internal_revenue_service number release date index number -------------------------------- ----------------- -------------------------- --------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ----------------------- id no -------------- telephone number ---------------------- refer reply to cc psi plr-138810-12 date date legend x y ------------------------------------------------------------ ----------------- ------------------------------------------------------------ ---------------------------- country date --------- ---------------------- dear ----------------- this letter responds to your letter dated date submitted on behalf of y by y’s representative requesting that the service grant an extension of time under sec_301_9100-3 of the procedure and administration regulations to elect to be treated as a disregarded_entity for federal tax purposes facts according to the information submitted x is a domestic_corporation on date x’s wholly owned foreign_subsidiary y formed under the laws of country y represents that it always intended to elect to be treated as a disregarded_entity effective date however y failed to timely file form_8832 entity classification election to elect to be treated as a disregarded_entity for federal tax purposes plr-138810-12 law and analysis sec_301_7701-3 provides that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes an eligible_entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner sec_301_7701-3 provides guidance on the classification of a foreign eligible_entity for federal tax purposes generally a foreign eligible_entity is treated as an association if all members have limited_liability unless the entity makes an election to be treated otherwise a foreign eligible_entity with a single member having limited_liability may elect to be treated as a disregarded_entity pursuant to the rules of sec_301_7701-3 sec_301_7701-3 provides that an entity classification election must be filed on form_8832 and can be effective up to days prior to the date the form is filed or up to months after the date the form is filed sec_301_9100-1 provides that the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose due_date is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin sec_301_9100-1 through provide the standards the commissioner will use to determine whether to grant an extension of time to make the election sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 provides the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government conclusion based solely on the facts submitted and the representations made we conclude that the requirements of sec_301_9100-3 have been satisfied as a result y is granted an extension of time of days from the date of this letter to file a form_8832 with the appropriate service_center to elect to be treated as a disregarded_entity for federal tax purposes effective date a copy of this letter should be attached to the form_8832 a copy is enclosed for that purpose plr-138810-12 this ruling is contingent on x filing within days of the date of this letter all required returns and amended returns for all open years consistent with the requested relief these returns may include but are not limited to the following forms i form_5471 information_return of u s persons with respect to certain foreign_corporations and ii form_8858 information_return of u s persons with respect to disregarded entities such that these forms reflect the consequences of the relief granted in this letter a copy of this letter should be attached to any such returns except as specifically set forth above no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter this ruling is directed only to the taxpayer s requesting it sec_6110 of the code provides that it may not be used or cited as precedent in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to your taxpayer_representative sincerely joy spies joy spies senior technician reviewer branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc


internal_revenue_service number release date index number ---------------------------------------- ---------------------------------- ---------------------------- -------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ---------------- id no ------------------ telephone number ---------------------- refer reply to cc psi b01 plr-139437-14 date date legend x ----------------------------------------------------- -------------------------------- y ----------------------------------------------------- --------------------------------------- date state ---------------------- --------- dear ------------------ this responds to a letter dated date submitted on behalf of x by x’s authorized representative requesting relief pursuant to sec_301_9100-3 of the procedure and administration regulations that x be granted an extension of time to elect to treat y as a qualified_subchapter_s_subsidiary qsub under section sec_1361 of the internal_revenue_code the code facts according to the information submitted and representations within x was incorporated under the laws of state and elected to be treated as an s_corporation effective date x represents that it owns of y and intended to elect to treat y as a qsub effective date however due to inadvertence x failed to timely file a qsub election for y x plr-139437-14 represents that x has filed tax returns for all tax years consistent with the treatment of y as a qsub law and analysis sec_1361 generally provides that a qsub shall not be treated as a separate corporation and all assets liabilities and items of income deduction and credit of a qsub shall be treated as assets liabilities and such items as the case may be of the s_corporation sec_1361 defines a qsub as a domestic_corporation which is not an ineligible_corporation if percent of the stock of the corporation is owned by the s_corporation and the s_corporation elects to treat the corporation as a qsub sec_1_1361-3 of the income_tax regulations prescribes the time and manner for making an election to be classified as a qsub sec_1_1361-3 provides that an election may be effective up to two months and days prior to the date the election is filed or not more than months after the election is filed the proper form for making the election is form_8869 qsub election sec_301_9100-1 provides that the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose due_date is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 provides the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government