OLDE RALEIGH REALTY CORP. v. COMMISSIONER

T.C. Summary Opinion 2002-61

UNITED STATES TAX COURT

OLDE RALEIGH REALTY CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1674-00S. Filed May 29, 2002.

Edgar H. Bridger, for petitioner.

Linda P. Azmon, for respondent.

PAJAK, Special Trial Judge: This case is before the Court

on a petition for a redetermination of a Notice Of Determination

Concerning Worker Classification Under Section 7436. Unless

otherwise indicated, section references are to the Internal

Revenue Code as amended, and all Rule references are to the Tax

Court Rules of Practice and Procedure. The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority. Sec. 7436(c).
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On November 10, 1999, respondent issued to petitioner a

Notice of Determination Concerning Worker Classification Under

Section 7436 (notice of determination). In the notice of

determination, respondent determined: (1) William Henderson (Mr.

Henderson) was an employee of Olde Raleigh Realty Corporation

(petitioner) for the tax periods ending December 31, 1995 and

1996, for purposes of Federal employment taxes, and (2)

petitioner was not entitled to relief from these taxes as

provided by section 530 of the Revenue Act of 1978, Pub. L. 95-

600, 92 Stat. 2885 (section 530 of 1978 Act). (For convenience,

we sometimes use the term “employment taxes” to refer to taxes

under the Federal Insurance Contributions Act (FICA-Social

Security taxes) and Federal Unemployment Tax Act (FUTA-

Unemployment taxes)).

The proposed Federal employment taxes, additions to tax, and

related penalties were detailed in the notice of determination as

follows:
Addition to tax Accuracy-related penalty
Year Tax Tax Sec. 6656 Sec. 6662(a)

1995 FICA $10,105.01 $505.25 $2,021.00
1995 FUTA 434.00 43.40 86.80
1996 FICA 11,926.09 $596.30 2,385.22
1996 FUTA 434.20 43.42 86.84

After concessions by petitioner that Mr. Henderson should be

legally classified as an employee of petitioner for purposes of

Federal employment taxes and that petitioner is not entitled to

relief under section 530 of the 1978 Act, the issues for decision
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are: (1) Whether certain payments made by petitioner to, or on

behalf of, Mr. Henderson should be recharacterized as wages

subject to Federal employment taxes; (2) whether petitioner is

liable for the additions to tax under section 6656; and

(3) whether petitioner is liable for the penalties under section

6662(a).

Some of the facts in this case have been stipulated and are

so found.

Petitioner is an S corporation that was incorporated in

North Carolina on or about May 7, 1991. At the time the petition

was filed, petitioner’s principal place of business was in

Raleigh, North Carolina. Petitioner operates a brokerage/real

estate company that is the sole source of its income. Since

petitioner’s incorporation and all during 1995 and 1996, Mr.

Henderson has owned 100 percent of petitioner’s stock and has

been the president of petitioner.

Mr. Henderson worked approximately 32 hours per week for

petitioner during 1995 and 1996. During the years in issue, Mr.

Henderson performed many services for petitioner. Mr. Henderson

negotiated with sellers of real property, reviewed development

budgets, reviewed development progress, assisted in the

negotiation of sales of lots to residential builders, reviewed

financial operations, arranged financing for joint ventures,

assisted in organizing and setting up development entities,
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solicited clients and business on behalf of petitioner, entered

into verbal and written agreements on behalf of petitioner,

oversaw petitioner’s finances, managed petitioner, hired and

fired independent contractors on behalf of petitioner, made

investment decisions on behalf of petitioner, entered into

development projects on behalf of petitioner, and had signatory

authority over petitioner’s bank accounts.

During 1995, petitioner recognized that the following

persons were employees: B.J. Stanfield, office assistant; Brenda

M. Gray, office assistant; and Michael Giaquinto, development

troubleshooting/assistant to Mr. Henderson. Petitioner timely

filed Forms 941, Employer’s Quarterly Federal Tax Return, for

each quarter in 1995 and 1996. Petitioner also timely filed

Forms 940-EZ, Employer’s Annual Federal Unemployment Tax Return,

for both 1995 and 1996.

Petitioner did not issue Forms W-2, Wage and Tax Statement,

or Forms 1099-MISC, Miscellaneous Income, to Mr. Henderson in

1995 or 1996.

