Chapman v. Commissioner

T.C. Memo. 1997-147

UNITED STATES TAX COURT

MILO G. AND SARAH E. CHAPMAN, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 20342-94, 20363-94, Filed March 20, 1997.
20560-94.

Joann K. Beck, for petitioners.

Kathey I. Shaw, for respondent.

MEMORANDUM OPINION

HAMBLEN, Judge: By four separate notices of deficiency,

respondent determined deficiencies, additions to tax, and

1
Cases of the following petitioners are consolidated
herewith: David E. and Gladys A. Christie, docket No. 20363-94;
and Dura-Craft, Inc., docket No. 20560-94.
 - 2 -

penalties in regard to petitioners' Federal income tax as

follows:

Milo G. and Sarah E. Chapman--docket No. 20342-94

Addition to Tax and Penalties
Year Deficiency Sec. 6653(a)(1) Sec. 6662(a)
1988 $25,424 $1,237 ---
1989 12,429 --- $2,357
1990 1,574 --- 315

David E. and Gladys A. Christie--docket No. 20363-94

Addition to Tax and Penalties
Year Deficiency Sec. 6653(a)(1) Sec. 6662(a)
1988 $19,469 $973 ---
1989 10,846 --- $2,040
1990 962 --- 192

Dura-Craft, Inc.--docket No. 20560-94

Taxable Year Addition to Tax and Penalty
Ending Deficiency Sec. 6653(a)(1) Sec. 6662(a)
10/31/88 $15,968 $798 ---
10/31/89 93,410 --- $3,591

Unless otherwise indicated, all section references are to

the Internal Revenue Code as in effect for the years at issue,

and Rule references are to the Tax Court Rules of Practice and

Procedure.

After concessions, the issues for decision are:

(1) Whether petitioners Milo and Sarah Chapman and David and

Gladys Christie received distributions from the Dura-Craft

profit-sharing plan (Plan) in 1988 and 1989 pursuant to section

72(p);
 - 3 -

(2) whether petitioners Milo and Sarah Chapman and David and

Gladys Christie received early distributions from the Plan in

1988 and 1989 and therefore are liable under section 72(t) for

the 10-percent additional tax for early distributions;

(3) whether petitioners Milo and Sarah Chapman and David and

Gladys Christie constructively received interest income in 1989

from the payments by Dura-Craft, Inc. (Dura-Craft), and

Springbrook Marketing (Springbrook) to the Plan;

(4) whether petitioners David and Gladys Christie received

constructive dividends in 1989 from the loan repayments by both

Dura-Craft and Springbrook to the Plan in amounts greater than

those actually owed to the individual petitioners; and

(5) whether the 5-percent processing fees charged by

Northwest Purchasing, Inc., were allowable as a part of Dura-

Craft's cost of goods sold for fiscal years ending October 31,

1988 and 1989.

Background

These consolidated cases were submitted without a trial

pursuant to Rule 122. The stipulation of facts and the attached

exhibits are incorporated by this reference, and the facts

contained therein are found accordingly. Petitioners Milo

Chapman and Sarah Chapman (collectively hereinafter referred to

as the Chapmans) resided in Newberg, Oregon, at the time the

petition was filed in docket No. 20342-94, and petitioners David

Christie and Gladys Christie (collectively hereinafter referred
 - 4 -

to as the Christies) resided in Aurora, Oregon, at the time the

petition was filed in docket No. 20363-94. Dura-Craft, Inc., is

a C corporation which maintained its principal place of business

in Newberg, Oregon, at the time the petition was filed in docket

No. 20560-94. During the years at issue, the Chapmans and the

Christies prepared their respective joint Federal individual

income tax returns using the cash receipts and disbursements

method of accounting, and Dura-Craft prepared its Federal

corporate income tax returns using an accrual method of

accounting.

This case involves three closely held corporations and their

shareholders. Northwest Purchasing, Inc. (Northwest), is a

subchapter S corporation which is owned equally by David Christie

and Milo Chapman. Northwest sells raw materials to Dura-Craft at

Northwest's cost, plus a 5-percent processing fee. During the

years at issue, Dura-Craft was owned by Milo Chapman (25 percent)

and David Christie (75 percent). Dura-Craft manufactures doll

house kits and sells these kits exclusively to Springbrook.

During the years at issue, Springbrook was owned by Milo Chapman

(75 percent) and David Christie (25 percent). Springbrook

markets the doll house kits to various outside retailers such as

Fred Meyer and Payless.

During the years at issue, Milo Chapman was an employee of

Springbrook, and David Christie was both an officer and an

employee of Dura-Craft. Milo Chapman controlled all of the
 - 5 -

financial decisions of Springbrook. His responsibilities

included signing checks, hiring employees, and establishing new

markets for the Dura-Craft kits. David Christie controlled all

of the financial decisions of Dura-Craft. His responsibilities

included signing checks, hiring employees, and making all major

decisions concerning production and new kit designs. Office

management and bookkeeping for both Dura-Craft and Springbrook

were performed at the office of Dura-Craft by employees of Dura-

Craft.

