (loan)
from the plan to acquire Sunshine Villa Apartments. Petitioners
executed a promissory note with the following terms: (1)
Interest at the rate of 10.5 percent per annum is payable
annually; (2) any unpaid interest is added to the principal
amount; and (3) the entire principal amount is due 8 years from
the date of the note or, if sooner, upon the sale of Sunshine
Villa Apartments. On August 15, 1991, Mr. Medina executed a
document providing that "Building C of Sunshine Villa Apartments
* * * [is] assigned to * * * [the plan]. * * * to ensure that
the loan is paid if and when the Sunshine Villa is sold."
Petitioners did not file Form 5330, Return of Excise Taxes
Related to Employee Benefit Plans, for any of the years in issue,
nor did they make any payments to the plan pursuant to the terms
of the promissory note.
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Discussion
Section 4975 imposes two tiers of excise taxes on a
prohibited transaction. The first tier is 5 percent of the
"amount involved" relating to a prohibited transaction for each
year, or part thereof, in the "taxable period". Sec. 4975(a).
If the first-tier excise tax applies and the transaction is not
corrected within the "taxable period", a 100-percent second-tier
tax is imposed on the "amount involved" relating to the
prohibited transaction. Sec. 4975(b).
I. Application of Section 4975 to a Loan Subject to
Section 72(p)
The lending of money between a plan and a disqualified
person generally is a prohibited transaction. See sec.
4975(c)(1)(B). Respondent determined that petitioners are
disqualified persons who participated in a prohibited transaction
(i.e., the loan) and, thus, are liable for section 4975 excise
taxes. Petitioners do not contest respondent's contention that
petitioners are disqualified persons. Petitioners contend,
however, that they did not participate in a prohibited
transaction during the years in issue (i.e., 1991 through 1997)
because, pursuant to section 72(p), the loan was a taxable
distribution in an earlier year (i.e., 1986). As a result,
petitioners contend, section 4975 excise taxes are not
applicable. Respondent contends that the loan was subject to
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section 4975 during the years in issue even though the loan,
pursuant to section 72(p), was treated as a distribution in an
earlier year.
To resolve this issue, we need not look beyond the plain and
ordinary meaning of the words used in section 72(p). See United
States v. Locke, 471 U.S. 84, 93 (1985); Phillips Petroleum Co.
v. Commissioner, 101 T.C. 78, 97 (1993). Section 72(p)(1)(A)
provides that a loan from a qualified employer plan to a plan
participant "shall be treated as having been received by such
individual as a distribution under such plan." The loan is
"treated" as a distribution only for purposes of section 72,
which determines the amount of a distribution subject to income
tax. See sec. 72(p). The characterization of the loan for
section 72 purposes does not change its inherent character for
section 4975 excise tax purposes. Accordingly, section 4975 may
apply to a loan even though such loan, pursuant to section 72(p),
was treated as a distribution. Section 4975 is applicable to
petitioners' loan transaction.
II. Correction of the Prohibited Transaction
Petitioners contend, in the alternative, that they are not
liable for section 4975 excise taxes because they "corrected" the
prohibited transaction on August 15, 1991, the date Mr. Medina
executed the document that assigned to the plan the proceeds from
a future sale of Sunshine Villa Apartments. Respondent contends
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that the prohibited transaction was not "corrected" within the
meaning of section 4975.
Disqualified persons are subject to the first-tier excise
tax only for years, or portions of years, within the "taxable
period." Sec. 4975(a). The second-tier excise tax does not
apply if the prohibited transaction was corrected within the
"taxable period". Sec. 4975(b). The "taxable period" is the
period beginning on the date the prohibited transaction occurs
(i.e., December 1, 1986) and ending on the earliest of three
dates: (1) The date of mailing the notice of deficiency (i.e.,
June 25, 1997); (2) the date on which the section 4975(a) excise
tax is assessed (no assessment has been made); or (3) the date on
which correction of the prohibited transaction is completed.
Sec. 4975(f)(2).
A prohibited transaction is corrected by "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." Sec. 4975(f)(5). Where the prohibited
transaction is the lending of money, the disqualified person
corrects the transaction by repaying the principal plus
reasonable interest. See Kadivar v. Commissioner, T.C. Memo.
1989-404; sec. 53.4941(e)-1(c)(4), Foundation Excise Tax Regs.
Mr. Medina's assignment to the plan of future sales proceeds did
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not result in the repayment of principal or interest. Therefore,
petitioners did not correct the prohibited transaction, and the
taxable period ended on June 25, 1997, the date respondent mailed
the notice of deficiency. Accordingly, petitioners are liable
for both tiers of section 4975 excise taxes.
