DocketNumber: No. 8049-01
Citation Numbers: 2003 T.C. Memo. 295, 86 T.C.M. 472, 2003 Tax Ct. Memo LEXIS 297
Judges: Laro
Filed Date: 10/23/2003
Status: Non-Precedential
Modified Date: 4/18/2021
*297 Decision was entered for respondent in part and for petitioner in part.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Petitioner petitioned the Court to redetermine deficiencies of $ 35,742 and $ 26,756 in his 1995 and 1996 Federal income taxes, respectively. Following concessions, 1 we decide:
1. Whether the notice of deficiency is "arbitrary". We hold it is not.
2. Whether petitioner*298 may deduct a forgiven debt in the amount claimed on his 1995 tax return. We hold he may.
3. Whether petitioner was personally engaged in the trade or business of developing industrial real estate. We hold he was.
4. Whether petitioner may under
5. Whether petitioner may under
FINDINGS OF FACT
Some facts were stipulated. The stipulated facts and the accompanying exhibits are incorporated herein by this reference. We find the stipulated facts accordingly. Petitioner resided in Rochester Hills, Michigan, when the petition was filed.
Petitioner's Business Pursuits
Petitioner has been*299 a business associate of Keith Pomeroy (Pomeroy) since the early 1980s. In 1983, he and Pomeroy entered into a Development Agreement (1983 Development Agreement). It provided, in relevant part:
1. Purpose. The principal purpose of the Parties acting
together is to acquire, hold, develop, operate, and sell various
real estate and building projects, primarily, although not
exclusively, nursing homes and housing for the elderly. The
Parties shall contribute equally funds as are required to
acquire, hold, develop, operate and/or sell projects that are
subject to this Agreement, and each shall own an undivided one-
half interest in such projects. Only those projects will be
acquired and developed on which there is unanimous agreement.
Either Party may decline to participate in any project for any
reason whatsoever. In such case, the other Party may not proceed
with such project individually.
Pursuant to the 1983 Development Agreement, petitioner and Pomeroy through the years have organized numerous entities primarily to acquire, develop, manage, and operate commercial real estate. Petitioner*300 directly owned an interest in approximately 21 real- estate-related entities during the subject years and was involved with numerous other entities primarily by virtue of contractual relationships through the entities which he owned. The relevant entities are Arbor Corporation (Arbor), Peachwood Nursing Center (PNC), H.K. Peach, Inc. (H.K. Peach), REH1 Corporation (REH1), TROY- SAK Associates (TROY-SAK), Lakeland Neuro Care Limited Partnership (Lakeland), and Crittenton Development Center (Crittenton).
Arbor was an S corporation that handled the day-to-day record-keeping and management of the entities owned in whole or in part by petitioner and Pomeroy. Its stock was owned equally by petitioner and Pomeroy until 1996 when Pomeroy transferred all of his stock in Arbor to petitioner in connection with the lawsuits discussed infra. Arbor employed and paid the management staff for the nursing homes that it managed. These management fees were then charged to the nursing home to the benefit of which the services in question inured. Petitioner was Arbor's president and managed its daily affairs.
H.K. Peach was an S corporation owned equally by petitioner and Pomeroy. PNC was a partnership*301 formed for the purpose of leasing certain land and nursing homes constructed thereon. PNC, an accrual basis taxpayer, was owned equally by H.K. Peach and Crittenton. REH1 was an S corporation which owned and operated the industrial real estate properties. REH1 was owned 25 percent by petitioner, 25 percent by Pomeroy, and 50 percent by other unrelated individuals. TROY-SAK was a real estate partnership owned 25 percent by petitioner and 75 percent by Pomeroy and two other individuals whose names are not material to this case. Lakeland was a partnership owned 90 percent by REH1 and 10 percent by an unrelated entity named CMS Lakeland, Inc. Lakeland was formed for the purposes of owning, developing, leasing, and operating a certain subacute rehabilitation unit. Crittenton was a real estate development entity owned by persons unrelated to petitioner and Pomeroy.