conclusion based solely on the facts submitted and representations made we conclude that the requirements of sec_301_9100-3 have been satisfied accordingly x is granted an extension of time of days from the date of this letter to elect to treat y as a qsub effective date the election should be made by filing form_8869 with the appropriate plr-139437-14 service_center and a copy of this letter should be attached to the election a copy is enclosed for that purpose except as specifically set forth above we express or imply no opinion concerning the federal tax consequences of the facts described above under any other provision of the code specifically we express or imply no opinion concerning whether x is a valid s_corporation or whether y is eligible to be a qsub this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent in accordance with the power_of_attorney on file with this office a copy of this letter is being mailed to x's authorized representative sincerely curt g wilson associate chief_counsel passthroughs special industries by david haglund david haglund branch chief branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy of this letter for sec_6110 purposes


t c memo united_states tax_court edward l provost and vicky l provost petitioners v commissioner of internal revenue respondent docket no filed date terrence j moore for petitioners lisa n primavera for respondent memorandum findings_of_fact and opinion marvel judge respondent determined a deficiency in petitioners' federal_income_tax of dollar_figure and an accuracy- related penalty of dollar_figure under sec_6662 ‘all section references are to the internal_revenue_code in effect for the year in issue and all rule references are to the tax_court rules_of_practice and procedure monetary amounts are rounded to the nearest dollar - - the issues for decision are whether petitioners’ advance of dollar_figure to richard magness is deductible as a business_bad_debt under sec_166 and whether petitioners are liable for an accuracy-related_penalty under sec_6662 we hold that the advance is not deductible as a business_bad_debt and that petitioners are liable for the accuracy-related_penalty findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts is incorporated herein by this reference petitioners are married and resided in dana point california at the time the petition was filed unless otherwise indicated petitioner refers to edward l provost petitioner is a business consultant who during also held a real_estate license prior to petitioner worked as an executive in a transportation company called industrial freight system ifs his employment at ifs ended in or about at which point he became a consultant to ifs petitioner was not in the business of lending money in although petitioner received income from other sources the majority of his income from through was received from consulting services these services were performed almost at one time petitioner owned a 40-percent interest in the corporation exclusively for ifs in petitioner reported income of dollar_figure from his consulting activities and from through he reported no income from consulting activities in or about petitioner became acquainted with richard magness a licensed framing contractor petitioner hired mr magness to perform framing work on two spec houses petitioner was building one in sherman oaks and one in los angeles petitioner also hired mr magness to perform framing work for the construction of petitioners’ own residence in mr magness requested a dollar_figure advance from petitioner to be used to construct two spec houses on lots mr magness purchased in 1987--one pincite corbin avenue and one pincite corbin avenue hereinafter collectively referred to as the corbin project or corbin properties mr magness already had borrowed substantial funds from commercial lenders for the purchase of the lots and construction of the residences and had given those lenders first and second deeds of trust on the corbin properties mr magness knew petitioner possessed a real_estate license and had built and sold spec houses for a profit in the past mr magness had never built a spec house of his own petitioner estimated that upon completion the corbin properties a spec house is a house constructed by a builder to the builder's specifications with the intention of selling it ata profit upon completion since petitioner has built at least six spec houses each of which was sold at a profit mr magness worked as a framer on at least four of petitioner’s spec houses q4e- would be listed for approximately dollar_figure each yielding a profit of approximately dollar_figure to dollar_figure petitioner and mr magness entered into an oral agreement in which petitioner agreed to advance mr magness dollar_figure in dollar_figure increments while the project was being completed mr magness agreed to hire petitioner as a consultant during the construction of the corbin project for a one-time consulting fee of dollar_figure due and payable when the corbin properties sold and mr magness agreed to repay the dollar_figure advance plus interest when the project was completed and sold at the time petitioner advanced the money both petitioner and mr magness understood that mr magness would not be able to pay petitioner any of the money required under the oral agreement unless the corbin properties sold on or about date petitioner hired mr magness to supervise the framing and foundation of three spec houses petitioner was building this arrangement was not connected in any way to petitioner's dollar_figure advance mr magness was not required to provide contracting services to petitioner as a condition of receiving the advance nor was he asked to provide petitioner with any bills for his services petitioner paid mr petitioner made the dollar_figure advance to mr magness with checks drawn from petitioners' personal checking account totaling dollar_figure and checks drawn from the account of p s leasing inc totaling dollar_figure p s leasing inc is an s_corporation owned and operated by petitioner - - magness at the rate of dollar_figure per hour for his contracting services upon completion of the work in date petitioner's attorney drafted a document entitled contract for services and consulting agreement contract the contract made effective as of date purportedly memorialized part of the oral agreement between petitioner and mr magness neither petitioner nor