Patrick v. Commissioner

T.C. Memo. 1998-30

UNITED STATES TAX COURT

WAYNE L. PATRICK, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

BRIAN J. PATRICK, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 26419-96, 26420-96. Filed January 26, 1998.

Joseph Falcone and Brian H. Rolfe, for petitioners.

Mark L. Hulse and Laurence D. Ziegler, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: On October 4, 1996, respondent issued separate

notices of deficiency to Brian J. Patrick (Brian) and Wayne L.

Patrick (Wayne) based on their failure to include in gross income

the distributions from a qualified profit-sharing plan and on
 - 2 -

Wayne's failure to include in gross income the distributions from

an individual retirement account (IRA). Respondent determined

deficiencies and additions to tax as follows:

Wayne L. Patrick--docket No. 26419-96:

Additions to Tax
Sec. Sec.
Year Deficiency 6651(a)(1) 6654

1992 $221,831 $55,458 $9,679
1993 11,647 2,912 488
1994 9,248 2,312 476

Brian J. Patrick--docket No. 26420-96:

Additions to Tax
Sec. Sec.
Year Deficiency 6651(a)(1) 6654

1992 $53,128 $13,157 $2,294
1993 5,701 1,425 239
1994 7,421 1,855 382

Petitioners separately petitioned the Court on December 10, 1996,

to redetermine respondent's determinations. On October 7, 1997,

the cases were consolidated for trial, briefing, and opinion.

Following concessions, we must decide:

1. Whether the money each petitioner received from Erie

Industries, Inc. Employees' Profit Sharing Plan (the Plan) is

includable in his gross income. We hold that it is.

2. Whether the money Wayne received from his IRA is

includable in his gross income for 1993 and 1994. We hold it is.
 - 3 -

3. Whether petitioners are liable for the 10-percent

additional tax determined by respondent under section 72(t).

We hold they are.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the years in issue. Rule

references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulations

and the exhibits attached are incorporated herein by this

reference, and the facts contained therein are so found.

Petitioners resided in West Bloomfield, Michigan, when they

petitioned the Court.

Before and during the years in issue, petitioners were the

owners, operators, employees, and shareholders of Erie

Industries, Inc. (Erie Industries). Erie Industries is a

subchapter S corporation engaged in precision machining and

grinding. At all times, petitioners were at least 10-percent

shareholders in the corporation.

Erie Industries maintained the Plan, which was a defined-

contribution profit-sharing plan established to operate as a

qualified plan described in section 401(a). The Erie Industries,

Inc. Employees' Profit Sharing Trust was formed under the Plan.

Wayne was the Plan trustee, and Erie Industries was the Plan

administrator. Petitioners participated in the Plan.
 - 4 -

The summary plan description provides for discretionary

loans made from the Plan to participants and beneficiaries.1

According to section VIII of the summary plan description, a

participant had to apply for a loan on forms provided by the Plan

administrator. The Plan administrator would then decide whether

a participant qualified for the loan and inform the trustee of

this decision. The trustee would review the administrator's

decision and make an independent decision on whether to approve

the loan. Also, according to the summary plan description, Plan

loan requirements included the following: (1) Loans must be made

available to all participants and their beneficiaries on a

uniform and nondiscriminatory basis; (2) loans must be adequately

secured, with up to one-half of a participant's vested account

balance as security for the loan; (3) loans must bear a

reasonable rate of interest; (4) loans must have a definite

repayment period which provides for payments to be made not less

frequently than quarterly, and for the loan to be amortized on a

level basis over a reasonable period of time, not to exceed

5 years;2 (5) loans must be limited by the rules of the Internal

1
At trial, petitioners submitted Exhibit 7-G entitled
"Erie Industries, Inc. Employees' Profit Sharing Trust Summary
Plan Description", and the Court allowed the exhibit into
evidence as a summary plan description and not as a
representative copy of the Plan itself. Petitioners failed to
locate and produce a copy of the Plan.
2
The 5-year amortization period could be extended if the
(continued...)
 - 5 -

Revenue Code; and (6) total loans to any one participant must be

limited to the lesser of $50,000, with some adjustment for

outstanding balance of loans, or one-half of a participant's or

beneficiary's vested account balance.3 Failure to make payments

when due under the terms of the loan agreement would result in a

default, whereby the trustee had the authority to collect the

balance of the loan through any reasonable action that included

instituting a lawsuit, foreclosing on any security, or

recharacterizing the loan as a deemed distribution.

