T.C. Memo. 2011-257
UNITED STATES TAX COURT
TREVE W. AND STEPHANIE L. KINSEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15862-09. Filed November 1, 2011.
Donald W. Wallis and Casey W. Arnold, for petitioners.
Joel D. McMahan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent determined a deficiency of $60,333
in petitioners’ 2004 Federal income tax and also asserts an
increased deficiency. On an amended 2004 joint income tax return
petitioners claimed over $347,000 as a loss on their Schedule E,
Supplemental Income and Loss, asserting that they held 100
percent of the ownership in Twentieth Century Mortgage, Inc.
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(TCM). The disallowance of this loss is the basis of the
original deficiency. Respondent disallowed the loss because he
determined petitioners were not owners of TCM in 2004.
Respondent also asserts that petitioners are judicially estopped
from claiming ownership of TCM for 2004 because Mr. Kinsey took a
contrary position in prior litigation. After this case was
docketed, respondent asserted an increased deficiency on the
basis of a claim that Mr. Kinsey had received income of
$44,152.44 upon TCM’s paying legal fees on his behalf in 2004.
For the reasons stated herein, we find that petitioners were not
shareholders of TCM in 2004, and respondent’s increased
deficiency is not sustained.
FINDINGS OF FACT
Petitioners resided in Florida when the petition was filed.
Before December 2004 petitioners resided in Colorado. In 1997
Mr. Kinsey founded TCM in Colorado to perform services as a
mortgage broker. TCM was a subchapter S corporation.
In February 2002 Mr. Kinsey consulted with Ronald Brasch to
sell TCM. Mr. Brasch was an experienced business broker working
for First Business Brokers in Colorado Springs, Colorado. In
early April 2002 Mr. Brasch began representing Mr. Kinsey to
market and sell TCM. Mr. Brasch created an advertising package
and began extensively marketing TCM on June 12, 2002. The value
of TCM declined between 2001 and 2003 because the profitability
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of TCM had declined during that period. In the beginning of 2003
Mr. Brasch updated TCM’s financials to reflect its poor
performance in 2002. Between January and June 2003 Mr. Brasch
received no formal offers for TCM.
Gerald Small, a principal of Amerifunding/Amerimax Realty
Group, Inc. (Amerifunding), a mortgage brokerage business,
emailed Mr. Brasch inquiring about the purchase of TCM in January
2003 but did not respond when contacted by Mr. Brasch’s office.
Mr. Small emailed Mr. Brasch again in May 2003 inquiring about
the purchase of TCM. On May 12, 2003, Mr. Small responded to Mr.
Brasch with appropriate confidentiality paperwork. On August 19
or 20, 2003, Mr. Brasch received Mr. Small’s letter of intent to
purchase TCM for $2.1 million. The terms of this initial offer
contemplated a payment of $500,000 at closing with the remainder
to be paid in three quarterly payments. One day after his
initial offer, Mr. Small increased his offer by approximately
$1.3 million.
On September 3, 2003, Mr. Kinsey proposed a $100,000
discount to the buyer for an all-cash transaction. On September
30, 2003, Mr. Brasch received a draft purchase agreement listing
Chad Heinrich, an employee of Amerifunding, as the buyer instead
of Mr. Small. After learning that Mr. Heinrich would be named as
the purchaser, Mr. Brasch informed Mr. Kinsey that a credit
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report should be completed on Mr. Heinrich. Mr. Kinsey claims to
have accepted a credit report given to him by Mr. Heinrich.
First Collateral Services, Inc. (First Collateral), was a
lending institution that provided credit lines to, among others,
TCM. Before the TCM sale closed, Mr. Kinsey knew that First
Collateral would not do business with Mr. Small. Mr. Kinsey did
not tell First Collateral of Mr. Small’s relationship to Mr.
Heinrich.
Mr. Kinsey was represented by an attorney, Robert Horen,
throughout the negotiations and sale of TCM. Mr. Kinsey, through
his representatives, structured the sale of TCM as $2 million in
cash for the sale of the stock, with the remainder in cash for
Mr. Kinsey’s retained earnings in TCM. The closing for the sale
of TCM occurred on December 2, 2003, at Mr. Horen’s office. To
complete Mr. Kinsey’s sale of TCM to Mr. Heinrich, a total of
$3,370,804.76 was wire transferred to First Business Brokers on
December 3, 2003.
At the closing, Mr. Heinrich received the stock certificate
of TCM. Mr. Brasch received $190,000 as a fee for brokering the
sale of TCM. Petitioners received $3,180,804.76 via wire
transfer dated December 3, 2003. In addition to cash, Mr. Kinsey
obtained an employment agreement to work for TCM as its president
for a $240,000 annual salary, plus bonuses and expenses. Mr.
