Culnen v. Commissioner

DANIEL J. CULNEN, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Culnen v. Commissioner

No. 25551-92; No. 6496-94

United States Tax Court

T.C. Memo 2000-139; 2000 Tax Ct. Memo LEXIS 169; 79 T.C.M. (CCH) 1933;

April 13, 2000, Filed

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Decisions will be entered under Rule 155.

The issues for decision are: (1) whether P had sufficient

   basis with respect to an S corporation to permit him to deduct

   his pro rata share of that corporation's ordinary losses for the

   years in question; and (2) whether (A) the corporation suffered

   a sec. 1231, I.R.C., loss from the disposition of property in

   one of those years and (B) P had sufficient basis to permit him

   to deduct his pro rata share of that loss.

     1. HELD: P established that he had sufficient basis for all

   years;

     2. HELD, FURTHER, P established that the S corporation

   suffered only a portion of the sec. 1231, I.R.C., loss claimed;

   HELD, FURTHER, P had sufficient basis to deduct his portion of

   the loss suffered.

Frank Agostino, for petitioner.

Steven W. Ianacone, for respondent.

Halpern, James S.

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HALPERN

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, JUDGE: These consolidated cases involve the following determinations by respondent of deficiencies in, additions to, and penalties on petitioner's Federal income tax:

               Additions to Tax & Penalties

               ____________________________

 Year  Deficiency  Sec. 6651(a)(1)  Sec. 6661  Sec. 6662   Sec. 6663

 ____  __________  _______________  _________  _________   _________

 1987  $ 271,885    $ 48,616     $ 67,971     --     --

 1989   217,204     42,824       --      --   $ 162,903

 1990   381,883     88,399       --    $ 75,524    --

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.

After concessions, the issues for decision are: (1) Whether petitioner had sufficient basis with respect to an S corporation for his taxable (calendar) years 1987, 1989, and 1990 to permit him to deduct his pro rata share of the corporation's ordinary losses for those years in the amounts of $ 388,106, $ 651,357, and $ 213,732, respectively; and (2) whether (A) the corporation suffered a section 1231 loss from the disposition of property in 1990 and (B) petitioner had sufficient basis to permit him to deduct his pro rata share, $ 1,759,987, of that loss.

FINDINGS OF FACT

Some facts have been stipulated and are so found. The stipulation of facts, with attached exhibits, is incorporated herein by this reference.

At the time the petitions were filed, petitioner resided in Totowa, New Jersey.

WEDGEWOOD ASSOCIATES, INC.

During the years in issue, Wedgewood Associates, Inc., a New Jersey corporation (Wedgewood), was an S corporation, see sec. 1361(a)(1), making its return of income on the basis of a calendar year. Wedgewood was in the restaurant business. In or before 1987, petitioner became a shareholder in Wedgewood. Beginning in 1987 and ending in 1990, petitioner owned the following percentages of Wedgewood's shares:

        Year         Percentage

        ____         __________

        1987          39.48

        1988          52.00

        1989          73.00

         1990          73.00

Wedgewood was unsuccessful in the restaurant business. It ceased doing business sometime in 1990, and, on or about March 14, 1990, by Deed of Assignment for the Benefit of Creditors (the deed), it conveyed its property for the benefit of those creditors. Attached to the deed is a "Statement of Assets", which lists restaurant fixtures, equipment and furnishings subject to liens of $ 1,865,000, a liquor license, cash on hand, accounts receivable, and liquor inventory. Only the liquor license and liquor inventory are shown to have a value, $ 100,000 and $ 1,000, respectively. ^{*173 of New Jersey. During those years, petitioner was the sole shareholder of Culnen & Hamilton. Culnen & Hamilton made its return of income on the basis of a fiscal year ending on January 31. From February 1, 1986, through May 31, 1987, Culnen & Hamilton was an S corporation; after May 31, 1987, Culnen & Hamilton was a C corporation. See sec. 1361(a)(2).}

WEDGEWOOD'S PAYMENTS

On 46 occasions, from April 1987 through January 1990, Culnen & Hamilton made payments by check and, on one of those occasions, by wire transfer to Wedgewood (without distinction, the 46 checks), in amounts totaling $ 4,034,017.41. *174 On 28 occasions, from April 1989 through March 1992, Culnen & Hamilton issued checks in payment of expenses of Wedgewood's, in amounts totaling $ 501,918.22 (the 28 checks). *175 respectively (for a total of $ 616,070.49.)