As participants in the Plan, petitioners entered into a

series of transactions with the Plan. During 1992, Brian

received $207,300 from the Plan.4 The following promissory notes

were prepared to evidence the transfers of the underlying

amounts:

Date on Note Amount of Note

01/31/92 $110,000
02/28/92 26,000
03/31/92 6,000
04/30/92 2,000
05/31/92 10,000
06/30/92 2,000
07/31/92 31,000
08/31/92 10,000

2
(...continued)
loan was used to acquire a participant's principal residence.
3
These requirements were intended to incorporate the loan
requirements embodied in sec. 72(p)(2)(A), (B), and (C).
4
At that time, Brian had not attained either retirement
age under the Plan or the age of 59-1/2. See sec. 72(t)(2).
 - 6 -

09/30/92 3,000
10/31/92 2,000
12/31/92 5,300
1
Total 207,300
1
Respondent's notice of deficiency incorrectly identifies
the total amount of the transfers as $205,300, and respondent's
deficiency determination is based on that figure. Respondent
does not seek an increase in the deficiency determination.

Most, if not all, of the notes were prepared after the

corresponding transfers, and the notes dated September 30,

October 31, and December 31, 1992, were not signed. Brian did

not report any income with respect to these transfers.

In 1992 and 1993, Wayne received $624,000 and $17,000,

respectively, from the Plan.5 The following promissory notes

were prepared to evidence the transfers of the underlying

amounts:

Date on Note Amount of Note

01/31/92 $190,000
02/28/92 15,000
03/31/92 66,000
04/30/92 75,000
05/31/92 115,000
06/30/92 10,000
07/31/92 73,000
08/31/92 35,000
10/31/92 35,000
12/31/92 10,000
Total 624,000

02/28/93 17,000

5
At that time, Wayne had not attained either retirement
age under the Plan or the age of 59-1/2. See sec. 72(t)(2).
 - 7 -

Most, if not all, of these notes were prepared after the

corresponding transfers, and the May 31, 1992, note is not

signed. Wayne did not report any income with respect to these

transfers.

Each of petitioners' promissory notes contains the following

terms: Repayment of principal with interest from date of

transfer at a rate of 10 percent per annum; and payment in equal

monthly installments commencing approximately 1 month after the

date of each transfer until the earlier of repayment of principal

and interest in full or 5 years from the date of the transfer.

As security for each transfer, petitioners pledged their

respective vested account balances. The record does not disclose

the amounts of these balances at any time that is relevant

herein.

During 1993 and 1994, Wayne maintained an IRA with Merrill

Lynch. He received $9,000 from this account in 1993 and $9,307

in 1994. He did not report any income with respect to these

amounts.

OPINION

We must decide whether the funds received by petitioners

from their retirement accounts are includable in their gross

incomes. Petitioners argue that the transfers from the Plan are

loans from the Plan and nontaxable to the extent of $50,000 for

each petitioner. Petitioners concede that the transfers over
 - 8 -

$50,000 to each of them are distributions and, as such, are

income to the recipients. See sec. 72(p)(2)(A). Respondent

argues that there were no bona fide loans between the Plan and

petitioners, and that no part of the transfers qualifies as a

nontaxable loan under section 72(p)(2). In the alternative,

respondent argues that even if the transfers were loans, the

amounts received would still be deemed distributions under

section 72(p) and, as such, income to petitioners. As to all

issues, petitioners bear the burden of establishing that

respondent's determinations are incorrect. Rule 142(a); Welch v.

Helvering, 290 U.S. 111 (1933).

I. Distributions From the Plan and Bona Fide Debt

Section 402(a) provides that "any amount actually

distributed to any distributee by any employees' trust described

in section 401(a) * * * shall be taxable to the distributee, in

the taxable year of the distributee in which distributed, under

section 72".6 Section 72(p)(1)(A) generally provides that loans

from a qualified employer plan to plan participants or

beneficiaries are treated as taxable distributions. Section

72(p)(2) provides an exception, however, where the following

requirements are met: (1) The loan does not exceed the lesser of

the amount set forth in section 72(p)(2)(A)(i) or (ii); (2) the

6
The provision applies to distributions made after
Dec. 31, 1992. For our purposes, the version of sec. 402(a) in
effect for distributions made in 1992 was essentially the same.
 - 9 -

loan, by its terms, must be repaid within 5 years from the date

of its inception or is made to finance the acquisition of a home

which is the principal residence of the participant; and (3) the

loan must have substantially level amortization with quarterly or

more frequent payments required over the term of the loan.