Debt Settlement
Peachwood Center Associates (PCA) 3 owned certain property which it leased to PNC. Beginning in 1989, PNC sublet the property to Lakeland. Shortly thereafter, Lakeland disputed the amount of rent payable under the sublease agreement and declined to pay the amount of that rate. The situation resulted in an arbitration*302 proceeding between Lakeland, on the one hand, and PCA and PNC, on the other hand. The parties to the arbitration proceeding resolved that and at least one other proceeding (the Oakland 2 lawsuit described infra in which PCA and Crittenton sued petitioner, Pomeroy, Arbor, and PNC) through an agreement that included a debt settlement agreement (debt settlement agreement) and a related redemption agreement (redemption agreement).
Pursuant to the debt settlement agreement, dated November 22, 1995, Lakeland agreed to pay PNC $ 600,000 in settlement of $ 992,796 of disputed rent that PNC consider owed (and had accrued as income) on the sublease. Lakeland agreed to pay $ 200,000 of the $ 600,000 immediately and make subsequent annual payments of at least $ 100,000 until the entire $ 600,000 (exclusive of interest at the prime rate) was fully discharged. The debt*303 settlement agreement provided:
Notwithstanding anything contained herein to the contrary, the
terms of this Agreement shall be contingent upon the
consummation of the contemplated redemption of Crittenton
Development Corporation's interest in Peachwood Center
Associates and Peachwood Nursing Center. Keith J. Pomeroy and
Horace D'Angelo Jr. hereby agree to pursue in good faith the
consummation of said redemption on an expeditious basis.
Pursuant to the redemption agreement, dated November 30, 1995, PNC redeemed Crittenton's 50-percent interest for cash. As of that date, PNC terminated for income tax purposes pursuant to
Because of the mandatory redemption of Crittenton and the resulting termination of PNC, PNC and H.K. Peach considered the eliminated debt of $ 392,796 (the original debt of $ 992,796 less the settlement amount of $ 600,000) as a worthless debt that belonged entirely to H.K. Peach. Accordingly, on their respective 1995 tax returns, PNC did not claim a deduction for the eliminated debt, but H.K. Peach did. Petitioner and Pomeroy, each in his capacity as a 50- percent shareholder of H.K. *304 Peach, claimed for 1995 a bad debt deduction of $ 196,398 (1/2 of $ 392,796). Respondent in the notice of deficiency issued to petitioner denied his claim to his 50-percent share of the bad debt deduction.
Legal Expenses
The differences between and among petitioner, Pomeroy, and other investors led to a number of lawsuits (lawsuits). Petitioner personally paid much of the legal fees connected to the lawsuits, and he now claims that he may deduct these fees as the ordinary and necessary expenses of his business, purportedly, the development of industrial real estate. The lawsuits involved defending petitioner's business practices, compelling petitioner's business associates to account for profits, and related issues. The lawsuits were handled mainly by the law firms of Plunkett & Cooney; Williams, Schaefer, Ruby & Williams; andJacob & Weingarten.
For 1995, petitioner incurred legal expenses in the following proceedings which are at issue in this case: (1) Oakland County Case No. 91-413151-CK (Oakland 1), (2) Oakland County Case No. 89-367018-CB (Oakland 2), and (3) Oakland County Case No. 93-455713 CK (Oakland 3). Oakland 1 was a lawsuit by Arbor against Pomeroy and others, to which petitioner was later added as a cross-plaintiff. The proceeding essentially involved claims of diversion of management fees and breach of fiduciary*305 duty. Oakland 2 was a lawsuit by PCA and Crittenton against petitioner, Pomeroy, Arbor, and PNC. The proceeding generally involved claims of breach of fiduciary duty, failure to pay rent, and failure to make appropriate partnership contributions. Oakland 3 was a lawsuit in which Pomeroy had accused petitioner of, among other things, taking over H.K. Peach and otherwise breaching his fiduciary duty. With respect to all these proceedings, petitioner claimed in 1995 as a deduction legal fees of $ 90,392 (relating to Oakland 1 and Oakland 2) and $ 770 (relating to Oakland 3).