A. Loans

On February 10, 1983, the Chapmans and the Christies each

requested a loan in the amount of $37,500 from the Dura-Craft

Profit-Sharing Plan (Plan) to meet unspecified "emergency

financial requirements". On February 22, 1983, the Chapmans and

the Christies each signed separate notes agreeing to pay $37,500

to the Plan, plus 12 percent interest, accruing from February 22,

1983, until the principal was paid. On April 22, 1983, the Plan

agreed to lend $37,500 to the Chapmans and $37,500 to the

Christies at 12 percent interest, with a repayment date of

December 31, 1984 (collectively hereinafter referred to as plan

loans).2

2
Nothing in the record indicates how to reconcile the fact
that the date that the Plan agreed to make the loans was after
the date that the individual petitioners signed separate notes
agreeing to repay the loans. We do not know whether this
discrepancy is the result of inadvertence or was intentional.
 - 6 -

Although the Plan agreed to these loans, the Plan instead

paid $50,000 to Dura-Craft on February 22, 1983, and $25,000 to

Springbrook on April 27, 1983. On February 22, 1983, Dura-Craft

signed a note agreeing to pay David Christie and Milo Chapman a

total of $50,000 plus 12 percent interest, and, on April 27,

1983, Springbrook signed a note agreeing to pay David Christie

and Milo Chapman $25,000 plus 12 percent interest (collectively

referred to as corporate loans).

In 1985, Dura-Craft paid David Christie $10,000 on its

$50,000 corporate loan, and Springbrook paid Milo Chapman $10,000

on its $25,000 corporate loan. At that time, Dura-Craft reduced

its loan payable balance reflected in its accounting records by

the $10,000 it paid to David Christie. Springbrook also reduced

its loan payable balance reflected in its accounting records by

the $10,000 it paid to Milo Chapman. Due to an error,

Springbrook included the 1985 $10,000 loan repayment to Milo

Chapman on his 1985 Form W-2. Neither David Christie nor Milo

Chapman reduced his loan balance with the Plan in 1985.

As of January 1, 1986, the accounting records of Dura-Craft

had a loan payable balance to David Christie and Milo Chapman of

$40,000, and the accounting records of Springbrook had a loan

payable balance of $15,000.

On April 25, 1989, Springbrook paid the balance of its

corporate loan by issuing a check to the Plan in the amount of

$43,315 with the notation "princ $25,000 - int $18,315". On the
 - 7 -

same day, Dura-Craft also paid the balance of its corporate loan

by issuing a check to the Plan for $87,185 with the notation

"princ $50,000, int $37,185". Dura-Craft's check register for

the $87,185 check to the Plan bears the notation "Loan Payback

from Milo-Dave-pd directly to Dura-Craft profit Share Trust."

Springbrook recorded the payment on its accounting records

as follows:

Wage expense $10,000
Interest expense 18,315
Loan payment 15,000
Paid to profit-sharing plan 43,315

At the time of the payment, Springbrook's accounting records

reflected a loan payable balance of $33,315. Springbrook

computed and paid interest to the Plan on the full amount of its

corporate loan despite the $10,000 loan payment which Springbrook

made to Milo Chapman in 1985. Accordingly, as of the date of its

payment, Springbrook owed to Milo Chapman and David Christie a

total of $14,000 in interest rather than the $18,315 which was

paid.

Dura-Craft recorded the $87,185 repayment on the same date

in its accounting records as follows:

Wage expense $10,000
Interest expense 37,185
Loan payment 40,000
Paid to profit-sharing trust 87,185

At the time of the payment, Dura-Craft's accounting records

reflected a remaining loan payable balance of $40,000.

Nonetheless, Dura-Craft computed the interest owed based upon an
 - 8 -

outstanding loan balance of $50,000 despite the $10,000 loan

payment which Dura-Craft made to David Christie in 1985.

Accordingly, as of the date of its payment, Dura-Craft owed

interest to Milo Chapman and David Christie in the amount of

$33,000 rather than the $37,185 which was paid.

On February 22, 1986, the loan principal and interest due to

the Plan for each of the plan loans exceeded the statutory limit

of $50,000, pursuant to section 72(p)(2)(A)(i). Total interest

of $9,000 and $3,000 accrued on the plan loans during 1988 and

1989, respectively.

The Chapmans and the Christies did not report any income

with respect to the corporate or plan loans. Respondent

determined that the Chapmans and the Christies each received two

plan distributions from the Plan pursuant to section 72(p): (1)

In 1988, in the amount of the principal balance of $37,500 and

one-half of the accrued interest ($4,500), and (2) in 1989, in an

amount of one-half of the interest accruing during that year

($1,500). In addition, respondent determined that petitioners

were liable for an additional 10-percent tax pursuant to section

72(t) on each distribution.

Respondent also determined that the Chapmans and the

Christies each received the following amounts of income in 1989:

(1) Dividends from Springbrook equal to one-half of the

difference between interest of $14,000 owed by Springbrook on its

corporate loan and the $18,315 actually paid by Springbrook to
 - 9 -

the Plan ($2,158); (2) dividends from Dura-Craft equal to one-

half of the difference between the $33,000 of interest owed by

Dura-Craft on its corporate loan and the $37,185 actually paid by

Dura-Craft to the Plan ($2,092); (3) interest income equal to

one-half of the interest owed by Dura-Craft ($16,500) and by

Springbrook ($7,000) on the respective corporate loans but paid

to the Plan.