Section 72(p)(2) applies only to distributions that are intended

to be loans.

Respondent argues that the transfers from the Plan were

taxable distributions and not loans. In support, respondent

cites the following factors: In all cases in which the notes

were signed, the notes were signed well after the transfers were

made; petitioners presented no evidence, other than copies of the

notes, that the Plan, the Plan administrator, the Plan trustee,

or petitioners maintained any records reflecting the transfers as

loans; any repayments on the notes, if in fact made, were

insignificant; there was at no time a demand for repayment and no

steps were taken to enforce the notes; neither petitioner had the

ability to repay the transferred funds; and the notes were

between related parties and the form of the transaction should

not be honored where it lacks economic reality. In response,

petitioners argue that sufficient "indicia of debt" are present

to justify characterizing the transfers as loans.

A transfer of money will be characterized as a loan for

Federal income tax purposes where "'at the time the funds were
 - 10 -

transferred, [there was] an unconditional intention on the part

of the transferee to repay the money, and an unconditional

intention on the part of the transferor to secure payment.'"

Geftman v. Commissioner, T.C. Memo. 1996-447 (quoting Haag v.

Commissioner, 88 T.C. 604, 616 (1987), affd. without published

opinion 855 F.2d 855 (8th Cir. 1988)). In other words, the

parties must intend to create bona fide debt. The intention of

the parties "relates not so much to what the transaction is

called, or even what form it takes as it does to an actual intent

that money advanced will be repaid." Berthold v. Commissioner,

404 F.2d 119, 122 (6th Cir. 1968), affg. T.C. Memo. 1967-102; see

also Livernois Trust v. Commissioner, 433 F.2d 879, 882 (6th Cir.

1970), affg. T.C. Memo. 1969-111. However, because direct

evidence of a taxpayer's state of mind is not generally

available, courts have focused on certain objective factors to

determine whether a bona fide loan exists: (1) The existence or

nonexistence of a debt instrument; (2) provisions for security,

interest payments, and a fixed repayment date; (3) whether the

parties' records, if any, reflect the transaction as a loan; (4)

the source of repayment and the ability to repay; (5) the

relationship of the parties; (6) whether any repayments have been

made; (7)whether a demand for repayment has been made; and (8)

failure to pay on the due date or to seek a postponement. See
 - 11 -

Smith v. Commissioner, 370 F.2d 178, 180 (6th Cir. 1966), affg.

T.C. Memo. 1964-278; Haag v. Commissioner, supra at 616 n.6.

The above factors are not exclusive, and no one factor is

dispositive. See John Kelley Co. v. Commissioner, 326 U.S. 521,

530 (1946); Smith v. Commissioner, supra. The factors are simply

objective criteria helpful to the Court in analyzing all relevant

facts and circumstances. The ultimate question remains whether

"there [was] a genuine intention to create a debt, with a

reasonable expectation of repayment, and did that intention

comport with the economic reality of creating a debtor-creditor

relationship". Litton Bus. Sys. Inc. v. Commissioner, 61 T.C.

367, 377 (1973). This is a factual issue, to be decided upon all

the facts and circumstances in each case. Geftman v.

Commissioner, supra. Petitioners must prove that a bona fide

debt was created and that the transfers were loans. Rule 142(a);

Welch v. Helvering, supra.

Both Brian and Wayne testified that it was their intention

to obtain Plan loans. Such testimony is, however, overcome by

other evidence and is therefore not controlling. See Livernois

Trust v. Commissioner, supra. We now turn to the objective

factors relevant to the instant case.

a. The Existence or Nonexistence of a Debt Instrument

The existence of a promissory note for each transfer of

funds is evidence of debt. However, respondent argues that the
 - 12 -

existence of notes in this case is not strong evidence of the

character of the transactions because the notes were not signed

on or around the time of the distributions. Petitioners argue

that the presence of the notes is strong evidence of debt.

