Jeyapalan v. Commissioner

T.C. Memo. 2000-207

UNITED STATES TAX COURT

KANDIAH AND NALINI JEYAPALAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9940-98. Filed July 5, 2000.

Kandiah and Nalini Jeyapalan, pro se.

Deanna R. Kibler and Albert B. Kerkhove, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined deficiencies in

petitioners’ Federal income tax of $8,691 and $5,024 for 1993 and

1994, respectively, and a penalty under section 6662(a) of $1,738

for 1993.
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After concessions by the parties, the issue remaining for

decision is whether petitioners may disregard their S corporation

and have its losses treated as partnership losses.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

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

Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

At the time of the filing of their petition, Kandiah and

Nalini Jeyapalan (petitioners) resided in Ames, Iowa. Kandiah

Jeyapalan is a professor of civil engineering at Iowa State

University, and Nalini Jeyapalan is a former professor of

business finance at Fresno State University. Petitioners filed

joint Forms 1040, U.S. Individual Income Tax Return, for both

years in issue.

In 1985, petitioners acquired an interest in the A.S.K.

Partnership (partnership), a California partnership whose major

asset was a 16-unit apartment complex on 1.4 acres of land in

Fresno County, California (Fresno property). The partnership

issued Forms K-1, Partner’s Share of Income, Credits, Deductions,

Etc., to petitioners from 1985 through 1990.
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On January 20, 1988, the partnership obtained a loan in the

amount of $403,000 from Great Midwestern Bank (Great Midwestern).

The loan was secured by a deed of trust on the Fresno property

and was individually and personally guaranteed by all of the

partners.

In 1991, to avoid the personal liability exposure inherent

in conducting business as a partnership, the partners agreed to

convert the partnership to an S corporation. The partners

incorporated Clovis A.S.K. Properties, Inc. (ASK Properties), an

Ohio corporation, on January 3, 1991. Since its incorporation,

ASK Properties has engaged in the business of renting out the

apartments on the Fresno property. Petitioners, together,

received 25 percent of the outstanding stock of ASK Properties

upon its incorporation. Petitioners acquired the remaining

75 percent of the outstanding stock in 1992. The Internal

Revenue Service informed petitioners in March 1991 that a request

by ASK Properties to be treated as an S corporation had been

approved.

The partners agreed that it would be in their best interests

to transfer all of the partnership assets and liabilities to ASK

Properties, including the Fresno property subject to the deed of

trust. Shortly after forming ASK Properties, the partners

attempted to transfer the Fresno property and their debt

obligation on the Great Midwestern loan to the corporation.
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However, upon learning that Great Midwestern would charge them

$10,000 to transfer the obligation, the partners abandoned their

plan. Title to the Fresno property was never transferred to ASK

Properties and remains in the name of the partnership.

Petitioners repeatedly represented to respondent that the

Fresno property was owned and operated by ASK Properties. The

partnership filed its tax return for 1990 as a final tax return.

Petitioners filed corporate tax returns for ASK Properties on IRS

Forms 1120S, U.S. Income Tax Return for an S Corporation, from

1991 to 1994. Despite petitioners’ failure to transfer title to

the Fresno property, ASK Properties listed both the Fresno

property and the loan on a balance sheet attached to its first

Federal income tax return filed for 1991. Both were continuously

listed as property of ASK Properties through 1994. Petitioners

also requested and received an employer identification number

(EIN) for ASK Properties that differed from the EIN of the

partnership.

ASK Properties suffered losses of $43,319 and $36,083 and

reported depreciation deductions from the Fresno property of

$39,690 and $38,143 in 1993 and 1994, respectively. The amount

of principal outstanding on the loan was $375,825 in 1993 and

$362,762 in 1994.

Petitioners’ basis in stock of ASK Properties, without

consideration of the loan, was $8,064 at the end of 1992.
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Petitioners made contributions to capital of ASK Properties of

$18,348 in 1993 and $11,136 in 1994.

Respondent disallowed the flow-through losses to petitioners

to the extent the losses exceed petitioners’ basis in stock

without consideration of the loan.

OPINION

Petitioners bear the burden of showing error in the

determinations of respondent in the notice of deficiency. See

Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioners argue that, under principles of equity, the

corporation should be disregarded, and the business entity should

be taxed as a partnership. Respondent contends that the form and

substance of the business entity is that of an S corporation, and

it should, therefore, be taxed as an S corporation.

Shareholders are only entitled to claim losses and

deductions to the extent that they do not exceed the sum of their

adjusted basis in stock of an S corporation. See sec.

1366(d)(1). If a business entity is taxed as an S corporation, a

loan obligation of the corporation to a third party, personally

guaranteed by taxpayers as shareholders, generally would not be

includable in shareholders’ basis in stock of an S corporation.

See Estate of Leavitt, 90 T.C. 206, 216 (1988), affd. 875 F.2d

420 (4th Cir. 1989). A mere promise to advance money to a

corporation if certain events occur to trigger a guaranty is not
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sufficient to increase shareholders’ basis because there is no

actual economic outlay. Economic outlay would not occur until

and unless the shareholders paid part or all of the obligation.

See id. at 211.

Without basis attributable to the loan, petitioners did not

have enough basis to recognize the full amount of flow-through

loss for the years in issue. See sec. 1366(d)(1). The

unrecognized loss would be suspended until petitioners acquired

basis to offset the loss. See sec. 1366(d)(2).

Partners in a partnership are also only entitled to claim

losses and deductions to the extent that they do not exceed the

sum of their adjusted basis in the partnership. See sec. 704(d).

However, partnership loans secured by a personal guaranty are

includable in a guaranteeing partner’s basis in the partnership.

See sec. 752(a).

Whether the existence of a corporation should be disregarded

for Federal income tax purposes is a question of Federal law.

