Midwest Stainless, Inc. v. Commissioner

T.C. Memo. 2000-314
UNITED STATES TAX COURT
MIDWEST STAINLESS, INC. AND
ROBERT A. AND MARY J. LECHNER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24616-97. Filed October 4, 2000.
After L incorporated his cash method sole
proprietorship, he received payments for its jobs in
progress and paid the associated expenses. In
accordance with the advice of L’s accountant, the
receipts and payments were treated as those of the
corporation for book and tax purposes, and the
corporation made a book entry on its accounting records
showing a receivable from L to the corporation in the
amount of the receipts, which, the parties agree, was
valid debt. Thereafter, L was indicted for failing to
report income of the sole proprietorship on his pre-
incorporation personal income tax returns. L incurred
and paid legal defense fees, which, in accordance with
his accountant’s advice, were deducted on the
corporation’s returns and treated on the corporation’s
accounting records as reducing the receivable. The
parties have agreed that the corporation is not
entitled to deduct the legal defense fees and that L is
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entitled to deduct them on his personal returns as
Schedule C expenses.
Held, the reduction of the receivable on the
corporation’s books, which reduced L’s debt to the
corporation and increased his net worth in a
corresponding amount, is a constructive dividend to L.
Alan L. Billings, for petitioners.
J. Paul Knap and George W. Bezold, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge: Respondent determined that petitioners Robert
A. and Mary J. Lechner (Lechners) and Midwest Stainless, Inc.
(Stainless), had the following Federal income tax deficiencies:
Petitioners Taxable years Deficiencies
Lechners
1994 $128
1995 24,184
Stainless
f/y/e Sept. 30, 1994 $159,362
f/y/e Sept. 30, 1995 19,956
Stainless has conceded, among other things, that respondent
properly disallowed a deduction claimed by Stainless for its
reduction of a debt owed by Mr. Lechner, its sole shareholder, in
reimbursement of his payments of legal fees incurred in defending
against his indictment for filing false individual income tax
returns; respondent has conceded that Mr. Lechner was entitled to
deduct those fees, which he did not claim on his individual
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returns. The sole issue remaining for decision is whether Mr.
Lechner’s debt to Stainless was actually reduced so as to be
included in his gross income as a constructive dividend. We hold
that Mr. Lechner’s debt to Stainless was reduced in such
circumstances as to require the reduction to be so included.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of fact and accompanying exhibits are
incorporated herein by this reference. The Lechners are husband
and wife. At the time the petition was filed, the Lechners
resided and Stainless had its principal office at Menomonie,
Wisconsin.
Mr. Lechner owned and operated a stainless steel fabricating
business known as Midwest Stainless Mechanical Contractors as a
sole proprietorship (the sole proprietorship) for 8 or more
years, ending on May 31, 1993.
Stainless was incorporated on June 1, 1993, in a section
3511 exchange of the assets of the sole proprietorship for stock
of Stainless. At all times thereafter, Mr. Lechner has been the
sole shareholder of Stainless.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 1993-1995, and all Rule
References are to the Tax Court Rules of Practice and Procedure.
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Mr. Lechner filed an individual income tax return for 1993,
and Stainless filed a corporation income tax return for the
fiscal year ended September 30, 1993. Attached to each of those
returns was a statement regarding the organization of Stainless
in a section 351 exchange. This statement recited that all
assets of the sole proprietorship, including “cash accounts and
other receivables”, were transferred to Stainless in exchange for
its common stock, but that the “only liability assumed was
withheld payroll taxes”.
The sole proprietorship and Stainless during the taxable
years in issue used the cash method of accounting for income tax
purposes without objection from respondent.
Mr. Lechner incurred $239,594.68 of debt to Stainless by
depositing in his personal bank account gross receipts of
Stainless attributable to payments, after May 31, 1993, for jobs
in progress of the sole proprietorship. On June 30, 1993,
Stainless accounted for the deposit by making a journal entry
(designated “Receivable from Officer”) in its accounting records
showing that Mr. Lechner owed Stainless the amount deposited in
his personal account. No promissory notes were ever made
representing this debt, and no interest was charged on this debt.