Brian testified that the notes were not prepared or signed

contemporaneously with the receipt of funds. He was unsure of

when he had signed the notes but believed it to be in either 1992

or 1993. Brian further stated that he signed the notes "at least

a year" after the receipt of the funds. Wayne did not know

exactly when he had signed the notes. Given this testimony and

other evidence in the record, the mere presence of notes is

assigned little weight unless supported by some other objective

evidence showing the distributions to be loans, especially

considering petitioners' relationship to Erie Industries and

Wayne's position as Plan trustee. Additionally, Brian's failure

to sign three of his notes and Wayne's failure to sign one of his

notes weakens petitioners' position that the notes are strong

evidence of debt. Under these circumstances, "form does not

necessarily correspond to the intrinsic economic nature of the

transaction". Fin Hay Realty Co. v. United States, 398 F.2d 694,

697 (3d Cir. 1968). This indicium offers no more than marginal

support for the existence of debt.

b. Provisions for Security, Interest Payments, and a Fixed
Repayment Date
 - 13 -

The notes contain provisions for security, payment of

principal and interest, and a fixed repayment schedule over a

5-year period. Respondent argues that the existence of these

provisions is weak evidence of debt because the notes were not

signed until after the distributions were received and the

provisions were ignored by both the Plan trustee and the

administrator.

Security, interest, and repayment arrangements are

ordinarily important proofs of intent to treat the transaction as

debt. Berthold v. Commissioner, supra at 122. However, the fact

that the funds were distributed before the drafting and signing

of the notes militates against assigning much weight to this

indicium.7 Accordingly, this indicium offers no more than

marginal support for the existence of debt.

c. The Parties' Records

Respondent notes that petitioners provided no evidence,

other than the notes, that the Plan, the Plan administrator, the

Plan trustee, or petitioners maintained any records reflecting

the transfers as loans. The record is indeed void of any other

evidence that the parties maintained records indicating that the

transfers created debt. This indicium supports a finding that

the transfers did not create bona fide debt.

7
We also note that no steps were taken to enforce these
provisions.
 - 14 -

d. The Source of Repayment and the Ability To Repay

Respondent argues that petitioners had no ability to repay

the transfers, and this indicium of debt is thereby lacking. The

monthly installments, including interest, for Brian's 1992

"loans" totaled $4,405.74. In 1992 through 1994, Brian received

wages, additional income, and interest income totaling $14,307,

$45,364, and $51,291, respectively. Brian testified that he was

aware of the fact that the 1992 notes required monthly payments

totaling approximately $52,000 a year. He also testified that he

entered into the transactions knowing that his wages for 1992

were only $14,000. The monthly installments, including interest,

for Wayne's 1992 and 1993 "loans" totaled $13,623.08. In 1992

through 1994, Wayne received wages, interest and dividend income

totaling $13,439, $45,359, and $57,352, respectively.

Petitioners' inability, ab initio, to meet their contractual

obligation to service these "loans" is evidence that petitioners

had no intention of treating the transactions as bona fide debt.

We also note that Wayne's testimony that his repayment of the

"loans" was contingent on the future success of Erie Industries

supports our finding that Wayne did not intend to treat the

transfers as bona fide debt. This indicium supports a finding

that the transactions did not create bona fide debt. Cf. Fuller

v. Commissioner, T.C. Memo. 1980-370 (taxpayers submitted

evidence that their net worth substantially exceeded the sum of
 - 15 -

the balances on the promissory notes, and thereby demonstrated

their ability to repay the obligation).

e. The Relationship of the Parties

Two facts color the transactions between petitioners and the

Plan: (1) Petitioners' status as owners, operators, employees,

and shareholders in Erie Industries; and (2) Wayne's position as

the Plan's trustee. Where the nominal creditor and debtor are

controlled by the same party and the arm's-length dealing that

characterizes the market is lacking, the substance of the

transaction and not its form is controlling. Road Materials,

Inc. v. Commissioner, 407 F.2d 1121, 1124 (4th Cir. 1969), affg.

on this issue T.C. Memo. 1967-187. In determining whether the

form of a transaction between closely related parties has

substance, we should compare their actions with what would have

occurred if the transaction had occurred between parties who were

dealing at arm's length. Peck v. Commissioner, 904 F.2d 525 (9th

Cir. 1990), affg. 90 T.C. 162 (1988); Maxwell v. Commissioner,

95 T.C. 107, 117 (1990).

We find that under the standards of parties dealing at arm's

length, the transactions at issue were not bona fide loans.

Among other things, an administrator, trustee, or other fiduciary

of a plan dealing at arm's length with a participant would not

have approved "loans" where the participant lacked any documented

ability to meet payment obligations. Although the Plan's
 - 16 -

administrator was required by the Plan to authorize any loan, we

find no such authorization during the subject years.

