Судебные дела / Зарубежная практика / AMW Investments, Inc. v. Commissioner., United States Tax Court - Memorandum Decision, T.C. Memo. 1996-235, Docket No. 3901-94., Filed May 22, 1996

AMW Investments, Inc. v. Commissioner., United States Tax Court - Memorandum Decision, T.C. Memo. 1996-235, Docket No. 3901-94., Filed May 22, 1996

24.06.2008

AMW Investments, Inc. v. Commissioner.

United States Tax Court - Memorandum Decision

T.C. Memo. 1996-235

Docket No. 3901-94.

Filed May 22, 1996.

Robert E. Miller, Farmington Hills, Mich., and Edith S. Thomas, for the petitioner. Alexandra E. Nicholaides and Eric R. Skinner, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: AMW Investments, Inc., petitioned the Court to redetermine the following deficiencies in Federal income taxes, additions to tax, and accuracy-related penalties determined by respondent:

Following concessions, we must decide:

1. Whether petitioner's payments to an escrow account (the Fund) are deductible as ordinary and necessary business expenses. We hold they are not.

2. Whether petitioner's payments to its sole shareholder are deductible as interest. We hold they are not.

3. Whether petitioner is liable for the additions to tax for delinquency determined by respondent under section 6651(a)(1). We hold it is.

4. Whether petitioner is liable for the addition to tax for negligence or intentional disregard of rules or regulations determined by respondent under section 6653(a). We hold it is.

5. Whether petitioner is liable for the accuracy-related penalties for negligence or intentional disregard of rules or regulations determined by respondent under section 6662. We hold it is.

Unless otherwise stated, section references are to the Internal Revenue Code in effect for the years in issue. Rule references are to the Tax Court Rules of Practice and Procedure. Dollar amounts are rounded to the nearest dollar. We refer to Harry V. Mohney as Mr. Mohney. We refer to petitioner's taxable year ended August 31, 1989, as the 1988 taxable year. We refer to petitioner's taxable year ended August 31, 1990, as the 1989 taxable year. We refer to petitioner's taxable year ended August 31, 1991, as the 1990 taxable year.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of facts and attached exhibits are incorporated herein by this reference. Petitioner's principal place of business was in Durand, Michigan, when it petitioned the Court. Petitioner filed a Form 1120, U.S. Corporation Income Tax Return, for each year in issue using a fiscal year ended August 31 and an accrual method of accounting. The 1988, 1989, and 1990 Forms 1120 were filed on August 15, 1991, March 6, 1992, and July 17, 1992, respectively.

Petitioner was incorporated on August 24, 1977, to purchase real property and to lease this property primarily to businesses engaged in adult entertainment. From its incorporation through August 31, 1988, petitioner was a wholly owned subsidiary of Dynamic Industries, Ltd. (Dynamic). During the subject years, Mr. Mohney owned all of petitioner's voting stock, and he was its president. At all times relevant herein, petitioner was a member of an organization of over 50 businesses that were engaged in the adult entertainment industry. All of these businesses were wholly or partially owned by Mr. Mohney, either directly or indirectly through various trusts.

In 1966, Mr. Mohney had started acquiring (and operating as sole proprietorships) numerous enterprises that were primarily engaged in adult entertainment. The assets of these enterprises included theaters, bookstores, peep machines, wholesale novelty stores, film distributorships, and "showgirl" clubs. As Mr. Mohney's business dealings evolved over time and he began to gain greater notoriety, his reputation as a proprietor of adult entertainment establishments preceded him and affected the future expansion of his business operations into new communities. Mr. Mohney decided to purchase property through nominees due to his concerns that he would encounter legal problems if he purchased property in his own name. For example, his mother was the nominee when he purchased a movie theater in Mishawaka, Indiana (Mishawaka property), on December 1, 1969, for $45,000. Mr. Mohney paid for the Mishawaka property by giving the seller $13,500 in cash and agreeing to pay the balance (with interest at 7 percent) through monthly payments of at least $500.

On October 31, 1970, Mr. Mohney purchased a drive-in theater located in Clarksville, Indiana (Clarksville property), for $120,000, signing a $114,500 promissory note (Clarksville note). From 1970 to the time that he transferred the Clarksville property to petitioner, Mr. Mohney made payments on the Clarksville note.

In the early 1970's, Mr. Mohney organized each aspect of his business as a separate corporation. Mr. Mohney also established five domestic trusts, of which he and his four children were beneficiaries. Each of these trusts owned an interest in another domestic trust, the Durand Trust, which owned all the stock of Dynamic, which owned many of Mr. Mohney's operating companies.

