T.C. Memo. 1999-54
UNITED STATES TAX COURT
KARL T. HARVEY AND KATHLEEN S. HARVEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14541-97. Filed February 26, 1999.
Steven M. Cyr, for petitioners.
Ann M. Murphy, for respondent.
MEMORANDUM OPINION
DINAN, Special Trial Judge: This case was submitted
pursuant to the provisions of section 7443A(b)(3) and Rules 180,
181, and 182.1
1
Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the taxable years in
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure.
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Respondent determined deficiencies in petitioners' Federal
income taxes for 1992, 1993, and 1994 in the amounts of $3,682,
$1,733, and $3,129, respectively, and accuracy-related penalties
pursuant to section 6662(a) in the amounts of $736.40, $346.60,
and $625.80, respectively.
The issues for decision are: (1) Whether petitioners
received and failed to report constructive dividends during the
taxable years in issue; and (2) whether petitioners are liable
for the section 6662(a) accuracy-related penalties for the
taxable years in issue.
This case was submitted fully stipulated. The stipulations
of fact and attached exhibits are incorporated herein by this
reference. Petitioners resided in Phoenix, Arizona, on the date
the petition was filed in this case.
All of the substantive adjustments in the statutory notice
of deficiency relate to petitioners' shareholder interests in the
Kathy Harvey Trust Corporation (KHTC). Petitioners have operated
KHTC as a painting business since its incorporation on May 16,
1984.
l. Constructive Dividends
The first issue for decision is whether petitioners received
and failed to report constructive dividends during the taxable
years in issue. Section 61(a) includes in gross income all
income from whatever source derived including, but not limited
to, dividends. Sec. 61(a)(7).
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In the statutory notice of deficiency, respondent determined
that petitioners received and failed to report constructive
dividends from KHTC during 1992, 1993, and 1994 in the amounts of
$12,218, $11,301, and $10,851, respectively. KHTC's Federal
income tax returns reveal that it had ample earnings and profits
during the taxable years in issue to cover the amounts of
constructive dividends determined by respondent. The parties
have stipulated that the determined amounts consist of the
following:
Dividends 1992 1993 1994
Forgone interest
under sec. 7872 $7,984.67 $7,324.29 $8,472.41
Petitioners' personal
expenses paid by KHTC 4,233.00 3,977.00 2,379.00
A. Forgone Interest Under Section 7872
KHTC advanced funds to petitioners before and during the
taxable years in issue. No loan documents were executed with
respect to the advanced funds. There is no evidence that
petitioners were obligated to pay or in fact paid any interest on
the advanced funds. Petitioners repaid some of the advanced
funds before and during the taxable years in issue.
Section 7872 sets forth the income and gift tax treatment
for certain categories of "below-market" loans; i.e., loans that
are interest free or that provide for interest that is lower than
the applicable Federal rate. Sec. 7872(e)(1); KTA-Tator, Inc. v.
Commissioner, 108 T.C. 100, 105 (1997); Mason v. Commissioner,
T.C. Memo. 1997-352. Pursuant to section 7872, a below-market
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loan is recharacterized as an arm's-length transaction in which
the lender made a loan to the borrower in exchange for a note
requiring the payment of interest at the applicable Federal rate.
The amount by which the interest which would have been payable on
the loan at the applicable Federal rate exceeds the interest
payable pursuant to the loan agreement is called "forgone
interest". Sec. 7872(e)(2). The forgone interest is treated as:
(1) Transferred from the lender to the borrower; and (2)
retransferred from the borrower to the lender as interest paid on
the loan. Sec. 7872(a)(1)(A) and (B). The first transfer is
treated as a gift, dividend, payment of compensation, or other
payment to the borrower, depending on the relationship between
the lender and the borrower. KTA-Tator, Inc. v. Commissioner,
supra at 102. The second transfer is treated as a payment of
interest by the borrower to the lender which is includable in the
lender's income and deductible by the borrower to the extent
allowable under section 163. Id.
Petitioners agree that the advances made by KHTC fall within
the section 7872(e)(1) definition of a below-market loan. They
contend, however, that respondent erred in determining the
amounts of the outstanding loans which were subject to section
7872 during the taxable years in issue. They argue that some of
the older loans were "unenforceable" during the taxable years in
issue by reason of Oregon's statute of limitation for commencing
actions upon a liability, effectively exempting such loans from
section 7872. Petitioners calculate that the correct amounts of
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their constructive dividends in the form of forgone interest for
1992, 1993, and 1994 are $8,310.81, $5,912.55, and $164.72,
respectively. Respondent argues that the Oregon law cited by
petitioners is irrelevant to the application of section 7872.