mr magness read the contract before signing it the contract contained two main sections contract for services and consulting agreement the contract for services required mr magness to perform contracting services at a rate of dollar_figure per hour on petitioners’ family residence in dana point california and to submit weekly bills for services performed the bills were payable on date the consulting agreement provided that petitioner would serve as a consultant and as an advisor to mr magness for a yearly salary of dollar_figure due on date offset provisions in the contract required that any money payable under either section of the contract would be offset by money due under the other section the contract also contained an automatic termination clause upon the occurrence of a bankruptcy or insolvency of either party this clause was applicable to the contract in its entirety the contract did not contain a reference to the corbin properties or to the dollar_figure advance there were however two handwritten notations at the bottom of the contract richard carl magness shall be responsible for framing and foundation and supervision as per ed provost and richard magness agreement and if ed provost does not have the money to fund this agreement there will no liability on his part mr magness and petitioner also executed a secured promissory note dated date wherein petitioner promised to lend mr magness dollar_figure in eight equal installments of dollar_figure in return mr magness promised to repay petitioner the principal sum of dollar_figure plus interest at a rate of percent per annum the principal and interest were due on date the note was secured_by deeds of trusts on the corbin properties mr magness was unable to sell the corbin properties on date mr magness and his wife filed chapter bankruptcy they received their bankruptcy discharge on date although petitioner filed a proof_of_claim in the magness bankruptcy he did not receive any distribution from the bankruptcy_estate although the promissory note referred to second deeds of trust petitioner received a second deed_of_trust on one of the corbin properties and a third deed_of_trust on the other - in the first mortgage lenders foreclosed on the corbin properties petitioners did not receive any distribution as a result of the foreclosure petitioner did not commence a lawsuit against mr magness to collect the money petitioner’s attorney advised him not to attempt to collect the money from mr magness because it would be useless to do so mr magness never repaid any of the funds advanced by petitioner on their federal_income_tax return for petitioners claimed the purported loan was worthless and deducted dollar_figure from their taxable_income as a business_bad_debt under sec_166 respondent disallowed the deduction opinion sec_166 authorizes a deduction for a business_bad_debt that becomes worthless during the year to be entitled to the deduction an individual taxpayer must prove the existence of a bona_fide debt that obligated the debtor to pay the taxpayer a fixed or determinable sum of money and that the bad_debt was created or acquired in proximate relation to the taxpayer's trade_or_business 405_us_93 95_tc_257 the court_of_appeals for the ninth circuit to which this case is appealable has identified factors to be considered --- - when resolving whether an advance is bona_fide debt ora contribution_to_capital names given to the certificates evidencing indebtedness presence or absence of a fixed maturity_date source of payments right to enforce the payment of principal and interest participation and management a status equal to or inferior to that of regular creditors intent of the parties thin or adequate capitalization identity of interest between creditor and stockholder payment of interest only out of profits and ability to obtain loans from outside lending institutions see 827_f2d_1409 9th cir 748_f2d_1365 9th cir revg tcmemo_1983_120 a r lantz co v united st424_f2d_1330 9th cir 93_tc_382 whether an advance constitutes debt or equity depends on the facts and circumstances of each case see calumet indus inc v commissioner supra pincite no single factor is determinative see id the various factors are only aids in answering the ultimate question whether the investment analyzed in terms of its economic reality constitutes risk capital entirely subject_to the fortunes of the corporate venture or represents a strict debtor- creditor relationship fin hay realty co v united_states --- - f 2d 3d cir our analysis of the factors is set forth below certificates evidencing indebtedness the outward form of the transaction is not controlling see bauer v commissioner supra pincite8 the court_of_appeals for the ninth circuit has stated although the inguiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties a distinction must be made between objective and subjective expressions of intent an objective expression of intent as contained in the documentation of an advance of money is generally not to be afforded special weight it alone cannot be controlling of the debt-equity issue x a r lantz co v united_states supra pincite where the form of the advance does not correspond to the intrinsic economic nature of the transaction labels are not an accurate expression of the subjective intention of parties to a transaction and lose their meaning see fin hay realty co v united_states supra pincite advances were contributions to capital where all the formal indicia of an obligation were meticulously made to appear and shareholders had power to create whatever appearance would be of tax_benefit to them despite the economic reality of the transaction in this case there were several discrepancies between the terms of the documents and the oral agreement between petitioner and mr magness for example according to the contract the dollar_figure yearly salary for consulting was due and payable on -- - date the oral agreement between petitioner and mr magness however required a one-time dollar_figure consulting fee to be paid only when the corbin project sold another example can be found in petitioner’s testimony that contrary to the terms of the contract neither he nor mr magness intended for an offset provision to be included in the contract both petitioner and mr magness testified that the contract and the promissory note purportedly evidencing their agreement did not accurately reflect the agreed-upon terms in fact on brief petitioner points out that