Shortly after petitioner's incorporation, Mr. Mohney transferred to it the Mishawaka property and the Clarksville property. ¹ The transfer was not negotiated, and the deeds on the Clarksville property and the Mishawaka property were recorded on September 5, 1978 and March 21, 1980, respectively. In connection with the transfer, petitioner assumed liability on the Clarksville note, the principal of which was then $34,350. Petitioner also issued Mr. Mohney a promissory note for the Clarksville property (Second Clarksville note). ² The Second Clarksville note stated that petitioner was to pay Mr. Mohney $120,000 on or before November 3, 1982. It set forth an interest rate of 10 percent, and it was signed by petitioner's then president. Petitioner made no payments of principal or interest to Mr. Mohney during the years 1977 through 1988 on the Second Clarksville note, and Mr. Mohney did not pursue collection of the note.

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¹ Mr. Mohney's 1977 Federal income tax return did not report either transfer as a sale.

² Petitioner also alleges that it issued a $45,000 note to Mr. Mohney in connection with the transfer of the Mishawaka property. Petitioner did not produce any such note at trial, and no payments were made on the alleged note before 1989. The record does not indicate that Mr. Mohney attempted to pursue collection of any obligation from petitioner to him with respect to the Mishawaka property.

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Around 1981, Mr. Mohney asked Janet Dingeman Fournier (Ms. Fournier) to serve as petitioner's president. Ms. Fournier served in this capacity until 1988. As petitioner's president, Ms. Fournier had no meaningful responsibility other than to sign tax returns and other documents on petitioner's behalf. Aside from Ms. Fournier, petitioner had no employees. Apart from the use of company cars, Ms. Fournier received no compensation from petitioner.

From 1974 through 1993, Ms. Fournier was also an employee of Modern Bookkeeping Services, Inc. (MBS). Mr. Mohney had formed MBS to handle and centralize the bookkeeping and tax preparation aspects of his businesses. Elizabeth L. Scribner (Ms. Scribner) was MBS' president and general manager. Thomas H. Tompkins (Mr. Tompkins) was MBS' accountant, and he was responsible for preparing petitioner's Federal income returns before the subject years. Lee J. Klein (Mr. Klein) provided legal services to MBS and MBS' clients.

Petitioner's financial affairs were maintained at MBS' office in Durand, Michigan, and MBS maintained all of petitioner's files, including its bank accounts, cash receipts journals, cash disbursements journals, and lease files. MBS paid petitioner's bills on behalf of it, and MBS prepared petitioner's financial statements. MBS charged petitioner a fee of $1,000 per month for its bookkeeping services.

In 1984, Federal agents, investigating a pattern of arsons at adult theaters, searched MBS' premises and seized books and records which included those of petitioner. In connection with this search, a grand jury, on September 9, 1988, handed down a seven-count indictment against Mr. Mohney, Ms. Scribner, Mr. Tompkins, and Mr. Klein (collectively referred to as the Defendants) for various criminal tax violations. The indictment generally charged that Mr. Mohney, through separate corporate tax returns, concealed his ownership of several adult-oriented businesses and filed false personal tax returns. The other defendants, who were all employees of MBS, were charged only in count I of the indictment. Count I charged the Defendants with conspiracy to defraud the Government through the concealment of ownership of the adult-oriented businesses on the tax returns, in violation of 18 U.S.C. sec. 371. The remaining counts charged Mr. Mohney with filing false individual income tax returns for the 1981, 1982, and 1983 taxable years (see sec. 7206(1)), and with aiding and assisting in the filing of false corporate income tax returns on behalf of Otis Mohney, Inc./International Amusements, Ltd. (see sec. 7206(2)). The remaining counts stemmed from the failure of International Amusements, Ltd., to report income it earned and diverted to Mr. Mohney for his personal benefit. All of the Defendants except Mr. Klein pleaded guilty to the conspiracy charge. ³ Mr. Mohney was subsequently convicted of the remaining charges, and his conviction was affirmed on appeal. United States v. Mohney [92-1 USTC ╤ 50,081], 949 F.2d 1397 (6th Cir. 1991).

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³ Mr. Klein was later convicted of this charge.