B. Northwest

Northwest was incorporated in 1978 as a corporation electing

small business status under subchapter S and is equally owned by

David Christie and Milo Chapman. During 1988, 1989, and 1990,

Northwest had no employees and had the same telephone number,

business address, and office space as Dura-Craft. For its

taxable years ending October 31, 1988 and 1989, Dura-Craft

purchased all of its raw materials from Northwest. Northwest

sold Dura-Craft these raw materials at Northwest's cost, plus a

5-percent processing fee. For the years ending October 31, 1988

and 1989, Dura-Craft paid Northwest processing fees of $39,840.83

and $55,572, respectively. As Northwest had no employees, all of

Northwest's orders were placed by Dura-Craft employees and

delivered directly to the Dura-Craft plant. Northwest maintained

its own set of accounting records and filed its own tax returns

for the taxable years ending July 31, 1989 and 1990. Respondent

disallowed the payments Dura-Craft claimed as cost of goods sold

for taxable years ending October 31, 1988 and 1989.
 - 10 -

Discussion

Petitioners bear the burden of establishing that

respondent's determinations of deficiencies, as contained in the

statutory notices of deficiency, are incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111 (1933). Petitioners' briefs

refer to several facts which were not included in the parties'

stipulation of facts. Statements in briefs do not constitute

evidence and will not be considered by the Court.3 Rule 143(b);

Evans v. Commissioner, 48 T.C. 704, 709 (1967), affd. per curiam

413 F.2d 1047 (9th Cir. 1969). The record of this case was

closed prior to the submission of the parties' briefs.

Accordingly, we hold that the additional facts contained in

petitioners' briefs that were not part of the stipulation of

facts or offered at trial are not a part of the record.

3
Examples of statements in petitioners' briefs that are not
in the record include:

(1) [Northwest] was formed * * * by the Chapman and
Chritie [sic] families for the purpose of locating and
brokering wood products for sale to others; (2) David
Christie oversees the administrative and accounting
portions of Northwest Purchasing while Milo Chapman
locates, evaluates and secures the raw materials
purchased by [Northwest] for sale; (3) the services of
Northwest's principals are not performed by anyone
else.
 - 11 -

I. Issues 1-4. Loans

The questions presented in the first four issues are related

to the corporate and plan loans, and we discuss them

correlatively. Distributions from a qualified plan are taxable

as provided in section 402(a). The Tax Equity and Fiscal

Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec. 236(a),

96 Stat. 324, 509, added section 72(p). Section 72(p)(1)(A)

generally treats loans from a qualified employer plan to plan

participants or beneficiaries as taxable distributions. Section

72(p)(1)(A) provides: "If during any taxable year a participant

or beneficiary receives (directly or indirectly) any amount as a

loan from a qualified employer plan, such amount shall be treated

as having been received by such individual as a distribution

under such plan."4 Section 72(p)(2)5 provides an exception to

4
Sec. 72(p)(1)(A) applies to any loan from a qualified
employer plan which was made after Aug. 13, 1982. Tax Equity and
Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec.
236(a), 96 Stat. 324, 510-511.
5
Sec. 72(p)(2) provides in pertinent part:

(2) Exception for Certain Loans.--

(A) General Rule.--Paragraph (1) shall not apply
to any loan to the extent that such loan (when added to
the outstanding balance of all other loans from such
plan whether made on, before or after August 13, 1982),
does not exceed the lesser of--

(i) $50,000, reduced by the excess (if any) of--

(I) the highest outstanding
balance of loans from the plan
(continued...)
 - 12 -

the general rule of section 72(p)(1) if the following

requirements are satisfied: (1) The balance of all outstanding

5
(...continued)
during the 1-year period ending on
the day before the date on which
such loan was made, over

(II) the outstanding balance
of loans from the plan on the date
on which such loan was made, or

(ii) the greater of (I) one-half of the
present value of the nonforfeitable accrued
benefit of the employee under the plan, or
(II) $10,000.

* * * * * * *

(B) Requirement That Loan be Repayable within 5
years.--

(i) In General.-- Subparagraph (A) shall
not apply to any loan unless such loan, by
its terms, is required to be repaid within 5
years.

* * * * * * *

(C) Requirement of Level Amortization.--Except as
provided in regulations, this paragraph shall not apply
to any loan unless substantially level amortization of
such loan (with payments not less frequently than
quarterly) is required over the term of the loan.

Sec. 72(p)(2)(A)(i) was amended by Tax Reform Act of 1986,
Pub. L. 99-514, sec. 1134(a), 100 Stat. 2085, 2483-2484.
Prior to the amendment, the statutory limit of $50,000 in section
sec. 72(p)(2)(A)(i) was not reduced by the excess, if any, of the
highest outstanding loan balance during the 1-year period ending
on the day before the date of the new loan, over the outstanding
balance of loans from the plan on the date on which the loan was
made. This revision to sec. 72(p)(2)(A)(i) applies to loans
made, renewed, renegotiated, modified, or extended after Dec. 31,
1986. Id.
 - 13 -

plan loans does not exceed the lesser of: (i) $50,000, or (ii)

the greater of $10,000 or half of the participant's vested

accrued benefit under the plan; and (2) the loan, by its terms,

requires repayment within 5 years. Sec. 72(p)(2)(A) and (B).