WEDGEWOOD'S INCOME TAX RETURNS

Wedgewood's Federal income tax returns for 1987 through 1990 show the following balance sheet entries with respect to loans from shareholders:

   Year       Beginning Balance     Ending Balance

   ____       _________________     _______________

   1987        $ 186,827        $ 1,773,887

   1988        1,773,887         3,530,306

   1989        3,530,306         4,380,992

   1990        4,380,992         6,097,200

Wedgewood's Federal income tax return for 1990 (the 1990 return) includes a Form 4797, Sale of Business Property, which shows a disposition of furniture and fixtures acquired on April 1, 1988, at a cost of $ 2,780,959, and disposed of on September 1, 1990. There is no gross sales price shown, and a loss is claimed in the amount of $ 2,506,244, which is the acquisition price less depreciation (the difference being Wedgewood's adjusted basis in the property). Taking into account certain other entries on the Form 4797, the net loss reported on that form is $ 2,410,941 (the Form 4797 loss). A Schedule K-1, Shareholder's Share of Income, Credits, Deductions, Etc., accompanying the 1990 return, reports that petitioner's share of the Form 4797 loss is $ 1,759,987.

CULNEN & HAMILTON'S INCOME TAX RETURNS

Culnen & Hamilton's Federal income tax returns for 1987 through 1989 show the following balance sheet entries with respect to loans to stockholders:

   Year       Beginning Balance     Ending Balance

   ____       _________________     ______________

   1987        $ 1,814,212        $ 1,712,517

   1988         1,712,517         4,329,091

   1989         4,329,091         6,702,399

PETITIONER'S INCOME TAX RETURNS

On petitioner's income tax returns for 1987, 1989, and 1990 he claimed the following losses from Wedgewood:

          Year        Loss

          ____        _____

          1987      $ 388,106

          1989       651,357

           1990       213,732

On petitioner's 1990 income tax return, he also claimed his share of the Form 4797 loss in the amount of $ 1,759,987 (the $ 1,759,987 loss).

OPINION

I. INTRODUCTION

Respondent disallowed petitioner's pro rata share of Wedgewood's ordinary losses for 1987, 1989, and 1990 because petitioner failed to convince respondent that he had an adequate basis with respect to his investment in Wedgewood. We must determine that basis. Respondent disallowed petitioner's share of the Form 4797 loss (the $ 1,759,987 loss) for the same reason and because petitioner failed to convince respondent that Wedgewood suffered the $ 1,759,987 loss. We must determine both his basis and whether Wedgewood suffered any loss. *178 Petitioner bears the burden of proof. See Rule 142(a).

II. PETITIONER'S BASIS WITH RESPECT TO WEDGEWOODA. PRINCIPAL STATUTORY PROVISIONS

Section 1366(a)(1) provides that a shareholder of an S corporation shall take into account his pro rata share of the S corporation's items of income, loss, deduction, or credit for the S corporation's taxable year ending in the shareholder's taxable year. Section 1366(d), however, imposes a limit on the amount of such losses and deductions (without distinction, losses) that a shareholder may take into account for any taxable year. He may not take into account an aggregate amount of such losses exceeding the sum of (1) his adjusted basis in the stock of the S corporation and (2) his adjusted basis in any indebtedness of the S corporation to the shareholder (collectively, his S corporation investment). See sec. 1366(d)(1). Any losses so disallowed may be carried forward indefinitely. See sec. 1366(d)(2).