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Petitioner and all of its related corporations jointly agreed to pay the legal fees of any officer, employee, or business associate called as a witness before the grand jury or any proceeding stemming therefrom. The legal expenses that were claimed by petitioner (and that are in issue herein) were the amounts that it paid to the Fund, which was an escrow account that was established by MBS in 1985 to administer this agreement. The Fund was a separate, interest-bearing account. MBS maintained the Fund's cash receipts journal, cash disbursements journal, and check book registers. There were no written agreements prepared and signed contemporaneous to the establishment of the Fund.

Petitioner made monthly payments of $200 to the Fund. During petitioner's 1985 through 1990 taxable years, petitioner made payments to the Fund totaling $11,400. During its 1989 taxable year, petitioner paid $1,948 to the Fund. The amounts paid to the Fund were recorded by petitioner in a prepaid asset account and were not deducted by petitioner until the amounts were spent by the Fund. As of September 1990, a total of $1,333,350 had been paid to the Fund by the various corporations.

David Shindel (Mr. Shindel) is a certified public accountant who was retained by Mr. Klein in 1987, on behalf of MBS and several of its clients, to review their corporate books and records for compliance with accounting practice and tax law. Upon reviewing petitioner's books, Mr. Shindel noticed the Second Clarksville note. Mr. Shindel brought this note to the attention of Mr. Mohney, recommending that it be satisfied with accrued interest. Mr. Shindel also recommended that the "note" on the Mishawaka property be satisfied with accrued interest. During 1989 and 1990, petitioner paid Mr. Mohney the balance due on the Mishawaka and Clarksville properties plus accrued interest. Petitioner deducted $55,000 and $105,000 as interest on its 1990 and 1991 returns respectively.

Mr. Shindel prepared all of petitioner's Federal tax returns that are in issue herein.

OPINION

1. Legal Expenses

We must decide whether petitioner may deduct its contributions to the Fund as ordinary and necessary business expenses under section 162(a). Petitioner argues that it may. Petitioner contends that these contributions were tied directly to its business because the contributions were made to protect or promote its business interest. Respondent argues that the Fund paid the Defendants' personal expenses. Petitioner bears the burden of proof. Rule 142(a); Welch v. Helvering [3 USTC ╤ 1164], 290 U.S. 111, 115 (1933).

We agree with respondent that the contributions are not deductible under section 162(a). Generally, a taxpayer may not deduct an expense of another person, Deputy v. duPont [40-1 USTC ╤ 9161], 308 U.S. 488 (1940); J. Cordon Turnbull, Inc. v. Commissioner [Dec. 26,428], 41 T.C. 358, 378 (1963), affd. [67-1 USTC ╤ 9220] 373 F.2d 87 (5th Cir. 1967); Royal Cotton Mill Co. v. Commissioner [Dec. 22,825], 29 T.C. 761, 788 (1958), and may not deduct expenses which are personal in nature, sec. 262; Johnson v. Commissioner [Dec. 36,068], 72 T.C. 340, 348 (1979). An exception is found where the taxpayer pays for legal services rendered to another person, in order to protect or promote the taxpayer's business interests. Commissioner v. Tellier [66-1 USTC ╤ 9319], 383 U.S. 687 (1966) (corporation could deduct legal fees of another when the related litigation threatened the corporation's existence); Commissioner v. Heininger [44-1 USTC ╤ 9109], 320 U.S. 467, 475 (1943); Gould v. Commissioner [Dec. 33,167], 64 T.C. 132, 134-135 (1975); Lorhrke v. Commissioner [Dec. 28,570], 48 T.C. 679, 684-685 (1967); Pepper v. Commissioner [Dec. 24,995], 36 T.C. 886, 895 (1961); Catholic News Publishing Co. v. Commissioner [Dec. 16,212], 10 T.C. 73, 77 (1948). The origin of the claim that gave rise to the legal fees, rather than the consequences of the underlying action, must be evaluated to ascertain whether the fees are business or personal in nature. United States v. Gilmore [63-1 USTC ╤ 9285], 372 U.S. 39 (1963). The fact that legal fees are paid by a taxpayer on behalf of another person's criminal defense will not foreclose a deduction by the taxpayer when the alleged criminal activity relates to the taxpayer's trade or business. See Commissioner v. Tellier, supra; Conforte v. Commissioner [Dec. 37,205], 74 T.C. 1160, 1189-1190 (1980), affd, in part and revd. in part [82-2 USTC ╤ 9659] 693 F.2d 587 (9th Cir. 1982); Johnson v. Commissioner, supra at 347-348 (1979); cf. Pantages Theatre Co. v. Welch [4 USTC ╤ 1295], 71 F.2d 68 (9th Cir. 1934) (corporation could not deduct legal expenses paid to defend its president and majority shareholder in defense of charges that he raped a prospective client of the corporation); Sturdivant v. Commissioner [Dec. 17,990], 15 T.C. 880 (1950) (partnership could not deduct legal expenses paid to defend two of its partners and an employee charged with the murder of a business associate); Price v. Commissioner [Dec. 31,899(M)], T.C. Memo. 1973-65 (taxpayer could not deduct legal fees incurred by management consultant for criminal defense of the fraudulent sale of securities because consultant was not in the trade or business of selling securities).