The Oregon statute of limitation relied upon by petitioners
generally requires that actions upon a contract or liability must
be commenced within 6 years. Or. Rev. Stat. sec. 12.080 (1997).
However, petitioners stated in their petition to the Court that
the loans were substantially repaid as of April 14, 1997, several
years after the loans allegedly became "unenforceable" under
Oregon law. In addition, KHTC listed all of the outstanding
advances as loans to stockholders on the Schedules L (balance
sheets) of its Federal income tax returns. We conclude from this
record that petitioners treated all of the loans as valid debt
during the taxable years in issue. Moreover, we agree with
respondent's position that State law does not control whether
these outstanding loans are subject to section 7872. Morgan v.
Commissioner, 309 U.S. 78, 80 (1940); Burnet v. Harmel, 287 U.S.
103, 110 (1932); see also Estate of Arbury v. Commissioner, 93
T.C. 136, 148 (1989) where State usury laws did not limit the
fair market interest rate to an amount less than the federal
statutory rate.
We have considered petitioners' other arguments with respect
to respondent's determinations of their constructive dividends in
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the form of forgone interest and find them either irrelevant or
lacking merit.2 Respondent's determinations are sustained.
B. Petitioners' Personal Expenses Paid by KHTC
If a corporation pays for the personal expenses of its
shareholders, it is well established that the shareholders are
charged with additional distributions from the corporation,
taxable to them as dividend income if the corporation has
sufficient earnings and profits. Melvin v. Commissioner, 88 T.C.
63, 79 (1987), affd. per curiam 894 F.2d 1072 (9th Cir. 1990);
American Properties, Inc. v. Commissioner, 28 T.C. 1100, 1115
(1957), affd. 262 F.2d 150 (9th Cir. 1958).
In their petition, their opening brief, and their reply
brief, petitioners failed to address respondent's determinations
that they are properly charged with constructive dividends for
KHTC's payment of their personal expenses. The stipulations of
fact include only a bald assertion by petitioners that such
amounts were paid for business expenses. The only evidence in
the record related to these expenses is the revenue agent's
explanation of why he determined that the amounts paid for such
expenses constitute constructive dividends.
Based on the record, we find that petitioners have failed to
prove any error in respondent's determinations that they are
properly charged with constructive dividends for KHTC's payment
2
The two cases relied upon by petitioners in their
briefs are not related in any manner to the issue of whether the
loans in issue are subject to section 7872. See Genest v. John
Glenn Corp., 696 P.2d 1058 (Or. 1985); Delaney v. Taco Time
Intl., Inc., 681 P.2d 114 (Or. 1984).
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of their personal expenses during the taxable years in issue. We
hold that respondent's determinations are sustained.
2. Accuracy-Related Penalties
The second issue for decision is whether petitioners are
liable for the section 6662(a) accuracy-related penalties for the
taxable years in issue. Respondent's determinations of
negligence are presumed to be correct, and petitioners bear the
burden of proving that the penalties do not apply. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933); Bixby v.
Commissioner, 58 T.C. 757, 791-792 (1972).
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment attributable to any one of various factors,
one of which is negligence or disregard of rules or regulations.
Sec. 6662(b)(1). Respondent determined that petitioners are
liable for accuracy-related penalties imposed by section 6662(a)
for the underpayments of tax for 1992, 1993, and 1994 because
such underpayments were due to negligence or disregard of rules
or regulations. "Negligence" includes a failure to make a
reasonable attempt to comply with the provisions of the Internal
Revenue laws or to exercise ordinary and reasonable care in the
preparation of a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1),
Income Tax Regs. "Disregard" includes any careless, reckless, or
intentional disregard of rules or regulations. Sec. 6662(c);
sec. 1.6662-3(b)(2), Income Tax Regs.
Section 6664(c)(1), however, provides that the penalty under
section 6662(a) shall not apply to any portion of an underpayment
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if it is shown that there was reasonable cause for the taxpayer's
position with respect to that portion and that the taxpayer acted
in good faith with respect to that portion. The determination of
whether a taxpayer acted with reasonable cause and in good faith
is made on a case-by-case basis, taking into account all the
pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income
Tax Regs. The most important factor is the extent of the
taxpayer's effort to assess his proper tax liability for the
year. Id.
Based on the record, we find that petitioners' underpayments
for 1992, 1993, and 1994 were not due to reasonable cause and
that they did not act in good faith. Accordingly, we hold that
petitioners are liable for the section 6662(a) accuracy-related
penalties for the taxable years in issue as determined by
respondent.
To reflect the foregoing,
Decision will be entered
for respondent.