B. DISAGREEMENT BETWEEN THE PARTIES

To deduct his pro rata share of Wedgewood's losses, petitioner must prove that he had sufficient adjusted basis in his S corporation investment (with respect to Wedgewood, petitioner's Wedgewood investment). Generally, cost defines an S corporation shareholder's initial basis in his S corporation investment acquired for cash. See sec. 1012. Adjusted basis is determined by making certain adjustments to cost basis. See sec. 1016. Section 1367 provides additional, special rules with respect to adjusting basis in an S corporation investment. The disagreement between the parties concerns only petitioner's cost basis in his Wedgewood investment. The parties disagree as to whether petitioner's cost basis in his Wedgewood investment includes the various payments represented by the 46 checks, the 28 checks, the 6 checks, and the 8 payments (collectively, the Wedgewood Payments). Respondent denies that the Wedgewood payments represent petitioner's cost in obtaining his Wedgewood investment. Respondent insists that the Wedgewood payments constitute an investment by Culnen & Hamilton (not petitioner) in Wedgewood. *180 C. PETITIONER'S BURDEN

To prevail, petitioner must prove that he, not Culnen & Hamilton, invested in Wedgewood. See, e.g., Prashker v. Commissioner, 59 T.C. 172">59 T.C. 172, 176 (1972) (estate, of which taxpayer was executrix and sole beneficiary, advanced funds to S corporation of which she was 50 percent shareholder: "[T]he key question is whether or not the debt of the corporation runs 'directly to the shareholder.'"). To prove that petitioner invested in Wedgewood, he must prove that the Wedgewood payments created indebtedness on the part of Wedgewood to him. See Bolding v. Commissioner, 117 F.3d 270">117 F.3d 270 (5th Cir. 1997) (true obligor on bank line of credit extended to S corporation was shareholder in his individual capacity and not on behalf of corporation), revg. on another issue T.C. Memo 1995-326">T.C. Memo 1995-326; Prashker v. Commissioner, supra at 176 ("a shareholder could borrow the money personally and then loan the money to the corporation. In that event, the corporation's debt would run directly to the shareholder.").

In his brief, respondent heads one of his arguments that petitioner did not have sufficient basis in his Wedgewood investment as follows:

   The fact that all payments to Wedgewood Associates, Inc. came

   directly from Culnen and Hamilton, precludes petitioner from

   claiming those amounts as his basis in Wedgewood and thus, the

   Schedule E losses. [Emphasis added.]

If respondent is suggesting that the question of whether Culnen & Hamilton lent those amounts to petitioner is irrelevant since, as a matter of law, direct payments by Culnen & Hamilton to Wedgewood establish Culnen & Hamilton's status as the investor in Wedgewood, he is wrong. In Hitchins v. Commissioner, 103 T.C. 711">103 T.C. 711 (1994), in explaining the statutory requirement that the indebtedness of the S corporation must run directly to the shareholder, we made it clear that an indebtedness to an entity with pass-through characteristics that has advanced the funds to the S corporation and is closely related to the taxpayer does not satisfy the statutory requirement. See id. at 715. We did not say, however, that the fact that the borrowed funds originate with the closely related entity precludes the indebtedness of the S corporation from running directly to the shareholder. Certainly, where there is a close relationship among the S corporation, the taxpayer, and the related entity, we will scrutinize the relationships established with respect to the transfer of funds to ensure that those relationships comport with the statutory requirement. Respondent proposes Underwood v. Commissioner, 63 T.C. 468">63 T.C. 468 (1975), affd. 535 F.2d 309">535 F.2d 309 (5th Cir. 1976), as a model for us to follow in this case. In Underwood, the taxpayer's S corporation was indebted to a second corporation owned by him. The taxpayer interposed himself between the two corporations by causing the corporations to substitute for the one-legged indebtedness running between the S corporation and the second corporation a two-legged indebtedness, running, first, from the S corporation to him and, second, from him to the second corporation. We concluded that the taxpayer had paid out no funds and would not until his note to the second corporation came due. On that basis, we were unable to distinguish his liability from that of a guarantor, who makes no investment until he pays his obligation. See 63 T.C. at 475-476. We relied on a long list of cases for the proposition (which we applied to the taxpayer) "that basis-giving indebtedness for the purposes of section 1374(c)(2)(B) does not arise where a shareholder merely guarantees a subchapter S corporation's debt". ^{Id. at 475. That is true, but that is not the case here.}