In Lohrke v. Commissioner, supra at 688, the Court adopted a two prong test for determining when a taxpayer may deduct the legal expenses of another. First, the Court looked to the purpose or motive that caused the taxpayer to pay the other person's expense. Deductibility will not be denied when the expense was incurred primarily for the payor's business, and any personal benefit conferred on the other party was merely incidental to the payor's objective. Second, the Court considered whether the expenditure was an ordinary and necessary expense of the taxpayer's business. We ask ourselves: "Was the expenditure an appropriate expense to further or promote the payor's trade or business"? Id.

With respect to the first prong, petitioner alleges that it stood to suffer direct and proximate adverse effects to its business as a result of the criminal investigation. Petitioner argues that its contributions to the Fund were related to petitioner's business in that its records were seized during the search of MBS, its President was called to testify about its tax returns, its relationship to Mr. Mohney was close and direct, and it had a similar relationship with the other enterprises connected to the grand jury hearing. Petitioner contends that it, not Mr. Mohney, was the primary beneficiary of the payments to the Fund, because the grand jury investigation and subsequent criminal proceedings threatened its corporate existence. Petitioner contends that its contributions to the Fund were necessary to defend itself in proceedings in which its own tax and accounting practices may have been called into question.

We find petitioner's arguments unpersuasive. Although legal expenses related to the determination of Federal income taxes are deductible under section 162, see, e.g., Greene Motor Co. v. Commissioner [Dec. 14,623], 5 T.C. 314 (1945), and a corporate taxpayer may deduct its expense of defending against criminal tax charges, see, e.g., Shapiro v. Commissioner [60-2 USTC ╤ 9494], 278 F.2d 556 (7th Cir. 1960), affg. International Trading Co. v. Commissioner [Dec. 23,018(M)], T.C. Memo. 1958-104, petitioner has not persuaded us that the legal expenses in issue stem from a clear, direct, and proximate adverse effect upon it or its business. Petitioner was not a defendant in the criminal proceeding, and it was not named in the indictment. Rather, the indictment and the resulting prosecutions were limited to Mr. Mohney and the other Defendants. The charges did not arise from petitioner's business of leasing real property, and petitioner was not under the threat of criminal prosecution or forfeiture. See O'Malley v. Commissioner [Dec. 45,008], 91 T.C. 352, 359 (1988); Matula v. Commissioner [Dec. 26,288], 40 T.C. 914, 920 (1963); Sachs v. Commissioner [Dec. 23,666], 32 T.C. 815, 820 (1959), affd. [60-1 USTC ╤ 9414] 277 F.2d 879 (8th Cir. 1960).

While there is a possibility that some of the claimed expenditures may have had some benefit to petitioner's business, petitioner has not shown this to be true. Put simply, petitioner has failed to carry its burden of proof. ⁴ Given the fact that the charges stemmed from the personal conduct of the Defendants, we are simply not persuaded that any of the payments made by petitioner to the Fund were petitioner's business expenses. ⁵

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⁴ Petitioner contends that a criminal conviction against Mr. Mohney would damage petitioner because he was indispensable to it. We are unpersuaded. Petitioner has not shown that it would have been inoperable as a result of Mr. Mohney's criminal conviction. Petitioner has also presented no evidence that it suffered any business decline or any damage to its business relationships as a result of Mr. Mohney's prosecution and/or conviction.

⁵ We also are not convinced that the expenses were ordinary and necessary. Suffice it to say that petitioner has not proven that they were.

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2. Interest Expense

Respondent disallowed petitioner's $160,000 interest deduction on the ground that the subject properties were contributed to petitioner's capital. Petitioner argues that it may deduct the interest because it acquired the Mishawaka property and the Clarksville property from Mr. Mohney.