After June 1, 1993, Mr. Lechner also made payments with funds
from his personal bank account of expenses related to the jobs in
progress, and those payments reduced his outstanding debt to
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Stainless. In so handling the receipts and expenses after
June 1, 1993, Mr. Lechner was acting in accordance with the
advice of his certified public accountant, Kenneth E. Noble (Mr.
Noble), who also acted as a bookkeeper of Stainless and made the
journal entry described above. Mr. Noble believed that this was
the appropriate way to handle the receivables receipts and the
payables payments with respect to the jobs in progress because
Mr. Lechner had closed out the checking account of the sole
proprietorship and had opened a corporate checking account for
Stainless with an initial balance of only $5,000.
The Lechners filed joint individual income tax returns
(Forms 1040) for the years 1987, 1988, 1989, and 1990. Each of
these individual returns included a Schedule C, Profit or Loss
from Business, for the sole proprietorship.
Mr. Lechner was indicted under section 7206(1) for filing
false individual income tax returns (Forms 1040) for the years
1987, 1988, 1989, and 1990. The principal false item alleged in
the indictment was the failure to report all gross receipts of
the sole proprietorship. Mr. Lechner pleaded guilty to and was
convicted under section 7206(1) of filing a false individual
income tax return for the year 1990.
Mr. Lechner was never charged with any criminal offense in
connection with the corporation income tax returns of Stainless.
The effect of the creation of the Receivable from Officer account
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was to treat the $239,594.68 as revenue of Stainless, which
reported it as such for corporation income tax purposes. The
payments of the expenses by Mr. Lechner were treated as reducing
the receivable and were reported by Stainless as deductible
expenses for corporation income tax purposes.
In defending himself in the criminal tax case, Mr. Lechner
paid $134,108.54 between October 1, 1993, and September 30, 1994,
to his attorneys (hereinafter “defense fees”). The defense fees
were paid from Mr. Lechner’s individual resources and not from
funds of Stainless. After Mr. Lechner paid the defense fees,
Stainless deducted them on its corporation income tax return for
the fiscal year ended September 30, 1994.
Stainless did not reimburse Mr. Lechner in cash or by check
or in goods or services for his payments of the defense fees.
However, Stainless reduced the debt owed to it by Mr. Lechner in
the amount of the defense fees and made a journal entry in its
books of account to reflect the reduction, in the same way that
it reduced the debt owed by Mr. Lechner to reflect his payments
of expenses attributable to jobs in progress of the sole
proprietorship. The entry showed a reduction of $134,108.54 in
the amount of debt Mr. Lechner owed Stainless for “corporate
legal fees paid personally” for the corporate fiscal year ended
September 30, 1994. The $134,108.54 debt reduction included
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$26,702.80 personally paid by Mr. Lechner for defense fees in
calendar year 1993 and $107,405.74 so paid in calendar year 1994.
In the notice of deficiency issued to the Lechners for 1994,
respondent added $113,495.00 to Mr. Lechner’s individual dividend
income. This amount reflects the $107,405.74 reduction during
1994 of Mr. Lechner’s debt to Stainless referred to above, and
$6,089.19 for other personal accounting and legal fees of Mr.
Lechner actually paid by Stainless in 1994. The parties agree
that the $6,089.19 referred to above is a constructive dividend
that should have been reported on the Lechners’ 1994 joint
individual tax return.
ULTIMATE FINDING OF FACT
In 1994 Mr. Lechner received an additional $107,405.74 in
gross income from Stainless as a constructive dividend that took
the form of a debt reduction.
OPINION
The apparent clarity and simplicity of the findings set
forth above is belied by some missing links and skewed by one of
respondent’s concessions, which might be considered overly
generous (although not the one respondent has in mind).2
2
The concession of respondent that respondent asserts on
brief might have been overly generous is respondent’s concession
that Mr. Lechner is entitled to a Schedule C deduction for his
payment of the defense fees in his criminal case. The concession
(continued...)
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Nevertheless, we wish to encourage parties in this Court to
stipulate facts to the greatest extent possible and to make
mutual concessions that will simplify and shorten trials. We
will do the best we can with the record at hand to supply the
missing links and to make inferences that properly give effect to
the parties’ stipulations and concessions.
The factual setting in the cases at hand, as well as the
overall issues raised by the deficiency notices, are similar to
those we recently considered in Hood v. Commissioner, 115 T.C.