During 1995, petitioner paid from its own bank account

$96,766 of Mr. Henderson’s personal expenses. (All dollar

amounts are rounded off in this opinion.) Likewise, during 1996

petitioner paid from its own bank account $143,221 of Mr.

Henderson’s personal expenses.

In the notice of determination, respondent based the FICA
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and FUTA tax liabilities on payments made by petitioner for Mr.

Henderson’s personal expenses in the amount of $86,766 and

$143,148 for 1995 and 1996, respectively. The record is silent

as to why the amounts in the notice of determination are $10,000

and $73 less than the amounts of Mr. Henderson’s personal

expenses paid by petitioner for 1995 and 1996, respectively.

These differences appear from time to time, but we shall decide

the case based on respondent’s notice of determination.

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

petitioner reported ordinary income from its trade or business

for 1995 and 1996 of $217,985 and $380,559, respectively.

Petitioner reported these amounts of ordinary income as Mr.

Henderson’s share of ordinary income from trade or business

activities on Schedules K-1 (Schedules K-1), Shareholder’s Share

of Income, Credits, Deductions, etc., filed with each Form 1120S

for 1995 and 1996.

Mr. Henderson and his wife timely filed Forms 1040, U.S.

Individual Income Tax Return, for 1995 and 1996. They reported

the $217,985 and $380,559 of ordinary income from the Schedules

K-1 on their returns for 1995 and 1996, respectively.

On or about December 3, 1992, Mr. Henderson filed a petition

with the United States Bankruptcy Court, Eastern District of

North Carolina (Bankruptcy Court), seeking relief from personal

indebtedness under Chapter 7 of the Bankruptcy Code. On or about
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March 19, 1993, Mr. Henderson received a discharge from

indebtedness from the Bankruptcy Court.

Respondent contends that amounts paid by petitioner to, or

on behalf of, Mr. Henderson for personal expenses in 1995 and

1996 constitute wages which subject petitioner to Federal

employment taxes on those wages. Petitioner argues that the

amounts the corporation paid with respect to Mr. Henderson’s

personal expenses during the years in issue were funds advanced

by Mr. Henderson to petitioner pursuant to an oral agreement

between the corporation and Mr. Henderson. Petitioner also

contends that the amounts used by the corporation for these

payments were advanced by Mr. Henderson to petitioner in a

“trust” capacity. Petitioner contends that the oral agreement

was a means for Mr. Henderson to deposit funds with petitioner

and then have petitioner pay Mr. Henderson’s personal expenses,

thus avoiding the reach of his creditors. In the alternative,

petitioner argues that the payments of Mr. Henderson’s personal

expenses represented repayment of loans made by Mr. Henderson to

the corporation.

Section 7491 is not applicable in the instant case because

the examination commenced before July 22, 1998. Petitioner bears

the burden of proof. Rule 142(a); Welch v. Helvering, 290 U.S.

111 (1933).

We note that this Court has jurisdiction to determine
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whether the Secretary’s determination of worker classification is

correct and to determine the amount of employment taxes,

additions to tax, and penalties provided by Chapter 68 of

Subtitle F (sections 6651 through 6751). Ewens & Miller, Inc. v.

Commissioner, 117 T.C. 263, 267-268 (2001).

Sections 3111 and 3301 impose FICA and FUTA taxes on

employers for wages paid to their employees. Wages for FICA and

FUTA purposes are defined as “all remuneration for employment,

including the cash value of all remuneration (including benefits)

paid in any medium other than cash” with exceptions not

applicable in this case. Secs. 3121(a), 3306(b). Generally, the

form of payment is immaterial. Secs. 31.3121(a)-1(c) and (d),

31.3306(b)-1(b), (e), Employment Tax Regs. Payment can be made

in cash or something other than cash. Secs. 31.3121(a)-1(c) and

(d), 31.3306(b)-1(b), (e), Employment Tax Regs. Thus, “an

officer who performs substantial services for a corporation and

who receives remuneration in any form for those services is

considered an employee whose wages are subject to Federal

employment taxes.” Veterinary Surgical Consultants, P.C. v.

Commissioner, 117 T.C. 141, 145 (2001).