Kinsey’s employment agreement with TCM required that he work at
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TCM’s offices in Aurora, Colorado. During 2004 Mr. Kinsey worked
for TCM pursuant to the employment agreement as a mortgage broker
and president.
In December 2003 false applications on behalf of
Amerifunding and TCM for a warehouse line of credit with Flagstar
Bank, FSB (Flagstar), a Michigan-based bank, were made in excess
of $15 million. Flagstar specializes in mortgage lending and, as
part of its mortgage-lending business, originates loans directly
on its own, provides various types of financing for mortgage
brokers, assists brokers on sales and underwriting, and buys and
sells mortgage-backed securities as a correspondent permanent
lender. A similar line of credit with Impac Warehouse Lending
Group (IMPAC) caused millions of dollars to be advanced to
Amerifunding through TCM in December 2003.
In April 2003 Flagstar entered into an agreement to advance
Amerifunding an amount not to exceed $20 million. These funds
were to be used to obtain residential mortgages that TCM would
originate and broker.
By March 2004 Flagstar had discovered that Amerifunding was
engaged in theft and a scheme to defraud Flagstar. Amerifunding
had used fraudulent buyers who used false identities and created
fraudulent mortgages in these individuals’ names. As a result
of the scheme, Flagstar advanced approximately $155 million to
Amerifunding and TCM on the basis of fraudulent loan applications
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and suffered losses of approximately $23.4 million. IMPAC
advanced approximately $99.7 million to Amerifunding on the basis
of fraudulent loan applications and suffered losses of
approximately $12.9 million. Mr. Heinrich, Mr. Small, and Mr.
Small’s wife were indicted.
As a result, in 2004 and 2005 various civil lawsuits were
filed, including a March 2004 suit by Flagstar against
Amerifunding, TCM, Mr. Heinrich, Mr. Small, Mrs. Small, and Mr.
Kinsey. All of the defendants with exception to Mrs. Small, Mr.
Kinsey, and TCM have defaulted. In the Flagstar lawsuit, Mr.
Kinsey testified that he was not liable to Flagstar for fraud and
negligence because he was not the owner of TCM and he reported to
Mr. Heinrich acting merely as an employee and under Mr.
Heinrich’s direction.
On February 18, 2005, Mr. Heinrich pleaded guilty to two
counts of felony fraud against Flagstar in the U.S. District
Court for the District of Colorado, for wire fraud. As part of
his plea, Mr. Heinrich admitted to his participation in a
conspiracy which used TCM to commit fraud against Flagstar and
IMPAC. Mr. Heinrich was imprisoned for 28 months and ordered to
pay restitution of $22.4 million to Flagstar and approximately
$12.6 million to IMPAC.
On May 25, 2005, Flagstar and IMPAC filed a civil action to
levy upon TCM stock held by Mr. Heinrich. As part of the
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bankruptcy case, TCM filed actions to prevent the transfer of the
stock to Flagstar. Flagstar also filed an action against Mr.
Kinsey and TCM. To settle these claims, Mr. Kinsey agreed to pay
Flagstar $1.5 million. For the payment, Mr. Kinsey and TCM would
receive a release of all claims and Flagstar’s agreement to
facilitate the return of TCM stock to Mr. Kinsey.
By letter dated June 28, 2004, TCM confirmed with Mr.
Heinrich that Mr. Kinsey was authorized to continue operating
TCM. In 2004 TCM paid Mr. Kinsey’s personal attorney’s fees in
an amount not less than $44,152.44.
On June 7, 2005, Mr. Kinsey, as president of TCM, filed for
chapter 11 bankruptcy in the U.S. Bankruptcy Court for the
District of Colorado (the bankruptcy court). In TCM’s bankruptcy
statement of financial affairs, Mr. Kinsey listed Mr. Heinrich as
the 100-percent owner of TCM.
On February 14, 2006, the bankruptcy court granted a motion
to approve the settlement agreement. In his testimony before the
bankruptcy court, in the settlement agreement, and in the motion
to approve settlement, Mr. Kinsey took the position that he had
sold 1,000 shares of stock in TCM to Mr. Heinrich on December 3,
2003, and that he was not an owner of TCM thereafter.
The bankruptcy court approved the settlement, and Mr. Kinsey
discontinued TCM as a business in 2006. Petitioners did not
report as income for 2004 TCM’s payments to Mr. Kinsey’s attorney
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in 2004. Petitioners did not report any distributive share of
income or loss from TCM on their initial 2004 return, but they
claimed the loss from TCM on an amended return, as previously
described.