For 1996, petitioner incurred legal expenses in the following proceedings which are at issue in this case: (1) Oakland 1, (2) Oakland 2, (3) Oakland County Case No. 91-413076-CK (Oakland 4), and (4) Oakland County Case No. 93-455889 (Oakland 5). Oakland 4 was a lawsuit where petitioner sued individually and on behalf of REH1 as coplaintiffs. The case included an allegation against Pomeroy and others for a failure to account for profits. Oakland 5 was a lawsuit by Pomeroy and his business partner, whose name is not material to this proceeding, to compel petitioner to turn over his partnership interest in TROY-SAK*306 pursuant to an agreement. In 1996, petitioner claimed as a deduction legal fees of $ 57,799 (relating to Oakland 1, Oakland 2, Oakland 3, Oakland 4, and Oakland 5).
Respondent maintains that petitioner may not deduct these amounts because he is not engaged in "any trade or business" within the meaning of
Office Expenses
For 1995, petitioner deducted $ 14,065 of expenses, which he personally bore after moving the office and the staff of Arbor into a house he owned. The move was precipitated by disagreements that had arisen between petitioner and Pomeroy. Petitioner and some of the Arbor employees worked in the office. Those employees were a bookkeeper, an administrative assistant, an individual responsible for Medical/Medicaid costing reports, a comptroller, a secretary, and another individual responsible for maintenance, landscaping, computers, and marketing.
The expenses deducted by petitioner included costs of furniture, asphalt repair, water softener, and other items. Respondent asserts that these expenses belong to Arbor and thus cannot be deducted by petitioner personally. Additionally, respondent*307 maintains that the following items should be capitalized and, if deductible, depreciated:
Expense Amount
Table $ 171
Water softener 188
Asphalt repair 1,850
Furniture 338
OPINION
In general, respondent's determinations are presumed correct, and taxpayers bear the burden of proving them wrong.
In that the record is sufficient for us to decide this case on its merits based on a preponderance of the evidence, we need not and do not decide which party bears the burden of proof in this case as to the substantive issues. We note, however, that we disagree with petitioner's assertion that the notice of deficiency is arbitrary because it, unlike a notice of deficiency issued to Pomeroy, did not include or refer to an exhibit that explained the income-adjustment allocations relating to H.K. Peach. The notice of deficiency at hand correctly identified petitioner, stated the disallowed amounts and the years to which they pertain, and adequately explained the calculations employed in arriving at them.
The parties agree that the $ 392,796 bad debt deduction resulted from the forgiveness in the debt settlement agreement of that amount of accrued rent and, more specifically, a settlement of the proceedings discussed above. The parties do not dispute that PNC was entitled to deduct the eliminated debt as a bad debt but challenge only the amount of that deduction allocable to petitioner.
Petitioner argues on brief that the debt was settled after Crittenton's termination*309 and that he, as a 50-percent shareholder of H.K. Peach, is entitled to deduct half ($ 196,398) of the debt. Petitioner focuses primarily on respondent's reference to the all events test and argues that this test was not met before Crittenton's redemption in that the redemption was a vital term of settlement. Alternatively, petitioner argues, respondent's earlier resolution of this issue, coupled with respondent's representations to the Court, means that respondent is now estopped from challenging the amount of his deduction in this proceeding.
Respondent argues on brief that the debt was settled before Crittenton's termination. Thus, respondent concludes, only half ($ 196,398) of the bad debt flowed through to H.K. Peach (the other half flowing through to Crittenton), and petitioner may deduct only half of that half (in other words, $ 98,199). Respondent reads PNC's pretermination financial statements to indicate that petitioner, in his capacity as president of Arbor, believed that the debt was settled before Crittenton's (and hence PNC's) termination. In particular, respondent observes, PNC recorded in those statements a $ 600,000 note receivable that it received from Lakeland in*310 connection with the debt settlement agreement. Respondent makes no mention of the terms of redemption in the debt settlement agreement but considers the reporting of the $ 600,000 note receivable to be dispositive of this issue.