See Stoody v. Commissioner, 66 T.C. 710, 716 (1976). Generally,

when taxpayers choose to conduct business through a corporation,

they will not be permitted subsequently to deny the existence of

the corporation if it suits them for tax purposes. See Moline

Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943).

Exceptions exist where the creation of the corporation was not

followed by any business activity, the corporation was the agent
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of the taxpayers, or the purpose of creating the corporation was

not a business purpose. See Commissioner v. Bollinger, 485 U.S.

340, 344-347 (1988). None of these exceptions apply here.

In Skarda v. Commissioner, 27 T.C. 137 (1956), affd. 250

F.2d 429 (10th Cir. 1957), a taxpayer claimed that a corporation,

which had previously been operated as a partnership, should be

disregarded because no corporate activities such as shareholder

meetings, adoption of bylaws, elections of officers, preparation

of minutes, issuance of stock, or transfers of title to property

by the partnership to the corporation had ever occurred. The

taxpayer had filed articles of incorporation, and a certificate

of incorporation was issued. The business activity of the

corporation was limited to the publication of a newspaper,

maintenance of a checking account, setting up books that

reflected a capital stock account, the receipt of supplies, and

the extension of credit. This Court concluded that, even though

corporate formalities were not adhered to, the entity held itself

out to the public as a corporation and conducted some business in

the ordinary meaning. See id. at 145. Therefore, the corporate

entity could not be disregarded.

In Doe v. Commissioner, T.C. Memo. 1993-543, affd. in part

and revd. in part on other grounds 116 F.3d 1489 (10th Cir.

1997), taxpayers, who owned stock in a corporation that managed a

bar and bowling alley, sought to disregard their S corporation
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and be treated as a partnership because they lacked enough basis

to realize their full amount of flow-through loss. Before

incorporating, the taxpayers as partners had personally

guaranteed a partnership loan. The loan was not includable in

their basis in the S corporation. The taxpayers had not

transferred title in the bar and bowling alley to the

corporation; however, they caused the corporation to report

ownership of the property on its Federal income tax returns.

This Court decided that, because the S corporation had legally

incorporated under State law, filed an election to be taxed as an

S corporation, filed corporate returns, and held itself out to

the public as the owner and operator of the bowling alley, it had

sufficient business activity to establish corporate existence.

This Court also decided that, because the taxpayers incorporated

their partnership to achieve limited liability from tort, the

corporation had a substantial business purpose. See id.

We conclude that ASK Properties is indistinguishable from

the corporations in Skarda and Doe. Petitioners have stipulated

that, since its formation, ASK Properties has engaged in the

business of renting out the apartments on the Fresno property.

As in Skarda and Doe, petitioners caused ASK Properties to hold

itself out to the public as the legal entity that owns and

operates the Fresno property even though title was never formally

transferred to the corporation. In addition, petitioners caused
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ASK Properties to file Federal income tax returns from 1991 to

1994 representing that it was the owner and operator of the

Fresno property. Therefore, ASK Properties has sufficient

business activities to require its recognition for Federal income

tax purposes.

An agency relationship exists when the facts indicate that

the corporation carried out only “the normal duties of an agent.”

National Carbide Corp. v. Commissioner, 336 U.S. 422, 437 (1949).

The same facts that establish sufficient business activities

indicate that ASK Properties held itself out as operating the

Fresno property in its own name and for its own account.

We also conclude that the business purpose of forming ASK

Properties, to protect its shareholders from personal tort

liability, is a valid business purpose. See Moline Properties v.

Commissioner, supra; Doe v. Commissioner, supra. Thus,

petitioners do not meet the limited exceptions set forth in

Commissioner v. Bollinger, supra, and they cannot disavow the

corporate existence and elect to have the corporation disregarded

for tax purposes.

Petitioners’ next argument is that they were misled by

respondent during the years in issue because respondent did not

challenge their 1991 and 1992 tax returns. In 1991 and 1992,

petitioners owned 25 percent of the outstanding shares of ASK

Properties. Petitioners included one-fourth of the Great
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Midwestern loan in their basis in stock. Petitioners contend

that, had the IRS raised an issue regarding basis in those years,

they would have corrected any error before 1993 and 1994 when

their amount of flow-through loss was much greater.

Failure to raise an issue in one tax year does not preclude

or affect the correct determination of that issue in another

year. See, e.g., Tollefsen v. Commissioner, 52 T.C. 671, 681

(1969), affd. 431 F.2d 511 (2d Cir. 1970). Respondent’s failure

to correct the basis allocation by petitioners in 1991 and 1992

does not prevent the correct treatment of that issue for 1993 and

1994. See Dickman v. Commissioner, 465 U.S. 330 (1984); Dixon v.

United States, 381 U.S. 68, 72-75 (1965); Automobile Club of

Michigan v. Commissioner, 353 U.S. 180, 183-184 (1957); Schuster

v. Commissioner, 800 F.2d 672, 676 (7th Cir. 1986), affg. 84 T.C.

764 (1985).

We have carefully considered all remaining arguments made by

petitioners for a result contrary to those expressed herein, and,

to the extent not discussed above, they are irrelevant, without

merit, or not supported by the record.

Petitioners apparently believe that this case was processed

as a small tax case under section 7463 because of the form of

their petition filed June 1, 1998. However, the combined amounts

placed in dispute for 1993 exceeded the $10,000 limitation in

effect when the petition was filed, prior to the increase to
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$50,000 under Internal Revenue Service Restructuring and Reform

Act of 1998, Pub. L. 105-206, sec. 3103, 112 Stat. 731.

Accordingly, they have a right to appeal the decision to be

entered in this case.

To reflect the foregoing and the concessions of the parties,

Decision will be entered

under Rule 155.