On March 27, 2009, respondent issued the notice of
deficiency for 2004 underlying this proceeding and also described
above. On June 30, 2009, petitioners timely filed their petition
with this Court.
OPINION
We decide this case on the factual record before us, and the
burden of proof does not affect the outcome.
I. The Original Deficiency Determination
A sale is generally defined as a transfer of property for
“money or its equivalent”. Commissioner v. Brown, 380 U.S. 563,
571 (1965). The key determination is “whether the benefits and
burdens of ownership have passed” from the seller to the buyer.
Grodt & McKay Realty, Inc. v Commissioner, 77 T.C. 1221, 1237
(1981). This is a factual determination based on the intent of
the parties “as evidenced by the written agreements, read in the
light of the attending facts and circumstances”. Haggard v.
Commissioner, 24 T.C. 1124, 1129 (1955), affd. 241 F.2d 288 (9th
Cir. 1956). Relevant factors used by this Court are: (1)
Whether legal title passed; (2) how the parties treated the
transaction; (3) whether equity was acquired in the property; (4)
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whether the contract created a present obligation on the seller
to deliver and an obligation on the buyer to make payments; (5)
whether the right of possessions vested with the purchaser; (6)
which party pays the taxes associated with the property; (7)
which party bears the risk of loss or damage to the property; and
(8) which party receives the profits from the operation and sale
of the property. Grodt & McKay Realty, Inc. v. Commissioner,
supra at 1237-1238.
Although their petition makes reference to Mr. Kinsey’s
“sale” of TCM in December 2003, petitioners’ amended petition
refers to the sale as an “event” and claims that the substance of
the “event” did not shift the benefits and burdens of ownership
in TCM. Petitioners argue that because Mr. Kinsey disagreed with
the buyer’s operation of TCM, the “event” somehow did not
transfer ownership to the buyer. Instead, petitioners argue the
substance of the transaction was a lease, rather than a sale.
Petitioners concede that if Mr. Kinsey is not the sole
shareholder of TCM throughout 2004, the notice of deficiency is
correct. However, for the reasons detailed below, the “event” in
2003 was indeed Mr. Kinsey’s sale of TCM stock, complete with a
purchase and sale agreement and a transaction closing that
occurred at the offices of Mr. Kinsey’s attorney. Mr. Kinsey’s
sale of TCM stock transferred the benefits and burdens of
ownership from Mr. Kinsey to Mr. Heinrich after the closing
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occurred on December 2, 2003. In fact, Mr. Kinsey and Mr.
Heinrich negotiated and signed a detailed “stock purchase and
sale agreement” with the assistance of counsel. The terms in
this document clearly indicate that the intent of both parties
was to transfer ownership of 1,000 shares of stock in TCM from
Mr. Kinsey to Mr. Heinrich.
Moreover, in exchange for his stock of TCM, Mr. Kinsey
received $3,370,804.76 in cash via a wire transfer through his
business broker, and Mr. Heinrich received legal title to TCM.
As a result, the “event” petitioners refer to was a transaction
through which Mr. Kinsey received the benefit of his bargain
(i.e., $3.3 million) in exchange for the stock of TCM. Mr.
Kinsey remained with TCM under an employment agreement, but he
relinquished control of the company to Mr. Heinrich.
Consequently, the benefits and burdens of TCM ownership shifted
in connection with the 2003 TCM stock purchase and sale
agreement.
The Court of Appeals for the Eleventh Circuit has held that
when a taxpayer attempts to disregard the form of a transaction,
the taxpayer must show that the agreement was a result of fraud,
duress, or undue influence. Bradley v. United States, 730 F.2d
718, 720 (11th Cir. 1984); Spector v. Commissioner, 641 F.2d 376,
382 (5th Cir. 1981) (relying on Commissioner v. Danielson, 378
F.2d 771, 775 (3d Cir. 1967)), revg. and remanding 71 T.C. 1017
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(1979). However, in this case, Mr. Kinsey was not defrauded but
instead received the full contract price for the sale of his
stock. Petitioners’ amended petition makes no allegation that
Mr. Kinsey was defrauded. Instead, Mr. Kinsey admits that he
received approximately $3.3 million via a wire transfer in
exchange for selling his TCM stock.
Petitioners argue that after the stock sale, Mr. Heinrich
and Mr. Small used TCM to defraud third-party banks that lent
funds to TCM. They assert that “kind of like with a stolen get-
away car used in a bank robbery, * * * [TCM’s buyer] just trashed
it and abandoned it on the side of the road.” However, the sale
is not avoided because of the manner in which TCM was later
operated. Mr. Kinsey was paid the agreed price; the fraud was
not perpetrated on him as part of the sale.
