Bergersen v. Commissioner

UNITED STATES COURT OF APPEALS
FOR THE FIRST CIRCUIT

No. 96-1730

EARL O. BERGERSEN and EVELYN K. BERGERSEN,

Petitioners,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

APPEAL FROM A DECISION OF THE UNITED STATES TAX COURT

[Hon. Edna G. Parker, Judge]

Before

Selya, Circuit Judge,

Bownes, Senior Circuit Judge,

and Boudin, Circuit Judge.

James M. O'Brien with whom Baker & McKenzie was on briefs for

petitioners.
Jonathan S. Cohen with whom Loretta C. Argrett, Assistant

Attorney General, and Frank P. Cihlar, Tax Division, Department of

Justice, were on brief for respondent.

March 21, 1997

BOUDIN, Circuit Judge. This appeal involves a tax

dispute posing two questions: whether certain payments to

the taxpayers by a controlled company were constructive

dividends (rather than loans) and whether the taxpayers were

residents of Illinois (rather than Puerto Rico) in 1986 and

1987. The Tax Court answered yes to both questions,

resulting in adverse consequences for the taxpayers, who now

appeal. We affirm the Tax Court.

The basic facts, derived from the record and the Tax

Court findings, are largely undisputed, although the

inferences and conclusions to be drawn are very much in

dispute. The taxpayers are Earl and Evelyn Bergersen, a

long-married couple who resided for many years in Illinois.

Earl Bergersen practiced as an orthodontist in Winnetka,

Illinois, starting in 1959. In addition to practice and

part-time teaching, Earl Bergersen invented and patented new

orthodontic products, which enjoyed a good deal of success.

In the early 1970s, the Bergersens incorporated Ortho-

Tain, Inc., under Delaware law, to manufacture and sell

products based upon Earl Bergersen's inventions. At all

times pertinent, the couple were the only members of the

Ortho-Tain board of directors. During the tax years at issue

in this case (1985-1987), the Bergersens also held all of the

class A voting shares in the company (56 each), with five

class B voting shares held by each of their three children.

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Each of the children also held between 100 and 300 shares of

class C nonvoting stock. Santos Ortiz, manager of the

company's Puerto Rico plant, held 200 shares of class D

nonvoting stock, and Thomas Sedwick, the tool and die maker

at the plant, held 190 shares of class E nonvoting stock.

Initially based in Winnetka, the plant was moved to

Puerto Rico in 1976. The Bergersens hoped to move to Puerto

Rico eventually; residents of Puerto Rico are exempt from

U.S. income tax on income derived from Puerto Rico sources.

26 U.S.C. 933. After the plant moved, Ortho-Tain elected

to be treated as a possessions corporation, exempting it from

U.S. income tax on Puerto Rico source income. Id. 936.

The company also received a 15-year industrial tax exemption

from Puerto Rico, which also permitted Puerto Rico residents

to receive company dividends free of income tax. See 13

L.P.R.A. 252 et seq.; id. 252b(a)(1).

During the late 1970s, Ortiz and Sedwick ran the Puerto

Rico plant while the Bergersens handled the company's

finances from Illinois. Ortho-Tain's sales grew from

$600,000 in 1977 to $1.2 million in 1987. During these

years, the taxpayers received no salary from the company, and

no dividends were declared on their stock until 1987. During

most of the period, modest dividends (ranging from $5,000 to

around $22,000) were paid annually to Ortiz and to Sedwick.

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In this same period, Ortho-Tain's accumulated

undistributed earnings grew from just under $350,000 in 1977

to just over $5 million in 1986. The company's possession

status freed it from the U.S. accumulated earnings tax. 26

U.S.C. 936(g). Meanwhile, starting in 1982, Earl Bergersen

borrowed substantial amounts from the company, totaling

almost $3,700,000 by 1987. The loans were evidenced by

unsecured demand notes and carried interest rates of 8.5 to

10 percent; the taxpayers regularly paid this interest to the

company and deducted the interest payments on their U.S.

income tax returns for the years 1982 through 1986.