Section 72(p)(2)(C) was added by the Tax Reform Act of 1986,

Pub. L. 99-514, sec. 1134(b), 100 Stat. 2085, 2484, and limits

the exception in section 72(p)(2) to those loans that are

required to be amortized in substantially level installments paid

at least quarterly. This provision applies to loans made,

renewed, renegotiated, modified, or extended after December 31,

1986. Id. Section 72(t)(1) imposes an additional tax on an

amount received from a qualified retirement plan equal to 10

percent of the portion of such amount that is includable in gross

income. Section 72(t)(2) exempts distributions from the

additional tax if the distributions are made, inter alia: (1) To

an employee age 59½ or older; (2) to a beneficiary (or the estate

of the employee) on or after the death of the employee; (3) on

account of disability; (4) as part of a series of substantially

equal periodic payments made for life; (5) to an employee after

separation from service after attainment of age 55; or (6) as

dividends paid with respect to corporate stock described in

section 404(k).
 - 14 -

Section 61(a) includes as gross income all income from

whatever source derived including, inter alia, interest and

dividends. Sec. 61(a)(4), (7). Section 316(a) defines dividends

as any distribution of property made by a corporation to its

shareholders to the extent of earnings and profits. Dividends

may be formally declared, or they may be constructive. Noble v.

Commissioner, 368 F.2d 439, 442 (9th Cir. 1966), affg. T.C. Memo.

1965-84.

A. Substance-Over-Form Argument

Petitioners do not dispute respondent's calculations of the

amounts of the distributions, interest, or dividends that flow

from the plan or corporate loans. Nor do petitioners challenge

the years in which respondent seeks to include the above amounts.

Rather petitioners ask us to ignore the form of the loans and

treat the loans as having been made from the Plan directly to the

corporations. Petitioners contend that the Chapmans and the

Christies obtained the plan loans for the purpose of advancing

the proceeds to Dura-Craft and Springbrook in order for the

corporations to avoid the prohibited transaction provisions

pursuant to section 4975.6 In other words, petitioners argue

6
Sec. 4975 imposes two levels of excise tax on "any
disqualified person who participates in [a] prohibited
transaction". Sec. 4975(a) and (b). Sec. 4975 imposes an excise
tax equal to 5 percent of the amount involved with the prohibited
transaction. Sec. 4975(a) provides:

SEC. 4975(a). Initial Taxes on Disqualified
(continued...)
 - 15 -

that the series of loans was not bona fide.7 The effect of

petitioners' recharacterization would be to relieve the Chapmans

and the Christies of any income tax consequences flowing from the

loans. In addition, petitioners seek to characterize the excess

interest payments made by the corporations to or on behalf of

Milo Chapman and David Christie as bookkeeping errors subject to

correction pursuant to section 4975(f)(5).

6
(...continued)
Person.--There is hereby imposed a tax on each
prohibited transaction. The rate of tax shall be equal
to 5 percent of the amount involved with respect to the
prohibited transaction for each year (or part thereof)
in the taxable period. The tax imposed by this
subsection shall be paid by any disqualified person who
participates in the prohibited transaction (other than
a fiduciary acting only as such).

Sec. 4975(b) imposes an additional excise tax on the prohibited
transaction equal to 100 percent of the amount involved if the
transaction is not timely corrected. The prohibited transactions
enumerated in sec. 4975© were designed to guard against over-
reaching by persons able to exert influence over the affairs of
the plan. A prohibited transaction includes, inter alia, any
direct or indirect lending of money or other extension of credit
between a plan and a disqualified person. Sec. 4975(c)(1)(B).
Disqualified persons are defined in terms of certain
relationships a person has with a plan. Sec. 4975(e)(2). Those
relationships include, inter alia, fiduciary, sec. 4975(e)(2)(A);
an employer whose employees are covered by the plan, sec.
4975(e)(2)(C); an owner of 50 percent or more of a corporation
any of whose employees are covered by the plan, sec.
4975(e)(2)(E); a member of the family of any individual described
within certain paragraphs in sec. 4975(e)(2), sec. 4975(e)(2)(F);
and any officer or director of a corporation which, among other
things, has employees covered by the plan, sec. 4975(e)(2)(H).
7
The parties stipulated that the Plan was a profit-sharing
plan, and neither party disputed that the Plan was a qualified
plan for purposes of sec. 401 or a qualified employer plan for
purposes of sec. 72(p).
 - 16 -

Respondent does not dispute the form in which petitioners

have cast the loans in question. Instead, respondent argues that

the Chapmans and the Christies have failed to recognize the

income tax consequences flowing from the corporate and plan

loans. Accordingly, we must decide whether petitioners should be

permitted to repudiate the loans from the Plan to the Chapmans

and the Christies and the loans from Milo Chapman and David

Christie to the corporations.

A taxpayer's ability to disavow the form it has chosen for a

transaction is circumscribed. Illinois Power Co. v.

Commissioner, 87 T.C. 1417, 1430 (1986); Bolger v. Commissioner,

59 T.C. 760, 767 n.4 (1973). The Supreme Court has observed

repeatedly that "while a taxpayer is free to organize his affairs

as he chooses, nevertheless, once having done so, he must accept

the tax consequences of his choice, whether contemplated or not *

* * and may not enjoy the benefit of some other route he might

have chosen to follow but did not." Central Tablet Manufacturing

Co. v. United States, 417 U.S. 673, 690 (1974); Commissioner v.

National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-149

(1974). It would be quite intolerable to pyramid the existing

complexities of tax law by a rule that the tax shall be that

resulting from the form of transaction taxpayers have chosen or

from any other form they might have chosen, whichever is less.

Television Indus., Inc. v. Commissioner, 284 F.2d 322, 325 (2d

Cir. 1960), affg. 32 T.C. 1297 (1959).
 - 17 -

Petitioners' assertion that they used Milo Chapman and David

Christie as intermediaries to avoid the excise tax of section

4975 is untenable. Petitioners now are bound by the form of the

loans that they have chosen and may not in hindsight recast the

transaction in another form. Don E. Williams Co. v.