the fact that the parties did not adhere to the terms of the documents is irrelevant as the documents which were not read by the parties prior to signature never reflected the true intent of the parties thus we give the documents little weight and determine the outcome of this case based on the facts and circumstances surrounding the transaction see calumet indus inc v commissioner supra pincite presence or absence of a fixed maturity_date the presence of a fixed maturity_date indicates a fixed obligation to repay a characteristic of a debt obligation the absence of the same on the other hand would indicate that repayment was in some way tied to the fortunes of the business indicative of an equity advance 464_f2d_394 5th cir see also sec b 97_tc_579 evidence that a creditor did not intend to enforce payment of the note or was indifferent as to the exact time the note was to be repaid belies an arm's-length debtor-creditor relationship see generally 23_tc_408 affd 236_f2d_159 6th cir in the instant case whether or not petitioner would be repaid was contingent upon the sale of the corbin properties although the terms of the promissory note stated that the dollar_figure principal and interest would be due and payable on date both petitioner and mr magness testified that the note did not properly reflect the terms of their agreement under their oral agreement repayment of the advance was due when the corbin properties sold and in fact neither mr magness nor petitioner anticipated the advance would be repaid on date petitioner testified june lst ‘92 the project wasn’t done but it was our understanding that he wasn’t going to pay-- he had no way of paying if the project didn’t sell and we both understood that in reality no fixed maturity_date existed and repayment was directly linked to the success of the corbin project this factor favors respondent’s position source of payments if the source of the debtor's repayment is dependent upon earnings or is from a restricted source such as a judgment recovery dividends or profits an equity_investment is indicated see estate of mixon v united_states supra pincite calumet indus inc v commissioner t c pincite 74_tc_476 irbco corp v commissioner tcmemo_1966_67 in such a case the ‘lender’ acts ‘as a classic capital investor hoping to make a profit not as a creditor expecting to be repaid regardless of the company’s success or failure ’ calumet indus inc v commissioner supra pincite quoting 862_f2d_112 7th cir when circumstances make it impossible to estimate when an advance will be repaid because repayment is contingent upon future profits or repayment is subject toa condition_precedent or where a condition may terminate or suspend the obligation to repay an equity_investment is indicated see 351_f2d_646 irbco corp v commissioner supra in this case repayment of the dollar_figure advance and payment of the consulting fee were contingent upon the fortunes of the corbin project see estate of mixon v united_states supra pincite 89_tc_816 at the time petitioner made the advance both petitioner and mr magness understood that mr magness had no way of repaying the money unless the corbin properties sold further they agreed the payments would be made from the sales proceeds of the corbin properties petitioner contends that his agreement with mr magness did not turn the loan into an investment because he was to be paid when the project sold not if it sold petitioner also stresses that mr magness’ failure to sell the corbin properties was due to california’s failing economy and real_estate market although we agree with petitioner that it is difficult to predict how the real_estate market will behave in the future a reasonably prudent person can foresee that the project may not be successful and the properties may not sell petitioner claims he has sold spec houses in the past for a profit thus petitioner either knew or should have known of the risks involved in the corbin project when he advanced mr magness the money petitioner knew at the time he made the advance to mr magness that repayment was impossible unless the corbin project sold under the circumstances petitioner acted more like a classic capital investor than a true creditor calumet indus inc v commissioner supra pincite this factor favors respondent’s position right to enforce the payment of principal and interest in determining whether petitioner intended to enforce repayment of the advance an essential element is whether a good- faith intent on the part of the recipient of the funds to make repayment and a good-faith intent on the part of the person advancing the funds to enforce repayment exists see 54_tc_905 we must consider whether under the facts and circumstances of this case there was a reasonable expectation of repayment in light of the economic realities of the situation see 379_f2d_569 citing irbco corp v commissioner supra we are not convinced petitioner had a good-faith intention of enforcing repayment the testimony clearly indicated that mr magness did not have the means to repay petitioner unless the corbin properties sold petitioner understood mr magness’ financial situation and did not intend to require repayment of the advance unless and until the corbin properties sold given petitioner’s interest in the corbin project we do not believe he would have demanded repayment if it would have imperiled the -- - financial condition or the potential success of the corbin project see dixie dairies corp v commissioner supra pincite gooding amusement co v commissioner supra pincite petitioner’s right to demand repayment of the advance was limited from its inception petitioner did not intend to demand repayment of the dollar_figure advance unless and until the corbin project was successful this factor favors respondent’s position participation and management if petitioner received a right to participate in the management of the corbin project in consideration for the advance such participation tends to demonstrate that the advance was not bona_fide indebtedness but rather was an equity_investment see american offshore inc v commissioner t c pincite prior to the corbin project petitioner and mr magness did not have a continuous business relationship petitioner had retained mr magness approximately four times over the past years to perform framing or construction services as a condition for advancing the money petitioner insisted he be retained as a consultant on the corbin project because he