(Aug. 25, 2000) (Court reviewed); see also Jack’s
Maintenance Contractors, Inc. v. Commissioner, 703 F.2d 154 (5th
Cir. 1983), revg. per curiam T.C. Memo. 1981-349. Here, however,
the parties’ concessions leave only one issue to be decided.
Here, as in Hood and Jack’s Maintenance Contractors, an
individual who had conducted business as sole proprietor
incorporated the business and was thereafter charged with tax
crimes in failing to report income of the sole proprietorship.
The corporations in Hood and Jack’s Maintenance Contractors paid
the legal fees incurred by their individual shareholders in
2
(...continued)
that the Court thinks might have been overly generous is
respondent’s concession that the corporation’s book entry setting
up the receivable of $239,594.68 evidenced a valid debt of Mr.
Lechner to Stainless. It’s a close call, which we have accepted
for the purpose of deciding the case at hand as the parties have
presented it.
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defending against the criminal charges and claimed the payments
as deductions on their corporation income tax returns. In the
case at hand, Mr. Lechner paid his own defense fees, but claimed
no deductions for the payments on his joint returns. Instead,
Stainless made a journal entry on its accounting records showing
that Mr. Lechner’s acknowledged debt to Stainless was reduced by
the amount of the defense fees, and Stainless deducted that
amount on its corporation income tax returns.
Respondent’s deficiency notices disallowed the deduction
claimed by Stainless and treated the corresponding debt reduction
shown on its books of account as constructive dividend income to
Mr. Lechner.3 Stainless has conceded that it is not entitled to
the deduction claimed on its return for the fiscal year ended
September 30, 1994, and respondent has conceded that the Lechners
are entitled to deductions in corresponding amounts–-which they
did not claim--on their individual income tax returns for the
years in which the fees were paid.
Mr. Lechner deposited to his own account $239,595 of
receipts that were attributable to work in progress of the sole
proprietorship as of the moment of incorporation. Against the
background of the criminal charges against Mr. Lechner for
3
There is no dispute that at all relevant times Stainless
had sufficient earnings and profits to cover any constructive
dividend that might be determined.
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failing to report taxable income of the sole proprietorship for
prior years, the parties took pains to agree and to assure the
Court that there was nothing improper in Mr. Lechner’s taking the
receipts and paying the associated expenses. We accept their
assurances and impute no wrongdoing to Mr. Lechner, who appears
merely to have been following the advice of his accountant, Mr.
Noble, at all times relevant to these proceedings.
What Mr. Lechner and Stainless did to “make it right”,
apparently on the assumption that the only proper way to handle
the incorporation was for Stainless to take over the receivables
and payables arising from the sole proprietorship’s work in
progress, was to set up a corporate receivable from Mr. Lechner
in the amount of the receipts and to reduce that receivable when
Mr. Lechner paid the associated expenses. The amount of the
receivable, reflected in the progress payments taken by Mr.
Lechner, and its reduction by the associated expenses that he
paid, were reported by Stainless as corporate income and
expense.4
4
Inasmuch as both the sole proprietorship and the
corporation used the cash method of accounting, this treatment
appears to have been proper and consistent with the way the
incorporation of a cash basis business can be handled under secs.
351, 357(c), and 358(d). See Hempt Bros., Inc. v. United States,
490 F.2d 1172 (3d Cir. 1974); Rev. Rul. 80-198, 1980-2 C.B. 113;
see also Focht v. Commissioner, 68 T.C. 223 (1977); Rev. Rul. 80-
199, 1980-2 C.B. 122. Notwithstanding that the sole
proprietorship earned the receipts and incurred the liabilities
(continued...)