On the basis of the facts and circumstances of this case, we hold for petitioner. We conclude from our reading of the debt settlement agreement that the $ 392,796 was not forgiven until after the redemption of Crittenton. The parties to that agreement went to great lengths to memorialize their understanding that this redemption was a condition precedent to the settlement of the debt. Respondent has not alleged that the debt settlement agreement was a sham or that the terms thereof should be disregarded by the Court. We respect the express terms of the debt settlement agreement and hold for petitioner. 4H.K. Peach, PNC's successor, may deduct the entire amount of the eliminated debt, and petitioner, as a 50-percent shareholder of H.K. Peach, may deduct $ 196,398, or one-half of the entire amount.
Petitioner argues that his extensive involvement in real estate business ventures places him in a trade or business of developing industrial real estate during the subject years. Respondent maintains that petitioner's involvement with the real estate has always been on behalf of Arbor. Respondent concludes that petitioner was not personally engaged in a trade or business. We agree with petitioner.
Petitioner began his real estate career more than 20 years ago. In 1995 and 1996, he was actively involved in developing the industrial real estate and nursing home businesses, in accordance with the terms of the 1983 Development Agreement. Over the years, petitioner and Pomeroy, alone and sometimes with others, built a number of industrial rental and nursing home rental partnership enterprises. Petitioner personally ran a substantial part of the operations, supervising Arbor's management activities and the partnerships' rental activities. Petitioner was also in charge of applying for and procuring the licenses necessary to conduct the operations relating to nursing homes within the State of Michigan.
A general partner may be deemed to be conducting*312 the trade or business activity of the partnership in which he or she is a member.
Respondent concedes that petitioner was materially involved in*313 developing the real estate and nursing home businesses. Nevertheless, respondent argues that at all times when petitioner was so involved, he was acting on behalf of Arbor. The record as a whole indicates otherwise.
We agree that merely providing services to a corporation to increase its value does not rise to the level of a trade or business other than a trade or business of performing services as an employee. However, while petitioner did devote substantial time and effort to running the business of Arbor, his activities were not so limited. Petitioner was actively involved in procuring licenses for operation of nursing homes, selecting location of buildings and their design, and similar engagements. Moreover, the 1983 Development Agreement attests to the intention of petitioner and Pomeroy to engage in a trade or business of developing "various real estate and building projects, primarily, although not exclusively, nursing homes and housing for the elderly." The record demonstrates that petitioner fulfilled that intention during the years in question.
A trade or business is a continuous and regular vocation engaged in for profit. See generally
At issue here are professional fees of $ 770 and $ 90,392 for 1995, and $ 57,799 for 1996. These amounts were incurred by petitioner in the course of his participation in several lawsuits in the Oakland County District Court in his capacity as an officer, partner, and/or shareholder of the entities he owned in whole or in part.
Petitioner maintains that these amounts are deductible by him under
Just because a particular expense fits within the literal language of
As we recently noted in
Here, the correct legal framework in determining whether the disputed legal fees are deductible is the origin of the claim test.
The first disputed fee, $ 770, relates to Oakland 3. The complaint by Pomeroy in this case alleged that petitioner, in his capacity as president of H.K. Peach, had seized control of the corporation and had operated the corporation "as his private fiefdom, *318 " to the exclusion of Pomeroy. The complaint alleged further that petitioner, in his capacity as a director, officer, and shareholder of H.K. Peach, "has engaged in a course of action constituting illegal, fraudulent, willfully unfair and oppressive acts", including the establishment of certain bank accounts, purportedly authorized by the board of directors of H.K. Peach, the fact of which authorization was denied by Pomeroy. Remedies sought by Pomeroy included attorney's fees, "appropriate damages", recovery of the misappropriated funds on behalf of H.K. Peach, and dissolution and liquidation of the assets and business of H.K. Peach.