An accrual method taxpayer may deduct interest that has accrued within the taxable year on debt. Sec. 163(a). The term "debt" connotes an existing, unconditional, and legally enforceable obligation for the payment of money. First Natl. Co. v. Commissioner [61-1 USTC ╤ 9411], 289 F.2d 861 (6th Cir. 1961), revg. and remanding [Dec. 23,665] 32 T.C. 798 (1959). Whether interest has accrued on debt is a factual determination. Roth Steel Tube Co. v. Commissioner [86-2 USTC ╤ 9676], 800 F.2d 625 (6th Cir. 1986), affg. [Dec. 41,871(M)] T.C. Memo. 1985-58; Smith v. Commissioner [67-1 USTC ╤ 9109], 370 F.2d 178, 180 (6th Cir. 1966), affg. [Dec. 27,019(M)] T.C. Memo. 1964-278; see Burrill v. Commissioner [Dec. 46,193], 93 T.C. 643, 669 (1989). Courts refer to numerous factors to determine whether a payment is for debt or equity. The Court of Appeals for the Sixth Circuit, to which appeal in this case lies, refers primarily to eleven factors. See Roth Steel Tube Co. v. Commissioner, supra at 630. These factors are: (1) The names given to the instruments evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed interest rate and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and stockholder; (7) the security for the advances; (8) the corporation's ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayment. Id.; Raymond v. United States [75-1 USTC ╤ 9289], 511 F.2d 185, 190-191 (6th Cir. 1975); Austin Village, Inc. v. United States [70-2 USTC ╤ 9620], 432 F.2d 741, 745 (6th Cir. 1970); Berthold v. Commissioner [68-2 USTC ╤ 9670], 404 F.2d 119, 122 (6th Cir. 1968), affg. [Dec. 28,456(M)] T.C. Memo. 1967-102; Smith v. Commissioner, supra at 180. In distinguishing debt from equity, the economic substance of the transaction prevails over form. Byerlite Corp. v. Williams [61-1 USTC ╤ 9138], 286 F.2d 285, 291 (6th Cir. 1960).

We now analyze and weigh all relevant facts to determine whether petitioner and Mr. Mohney intended to create a debt, and whether their intention comported with the economic reality of a debtor-creditor relationship. Petitioner carries the burden of establishing that the subject transfers generated debt rather than equity. Rule 142(a).

i. Name of Certificate

We look to the name of the certificate evidencing purported debt to determine the "debt's" true label. The issuance of a note weighs toward debt. Estate of Mixon v. United States [72-2 USTC ╤ 9537], 464 F.2d 394, 403 (5th Cir. 1972). The mere fact that a taxpayer issues a note, however, is not dispositive of debt. An unsecured note, with no payments made thereon until long after the due date, weighs toward equity. Stinnett's Pontiac Serv. v. Commissioner [84-1 USTC ╤ 9406], 730 F.2d 634, 638 (11th Cir. 1984), affg. [Dec. 39,077(M)] T.C. Memo. 1982-314.

Although petitioner issued the Second Clarksville note to Mr. Mohney, we give this fact little weight. The record shows that the transfer of the subject properties to petitioner occurred in 1977, yet the related deeds were not recorded until sometime thereafter. We also find that Mr. Mohney's 1977 individual income tax return did not report a sale of either of the properties, and petitioner did not make any payments on either of the properties until 1989. Petitioner focuses on the fact that it recorded debt on its books in connection with the transfer. We are not impressed. Under the facts at hand, petitioner's accounting entry lends little (if any) support for a finding of debt. See Raymond v. United States, supra at 191. This is particularly true, given the fact that the parties did not deal at arm's length.

This factor is neutral.

ii. Fixed Maturity Date

The presence of a fixed maturity date weighs toward debt, but is not dispositive of a debtor-creditor relationship. American Offshore, Inc. v. Commissioner [Dec. 47,750], 97 T.C. 579, 602 (1991). The presence of a fixed maturity date may be offset by other facts in the record.

Although the Second Clarksville note bore a maturity date of November 3, 1982, petitioner made no payments on this note until 1989. Petitioner also made no payments for the Mishawaka property until 1989. The timing of these payments indicates that a debtor-creditor relationship was not contemplated by petitioner and Mr. Mohney. The presence of the fixed maturity date on the Second Clarksville note is further downplayed by the fact that Mr. Mohney did not pursue collection or inquire as to payment. Mr. Mohney testified that he simply forgot about the transaction and the debt owed to him. We find this testimony unbelievable, and, even assuming arguendo that it was credible (which it was not), we find this testimony to be uncharacteristic of a bona fide creditor.