Commissioner, 429 U.S. 569 (1977); Commissioner v. National

Alfalfa Dehydrating & Milling Co., supra; Lomas Santa Fe, Inc. v.

Commissioner, 693 F.2d 71, 73 (9th Cir. 1982), affg. 74 T.C. 662

(1980).

Petitioners seek to circumvent the above outcome by relying

upon examples 3, 5, and 6 found in 29 C.F.R. sec. 2550.408b-

1(a)(4) (1989), which they contend support treating the plan

loans as prohibited transactions rather than as participant

loans. These examples provide in pertinent part:

Example (2): P is a plan covering all the employees of
E, the employer who established and maintained [the
plan] P. F is a fiduciary with respect to P and an
officer of E. The plan documents governing P give F
the authority to establish a participant loan program
in accordance with section 408(b)(1) of the [Employer
Retirement Income Security Act of 1974] Act. Pursuant
to an arrangement with E, F establishes such a program
but limits the use of loan funds to investments in a
limited partnership which is established and maintained
by E as general partner. Under these facts, the loan
program and any loans made pursuant to this program are
outside the scope of relief provided by section
408(b)(1) because the loan program is designed to
operate for the benefit of E. Under the circumstances
described, the diversion of plan assets for E's benefit
would also violate sections 403(c)(1) and 404(a) of the
Act.

Example (3): Assume the same facts as in Example 2,
above, except that F does not limit the use of loan
 - 18 -

funds. However, E pressures his employees to borrow
funds under P's participant loan program and then
reloan the loan proceeds to E. F, unaware of E's
activities, arranges and approves the loans. If the
loans meet all the conditions of section 408(b)(1),
such loans will be exempt under that section. However,
E's activities would cause the entire transaction to be
viewed as an indirect transfer of plan assets between P
and E, who is a party in interest with respect to P,
but not the participant borrowing from P. By coercing
the employees to engage in loan transactions for its
benefit, E has engaged in separate transactions that
are not exempt under section 408(b)(1). Accordingly, E
would be liable for the payment of excise taxes under
section 4975 of the Code.

* * * * * * *

Example (5): F is a fiduciary with respect to plan P.
D is a party in interest with respect to plan P.
Section 406(a)(1)(B) of the Act would prohibit F from
causing P to lend money to D. However, F enters into
an agreement with Z, a plan participant, whereby F will
cause P to make a participant loan to Z with the
express understanding that Z will subsequently lend the
loan proceeds to D. An examination of Z's credit
standing indicates that he is not creditworthy and
would not, under normal circumstances, receive a loan
under the conditions established by the participant
loan program. F's decision to approve the participant
loan to Z on the basis of Z's prior agreement to lend
the money to D violates the exclusive purpose
requirements of sections 403© and 404(a). In effect,
the entire transaction is viewed as an indirect
transfer of plan assets between P and D, and not a loan
to a participant exempt under section 408(b)(1). Z's
lack of credit standing would also cause the
transaction to fail under section 408(b)(1)(A) of the
Act.

Example (6): F is a fiduciary with respect to Plan P.
Z is a plan participant. Z and D are both parties in
interest with respect to P. F approves a participant
loan to Z in accordance with the conditions established
under the participant loan program. Upon receipt of
the loan, Z intends to lend the money to D. If F has
approved this loan solely upon consideration of those
factors which would be considered in a normal
commercial setting by an entity in the business of
 - 19 -

making comparable loans, Z's subsequent use of the loan
proceeds will not affect the determination of whether
loans under P's program satisfy the conditions of
section 408(b)(1). [Emphasis added.]

Petitioners misconstrue the scope of 29 C.F.R. sec.

2550.408b-1. Section 406(a)(1)(B) of the Employee Retirement

Income Security Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat.

879, generally prohibits loans between a plan and a party-in-

interest. Section 408(b)(1) of ERISA exempts loans to

participants and beneficiaries if the loans meet certain

requirements. The ERISA sec. 408(b)(1) exemption of ERISA

parallels section 4975(d)(1). 29 C.F.R. sec. 2550.408b-1(v).

The regulation merely explains the circumstances in which these

exemptions are available for purposes of ERISA sec. 408(b)(1) and

section 4975(d)(1).8

The examples in 29 C.F.R. sec. 2550.408b-1 are merely

illustrative of those circumstances; they do not purport to limit

the situations in which section 72 may apply or to describe the

income tax consequences of loans from a qualified profit-sharing

plan.

We are satisfied that this is not a case in which

petitioners are entitled to avoid the tax consequences arising

8
ERISA and the Code provide an exemption from the prohibited
transaction rules where loans are available to all participants
on a reasonably equivalent basis, are not available to highly
compensated employees in greater amounts, bear a reasonable rate
of interest, and are adequately secured. See 29 C.F.R. sec.
2550.408b-1 (1989).
 - 20 -

from their loan agreements on the ground that the loans reflected

therein were not as documented. Petitioners have not acted in

accordance with what they argue is the substance of the loans.

Rather, petitioners freely admit the purpose of the corporate and

plan loans was to permit Dura-Craft and Springbrook to escape the

imposition of the excise tax pursuant to section 4975.

Petitioners now seek relief from the unforeseen tax consequences

arising from the misrepresentation they deliberately perpetrated.