wanted in addition the promissory note was not protected by an acceleration clause or sinking_fund in the event of default see a r lantz co v united st424_f2d_1330 9th cir -- - input into the project to make sure that they would be successful respondent contends the dollar_figure consulting fee was a handsome profit on petitioner’s dollar_figure investment and the agreement was indicative of a joint_venture we agree that petitioner’s participation in the corbin project and his relationship with mr magness more closely resembled a joint_venture than a debtor-creditor relationship this factor favors respondent’s position status equal to or inferior to that of regular creditors whether an advance is subordinated to regular creditors bears on whether the taxpayer was acting as a creditor or an investor see estate of mixon v united_states f 2d pincite in addition failure to demand timely repayment effectively subordinates the intercompany debt to the rights of other creditors who receive payment in the interim american offshore inc v commissioner supra pincite citing inductotherm indus inc v commissioner tcmemo_1984_281 affd without published opinion 770_f2d_1071 3d cir mr magness continued to pay other creditors in lieu of petitioner after date the date when petitioner was entitled to repayment of the dollar_figure advance plus interest under the promissory note and to payment of the consulting fee under the contract petitioner did not demand or expect payment on date because as both petitioner and mr magness testified payment was due only when the corbin properties were sold this factor favors respondent’s position intent of the parties t he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties a r lantz co v united_states f 2d pincite citing 314_f2d_620 9th cir in taft the court held that an advance constituted indebtedness where the parties executed a promissory note the taxpayer’s right to enforce payment of the note and the obligation to pay was positive and unconditional the note was not subordinated to any other indebtedness there was no change in proportionate equity_interest or voting power in the corporation and repayment of the note was not contingent upon earnings the parties in taft intended the advance to be indebtedness and the advance was carried on the books as a long-term debt as payments were made over the years the indebtedness was reduced on the books of the corporation the note was paid in full in this case mr magness never made a single payment on the alleged debt nor did he attempt to pay petitioner his dollar_figure consulting fee moreover there is no evidence that the debt was carried as indebtedness on the books of the corbin project indeed the record contains no evidence that any such books -- - existed it is clear that mr magness viewed his obligation to repay petitioner as a conditional obligation dependent solely on the success of the corbin project mr magness was asked at trial are you going to repay mr provost the dollar_figure loan mr magness responded no the relevant facts and circumstances support a conclusion that petitioner and mr magness did not intend to create a debtor-creditor relationship this factor favors respondent’s position thin or adequate capitalization thin_capitalization is strong evidence of a capital_contribution where the debt-to-equity_ratio was initially high the parties realized that it would likely go higher and substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations see american offshore inc v commissioner supra pincite citing 375_f2d_36 5th cir we give this factor no weight however because the parties did not argue that the evidence directly supported or negated this factor and the record does not contain sufficient evidence to make our own analysis identity of interest between creditor and stockholder this factor generally compares the equity ownership of stockholders with their position as creditors in order to determine whether there is an identity of interest between the two positions see american offshore inc v commissioner supra pincite if stockholders’ advances to a corporation are in substantially the same proportion as their equity ownership in the corporation it tends to demonstrate that the advances are more in the nature of equity see estate of mixon v united_states supra pincite on the other hand a sharply disproportionate ratio between a stockholder’s percentage stockholdings and debt is strongly indicative that the alleged debt is bona_fide american offshore inc v commissioner t c pincite in this case mr magness undertook the corbin project ostensibly as a sole_proprietor when petitioner advanced the funds to mr magness petitioner had no existing ownership_interest in the project although we view the involvement of petitioner in the corbin project as being more in the nature of a joint_venture the identity of interest usually examined by this factor simply does not exist in this case consequently we do not rely upon or apply this factor in making our analysis payment of interest only from profits this factor is essentially the same as the third factor ‘the source of the payments ’ 827_f2d_1409 9th cir it focuses however on how the parties to the alleged debt treated interest as we have stated - - a true lender is concerned with interest american offshore inc v commissioner supra pincite citing estate of mixon v united_states f 2d pincite the failure to insist on interest payments indicates that the payors expect to be paid out of future earnings or through the increased market_value of their equity_interest see american offshore inc v commissioner supra pincite citing 396_f2d_630 5th cir the alleged debt in this case was to be paid if at all from the proceeds generated when the corbin project was sold although petitioner claims that interest was due and would be paid at that time the critical fact is that mr magness’ obligation to make any payment to petitioner was contingent on the liquidation of the corbin properties mr magness simply was not required to pay for the ongoing use of petitioner’s money as one would expect mr magness to do if the advance were a bona_fide debt although the advance was dressed up to look like a short-term debt payable in year petitioner and mr magness did not intend it to be so nor did they treat it as such we conclude therefore that this factor favors respondent’s position ability to obtain loan from outside lending institutions t he touchstone of economic reality