USCA1 Opinion
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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