Apart from one loan repayment of about $400,000 in 1984,

the loans were carried on Ortho-Tain's books until March

1987, when Ortho-Tain issued dividends of about $2,800,000 to

the taxpayers, which they treated as exempt from U.S. income

tax under section 933 and immediately paid back to the

company to reduce their outstanding loans. The remaining

loan balance was repaid after further dividends of just over

$2,000,000 to taxpayers in 1988. As one might guess, it is

the position of the Internal Revenue Service that the loans

were constructive dividends subject to U.S. income tax when

made.

The other issue in dispute concerns the timing of the

Bergersens' move to Puerto Rico. Looking toward this move,

they purchased land in Puerto Rico in 1981 and, over the next

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several years, planned an elaborate house. Construction

began in 1984 but, because of delays, the house was not

finished as expected by late 1985. In the meantime, starting

in 1984, Earl Bergersen turned over much of his orthodontics

practice to another dentist and spent only a few days a month

with established patients.

In July 1985, the Bergersens sold their Winnetka house

and in September 1985 agreed to buy a town house in Glenview,

Illinois. In April 1986, they joined a Glenview social club.

They also sublet an apartment in Puerto Rico from their

employee Sedwick from November 1985 through October 1986.

When the sale closed on the Winnetka house in November 1985,

the Bergersens dispersed their belongings to various places

in Illinois and Puerto Rico.

By summer 1986, the Bergersens' new Puerto Rico house

had one bedroom finished, which they used on occasion, and

they installed a housekeeper couple in the house. More of

their furnishings were shipped there in August 1986. At

about the same time, the Bergersens shipped a car to Puerto

Rico, registered it, and activated a country club membership

there. They obtained an occupancy permit for the new house

in January 1987, but construction continued until August

1987.

During 1986 and 1987, the Bergersens traveled a good

deal for both business and pleasure, dividing their time

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between Puerto Rico and the United States mainland. They

spent 108 days in Puerto Rico in 1986 and 93 there in 1987.

They spent 107 days in the Glenview town house in 1986 and

138 days there in 1987. Thus, in 1986, they spent 150 days

in places other than Illinois and Puerto Rico; in 1987, the

figure was 134 days. Earl Bergersen spent no more than a few

weeks each year seeing patients in Winnetka.

In February 1987, the Bergersens replaced Illinois

drivers' licenses that they had lost. In August 1987, the

new Puerto Rico house was completed, and the government

admits that the taxpayers used it as their principal

residence thereafter. Earl Bergersen wound up his Winnetka

practice in late 1987. In 1988, the Bergersens acquired

Puerto Rico voting cards and, in 1989, Puerto Rico drivers'

licenses.

The present case began after the Internal Revenue

Service reviewed the taxpayers' income tax returns for 1985

through 1987. In due course, the IRS ruled that the loans

made to the Bergersens in these years were not bona fide

loans but constructive dividends; the result was to include

the amounts received as part of the taxpayers' reportable

income and to disallow deductions taken by them for interest

payments on the loans.

The IRS also concluded that the Bergersens in 1986 and

1987 were not bona fide residents of Puerto Rico for the

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entire year, as they claimed, but were residents of Illinois

for all of 1986 and part of 1987. It is common ground that

section 933 excludes Puerto Rico source income from U.S.

income tax only where the taxpayer is a resident of Puerto

Rico for the entire year in question. Vazquez v.

Commissioner, 66 T.C.M. (CCH) 406, 407 (1993); Treas. Reg.

1.933-1(a). Accordingly, the IRS determination meant that

the moneys the Bergersens received from Ortho-Tain in those

years were not excludable from U.S. income tax under section

933.

The Bergersens petitioned the Tax Court to redetermine

various disputed issues pertaining to their returns. 26

U.S.C. 6213. The case was tried before the Tax Court in

April 1994. In August 1995, the Tax Court issued a 66-page

decision, resolving a number of issues including the two now

presented on appeal. On those two issues, the Tax Court held

that the loans were constructive dividends and that the

Bergersens were not residents of Puerto Rico for the entire

year either in 1986 or 1987. Bergersen v. Commissioner, 70

T.C.M. (CCH) 568, 588 (1995). This appeal followed.