D. DISCUSSION

1. PETITIONER'S CASE

Petitioner called four witnesses, including himself, all of whom testified consistently that, for many years (including the years in question), petitioner had used Culnen & Hamilton as an incorporated pocketbook, having the corporation make payments on his behalf, which payments were posted to Culnen & Hamilton's books as loans to petitioner. Robert Levin, one of those four witnesses, had been petitioner's accountant for more than 20 years. He also did accounting work for Culnen & Hamilton. He testified that, from time to time, petitioner would reduce the balance of his Culnen & Hamilton loan account by liquidating investments he had made and paying the proceeds to Culnen & Hamilton. Mr. Levin explained the rationale for that procedure as follows:

     Culnen & Hamilton was an "S" corporation. There was a lot

   of undistributed taxable income. He [petitioner] wouldn't take

   all the -- he'd pay taxes on it, and, God knows, he paid a lot

   of taxes over the years, but he felt the money that was left in

   Culnen & Hamilton, because it was undistributed to him, that he

   could spend and do what he wanted with.

     So, rather than write a check to himself and write a check

   to a third party, he would just -- if he wanted to buy a company

   or whatever, he would just write it out -- have Beatrice, the

   bookkeeper, write it out of Culnen & Hamilton, charge it to his

   loan account, okay, and that's the way he did business for the

   20 years that I've been his accountant.

Although Culnen & Hamilton was an S corporation only until May 31, 1987, Mr. Levin's testimony presents a credible explanation of petitioner's relationship with Culnen & Hamilton.

Janet Sacklow is a partner in the accounting firm of Amsterdam, Sacklow & Acox. That firm also did accounting work for Culnen & Hamilton, including preparing various financial records and its income tax returns for the years in question. Ms. Sacklow testified that she treated the Wedgewood payments as loans to petitioner for purposes of both Culnen & Hamilton's books and records and its income tax returns. She testified that the initial record of the Wedgewood payments was made by Culnen & Hamilton's bookkeeper, Beatrice, who would record the Wedgewood payments on the corporation's general ledger under the heading "Wedgewood" (the Wedgewood entries). Beatrice made the Wedgewood entries monthly. Ms. Sacklow testified that she was responsible for classifying the Wedgewood entries as loans to petitioner. She testified that she made that determination based on conversations with petitioner and because she believed that Culnen & Hamilton had no association with Wedgewood: "It was only because of Dan Culnen that the money was coming from that location [i.e., from Culnen & Hamilton]." The parties have stipulated a letter dated February 11, 1993, from Ms. Sacklow to Walter J. Pagano, c.P.A. (the Sacklow letter). *186 schedules of amounts loaned to Wedgewood Associates and Dan's acquisition costs for stock and partnership interests." Ms. Sacklow testified that she prepared those schedules (the schedules) from the books and records of Culnen & Hamilton. The first of the schedules relates to the 46 checks and states that they were "deposited into Wedgewood Associates accounts, on behalf of Daniel Culnen." The third of the schedules relates to the six checks and states: "Daniel Culnen's purchase of Dr. Nagle's Interest". The final page of the schedules states:

   Summary

   Net Checks Written to Wedgewood from

    Culnen and Hamilton          $ 3,659,017.41

   Checks written from Culnen and

    Hamilton on behalf of Wedgewood      501,918.22

   Dan's purchase of Dr. Nagle's interest    568,152.17

   Other Items                 737,733.27

   Interest Accrued               616,070.49

                       _____________

    Total                 $ 6,082,891.56

                       =============

   Of this total, $ 300,000 is classified as Capital Stock in

   Wedgewood Associates, and $ 300,000 is Dan's cost of

   purchasing Manning's partnership interest. $ 568,152.17 is Dan's

   cost for Nagle's interest in stock and partnership. This leaves

   a balance of $ 4,914,739.39 as a loan to the corporation.

Ms. Sacklow's firm also did accounting work for Wedgewood. She would assist Wedgewood's employees in keeping Wedgewood's books and would prepare Wedgewood's end-of-the-year tax returns. She testified that the Wedgewood payments were shown as an indebtedness from Wedgewood to petitioner on Wedgewood's books and records. Mr. Levin, who prepared petitioner's personal financial statements, which showed Wedgewood as an investment of petitioner's, believed "absolutely" that petitioner owned the shares of Wedgewood individually.