Petitioner sought to prove the existence of an oral

agreement between the corporation represented by its president,

Mr. Henderson, and its sole shareholder, Mr. Henderson. In

essence, petitioner seeks to prove an oral agreement by Mr.
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Henderson with himself. Petitioner cites an 1835 North Carolina

opinion containing dicta to the effect that an oral agreement may

be proven by “any competent witness, who was present at the time,

or who heard the defendant admit the existence of such contract.”

Pender v. Forbes, 18 N.C. 250 (1835). Whether or not this is the

law, petitioner provided no witness, much less a competent

witness, to prove such an oral contract. Mr. Henderson, the

president of petitioner, did not testify at trial. Mr.

Henderson, as an individual, did not testify. Nor did any of

petitioner’s other officers or employees testify as to the

alleged oral agreement and its execution.

Petitioner’s sole witness was C. Gilbert Smith (Mr. Smith),

petitioner’s certified public accountant. Mr. Smith offered no

testimony as to the existence of the purported oral agreement

between petitioner and Mr. Henderson. Mr. Smith did not testify

that he was present at the time of the purported oral agreement.

Mr. Smith testified only about how petitioner’s books reflected a

purported arrangement. Petitioner provided no objective records

to evidence the execution of the oral agreement: no deposit

slips, no canceled checks, no bank statements, and no other

evidence of receipt by petitioner of funds from Mr. Henderson to

act in a “trustee” capacity in accordance with the alleged oral

agreement.

The record before this Court contains no evidence that,
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during the years in issue, an oral agreement existed between

petitioner and Mr. Henderson for him to advance funds to the

corporation and for the corporation to pay his personal expenses.

Accordingly, we hold that there was no oral agreement between

petitioner and Mr. Henderson and that petitioner has failed to

show that amounts withdrawn from the corporation to pay Mr.

Henderson’s personal expenses were pursuant to a “trust”

arrangement.

Petitioner argues in the alternative that the corporation’s

payment of Mr. Henderson’s personal expenses represented

repayments of loans made between the two parties. Respondent

argues that any funds advanced by Mr. Henderson were

contributions to capital and any payment of Mr. Henderson’s

personal expenses constitutes the payment of wages to an

employee.

In resolving the question of whether a payment is debt or

equity for Federal tax purposes, each case must be decided on its

own facts. Calumet Indus., Inc. v. Commissioner, 95 T.C. 257,

285 (1990).

Courts have identified and considered various factors in

determining whether a payment is debt or equity. Some of the

factors considered are: The names given to the certificates

evidencing the indebtedness, presence or absence of a fixed

maturity date, source of payments, right to enforce payments,
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participation in management as a result of the advances, status

of the advances in relation to regular corporate creditors,

intent of the parties, identity of interest between creditor and

stockholder, thinness of capital structure in relation to debt,

ability of corporation to obtain credit from outside sources, use

to which advances were put, failure of debtor to repay, and the

risk involved in making advances. Dixie Dairies Corp. v.

Commissioner, 74 T.C. 476, 493 (1980).

The identified factors are not equally significant, and no

single factor is determinative or relevant in each case. Id. at

493-494. This Court has stated that the ultimate question is

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). However, without evidence substantiating the

existence of a bona fide debt, a mere declaration of intent is

not determinative. Cordes v. Commissioner, T.C. Memo. 1994-377.

Petitioner contends that, during the years in issue, Mr.

Henderson deposited moneys in the corporation which were loans.

Mr. Smith testified that the alleged deposits made by Mr.

Henderson to petitioner totaled $98,894 in 1995 and $170,000 in

1996. Petitioner had two corporate receipts totaling $8,000 and

a promissory note executed between petitioner and Mr. Henderson
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in the amount of $9,000 as evidence of the existence of the

purported loans made by Mr. Henderson. Petitioner had a

corporate resolution dated December 31, 1995, which acknowledged

receipt by the corporation of alleged loans from Mr. Henderson

during 1995 totaling $18,575. Petitioner also had a similar

corporate resolution dated December 31, 1996, which acknowledged

receipt of alleged loans from Mr. Henderson in 1996 totaling

$186,800. Mr. Smith testified that petitioner maintained a loan

account titled “Loans Payable-W.R. Henderson”. He also testified

that charges were made against the loan account for “expenses, of

a personal nature, such as mortgage payment on [Mr. Henderson’s]

home, contributions to charities, credit card payments,...and

various other personal expenses.” During 1995 and 1996, the

charges against the “Loans Payable-W.R. Henderson” account

totaled $96,766 and $143,421, respectively.