The Loan or Dividend Issue. The loan or dividend

issue, which is not uncommon in tax cases involving

controlled companies, usually poses the question whether the

owner is trying to smuggle earnings out of the company

without paying personal income tax. A dividend or salary

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paid to an owner is taxable as income; a loan, being only a

temporary transfer, is not. But if a "loan" by the company

to an owner is not intended to be repaid, then allowing that

label to control would effectively deprive the government of

its tax bite on dividends and salaries.

The conventional test is to ask whether, at the time of

the withdrawal in question, the parties actually intended

repayment. Crowley v. Commissioner, 962 F.2d 1077, 1079 (1st

Cir. 1992). Explaining that "intent" is difficult to

discern, courts regularly resort to objective criteria,

asking whether the transaction bears the traditional

hallmarks of a loan or of a dividend. Id. In any event,

purporting to be looking at intent, appeals courts generally

describe such intent as a fact, id. at 1080, and subject the

fact-finder's determination to clear error review, see id.;

see also Commissioner v. Duberstein, 363 U.S. 278, 290-91

(1960).

Here, the government invokes this deferential standard

of review. It argues that the finding of constructive

dividends cannot be clearly erroneous in light of the various

indicia mentioned by the Tax Court as suggesting dividend

status: that the loans had no collateral and no fixed

repayment schedule; that no limits were set on the amounts to

be borrowed; that the proceeds were used by the Bergersens

for personal purposes; and that Ortho-Tain accumulated huge

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earnings but paid the Bergersens no dividends during the

years of the loans until 1987.

The Bergersens, on the other hand, say that the Tax

Court made an error of law by stressing that the Bergersens

were trying to "avoid taxes" by delaying dividends until they

moved to Puerto Rico; Congress, the Bergersens point out,

chose in section 936(g) to allow possessions companies to

accumulate earnings in Puerto Rico and to distribute the

amounts free of U.S. income tax to those who have moved

there. And the Bergersens dispute the government's portrayal

and weighing of the objective factors.

Like white asparagus or a blood orange, this first issue

is not ordinary fare but an odd variation, caused by the

interplay of ordinary factors with Puerto Rico tax status.

The Bergersens may well have intended to repay the loans

after they moved to Puerto Rico. After all, at that point

they could do so by declaring a dividend to themselves free

of U.S. (and Puerto Rico) income tax; and after using the

dividends to repay the loans, they remained free to use the

repaid funds for a new dividend, again without U.S. (or

local) tax consequences.

The situation is thus very different from the ordinary

loan-or-dividend case, where repayment of the loan to the

company would effectively preclude a tax-free distribution.

Here, the Bergersens could reasonably have intended to repay

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the money and reap the benefits of a tax-free distribution.

Nor would there have been anything wrong if the Bergersens,

knowing that they were moving eventually to Puerto Rico, had

accumulated earnings in the company but refrained from

withdrawing them until after the move.

The question here, then, is whether the Bergersens could

pay out moneys to themselves before moving to Puerto Rico and

avoid U.S. income taxes by designating the payments as loans.

We think that this ought to depend upon whether, in overall

character and context, the payments were more like loans or

more like dividends. After all, "intent to repay" is merely

a functional test that is usually suitable; but the purpose

of the tax law is to tax transactions, not rubrics or labels.

Cf. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934),

aff'd, 293 U.S. 465 (1935).

Here, the payments had some of the traditional indicia

of loans (notes existed, interest was paid). In other

respects, formalities were absent (no fixed repayment date,

no collateral, no credit limit). But regardless of

formalities, the nominal loans, paid by a controlled company

that was accumulating large earnings but paying its main

owners no dividends, effectively gave the Bergersens

permanent tax-free control over the moneys.

If after their move, the Bergersens had decided not to

repay but to cancel the loans as a form of dividend, there

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would have been no tax due on this dividend. If instead--as

actually happened--they declared cash dividends and repaid

the loans, the effect was to redeposit the money in their own

corporate vehicle, available for redistribution to them at

any time, again with no tax consequences. As the Tax Court

observed, the repayment was effectively a "meaningless

exchange of checks." Bergersen, 70 T.C.M. at 585-86.