Applying the test of
The "origin of the claim" test yields the same result. In Oakland 3, the origin of the claim was Pomeroy's allegations that petitioner had breached his fiduciary duty and mismanaged the entities. Petitioner's defense was no more than an attempt to preserve the status quo; namely, to defend his business practices against those allegations and to preserve his already established position within H.K. Peach. Petitioner did not attempt to create a separate or distinct asset, produce a significant future benefit, or acquire a capital asset. See
Respondent relies exclusively on
The second portion of the disputed legal expenses, $ 90,392, was incurred by petitioner with respect to Oakland 1 and Oakland 2. Oakland 1 was brought against Pomeroy and others, and involved claims of diversion of Arbor funds to Pomeroy's own management company, failure to pay to Arbor the management fees to which it was entitled, and breach of fiduciary duty. The remedies sought in that proceeding included restitution and exemplary damages. Claims in Oakland 2 focused on the alleged breach of fiduciary duty by petitioner and Pomeroy, and their purported financial manipulation of Crittenton through "corporate instrumentalities" *321 which included H.K. Peach, Arbor, and PNC. This proceeding also involved claims of failure to pay rent on the part of PNC and failure to make partnership contributions by H.K. Peach.
For reasons similar to those described above as to the $ 770, we conclude that the Lincoln Sav. & Loan Association test has been met as to the $ 90,392. Our analysis of the origin of the claim test here is also similar to that of the fees relating to Oakland 3. We find that in Oakland 1, petitioner's position originated from his desire to negate the claims of breach of fiduciary duty and diversion of fees. In addition, he counterclaimed against Pomeroy under the same theories. Regardless of the success of those claims, petitioner did not seek to create a separate or distinct asset, produce a significant future benefit, or acquire a capital asset. Again, to the extent a benefit inured to petitioner by virtue of defending and counterclaiming in this lawsuit, it appears to us more immediate than future, in that an imminent harm to petitioner would ensue if he failed to defend himself in this proceeding.
Examination of the fees incurred in Oakland 2 yields the same result. Those fees were (1) paid or incurred*322 during 1995, (2) incurred in connection with carrying on petitioner's trade or business, (3) an expense, (4) a necessary expense in that petitioner's participation in the lawsuit was mandated by virtue of claims brought against him, and (5) an ordinary expense in that businessmen such as petitioner, who are actively and closely involved in a trade or business, are subject to litigation and to incurring the associated expenses. As for the origin of the claim in Oakland 2, we do not find the claim to have sought to create a separate or distinct asset, produce a significant future benefit, or acquire a capital asset.
Again, respondent argues that the similarity of these claims to those in
Respondent also notes that Oakland 2 involved a claim for failure to make partnership contributions. Citing
The last segment of the legal expenses at issue pertains to 1996. That amount ($ 57,799) was incurred during that year by petitioner in connection with Oakland 1, Oakland 2, Oakland 3, Oakland 4, and Oakland 5. As we have already discussed the deductibility of the litigation expenses relating to the first three proceedings and find the reasoning equally applicable here, we focus our analysis on the fees relating to Oakland 4 and Oakland 5.
Petitioner brought the Oakland 4 suit individually and as a shareholder of REH1. The suit included claims for breach of fiduciary duty by Pomeroy and others, by virtue of their managing the affairs of REH1 to the exclusion of petitioner and to the possible detriment to REH1. Petitioner sought the appointment of a receiver for REH1 and damages for failure to account for and distribute corporate profits to petitioner and REH1.
In Oakland 5, petitioner was forced to defend against Pomeroy and others who were trying to compel the surrender of his interest in*325 TROY-SAK pursuant to the terms of the TROY-SAK partnership agreement. In response to petitioner's earlier action for dissolution of TROY-SAK and motion for preliminary injunction to arrest the development of this proceeding, the plaintiffs in Oakland 5 sought a court order compelling petitioner to transfer his partnership interest in TROY-SAK to them, so as to achieve the termination of the partnership on their terms.