Mr. Henderson was president and sole shareholder of

petitioner during the years in issue. The fact that the debtor

and creditor are related parties does not preclude the existence

of a bona fide debt. Calumet Indus., Inc. v. Commissioner, supra

at 286. However, transactions between closely held corporations

and their shareholders are examined with special scrutiny. Elec.

& Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971), affd.

without published opinion 496 F.2d 876 (5th Cir. 1974).

In Smith v. Commissioner, T.C. Memo. 1995-410, payments made
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by the corporation to pay the personal expenses of its sole

shareholder were held not to be loan repayments. In that case,

the taxpayer did not testify, and the only evidence of a loan was

the accountant’s testimony. There were no loan agreements or

other documentary evidence relating to the alleged loans. Id.

Like Smith v. Commissioner, supra, petitioner has not

convinced this Court that Mr. Henderson made bona fide loans to

the corporation during the years in issue. In this case, neither

Mr. Henderson nor any other officer or employee of petitioner

testified as to the existence of any such loans. Petitioner

primarily relies on the testimony of Mr. Smith, the corporation’s

accountant. Mr. Smith testified that, other than the $9,000

promissory note, there were no written agreements or notes

evidencing additional loans. Specifically, Mr. Smith testified

that the only record of the purported loans indicated by the 1995

and 1996 corporate resolutions were found in petitioner’s own

general ledger. Such records, absent objective evidence of a

loan, will be given little weight. Dixie Dairies Corp. v.

Commissioner, supra at 495. Petitioner provided no other

receipts, bank statements, or canceled checks evidencing the

receipt by the corporation of the amounts purported to have been

loaned by Mr. Henderson. Mr. Smith testified that the purported

loans evidenced by the 1995 and 1996 corporate resolutions did

not provide for interest, repayment terms, or enforcement rights
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in Mr. Henderson. Additionally, there were no set maturity dates

or security pledged for the alleged loans. Mr. Smith also

testified that no bank would consider making a loan to

petitioner.

As to the lone $9,000 promissory note, whether it represents

a legitimate debt instrument is irrelevant to the disposition of

whether the payments of Mr. Henderson’s personal expenses by

petitioner are repayments of loans made between the two parties.

Petitioner has shown no evidence that any of the personal

expenses paid on behalf of Mr. Henderson represented repayment of

the $9,000 promissory note. The $9,000 promissory note has a

“Satisfaction” clause reserved at the top of the promissory note

so that the date on which the promissory note was satisfied in

full could be documented by date and signature. Nothing on the

face of the $9,000 promissory note indicates that any of the

payments of Mr. Henderson’s personal expenses were in

satisfaction of the alleged debt.

In this case, there is no objective evidence that any of the

personal expenses paid by petitioner on behalf of Mr. Henderson

represented repayment of loans between Mr. Henderson and the

corporation. Accordingly, we hold that none of the personal

expenses paid by petitioner on behalf of Mr. Henderson

represented repayment of loans made by him to the corporation.

This Court must now decide whether the payments of Mr.
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Henderson’s personal expenses by petitioner were compensation or

constructive dividends to him. If the payments are constructive

dividends, the amounts are not deemed compensation to Mr.

Henderson. Thus, the payments would not be wages for purposes of

FICA and FUTA taxes. Respondent contends that the payment of the

personal expenses represented compensation to Mr. Henderson, and

therefore petitioner is liable for the related employment taxes.

Whether a corporation’s payment of a shareholder’s personal

expense is a constructive dividend or compensation is a question

of fact. See Goldstein v. Commissioner, 298 F.2d 562, 566 (9th

Cir. 1962), affg. T.C. Memo. 1960-276. Regardless of how an

employer chooses to characterize payments made to employees, “the

true analysis is whether the payments are for remuneration for

services rendered.” Spicer Accounting, Inc. v. United States,

918 F.2d 90, 93 (9th Cir. 1990).

When a corporation’s earnings are due to the efforts of its

employees, it is entirely appropriate for the corporation to make

substantial payments to its employees. Langer v. Commissioner,

T.C. Memo. 1990-268. In Smith v. Commissioner, supra, this Court

determined that the payment of the shareholder’s personal

expenses constituted compensation payments instead of

constructive dividends. The Court was persuaded by the fact that

the corporation did not pay a salary to the shareholder and that

the taxpayer’s earnings arose solely from the shareholder’s
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efforts. Id.