is whether an outside lender would have made the payments in the same form and on the --- - same terms segel v commissioner t c pincite citing 555_f2d_364 3d cir see also calumet indus inc v commissioner t c pincite petitioner’s advance was far more speculative than what an outside lender would have made further suggesting it was a loan in name only see fin hay realty co v united_states f 2d pincite dixie dairies corp v commissioner t c pincite conclusion in calumet indus inc v commissioner supra pincite we found the advances were made at the risk of the business and it was unlikely that disinterested investors would have given a similar loan there were no principal or interest payments and no evidence that the obligations in fact bore interest further the taxpayer failed to prove the existence of formal debt instruments the presence of any fixed maturity dates for repayment of the advances or the presence of any security for the advances we also found the advances were made in proportion to the taxpayer’s interest in the venture and the company which was experiencing financial problems was unable to establish its own lines of credit or to borrow funds from banks without the guaranty of the taxpayer significantly the taxpayer expected to be repaid from the debtor’s future earnings_and_profits we held that the advances were in the nature of -- - capital contributions and the taxpayer was a classic capital investor id pincite like the alleged debt in calumet indus the dollar_figure advance was made at the risk of the corbin project and petitioner expected to be repaid from the future profits generated by the sale of the properties petitioner also conceded on brief that mr magness was unable to secure additional loans from outside lenders although the mere fact that a loan could not be obtained from an unrelated source does not preclude the existence of a bona_fide loan jack daniel distillery v united_states f 2d pincite evidence that mr magness could not obtain additional loans from outside lenders is an indication petitioner's advance was an equity_investment especially in light of the fact that repayment was conditioned upon the success of the corbin project when the terms of the advance by petitioner are considered it is almost inconceivable an outside lender would have advanced mr magness money on similar terms this factor favors respondent’s position the evidence supports respondent’s contention that the advance more closely resembled that of an investment in a joint_venture between petitioner and mr magness upon consideration of the above factors we hold that petitioner’s advance was not a - - bona_fide debt within the meaning of sec_166’ and that petitioner is not entitled to a bad_debt deduction under sec_166 accuracy-related_penalty sec_6662 authorizes the imposition of an accuracy- related penalty equal to percent of the portion of an underpayment attributable to among other things negligence or disregard of rules or regulations see sec_6662 and b negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws to exercise ordinary and reasonable care in the preparation of a tax_return to keep adequate books_and_records or to substantiate items properly sec_6662 925_f2d_348 9th cir affg t cc bunney v commissioner t c __ sec_1_6662-3 income_tax regs the term disregard includes any careless reckless or intentional disregard sec_6662 sec_1_6662-3 income_tax regs if a taxpayer shows there was reasonable_cause for any portion of an underpayment and the taxpayer acted in good_faith with respect to that portion the penalty does not apply see sec_6664 sec_1_6664-4 income_tax regs the ‘our holding eliminates the need to discuss whether the advance was a business debt and if so whether it was worthless see sec_166 d -- - determination of whether a taxpayer acted in good_faith is made on a case-by-case basis taking into account all the pertinent facts and circumstances see compag 113_tc_214 sec_1_6664-4 income_tax regs petitioners have the burden_of_proof on this issue see rule a allen v commissioner supra petitioners argue that they acted in good_faith in determining the correct_tax treatment of the dollar_figure advance petitioners’ argument is that the internal_revenue_service audited their joint federal_income_tax return upon which they had claimed a similar_business bad_debt deduction that was ultimately allowed and that they are entitled to rely on the result in the prior audit respondent argues that petitioners acted negligently or with disregard of the rules or regulations because petitioner manipulated the form of the transaction in order to obtain an ordinary_loss deduction in the event the corbin project did not succeed respondent further argues petitioners have not shown reasonable_cause or that they acted in good_faith we agree with respondent that petitioners have not shown reasonable_cause or that they acted in good_faith as required by sec_6664 petitioner testified that in he was consulting for o’neill associates which went into bankruptcy that he claimed a business_bad_debt deduction for an advance made in connection - - with those consulting services and that the internal_revenue_service audited petitioners and ultimately issued a no change on their tax_return the record is devoid of any evidence regarding the audit except for petitioner’s brief self- serving testimony on the topic we are not obligated to accept the self-serving and uncorroborated testimony of petitioner under these circumstances see 87_tc_74 other than petitioner’s testimony regarding the prior audit petitioner has offered no evidence to prove that petitioners are entitled to relief from the accuracy-related_penalty we conclude therefore that petitioners have failed to carry their burden_of_proof and are liable for the accuracy- related penalty under sec_6662 we have carefully considered all remaining arguments for contrary holdings and to the extent not discussed find them to be irrelevant or without merit to reflect the foregoing decision will be entered for respondent sthe additional factual assertions in petitioners’ reply brief are not part of the evidentiary record see rule b