III. Amount Involved
Section 4975 excise taxes are imposed on the "amount
involved" relating to the prohibited transaction. Sec. 4975(a)
and (b). This section states that the "amount involved" is the
"greater of the amount of money and the fair market value of the
other property given or the amount of money and the fair market
value of the other property received". Sec. 4975(f)(4). Where
the use of money is involved (i.e., a loan), the regulations
define the "amount involved" as the "greater of the amount paid
for such use or the fair market value of such use". Sec.
53.4941(e)-1(b)(2)(ii), Foundation Excise Tax Regs.; see also id.
subpar. (4), Example (2). See generally sec. 141.4975-13,
Temporary Excise Tax Regs., 41 Fed. Reg. 32890 (Aug. 5, 1976) and
51 Fed. Reg. 16305 (May 2, 1986) (providing that the Foundation
Excise Tax Regulations define the term "amount involved" for
purposes of section 4975 until permanent regulations under
section 4975 are promulgated).
Petitioners contend that the "amount involved" relating to a
loan is the greater of the interest paid or the fair market
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interest. Respondent contends that the amount involved is the
greater of the "interest actually charged" (i.e., the 10.5-
percent stated interest rate) or the fair market interest.
Respondent relies on Thoburn v. Commissioner, 95 T.C. 132, 139
(1990), and Janpol v. Commissioner, 101 T.C. 518, 529 (1993), as
support for this contention. In Thoburn, the Court paraphrased
the regulations' "amount paid" language as "interest actually
charged". See Thoburn v. Commissioner, supra at 139. The
Court's statement is dicta. In Janpol, the Court repeated this
statement without discussion or necessity. See Janpol v.
Commissioner, supra at 529. In these cases, it is not clear
whether "interest actually charged" means interest stated,
billed, or paid.
We hold that, in the case of a loan, the "amount involved"
is the greater of the interest paid or the fair market value of
the use of the loan proceeds. Our holding and the Treasury
regulations are consistent with the statute's express language.
The statute refers to the greater of "money and * * * other
property given" or "money and * * * other property received".
See sec. 4975(f)(4). In the case of a loan, the money "given"
and "received" is the interest paid by one party and received by
the other. "Interest actually charged" can be interpreted as the
stated or billed interest, and such interest is not, necessarily,
"given" or "received".
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IV. Value of the Use of Loan Proceeds
Petitioners paid no interest on the loan. As a result, the
"amount involved" is the fair market value of the use of the loan
proceeds (i.e., as reflected by the interest rate). Petitioners
contend that the loan violates Michigan's usury laws, which
prevent a lender from recovering any interest on loans that
provide for interest at a rate that exceeds 7 percent. See Mich.
Comp. Laws Ann. sec. 438.31 and .32 (1978). Petitioners further
contend that the fair market value of the use of the loan
proceeds is zero. Respondent contends that the Court should
conclude that the Employee Retirement Income Security Act of 1974
(ERISA), Pub. L. 93-406, 88 Stat. 829, preempts Michigan's usury
laws and that the "amount involved" should be calculated using a
10.5-percent interest rate.
We reject petitioners' contentions. Petitioners contend
that the fair market value of the use of the loan proceeds equals
what a third-party buyer of the usurious loan would assign to the
loan's stated interest. This value should be based, however, on
a hypothetical loan between a willing lender and a willing
borrower rather than a hypothetical sale of the loan to a third-
party buyer.
We agree with respondent that the fair market interest rate
is 10.5 percent, but we reject his reasoning. A hypothetical
lender would not lend money to a hypothetical borrower at a rate
less than the fair market interest rate. The usury laws,
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however, do not necessarily establish the fair market rate. See
Estate of Arbury v. Commissioner, 93 T.C. 136, 143 (1989)
(stating that the maximum rates set by usury laws do not
necessarily reflect the economic value of the use of borrowed
funds). Therefore, we need not decide whether ERISA preempts
Michigan's usury laws. Respondent determined that the fair
market interest rate is 10.5 percent and petitioners have not
established that this rate is erroneous. See Welch v. Helvering,
290 U.S. 111, 115 (1933). Accordingly, we hold that, in
determining the "amount involved" relating to petitioners' loan,
10.5 percent is the fair market interest rate.
V. Addition to Tax
Each disqualified person liable for section 4975 excise
taxes with respect to a prohibited transaction is required to
file Form 5330 for each taxable year, or portion thereof, in the
taxable period. Sec. 6011; sec. 54.6011-1(b), Pension Excise Tax
Regs. Section 6651(a)(1) imposes an addition to tax for the
failure to file a required return, unless petitioners establish
that such failure is due to reasonable cause and not due to
willful neglect. Petitioners failed to file excise tax returns
for the years in issue and have failed to establish that they had
reasonable cause not to file such returns. Accordingly,
petitioners are liable for the section 6651(a)(1) additions to
tax.
Decision will be entered
for respondent.