Indeed, even the earlier interest payments could be recovered

by the Bergersens without tax effects.

Thus, at the very outset of the loans, the Bergersens

knew that there was no effective corporate constraint to

induce repayment, nor (given the intended move to Puerto

Rico) any meaningful tax consequences from a permanent

failure to repay. An effective permanent transfer of

corporate funds to an owner is the hallmark of a dividend or

a salary, and not a loan. There is nothing wrong with an

owner making such a transfer. But when made to a U.S.

mainland resident, the transfer is subject to U.S. income

tax.1

1Nor does it matter that the Bergersens might have
achieved their ends through a different device, say, by
borrowing the money from a bank--a real loan requiring
repayment--and repaying it with a tax-free dividend declared
after the move to Puerto Rico. The taxpayers are stuck with
the transaction they chose to employ. See Commissioner v.

National Alfalfa Dehydrating & Milling Co., 417 U.S. 134,

148-49 (1974).

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Looking through form to substance, see Commissioner v.

Court Holding Co., 324 U.S. 331, 333-34 (1945), we reach the

same result as the Tax Court and therefore need not concern

ourselves on this issue with the proper standard of review

(since even de novo review would lead to affirmance). The

claim that the Tax Court made a mistake of law in construing

section 933 without giving sufficient consideration to

section 936(g) is a red herring. Congress' policy permitted

the company to accumulate earnings in Puerto Rico free of

tax; it did not authorize tax-free dividends to Illinois

residents.

The Residence Issue. We turn now to a more conventional

issue, namely, whether the Bergersens were residents of

Illinois during 1986 and at least part of 1987, as the Tax

Court ruled, or whether they were residents of Puerto Rico

for either or both years in their entirety. Determining

residence can present distinctive issues either of law or

fact; but quite commonly in the end the question--often

called a "mixed question of law and fact"--turns on applying

a legal label, refracted into a set of legal criteria, to a

unique set of facts. That is so here.

"Mixed question" is something of a misnomer; once the

raw facts are determined (and such determinations are

normally reviewed only for clear error), deciding which legal

label to apply to those facts is a normative decision--

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strictly speaking, a legal issue. United States v. McConney,

728 F.2d 1195, 1202 (9th Cir.) (en banc), cert. denied, 469

U.S. 824 (1984). But a fact-finder closer to the evidence

may still have a superior "feel"; and the value of precedent

is limited, since the next shake of the kaleidoscope will

produce a different fact pattern.

We think that a mixed question of fact and law is

presented in this case, and that some deference should be

afforded to the Tax Court's ultimate determination. Johnson

v. Watts Regulator Co., 63 F.3d 1129, 1132 ((1st Cir. 1995).

See generally 9A C. Wright & A. Miller, Federal Practice and

Procedure 2589 (1995 & Supp. 1996). In certain narrow

situations involving residency, subjective intent may be very

important, and review limited to clear error. Cf. Treas.

Reg. 1.871-3, 1.871-4(c) (residency of alien seamen). But

the ordinary case presenting the residency question, which

arises under several tax code provisions,2 is decided by

using largely objective criteria, developed in the decisions.

E.g., Sochurek v. Commissioner, 300 F.2d 34, 38 (7th Cir.

1962).

These laundry lists have to be used with some caution

because they are framed broadly, to cover disparate problems.

Deciding when the Bergersens became bona fide "residents" of

2See, e.g., 26 U.S.C. 871 (nonresident aliens); id.

911 (foreign earned income exclusion for U.S. citizens
residing abroad); id. 933 (Puerto Rico residents).

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Puerto Rico is somewhat different from determining, albeit

for U.S. tax purposes, when an American airline pilot based

abroad is a "resident" of Japan, or a visiting French

consultant is a "resident" of New York. Cf. Jones v.

Commissioner, 927 F.2d 849, 855-57 (5th Cir. 1991); Friedman

v. Commissioner, 37 T.C. 539, 551 (1961).