Furthermore, Wayne testified that he never reviewed the Plan or

supporting documents, even though he was the Plan's trustee. We

are left to conclude that petitioners rubberstamped these

transfers. This indicium supports a finding that the transfers

did not create bona fide debt.

f. Whether Repayments Have Been Made

Respondent argues that any repayment made by petitioners is

insignificant. Brian testified that in 1995 he repaid

approximately $3,000. Wayne testified that he had repaid only "a

few thousand dollars". He stated that he did not remember making

any payments or when the alleged payments had been made. We are

unpersuaded by this testimony, and neither petitioner presented

any objective evidence that any payment had been made on the

notes. This indicium supports a finding that the transfers did

not create bona fide debt.

g. Demand for Repayment

Respondent points to the fact that no demand for repayment

has been made as evidence that these transactions were not loans.

The record supports a finding that no steps were taken to enforce

the loans. Wayne was not aware of his duties as Plan trustee,

and he took no steps to collect on either his or Brian's notes.

Moreover, Wayne testified that he was not even aware of whether
 - 17 -

Brian was in default. This indicium supports a finding that

there was no bona fide debt.

h. Failure To Pay or Seek a Postponement

Brian testified that he repaid "a little bit" of the

transfers, "approximately $3,000". He further testified that he

made no repayments in 1992, 1993, or 1994. Supposedly a small

repayment was made in 1995, and then only after he became aware

that there might be "a problem" with the "loans". Brian made no

effort to seek a postponement of payment on the alleged

liability. Wayne testified that he had repaid only "a few

thousand dollars". He had no idea of when these repayments were

made. Wayne also made no effort to seek a postponement of

payment on the alleged liability. This indicium supports a

finding that there was no bona fide debt.

i. Conclusion

On the basis of our review of all relevant factors, we find

that the 1992 and 1993 transfers from the Plan to petitioners

were taxable distributions and not loans.

II. Distributions From Wayne's IRA

Respondent determined that Wayne received taxable

distributions from his IRA during 1993 and 1994 in the amounts of

$9,000 and $9,307, respectively. In his petition, Wayne contends

that he did not receive taxable premature distributions from his

IRA. In his response to respondent's request for admissions,
 - 18 -

Wayne further contends that the funds received from the IRA were

loans. Wayne did not address this issue at trial or on brief.8

Under section 408(d)(1), "any amount paid or distributed out

of an individual retirement plan shall be included in gross

income by the payee or distributee * * * in the manner provided

under section 72." See also Campbell v. Commissioner, 108 T.C.

54 (1997). Generally, any amount distributed from an IRA is

includable in the gross income of the recipient in the year in

which the distribution is received. Sec. 408(d)(1); sec. 1.408-

4(a)(1), Income Tax Regs. Because there is no evidence in the

record that Wayne made nondeductible contributions to his IRA, we

find that his tax basis in the IRA was zero. Sec. 1.408-4(a)(2),

Income Tax Regs.; see also sec. 72(e)(2)(B). Therefore, he is

afforded no credit for any investment in the IRA within the

meaning of section 72(e)(3)(A) and (6). See also Vorwald v.

Commissioner, T.C. Memo. 1997-15. The distributions are thereby

allocated to, and included in, Wayne's gross income as follows:

$9,000 for 1993 and $9,307 for 1994.

8
Wayne appears to have abandoned his untenable position
that the funds were received in the form of loans. Unlike a loan
from a qualified plan, a loan from an IRA to its owner is always
a prohibited transaction (there is no exception for loans from an
IRA to its beneficiary). Sec. 4975(d); Employee Retirement
Income Security Act of 1974, Pub. L. 93-406, sec. 408(d), 88
Stat. 829, 885. If such a loan was made, the IRA would lose its
exemption and all assets would be deemed distributed. Sec.
408(e)(1) and (2).
 - 19 -

III. Section 72(t) -- Additional Tax

Respondent determined a 10-percent additional tax under

section 72(t) for premature distributions made from a qualified

retirement plan to petitioners. Section 72(t) imposes an

additional tax on any amount received from a qualified retirement

plan equal to 10 percent of the amount includable in gross

income. For purposes of the 10-percent tax, a qualified

retirement plan includes an IRA described under section 408(a).

See sec. 4974(c)(4). Several exceptions to the imposition of the

additional tax are enumerated in section 72(t)(2). Petitioners

presented neither evidence nor argument in support of the

application of any of the exceptions. Therefore, we find that

petitioners are liable for the 10-percent additional tax under

section 72(t) as follows: Brian as to the entire 1992 Plan

distributions; Wayne as to the entire 1992 and 1993 Plan

distributions and as to the entire 1993 and 1994 IRA

distributions.

We have considered all other arguments made by the parties

and found them to be either irrelevant or without merit.

To reflect the foregoing,

Decisions will be entered

for respondent.