Petitioners may not disavow their chosen form of the loans

on the belated assertion that the entire loan transaction was

fictitious and was designed to avoid the prohibited transaction

provisions of section 4975. "One should not be garroted by the

tax collector for calling one's agreement by the wrong name",

Pacific Rock & Gravel Co. v. United States, 297 F.2d 122, 125

(9th Cir. 1961), but to allow petitioners "to disavow their prior

representations, under such circumstances would invite similar

intentional deceit on the part of other taxpayers seeking to gain

a tax benefit", Cluck v. Commissioner, 105 T.C. 324, 332 (1995);

Lefever v. Commissioner, 103 T.C. 525, 544 (1994), affd. 100 F.3d

778 (10th Cir. 1996). Having determined that petitioners may not

disavow the form of their loans, we turn to consider the tax

consequences flowing from that form.
 - 21 -

B. Tax Consequences of Loans

1. Plan Loans

First, we direct our attention to the income tax

consequences of the plan loans. Section 72(p)(1)(A) provides in

pertinent part that "If during any taxable year a participant

* * * receives (directly or indirectly) any amount as a loan

* * *, such amount shall be treated as having been received * * *

as a distribution under such plan." (Emphasis added.) Section

72(p)(2) carves out an exception permitting the tax-free

withdrawal of funds from a qualified plan by a plan participant,

in the form of a loan, if, inter alia, the terms of the loan

prescribe a repayment period of 5 years or less.

Respondent contends that the legislative history of section

72(p)(2) interprets the statute to provide that any unpaid

principal or interest is treated as distributed at the end of the

5-year period. The legislative history of section 72(p) states

in pertinent part: "if payments under a loan with a repayment

period of less than 5 years are not in fact made, so that an

amount remains payable at the end of 5 years, the amount

remaining payable is treated as if distributed at the end of the

5-year period." H. Conf. Rept. 97-760, at 619 (1982), 1982-2

C.B. 600, 672 (emphasis added). Respondent further argues that

any interest accruing after the 5-year period but before the
 - 22 -

loans are repaid is an additional distribution pursuant to

section 72(p)(1).9

For clarity, we will address separately the applicability of

section 72(p)(1)(A) to the principal and accrued interest of the

plan loans. Petitioners do not dispute that the distribution of

the $75,000, i.e., the principal of the plan loans, if it is

taxable to them at all, is taxable in 1988, pursuant to the

legislative history of section 72(p) as interpreted by

respondent. Accordingly, we sustain respondent's determination

that the Chapmans and the Christies each received a distribution

from the Plan in the amount of $37,500 in 1988.10

We are not convinced, however, that Congress intended that

interest accruing during or after the 5-year period be treated as

a taxable distribution for purposes of section 72(p)(1).

Respondent's argument relies upon the fiction that the accrued

interest constitutes an additional loan. From the language of

section 72(p)(1), it is apparent that, to be a taxable

distribution, the loan amount must be received either directly or

9
Respondent's argument assumes that Milo Chapman and David
Christie were participants in the Plan and that the Plan loans
otherwise satisfied the requirements of the exception in sec.
72(p)(2)(A). Petitioners do not challenge these assumptions.
10
There seems to be a gulf between the language of the
statute and the legislative history. In other circumstances, we
might be concerned about this disparity, which indicates
legislation by conference report rather than by concise
statements in the statute. Taxpayers should not be compelled to
look at legislative history to determine the tax consequences of
their activities.
 - 23 -

indirectly by the participant or beneficiary. The accrued

interest does not satisfy the requirement that the loan must be

received to be a distribution. Accordingly, we find that for

purposes of section 72(p)(1) neither Milo Chapman nor David

Christie received distributions in 1988 or 1989 equal to the

interest in the amounts of $4,500 and $1,500 which accrued on the

plan loans.

Section 72(t)(1) imposes an additional 10-percent income tax

on amounts received from a qualified retirement plan.

Petitioners do not claim to come within one of the enumerated

exceptions of section 72(t)(2). We sustain respondent's

determination that the distributions of $37,500 are subject to

the 10-percent additional income tax of section 72(t)(1). Having

decided, however, that the accrued interest amounts of $4,500 and

$1,500 are not plan distributions, we find that section 72(t)

does not apply to these amounts.

2. Corporate Loans

We first consider whether the Chapmans and the Christies

earned interest income in 1989 from the corporate loans to them.

It is well settled that if a taxpayer's obligation is paid by a

third party, the effect is the same as if the third party had

paid the taxpayer who in turn paid his creditor. Douglas v.

Willcuts, 296 U.S. 1 (1935); United States v. Boston & M.R.R.,

279 U.S. 732 (1929); Old Colony Trust Co. v. Commissioner, 279

U.S. 716 (1929); Wall v. United States, 164 F.2d 462 (4th Cir.
 - 24 -

1947). Petitioners concede that Dura-Craft and Springbrook owed

interest to Milo Chapman and David Christie in the amounts of

$33,000 and $14,000 on their respective corporate loans. Instead

of paying the interest directly to the individual petitioners,

the corporations paid the Plan. Having found that petitioners

may not disavow the loans, we must also conclude that the $47,000

in interest owed by the corporations to Milo Chapman and David

Christie was paid to the Plan for their benefit and used to

satisfy their own obligations with respect to the personal loans

to them from the Plan. Accordingly, we sustain respondent's

determination that the Chapmans and the Christies each received

interest income in the amount of $23,500 in 1989.