2. RESPONDENT'S CASE

Respondent called no witnesses and introduced no exhibits other than those attached to the stipulation. Besides respondent's argument (which we have rejected) that, because of the Wedgewood payments, petitioner is precluded from claiming basis in his Wedgewood investment, respondent's other argument is, basically, that the testimony of petitioner and his witnesses is unsupported and, thus, not to be believed.

Petitioner, Mr. Levin, and Ms. Sacklow (the witnesses) all testified that the Wedgewood payments were made by Culnen & Hamilton to Wedgewood on petitioner's behalf. The fact that the payments were made is beyond question. Indeed, during the trial, the Court asked counsel for respondent: "Mr. Ianacone, is it a fact for purposes of this case that those checks [the 46 checks] * * * were written by Culnen & Hamilton and deposited for the benefit of Mr. Culnen into the accounts of Wedgewood? Is that a fact: Yes or no?" Mr. Ianacone responded: "Yes, it is." Thus, the only question subject to proof is whether the Wedgewood payments were made by Culnen & Hamilton on behalf of petitioner. While it is true that there are no original Culnen & Hamilton accounting records in evidence (other than copies of its tax returns), the Sacklow letter is in evidence, and it supports the testimony of the witnesses. Ms. Sacklow testified that she prepared the Sacklow letter from the books and records of Culnen & Hamilton, and she traced the treatment of the Wedgewood payments from the bookkeeper's scheduling of them through her (Ms. Sacklow's) classification of them as loans to petitioner, to their entry onto the books and records of Culnen & Hamilton. *190 that petitioner justifiably concluded that the content of Culnen & Hamilton's books was not an issue in this case. Respondent's claim that, essentially, the witnesses' testimony should be disregarded because it is unsupported is not persuasive.

Beyond respondent's claim that petitioner's witnesses' testimony is unsupported, respondent makes unsupported, unpersuasive, and offensive attacks on the credibility of petitioner and the ethics of his witnesses. There are legitimate issues in this case, but the ethics of petitioner's witnesses are not among them. Respondent has, here, all too clearly relied on the tactic of trial by cross- examination, and that tactic has failed. A resort to name-calling is not an acceptable fallback position. We disapprove of that tactic.

E. CONCLUSIONS

We conclude, and find, that petitioner had adequate adjusted basis in his Wedgewood investment to deduct his pro rata share of Wedgewood's losses for 1987, 1989, and 1990 and his share of the Form 4797 loss (if any). *192 the assets were subject to liens of secured creditors totaling $ 1,865,000 (the liens). Wedgewood's adjusted basis in the assets at the time of disposition was $ 2,506,244. Pursuant to the deed, Wedgewood received nominal consideration of $ 1, and the disposition was part of a bankruptcy-like proceeding carried out under the laws of New Jersey. See N.J. Stat. Ann. secs. 2A:19-1 to 2A:19-50 (West 1987). The disposition was to an assignee for the benefit of Wedgewood's creditors (the assignee), whose duty it was to liquidate the assets and apply the proceeds to reduce Wedgewood's indebtedness. See In re: Gen. Assignment for Benefit of Creditors, 66 N.J. Super. 423">66 N.J. Super. 423, 169 A.2d 236">169 A.2d 236 (N.J. Super. Ct. 1961).

B. CODE AND REGULATIONS

In pertinent part, section 1001(a) provides that the loss from the disposition of property shall be the excess of the adjusted basis in the property over the amount realized. As used in section 1001(a), the term "amount realized" is defined in section 1001(b). In pertinent part, that definition is: "The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. " Section 1.1001-2, Income Tax Regs., addresses the discharge of liabilities in connection with the disposition of property. Paragraph (a)(1) of section 1.1001-2, Income Tax Regs., provides the general rule that the amount realized from the sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the disposition. Paragraph (a)(4) of section 1.1001-2, Income Tax Regs., provides that, for purposes of that section, the sale or other disposition of property that secures a nonrecourse liability discharges that liability. Paragraph (b) of section 1.1001-2, Income Tax Regs., provides that, generally, the fair market value of the security at the time of sale is not relevant for determining the amount of liabilities from which the taxpayer is discharged, or treated as discharged.