t c memo united_states tax_court wy'east color inc an oregon corporation petitioner v commissioner of internal revenue respondent docket no filed date christopher h kent kevin o'connell and steve hval specially recognized for petitioner brenda m fitzgerald for respondent memorandum findings_of_fact and opinion colvin judge respondent determined deficiencies in petitioner's federal_income_tax of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively after concessions we must decide the following issues whether petitioner may deduct as management fees dollar_figure dollar_figure and dollar_figure for fiscal years and respectively as petitioner contends dollar_figure dollar_figure and dollar_figure as respondent contends or some other amount we hold that petitioner may deduct percent of the management fees it paid for those years ie dollar_figure dollar_figure and dollar_figure whether or to what extent petitioner may deduct rent it paid to its sole shareholder for the sublease of property in excess of the rent its sole shareholder paid for the prime lease of the property petitioner contends it may deduct rent of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively respondent contends petitioner may deduct rent of dollar_figure for each of those years we hold that petitioner may deduct rent of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively 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 unless otherwise stated references to years are to calendar years and references to fiscal years are to petitioner's fiscal_year which ends on march findings_of_fact some of the facts have been stipulated and are so found a petitioner petitioner’s activities and growth petitioner is an oregon corporation the principal_place_of_business of which is in portland oregon dwight a cummings mr cummings owned all of petitioner's stock during the years in issue he and his family the cummings founded petitioner and built it into a successful business petitioner is a graphic arts prepress company it uses original art photographs and page layouts to prepare film to make plates for printing it also processes photographs for commercial photographers and makes large display prints petitioner's workforce grew from employees to employees during the years in issue petitioner had gross_sales of about dollar_figure million and had about percent of the portland market in the late 1980's for each year in issue petitioner had retained earnings_of dollar_figure to dollar_figure million mr and mrs cummings organized petitioner into various departments there were three production departments stripping color and planning department managers reported to mr and mrs cummings mrs cummings held weekly management meetings petitioner's managers did not have written employment contracts petitioner’s management employees a grady preston grady preston preston managed petitioner's color department during the years in issue preston is well informed about the technical aspects of petitioner’s industry he keeps current with new technology preston was responsible for electronics in his division which was a large part of petitioner's operation he tried to keep petitioner efficient and competitive petitioner paid preston dollar_figure in dollar_figure in and dollar_figure in b steve philps steve philps philps managed petitioner's color lab division during the years in issue he worked to hours per day philps supervised film printing and processing slide production display material production and some advertising sales and customer relations he also interviewed hired fired trained and supervised employees petitioner paid philps dollar_figure in dollar_figure in and dollar_figure in c rick capatosto rick capatosto managed petitioner's planning department during part of the years in issue he also handled the payless account petitioner paid him dollar_figure in dollar_figure in and dollar_figure in d larry deal larry deal deal managed petitioner's planning department at some time during the years in issue petitioner paid deal dollar_figure in dollar_figure in and dollar_figure in e jim faust jim faust faust managed petitioner's planning department at some time during the years in issue petitioner paid faust dollar_figure in dollar_figure in and dollar_figure in management fees sales assets and taxable_income petitioner did not deduct any officer compensation_for the years in issue petitioner deducted management fees of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively petitioner deducted salaries and wages of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively petitioner included in costs of goods sold labor costs of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively management fees as a percent of petitioner's salaries wages and labor were dollar_figure percent dollar_figure percent and dollar_figure percent in fiscal years and respectively petitioner had sales assets and taxable_income before deducting net operating losses and management fees and before adding to income deductions petitioner concedes are not allowable taxable_income before certain adjustments as follows fiscal_year gross_sales assets dollar_figure big_number big_number dollar_figure big_number big_number taxable_income before certain adjustments dollar_figure big_number big_number b the cummings family mr cummings is married to karen r cummings mrs cummings their children are grant bruce dwight d deen karen ann and cynthia who is married to jim medding medding mr cummings mr cummings lived in redmond washington during the years in issue mr cummings knew the technology that affected petitioner's business he was president and a director of petitioner dacor inc dacor petitioner's management company see par c-1 below and lasercolor inc lasercolor another photographic processing business see par d below he had offices at petitioner's portland facility and at lasercolor's bellevue washington facility near seattle mr cummings did not keep records of how much time he worked for petitioner or lasercolor he was a shareholder and officer of kadac inc kadac petitioner's management company that succeeded dacor see par c-2 below he reported on kadac's income_tax return that he devoted all of his time to kadac he attended some of petitioner's weekly management meetings he helped decide which equipment petitioner would buy for the color lab mr cummings served on the boards of the international prepress association and dupont crossfield users group and as president and vice president of the western states prepress conference mrs cummings mrs cummings lived in redmond washington during the years in issue she resigned as associate administrator for children’s hospital in seattle in to help manage petitioner she was earning about dollar_figure per year at children's