Under the Lincoln Sav. & Loan Association test, the fees in Oakland 4 were (1) paid or incurred during 1996, (2) incurred in connection with carrying on petitioner's trade or business, (3) an expense, (4) a necessary expense in that petitioner was fulfilling his fiduciary duty by bringing the lawsuit, and (5) an ordinary expense in that breaches of fiduciary duty are not uncommon in business affairs. Furthermore, the claims in this proceeding did not have as their origin the creation of a separate or distinct asset, production of a significant future benefit, or an acquisition of a capital asset. Petitioner instead sought to enforce the fulfillment of the fiduciary duty owed to REH1 by Pomeroy and others. We conclude that the fees relating to Oakland 4 are deductible*326 under
Further, we find the fees relating to Oakland 5 to have been (1) paid or incurred during 1996, (2) incurred in connection with carrying on petitioner's trade or business of developing real estate as they relate to his involvement with TROY-SAK, (3) an expense, (4) a necessary expense in that petitioner was required to defend himself in a lawsuit, and (5) an ordinary expense in that souring of business relationships between the partners is a routine business reality. See
In view of the above, we hold that petitioner may deduct the legal fees in the amounts of $ 770 and $ 90,392 for 1995 and $ 57,799 for 1996.
For 1995, petitioner deducted $ 14,065 of office expenses as expenses*327 paid in carrying on his trade or business. Petitioner and some of the Arbor employees worked in the office. Evidence in the record supports the conclusion that Arbor was an "umbrella" entity organized to develop and manage industrial real estate and nursing homes owned by petitioner and his co-venturers. The office in question was used by petitioner to house Arbor's intended business activities. The expenses at issue are those of Arbor, not those of petitioner. Thus, he cannot deduct the fees at issue under
Nor do we find any evidence of payment of rent by Arbor to petitioner, so as to justify writing off the office expenses by him personally, in his capacity as a landlord, under
Short of disregarding*328 the corporate integrity of Arbor for petitioner's benefit, we see no basis for allowing petitioner to personally expense Arbor's office costs. We hold that the $ 14,065 of office expenses may not be deducted by petitioner.
We have considered all arguments of the parties related to our holdings set forth herein and, to the extent not discussed herein, find those arguments to be irrelevant or without merit.
Decision will be entered under
1. In addition to the explicit concessions, we consider petitioner to have conceded respondent's determination that he is entitled to deduct certain prepaid expenses in 1996, not in 1995. Petitioner failed to advance any arguments as to this issue in his brief. Accordingly, we deem the issue abandoned.
2. Unless otherwise stated, section references are to the applicable versions of the Internal Revenue Code, Rule references are to the Tax Court Rules of Practice and Procedure, and dollar amounts are rounded to the nearest dollar.↩
3. Peachwood Center Associates was a partnership in which petitioner and Pomeroy each owned a 25-percent interest in 1995 and a 50-percent interest in 1996.↩
4. On the basis of our holding, we need not and do not discuss petitioner's alternative argument.↩
5. The parties stipulated allocating 50 percent of the $ 90,392 at issue to Oakland 2.↩
Flood v. United States , 133 F.2d 173 ( 1943 )
E.A. Brannen and Frances K. Brannen v. Commissioner of ... , 722 F.2d 695 ( 1984 )
Dwight A. Ward v. Commissioner of Internal Revenue, Hanna P.... , 224 F.2d 547 ( 1955 )
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Oliver v. Commissioner of Internal Revenue , 138 F.2d 910 ( 1943 )
Raymond Bauschard v. Commissioner of Internal Revenue , 279 F.2d 115 ( 1960 )
Kornhauser v. United States , 48 S. Ct. 219 ( 1928 )
Robert P. Wilcox v. Commissioner of Internal Revenue , 848 F.2d 1007 ( 1988 )
Moline Properties, Inc. v. Commissioner , 63 S. Ct. 1132 ( 1943 )
Welch v. Helvering , 54 S. Ct. 8 ( 1933 )
Interstate Transit Lines v. Commissioner , 63 S. Ct. 1279 ( 1943 )
Commissioner v. Idaho Power Co. , 94 S. Ct. 2757 ( 1974 )
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Woodward v. Commissioner , 90 S. Ct. 1302 ( 1970 )
Metrocorp, Inc. v. Commissioner , 116 T.C. 211 ( 2001 )
Ward v. Commissioner , 20 T.C. 332 ( 1953 )
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Commissioner v. Groetzinger , 107 S. Ct. 980 ( 1987 )
Indopco, Inc. v. Commissioner , 112 S. Ct. 1039 ( 1992 )