Finally, we must determine whether Milo Chapman and David

Christie received dividend income in 1989 to the extent that the

loan payments made by Dura-Craft and Springbrook exceeded the

amounts actually owed to Milo Chapman and David Christie.11

Petitioners contend that the excess loan payments should not be

treated as dividends because those payments were bookkeeping

errors, which should be corrected pursuant to section 4975(f)(5).

Section 4975(f)(5) defines the terms "correction" and "correct"

to mean "with respect to a prohibited transaction, undoing the

transaction to the extent possible, but in any case placing the

plan in a financial position not worse than that in which it

11
We note that petitioners did not argue that the dividends
exceeded the earnings and profits of the corporations.
 - 25 -

would be if the disqualified person were acting under the highest

fiduciary standards." (Emphasis added.)

Petitioners' reliance on section 4975(f)(5) is misplaced.

It is evident from the above language that section 4975(f)(5) has

no relevance to the income tax imposed upon dividend income

arising from a corporation's conferring a benefit upon its

shareholders. This is apparent from the structure of the Code.

Section 4975(f)(5) is contained in subtitle D, chapter 43,

whereas the provisions governing taxation of dividends are found

in subtitle A, chapter 1. There is no cross-reference between

section 4975(f)(5) and those provisions.

Petitioners further contend that bookkeeping errors do not

give rise to a penalty tax, relying upon Ahlberg v. United

States, 780 F. Supp. 625 (D. Minn. 1991). In Ahlberg, the sole

beneficiary and administrator misallocated contributions between

a pension plan and profit-sharing plan, the funds of which were

maintained in a commingled mutual fund. The District Court

granted summary judgment sua sponte, holding that the taxpayer

was not subject to the excise tax of 5 percent for maintaining a

plan with an accumulated funding deficiency. The court concluded

that the misallocations were bookkeeping errors, from which the

taxpayer did not receive any extra benefit, and that no harm came

to the plans.

Ahlberg is distinguishable from the instant case. Unlike

the taxpayer in Ahlberg, Milo Chapman and David Christie did
 - 26 -

receive a benefit from the bookkeeping errors. Corporate

payments to third parties at the direction of shareholders, or in

discharge of the shareholders' debts and liabilities, may

constitute a constructive dividend. Tennessee Sec. Inc. v.

Commissioner, 674 F.2d 570, 573 (6th Cir. 1982), affg. T.C. Memo.

1978-434; Gardner v. Commissioner, 613 F.2d 160 (6th Cir. 1980),

affg. T.C. Memo. 1976-349; Wortham Mach. Co. v. United States,

521 F.2d 160, 164 (10th Cir. 1975); Noble v. Commissioner, 368

F.2d at 442; Sachs v. Commissioner, 277 F.2d 879, 882 (8th Cir.

1960), affg. 32 T.C. 815 (1959); Yelencsics v. Commissioner, 74

T.C. 1513, 1529 (1980); Magnon v. Commissioner, 73 T.C. 980, 997

(1980). Petitioners seek to distinguish the facts in many of the

above cases from those in the instant case on grounds that are

immaterial to the outcome. The basic issue is whether the

corporate expenditures were incurred primarily to benefit the

corporations' trade or business or primarily for the benefit of

the shareholders. Ireland v. United States, 621 F.2d 731, 735

(5th Cir. 1980); Loftin & Woodard, Inc. v. United States, 577

F.2d 1206, 1215 (5th Cir. 1978); Noble v. Commissioner, supra at

443; Magnon v. Commissioner, supra at 993-994. When a

corporation confers an economic benefit upon a shareholder in his

capacity as such, without an expectation of repayment, that

economic benefit becomes a constructive dividend, taxable to the

shareholder whether or not the corporation intended to confer a
 - 27 -

benefit upon him. Loftin & Woodard, Inc. v. United States, supra

at 1214; Noble v. Commissioner, supra at 443.

To the extent that Dura-Craft and Springbrook made payments

to the Plan in excess of the amounts actually owed on the

corporate loans, the corporations conferred an economic benefit.

While Dura-Craft and Springbrook may have mistakenly paid too

much principal and interest, those payments, nonetheless,

satisfied the plan loans, which were the Chapmans' and the

Christies' personal debts due to the Plan. As such, they

provided a taxable benefit to the individual petitioners. We are

satisfied that Milo Chapman and David Christie each received

dividend income during 1989 in the amount of $4,250.12

I. Issue 5. Processing Fee

Finally, we must consider whether the 5-percent processing

fees paid to Northwest and included as a part of Dura-Craft's

cost of goods sold are allowable. Section 61(a) includes "gross

income derived from business" in its general definition of gross

income. Sec. 61(a)(2). Gross income from business means total

sales, less cost of goods sold, plus any income from investments

and from incidental or outside operations or sources. Sec.

1.61-3(a), Income Tax Regs.

12
We express no opinion here as to any liability with
respect to the excise tax of sec. 4975 with regard to the plan
loans.
 - 28 -

Respondent disallowed the processing fees on the grounds

that the transactions were shams lacking a business purpose and

economic substance. Petitioners, however, argue that the

separate corporate entity status of Northwest should be

recognized, citing the test in Moline Properties, Inc. v.

Commissioner, 319 U.S. 436 (1943), and the line of cases resting

thereon.

We are not required to find Northwest was a sham in order to

uphold respondent's determinations. The notice of deficiency

focuses on the sham nature of the transactions rather than the

sham nature of the corporation.