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The parties have stipulated that the journal entry evidenced
the receivable as valid debt of Mr. Lechner to Stainless.5
Although in many cases we have found that corporate accounting
entries setting up a receivable from a shareholder were equivocal
and insufficient to create valid debt, particularly in the
absence of an accompanying note and interest payments, see, e.g.,
Haber v. Commissioner, 52 T.C. 255, 266 (1969), affd. 422 F.2d
198 (5th Cir. 1970), the pattern of repayments and reductions of
the receivable, evidenced by Mr. Lechner’s payment of the
liabilities for the associated expenses, supports the treatment
4
(...continued)
to make the payments, the transferee corporation, if it also uses
the cash method, is treated as a successor and allowed to report
the receipts and payments on its own income tax return if the
receivables and payables were transferred to it in the sec. 351
exchange. However, there is no intimation in the foregoing
authorities that the receivables and payables must be so
transferred; an acceptable alternative would be for the
transferor to retain and collect and pay the respective
receivables and payables and to use the new corporation to make a
“fresh start” with new business. We treat as of no account the
discrepancy between the recital in the sec. 351 statement that
the only liability assumed by Stainless was withheld payroll
taxes and its claiming of Mr. Lechner’s payments of liabilities
related to the work in progress as its deductible expenses.
5
If the journal entry had not been so stipulated, Mr.
Lechner’s taking of the corporate receipts would have been
treated as a constructive distribution to him in 1993, taxable as
a dividend to the extent of corporate earnings and profits for
the corporate fiscal year in which it occurred, and his payments
of the expenses would have been treated as capital contributions
to Stainless.
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of the receivable as valid debt. We have accepted the parties’
stipulation to this effect.
With his accountant’s advice, Mr. Lechner and Stainless
treated his payments of his defense fees as payments of
corporate expenses that reduced the receivable. Respondent and
petitioners have agreed and made mutual concessions to the
effect, first, that the corporate deduction of the defense fees
is to be disallowed, contributing to a corporation income tax
deficiency, and, second, that Mr. Lechner is to be allowed a
Schedule C deduction in a corresponding amount, although he did
not claim a deduction for the defense fees on his income tax
returns. Although respondent characterizes his concession as
perhaps overly generous, it is identical to the Commissioner’s
concession in Hood v. Commissioner, supra, and appears to us to
be appropriate. However, this concession of the unclaimed
Schedule C deduction to Mr. Lechner will give him a personal tax
windfall unless his individual deduction is offset by a
constructive dividend in the amount of the debt reduction
evidenced by the corporate accounting entry reducing the
Stainless receivable from Mr. Lechner.
As this Court has recited numerous times, see, e.g., Halpern
v. Commissioner, T.C. Memo. 1982-31, the test for a constructive
dividend has two prongs: First, the corporation must have
conferred an economic benefit on the shareholder without
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expectation of repayment, see Magnon v. Commissioner, 73 T.C.
980, 983-994 (1980), and second, the benefit conferred by the
corporation must primarily advance the shareholder’s personal
interest as opposed to the business interest of the corporation,
see Jack’s Maintenance Contractors, Inc. v. Commissioner, 703
F.2d at 156.
Whether the corporate journal entry reducing the debt
reflected by the Receivable from Officer account resulted in a
constructive dividend to Mr. Lechner, the individual shareholder,
does not turn on whether the reduction primarily benefited the
corporation or the shareholder; this is the second prong question
addressed by Hood and Jack’s Maintenance Contractors. Stainless
has conceded that it is not entitled to the deduction, and thus
that it received no primary benefit, or at least that any benefit
that it might have received is to be disregarded for tax
purposes. Our sole question for decision is a first prong
question: Whether the action by Stainless in reducing the amount
of the debt on its accounting records conferred an economic
benefit on Mr. Lechner without expectation of repayment that
constituted or evidenced a distribution to him or for his benefit
that should be treated as a constructive dividend.
Respondent’s briefs characterize the distribution as
cancellation of indebtedness. Because the deficiency notice did
not mention cancellation of indebtedness, petitioners argue that
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respondent has raised a new issue. This argument has no merit.
Cancellation of indebtedness takes its tax significance from the
context in which it occurs; cancellation of indebtedness is just
a means by which a benefit can be conferred or a constructive
payment made. See OKC Corp. & Subs. v. Commissioner, 82 T.C.
638, 647-648 (1984). When a corporation with earnings and
profits cancels its shareholder’s debt to it, cancellation of
indebtedness is the means by which a constructive dividend
distribution to the shareholder can be accomplished. See Haber
v. Commissioner, supra; Schneller v. Commissioner, T.C. Memo.
1996-62, affd. without published opinion 129 F.3d 1265 (6th Cir.