But in all three situations, "residence" implies that

the individual has established his or her residential base,

planning to remain indefinitely or at least for a substantial

period. See Treas. Reg. 1.871-2(b). Clearly the

Bergersens did intend eventually to base themselves and

remain permanently in Puerto Rico; that is why they embarked

on construction of a very expensive house in 1984, before the

tax years in dispute. The question for us, as we see it, is

when the Bergersens had effectively moved their base to

Puerto Rico and established their residence there.

As the Tax Court candidly said, the Bergersens' conduct

amounts to a move to Puerto Rico carried out over a period of

time. Bergersen, 70 T.C.M. at 582. Here, some of the

conduct was completed by 1986. Prior to 1986 they had moved

some furnishings to Puerto Rico and rented an apartment. In

1986, they began to use portions of their partly completed

house, installed a housekeeper couple, activated a club

membership in Puerto Rico, and shipped over a car and some

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remaining furnishings. Apparently they also spent Christmas

there in 1986.

But the links with Illinois extended into 1987. The

Bergersens continued to use their Glenview house in 1987,

spending 138 days there in that year and only 93 in Puerto

Rico. They maintained Illinois drivers' licenses, and Earl

Bergersen still did occasional work in his Winnetka office.

The Puerto Rico house was not fully completed until August

1987, and the Bergersens did not register to vote in Puerto

Rico or get drivers' licenses there until 1988 and 1989,

respectively.

We agree with the Tax Court that for 1986 and at least

part of 1987, the Bergersens were residents of Illinois and

not yet of Puerto Rico. No one consideration is decisive:

the center of gravity was shifting from Illinois to Puerto

Rico throughout the period. But taking account of all of the

ties to both places, the Tax Court's conclusion seems to us

not only reasonable but right. While we would ordinarily

give some weight to its view in applying a tax code concept

to specific facts, see, e.g., Manzoli v. Commissioner, 904

F.3d 101, 103 (1st Cir. 1990), we would reach the same result

here even if review were de novo.

The Bergersens imply that the Tax Court erred as a

matter of law by giving weight, in deciding the residency

issue, to an alleged tax avoidance motive. The Tax Court

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made one reference to tax avoidance as a relevant concern

(the other reference was to an argument by the government).

Bergersen, 70 T.C.M. at 581, 583. But in the very same

passage, the Tax Court made clear that it was the time of the

move to Puerto Rico, judged by objective factors, that was

decisive. We reach the same result, giving no weight to the

alleged motive.

A tax avoidance motive is often included in the laundry

list of factors bearing on bona fide residency, see, e.g.,

Sochurek, 300 F.2d at 38, so it is not surprising that the

Tax Court mentioned it in passing. But the Bergersens were

perfectly free to consider tax advantages in moving their

residence to Puerto Rico, and here we think that tax motives

provide little help in determining when this move occurred.

(A tax motive does, however, help explain why the payments

were structured as loans.)

The balance of the Bergersens' argument on the residency

issue is an effort to stress factors favorable to an early

residence in Puerto Rico (e.g., that work on the house was

largely completed in 1986) and to explain away some of the

factors pointing to Illinois (e.g., the retention of Illinois

drivers' licenses). The arguments are perfectly legitimate

and well presented. They serve to explain why the case is a

close one on the issue of residency at least as to 1987.

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But a number of important considerations--such as the

purchase and maintenance of the house in Glenview and the

time spent in Illinois in 1987--cannot be minimized. And

even if small adjustments are made in other elements, the

overall balance still seems to us to favor the government.

When dealing with incommensurable factors, it is often hard

to do more than fairly array the factors on both sides, as we

have done in summary and the Tax Court in detail, and then

state the result.

Because the Bergersens were not bona fide residents of

Puerto Rico either in 1986 or for the full year in 1987, they

were not entitled to avoid U.S. income tax on Puerto Rico

source income in those years. 26 U.S.C. 933. As the

"loans" were constructive dividends, they were taxable income

to the Bergersens when made, and the Bergersens were not

entitled to deduct the interest payments to the company. See

Knetsch v. United States, 364 U.S. 361, 365-66 (1960).

Affirmed.

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