A "sham" transaction is one that lacks economic substance

beyond the creation of tax benefits. Knetsch v. United States,

364 U.S. 361, 365-366 (1960); Karr v. Commissioner, 924 F.2d

1018, 1022-1023 (11th Cir. 1991), affg. Smith v. Commissioner, 91

T.C. 733 (1988). Petitioners bear the burden of proving that the

challenged transactions were not shams. Rule 142(a); Sheldon v.

Commissioner, 94 T.C. 738, 753 (1990).

Alternatively, petitioners appear to argue that the proper

test for sustaining the deduction of the processing fee is the

test in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221,

1237-1238 (1981). In Grodt, we set forth eight factors by which

to determine whether the benefits and burdens of ownership have
 - 29 -

passed and a sale has occurred between contracting parties.13

While the shifting of benefits and burdens of ownership is a key

indicator of the presence or a lack of economic substance, it is

only one of several considerations. Rose v. Commissioner, 88

T.C. 386, 410 (1987), affd. 868 F.2d 851 (6th Cir. 1989).

The U.S. Court of Appeals for the Ninth Circuit, the circuit

in which this case is appealable, Golsen v. Commissioner, 54 T.C.

742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), determines

whether a transaction is a sham by the following two-part test:

(1) Has the taxpayer shown a business purpose for engaging in the

transaction other than tax avoidance? (a subjective test) and

(2) has the taxpayer shown that the transaction had economic

substance beyond the creation of tax benefits? (an objective

test), Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir.

1990) (citing Bail Bonds By Marvin Nelson, Inc. v. Commissioner,

820 F.2d 1543, 1549 (9th Cir. 1987), affg. T.C. Memo. 1986-23),

affg. T.C. Memo. 1987-628. This two-part test, however, is not

13
The factors included:

(1) Whether legal title passes; (2) how the parties
treat the transaction; (3) whether an equity was
acquired in the property; (4) whether the contract
creates a present obligation on the purchaser to make
payments; (5) whether the right of possession is
vested in the purchaser; (6) which party pays the
property taxes; (7) which party bears the risk of
loss or damage to the property; and (8) which party
receives the profits from the sale of the property.
[Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C.
1221, 1237-1238 (1981); citations omitted.]
 - 30 -

to be used as a "rigid two-step analysis." Id. at 1363.

Instead, business purpose and economic substance are simply more

precise factors to be considered in the application of the

traditional sham analysis; that is, whether the transaction had

any practical economic effects other than the creation of income

tax losses. Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir.

1988).

The business purpose factor often involves an examination of

the subjective factors which motivated a taxpayer to enter into

the transaction at issue. Bail Bonds By Marvin Nelson, Inc. v.

Commissioner, supra at 1549. The economic-substance factor

involves a broader examination of whether the substance of a

transaction reflects its form, and whether from an objective

standpoint the transaction was likely to produce economic

benefits aside from a tax deduction. Id.

Dura-Craft and Northwest, both of which acted under the

effective control or direction of Milo Chapman and David

Christie, were related parties. In determining whether the form

of a transaction between related parties has substance, we

compare their actions with what would have occurred if the

transaction had occurred between parties who were dealing at

arm's length. Maxwell v. Commissioner, 95 T.C. 107, 117 (1990).

The question of whether an expense is lacking in economic

substance is essentially a factual determination. Commissioner
 - 31 -

v. Heininger, 320 U.S. 467, 475 (1943); Thompson v. Commissioner,

631 F.2d 642, 646 (9th Cir. 1980), affg. 66 T.C. 1024 (1976).

Tax laws affect the shape of many business transactions.

The parties to a transaction are entitled to take into account

and to maximize favorable tax results so long as the transaction

is compelled or encouraged by nontax business reasons. Frank

Lyon Co. v. United States, 435 U.S. 561, 580 (1978); James v.

Commissioner, 87 T.C. 905, 918 (1986), affd. 899 F.2d 905 (10th

Cir. 1990). We agree with respondent, however, that the payments

of the processing fees by Dura-Craft to Northwest were shams.

Dura-Craft is a subchapter C corporation, and Northwest is a

subchapter S corporation as defined in section 1361. The profits

of a C corporation are subject to corporate income tax, sec. 11,

and any distributions to shareholders are then subject to the

shareholders' personal income tax, secs. 61(a), 316. The profits

of a subchapter S corporation, however, are generally not subject

to a corporate tax, sec. 1371(a), but pass through to be taxed on

the individual shareholders' returns, sec. 1366, thereby

eliminating the double taxation of distributions to the

shareholders of C corporations. Moreover, petitioners have

failed to show that Dura-Craft had a business purpose in making

the payments. Furthermore, the payments served no purpose other

than the generation of tax benefits by shifting money and income

between Dura-Craft and Northwest. The record is devoid of
 - 32 -

evidence that services were provided or value was added by

Northwest, while the tax benefits are quite apparent. Northwest

had no employees during the years at issue. Moreover, Dura-Craft

employees placed all of the orders in Dura-Craft office space and

received all of the raw materials directly at the Dura-Craft

plant. Simply, there was no "arm's-length" reason beyond these

tax benefits for Dura-Craft to compensate Northwest.

Based upon the entire record in this case, we conclude that

Dura-Craft is not entitled to include the 5-percent processing

fees paid to Northwest as part of its cost of goods sold for its

taxable years ending October 31, 1988 and 1989. We have

considered all of the other arguments made by petitioners and, to

the extent we have not addressed them, find them to be without

merit.

To reflect the foregoing and concessions by the parties,

Decisions will be entered

under Rule 155.