C. DISCUSSION

Respondent's position is that Wedgewood did not realize any loss. Petitioner's position is that, since Wedgewood's adjusted basis in the assets exceeded the $ 1 received pursuant to the deed, of course it suffered a loss. Petitioner has failed to prove that $ 1 was the full amount realized on the disposition of the assets. On brief, petitioner states: "Wedgewood's liabilities greatly exceeded the fair market value of its assets." That may be so. Nevertheless, petitioner has failed to show that the indebtedness secured by the liens was other than nonrecourse. If it was nonrecourse, then, notwithstanding the fair market value of the assets subject to those liens, the amount realized on the disposition of those assets included the amount of the liens, $ 1,865,000. We assume that the liquor license and liquor inventory were sold for $ 126,000. ^{*195 D. CONCLUSION}

We find that Wedgewood realized a loss of $ 515,243 on the disposition of the assets. Petitioner's pro rata share of that loss was $ 376,127 (i.e., 73 percent of $ 515,243). We have already found in section II.E., supra, that petitioner had sufficient basis to deduct his pro rata share of the Form 4797 loss, $ 376,172.

Decisions will be entered under Rule 155.

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Footnotes

• 1. The record is unclear with regard to the total value of the liquor license and liquor inventory. While they were the only assets listed as having value, the statement of assets listed the total value of assets as $ 110,000 (not $ 101,000).↩

• 2. The amounts for each year are as follows:

  ↩

  Year	Amount
  ----	------
  1987	$ 1,968,000.00
  1988	1,691,537.36
  1989	368,410.05
  1990	6,070.00
  Total	4,034,017.41

• 3. The amounts for each year are as follows:

  ↩

  Year	Amount
  ----	------
  1989	$ 97,078.50
  1990	404,130.86
  1991	683.86
  1992	25.00
  Total	501,918.22

• 4. The amounts for each year are as follows:

  ↩

  Year	Amount
  ----	------
  1987	$ 335,000.00
  1989	80,214.07
  1990	152,938.10
  Total	$ 568,152.17

• 5. The amounts for each year are as follows:

  ↩

  Year	Amount
  ----	------
  1987	$ 72,143.21
  1988	300,000.00
  1989	202,000.00
  1990	135,061.97
  1991	28,528.09
  Total	737,733.27

• 6. In the statutory notice of deficiency, respondent sets forth numerous grounds for disallowing the $ 1,759,987 loss. On brief, respondent's principal argument (other than that petitioner lacks sufficient adjusted basis in his investment in Wedgewood) is that petitioner has failed to show that Wedgewood realized any loss. We assume that respondent has conceded any other grounds.↩

• 7. Although respondent denies that the Wedgewood payments represent petitioner's cost in obtaining his Wedgewood investment, respondent agrees with our finding that, for 1987 through 1990, petitioner's percentage ownership in Wedgewood increased from 39.48 to 73 percent. Petitioner testified credibly that all of his investment in Wedgewood was reflected in the Wedgewood payments. We cannot reconcile respondent's agreement that petitioner owned a substantial portion of Wedgewood's shares with his argument that the Wedgewood payments constitute an investment by Culnen & Hamilton.↩

• 8. Sec. 1374(c)(2)(B)↩, as in effect at the time, determined basis in indebtedness as of the close of the corporation's year.

• 9. By the stipulation, respondent reserved the right to make a relevance objection to the Sacklow letter, but respondent waived all other evidentiary objections, including an objection based on hearsay. See Fed. R. Evid. 802↩.

• 10. Ms. Sacklow testified that consistent entries were made on the books and records of Wedgewood.↩

• 11. Apparently, respondent's position is that none of the Wedgewood payments add to petitioner's adjusted basis in his Wedgewood investment (but see supra note 7). Petitioner's position is that all of the Wedgewood payments add to petitioner's adjusted basis in his Wedgewood investment. We have not made specific findings as to the amount of petitioner's adjusted basis in his Wedgewood investment for each of the years here in question because we believe that the parties are in agreement that we should make an across-the-board decision with respect to the Wedgewood payments.↩

• 12. According to Wedgewood's Form 4797 for taxable year 1990, the liquor license sold for $ 125,000. We add to that amount the $ 1,000 listed value of the liquor inventory from the deed for $ 126,000.↩