Petitioner concedes that Mr. Henderson should be classified

as an employee for purposes of Federal employment taxes. Mr.

Henderson worked approximately 32 hours a week for petitioner

during the years in issue. The services performed by Mr.

Henderson for petitioner during the years in issue were more than

minor. Mr. Henderson clearly performed regular and substantial

services for the corporation. In fact, the services Mr.

Henderson performed for petitioner were integral to the

corporation’s operations and income-producing activities.

Petitioner’s other employees only assisted Mr. Henderson.

In 1995 and 1996, petitioner reported ordinary income on its

Federal income tax returns of $217,985 and $380,559,

respectively. Mr. Smith testified that during the years in issue

petitioner did not pay Mr. Henderson a salary. Additionally, in

1995 and 1996 there were no distributions of dividends to Mr.

Henderson in his capacity as sole shareholder. It was Mr.

Smith’s testimony that “None of the profits, to my knowledge,

were distributed during the years 1995 and 1996.” Mr. Smith also

testified that “it was the decision of management that no

distribution should be made.” However, the corporation paid

personal expenses of Mr. Henderson in 1995 and 1996 totaling

$96,766 and $143,221, respectively. Respondent does not contest

the reasonableness of these payments. Mr. Henderson clearly
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performed substantial services essential to petitioner, and the

amounts of personal expenses paid on his behalf were

compensation. Such compensation constitutes wages for purposes

of FICA and FUTA taxes. Accordingly, we hold that petitioner is

liable for the related FICA and FUTA taxes on the amounts deemed

wages to Mr. Henderson.

Respondent contends that petitioner is liable for the

addition to tax imposed by section 6656 for failure to make

timely deposits of taxes with respect to both 1995 and 1996.

Section 6656(a) imposes an addition to tax for failure to timely

deposit any required tax in a Government depository, unless it is

shown that such failure is due to reasonable cause and not due to

willful neglect. The addition to tax is equal to the applicable

percentage of the amount of the underpayment. Sec. 6656(a). The

applicable percentage is 10 percent if the failure to deposit is

more than 15 days. Sec. 6656(b)(1)(A)(iii).

Petitioner did not address the section 6656 failure to

deposit additions to tax at trial. Petitioner presented no

evidence to establish reasonable cause for its failure to deposit

the required FICA and FUTA taxes. Accordingly, we hold that,

with respect to the deemed wages to Mr. Henderson, petitioner is

liable for the section 6656 additions to tax with respect to the

FICA and FUTA tax liabilities for both years in issue.

Finally, we must decide whether petitioner is liable for the
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accuracy-related penalties for 1995 and 1996. Section 6662(a)

imposes an accuracy-related penalty in the amount of 20 percent

of the portion of an underpayment of tax attributable to

negligence or disregard of rules or regulations. Negligence is

any failure to make a reasonable attempt to comply with the

provisions of the internal revenue laws or to keep adequate books

and records or to substantiate items properly. Sec. 6662(c);

sec. 1.6662-3(b)(1), Income Tax Regs. Moreover, negligence is

the failure to exercise due care or the failure to do what a

reasonable and prudent person would do under the circumstances.

Neely v. Commissioner, 85 T.C. 934, 947 (1985). Disregard

includes any careless, reckless, or intentional disregard of

rules or regulations. Sec. 6662(c); sec. 1.6662-3(b)(2), Income

Tax Regs. No penalty will be imposed with respect to any portion

of any underpayment if it is shown that there was a reasonable

cause for such portion and that the taxpayer acted in good faith

with respect to such portion. Sec. 6664(c). This determination

is based on all the facts and circumstances. Sec. 1.6664-

4(b)(1), Income Tax Regs.

Petitioner presented no evidence regarding the section

6662(a) accuracy-related penalties. Petitioner failed to keep

adequate records necessary to document the alleged loan

transactions. Nor did petitioner provide other evidence to

substantiate the alleged loan transactions. Petitioner failed to
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meet its employment tax obligations on amounts that were

compensation to Mr. Henderson. Accordingly, we sustain

respondent’s determination as to the section 6662(a) accuracy-

related penalties.

Reviewed and adopted as the report of the Small Tax Case

Division.

Decision will be entered

sustaining respondent’s notice

of determination.