1997); Estate of Shapiro v. Commissioner, T.C. Memo. 1987-126;
Shephard v. Commissioner, T.C. Memo. 1963-294, affd. per curiam
340 F.2d 27 (6th Cir. 1965).
The notions of constructive dividend and cancellation of
indebtedness merge in their common elements: the conferring of
an economic benefit without expectation of repayment, which
constitutes the first prong of a constructive dividend, with the
existence of a debt and its discharge, see Waterhouse v.
Commissioner, T.C. Memo. 1994-467, which occurs when it becomes
clear that the debt will not have to be repaid, see Cozzi v.
Commissioner, 88 T.C. 435 (1987). The inquiry requires a
practical assessment of the facts relating to the likelihood of
repayment, see id., as they existed at the time the transaction
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under review occurred; i.e., at the time of the entry on the
corporate books reducing the debt.
Petitioners make two arguments. With respect to economic
benefit, they argue that treating the accounting entry reducing
Mr. Lechner’s debt to Stainless as a constructive dividend would
give dispositive effect to “bookkeeping subtleties”, of the sort
we deemed “irrelevant” in Halpern v. Commissioner, supra.6
Petitioners assert the need to show an actual corporate payment
or other outlay to justify a finding that Mr. Lechner received a
constructive dividend distribution.
6
We observe that the Court in Halpern v. Commissioner, T.C.
Memo. 1982-31, made the comment about “accounting subtleties” in
rejecting an individual shareholder’s argument that corporate
bookkeeping entries treating as loans advances to him for travel
and entertainment expenses that he never substantiated or repaid
should not be treated as dividends to him:
Halpern contends that the corporation’s method of
recording its expenses should not cause the
corporation’s payment of a legitimate business expense
to result in a constructive dividend to petitioner. We
feel, however, that such bookkeeping subtleties are
irrelevant. The question is whether Halpern used the
amount advanced for his personal benefit or for the
benefit of the corporation.
* * * * * * *
Without evidence that these expenses were for the
benefit of his corporation, we hold that its payment of
these expenses resulted in Halpern’s receiving
constructive dividends in the amount of $6,706.06.
[Halpern v. Commissioner, T.C. Memo. 1982-31, 43 T.C.M.
(CCH) 346, 352, 1982 T.C.M. (RIA) par. 82,031, at 104-
82.]
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With respect to the likelihood of repayment, petitioners’
argument seems to be that the accounting entry reducing the
receivable is equivocal, and that it doesn’t have the effect of a
payment or distribution because it might be reversed. Mr. Noble
testified that if respondent’s dividend determination is not
sustained by the Court, that is, if petitioner wins his case, the
receivables ledger of Stainless will be adjusted to add back the
amount by which the Receivable from Officer account was reduced
to reflect Mr. Lechner’s payment of his defense fees, which--Mr.
Noble originally advised--should be treated as corporate
expenses.
Petitioners’ argument that a constructive dividend
distribution requires corporate payment or outlay of funds also
has no merit. It ignores the circumstances in which the original
debt was created. When Mr. Lechner deposited in his personal
bank account receipts that-–the parties agree--belonged to the
corporation, he received payments of corporate funds that would
have been includable in his gross income (or at least treated as
corporate distributions to him at that earlier time) but for Mr.
Noble’s corporate journal entry creating the receivable that
treated the receipts as giving rise to what--the parties also
agree-–thereby became valid debt. Because the original payment
to Mr. Lechner was offset by the debt, there was no increase in
his net worth and no distribution supporting a dividend to him at
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the earlier time. When the debt was reduced in circumstances
that the parties now agree did not include a repayment of the
debt by Mr. Lechner, his net worth correspondingly increased.
This increase in his net worth, which results from the reduction
of his indebtedness to the corporation, see sec. 61(a)(12), is
the economic benefit that satisfies the first prong of the
constructive dividend test.
Petitioners’ second argument is based on what they assert is
the equivocal nature of the book entry reducing the receivable.
The creation of the debt in this case, whose existence and
intention to repay at inception the parties acknowledge, was
evidenced only by a journal entry on the corporate books. We
find that the subsequent reduction of the receivable by journal
entry evidenced, pro tanto, the intention not to repay.