The Kinseys cite Black v. First Fed. Sav. & Loan Association
of Fargo, N.D., 830 P.2d 1103 (Colo. App. 1992), and claim that
each of the fraud elements described in Black are present in the
instant case. The court in Black upheld the lower court’s
conclusion that “First Federal was fraudulently induced to loan
money”. Id. at 1114. In their argument, petitioners explicitly
concede that “In this case, the contract and the transaction
based on it were not induced by fraud.”
Next, citing Colo. Plasterers’ Pension Fund v. Plasterers’
Unlimited, Inc., 655 F. Supp. 1184 (1987), petitioners argue that
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the doctrine of fraud in the execution should void Mr. Kinsey’s
sale of TCM ab initio. However, the court in Colo. Plasterers’
Pension Fund explained that in Colorado, “fraud in the execution
‘is fraud exercised in reference to the acts of signing and
delivering an instrument, sometimes by a deceptive substitution
of documents causing someone to sign an instrument without
knowing the consequences of his act.’” Id. at 1186-1187 (quoting
Meyers v. Johanningmeier, 11 Brief Times Reporter 122 (Feb. 6,
1987)).
Quoting the Restatement (Second) of Contracts, sec. 163
Illustration 2 (1981), the court explained by way of example:
A and B reach an understanding that they will execute
a written contract containing terms on which they have
agreed. It is properly prepared and is read by B, but
A substitutes a writing containing essential terms
that are different from those agreed upon and thereby
induces B to sign it in the belief that it is the one
he has read. B’s apparent manifestation of assent is
not effective.
Colo. Plasterers’ Pension Fund v. Plasterers’ Unlimited, Inc.,
supra at 1187.
There has been no allegation and no evidence to suggest that
the TCM sale contract negotiated by Mr. Kinsey’s attorney and
executed in his attorney’s office was surreptitiously replaced by
some other document. Instead, the record is clear that (1) Mr.
Kinsey was well represented in his transaction by a business
broker and legal counsel, (2) he closed the transaction at the
office of his own counsel, and (3) he received in excess of $3.3
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million via wire transfer at the conclusion of the transaction.
We can see no fraud in the execution.1
Petitioners’ alternative arguments that the transaction must
be voided on the basis of fraud and illegality fail for the
reasons explained regarding the fraud in the execution argument.
II. The Increased Deficiency
Section 612 provides that gross income includes all income
from whatever source derived, unless the taxpayer can establish
the application of a specific legislative authorization to
exclude income from taxation. Commissioner v. Glenshaw Glass
Co., 348 U.S. 426, 429-430 (1955). In this respect, a third
party’s discharge of a taxpayer’s obligation is income to the
taxpayer. Old Colony Trust Co. v. Commissioner, 279 U.S. 716
(1929). During 2004 TCM paid attorney’s fees of $44,152. The
fees related to the representation of Mr. Kinsey and TCM in TCM’s
bankruptcy proceeding. As a result, respondent asserts that Mr.
Kinsey should have included in income the amounts paid as
attorney’s fees. “That the funds were paid directly to
petitioner’s attorney and not to petitioner does not alter this
result.” Sanford v. Commissioner, T.C. Memo. 2008-158. There is
1
Respondent also asserts judicial estoppel regarding the
sale of TCM stock in 2003 as a result of the representations in
the bankruptcy filing. Because we reject petitioners’ claims
that the sale should be disregarded, it is unnecessary for us to
reach this argument.
2
All section references are to the Internal Revenue Code in
effect for 2004.
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no dispute the amount was paid, and petitioners did not report
this amount on their 2004 tax return or amended return. At the
time of the legal fee payment, the legitimate operations of TCM
were still directed by Mr. Kinsey. This issue turns on whether
in directing payment of these legal fees, Mr. Kinsey was paying a
legitimate expense of TCM, rather than his own personal expense.
We find on the facts before us that the payment in 2004 was a
reasonable expenditure of TCM funds in attempting to extricate
TCM and its president, Mr. Kinsey, from the results of the
fraudulent actions after the sale in 2003. We do not find that
the payment was primarily for Mr. Kinsey’s personal benefit.
Consequently, petitioners’ income should not be increased by
$44,152.44 for the 2004 taxable year.
To reflect the foregoing,
Decision will be entered
for respondent as to the
original deficiency
determination and for
petitioners as to the
asserted increased deficiency.