We acknowledge that this is not an open and shut
proposition. Accounting entries can be equivocal, as we have
held numerous times in finding that accounting entries purporting
to create a corporate receivable from a shareholder did not
persuade us that valid debt had been created. See, e.g., Haber
v. Commissioner, 52 T.C. 266. Respondent has requested the
Court to find that “Lechner understood that the debt had been
reduced and he believed that he need not pay it”. Petitioners’
requests for findings stress that the journal entries on the
corporate books of account reducing the account receivable were
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made by Mr. Noble, the accountant for Stainless and Mr. Lechner,
“consistent with Mr. Noble’s handling of similar items in his
practice for the last thirty (30) years and was consistent with
standard and accepted accounting practice”. Mr. Lechner disputes
the irrevocability of the reduction of the receivable, relying on
Mr. Noble’s testimony that if the Court upholds Mr. Lechner’s
position, the debt will be restored on the corporate books by an
adjusting entry.
We have concluded that Mr. Lechner’s state of mind, whatever
it may been, is not determinative. A case such as this should be
decided by recourse to objective facts and circumstances, see
Dean v. Commissioner, 57 T.C. 32, 43-44 (1971), with due regard
for the desirability of consistency in the dealings between
shareholders and the closely held corporations that they control.
We are not persuaded by Mr. Noble’s testimony--that the
receivable will be adjusted upward if the Court upholds
Mr. Lechner’s position--that the reduction of the receivable on
the corporate books was not a corporate dividend distribution to
Mr. Lechner. Mr Noble’s testimony flies in the face of the
parties’ stipulation that the book entry reducing the receivable
reduced the debt.7
7
Petitioners’ offer, embodied in Mr. Noble’s testimony,
which petitioners adopted on brief, seems counterintuitive. One
would think that if the Court were to hold that the debt
(continued...)
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In further response to petitioners’ argument based on Mr.
Noble’s testimony, we would observe that our acceptance of this
argument would compromise the integrity of corporate books and
records as evidence of corporate action by encouraging “wait and
see” game playing. Notwithstanding that all corporate action
taken in this case was at the direction and advice of Mr. Noble,
we have only his after-the-fact testimony about the corporate
action that will be taken in response to a decision of the Court
that treats the reduction of the liability as a nullity. There
was no preexisting binding agreement between Mr. Lechner and
Stainless regarding the circumstances, if any, in which the
reduction of the debt on the corporate books would be reversed.8
7
(...continued)
reduction created no constructive dividend to Mr. Lechner, he and
Stainless would be content to leave well enough alone by not
undoing the reduction of the receivable. The offer implies that
the reduction did increase Mr. Lechner’s net worth and that a
retroactive restoration of the receivable would be necessary to
prevent the increase from having occurred. If the issue before
the Court had not been raised by respondent’s deficiency notice
to Mr. Lechner, there is no reason to believe that Mr. Lechner
would have voluntarily caused Stainless to restore the
receivable. Nor is there any procedure that we know of (or would
be interested in exploring) under which a decision in Mr.
Lechner’s favor could be conditioned on the restoration of the
receivable. In these circumstances, we accept and take at face
value the stipulation of the parties that the receivable was
reduced in an amount equal to the legal defense fees paid by
Mr. Lechner.
8
Only if the shareholder-employee enters into a binding
repayment agreement with his corporation, prior to the time of
its payment to the employee for which the corporation claims a
(continued...)
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In the circumstances of this case, we are loath to impute such an
agreement. We also doubt that such an agreement, even if it
occurred and was formally binding, would change the result
generated by giving effect at face value to the corporate book
entry reducing the receivable. Cf. Harwood v. Commissioner, 82
T.C. 239 (1984).
We conclude that in 1994 Mr. Lechner received an additional
$107,405.74 in gross income from Stainless as a constructive
dividend that took the form of a debt reduction, which was
evidenced by the journal entry reducing the Receivable from
Officer account in the books and records of Stainless.
To reflect the foregoing and the concessions of the parties,
Decision will be
entered under Rule 155.
8
(...continued)
deduction, will a repayment by the employee of an amount
disallowed as a corporate deduction, be allowed as a deduction of
the amount previously included in his gross income. See Pahl v.
Commissioner, 67 T.C. 286 (1976); Oswald v. Commissioner, 49 T.C.
645 (1968); Rev. Rul. 69-115, 1969-1 C.B. 50.