hospital mrs cummings performed services for petitioner in as an employee of dacor she was petitioner's general manager from to mrs cummings interviewed all job applicants who passed petitioner's color laboratory manager's inspection mrs cummings had offices at petitioner's portland facility and at lasercolor's facility in bellevue washington when in portland she lived at a house that petitioner owned the previous occupants used the house as an office petitioner paid to remodel the house into a residence deen cummings deen cummings worked for petitioner in and in until kadac was formed he then worked for kadac he began to live in oregon in he performed services through kadac for petitioner and lasercolor during the years in issue he worked to hours a week for kadac in and he was on call hours per day days per week he managed petitioner's plant facilities and dispatch functions he handled sales to one of petitioner's major retail accounts in or he provided many more hours than usual of services to lasercolor for to weeks grant cummings grant cummings was president of kadac he performed services for lasercolor and petitioner during the years in issue at bellevue washington grant cummings worked full time for kadac from may to date and in and he worked to hours per week for kadac during the years in issue he spent about percent of his time working for lasercolor and about percent working for petitioner during the years in issue lasercolor and kadac paid him as follows corporation lasercolor lasercolor kadac kadac kadac year amount dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure he attended some of petitioner's management meetings during the years in issue he reported earning no income from services performed in oregon in and bruce cummings bruce cummings performed technical services for petitioner pertaining to telephones computers and lithography by he was project manager for a group of people who worked for preston bruce cummings was a system operator for petitioner at a time not specified in the record he worked full time for kadac in and karen ann cummings during the years in issue karen ann cummings worked as a planner for petitioner's lithography department she provided daily planning services not otherwise described in the record to petitioner she attended some management meetings from to jim medding medding married cynthia cummings daughter of mr and mrs cummings in and medding performed research_and_development for petitioner and was current with new technology kadac paid him dollar_figure in and dollar_figure in c dacor inc and kadac inc dacor and kadac provided management services to petitioner and lasercolor dacor and kadac did not compare the salaries they paid to their employees to other salaries in the portland area dacor did not have a written contract to perform services during the years in issue dacor inc mr cummings owned all of the stock of dacor dacor did not pay dividends during the years in issue dacor provided services only to petitioner and lasercolor dacor's fiscal_year ended on march kadac inc mr cummings formed kadac to replace dacor he incorporated kadac in nevada on date mr cummings mrs cummings and their sons deen grant and bruce each owned shares of kadac stock kadac and lasercolor share facilities in bellevue washington kadac did not pay dividends during the years in issue kadac provided management services to petitioner and lasercolor neither dacor nor kadac kept time sheets or other records of the services they or any member of the cummings family performed for petitioner kadac's taxable_year ended on december during the years in issue kadac’s only employee from to who was not related to the cummings was wendy jo goddard management fees dacor received management fees of dollar_figure in its fiscal_year ending date and kadac received dollar_figure dollar_figure and dollar_figure in calendar years and respectively a total of dollar_figure from date to date dacor paid officer compensation salary petitioner deducted management fees totaling dollar_figure for fiscal years and ie from date to date the record does not indicate whether petitioner paid the dollar_figure ratably throughout if petitioner paid the dollar_figure ratably throughout then kadac would have received one-fourth of that amount dollar_figure by date and dacor and kadac would have received dollar_figure from date to date and wages of dollar_figure in its fiscal_year ending date kadac paid dollar_figure dollar_figure and dollar_figure in and respectively a total of dollar_figure from date to date as shown below calendar payor year employee officer compensation dacor mr cummings mrs cummings total dacor mr cummings mrs cummings total dacor kadac mr cummings mrs cummings grant cummings karen ann cummings dollar_figure total kadac total dacor and kadac salaries and wages dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number totals dollar_figure big_number big_number big_number mr cummings mrs cummings grant cummings deen cummings bruce cummings karen ann cummings jim medding wendy jo goddard total mr cummings mrs cummings grant cummings deen cummings bruce cummings karen ann cummings jim medding big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number total total for - big_number big_number the record does not indicate whether kadac paid the dollar_figure ratably throughout if kadac paid the dollar_figure ratably throughout then kadac would have paid one-fourth of that amount dollar_figure by date and dacor and kadac would have paid dollar_figure from date to date the parties agree that dacor paid these amounts to mr cummings in and that dacor paid dollar_figure to dwight cummings in its fiscal_year date to date the parties stipulated that kadac paid dollar_figure to grant cummings in and that a form_w-2 for showed that kadac paid him dollar_figure in we find that kadac paid him dollar_figure in the dollar_figure difference does not alter our analysis respondent determined that kadac paid dollar_figure to deen cummings petitioner contends that kadac paid dollar_figure we accept respondent's determination the dollar_figure difference does not alter our analysis d lasercolor inc lasercolor was a washington corporation that did business in washington as wy'east color mr cummings acquired lasercolor in he owned all of lasercolor's stock during its fiscal years ending date and dacor filed a consolidated tax_return with lasercolor for its fiscal_year ending date on which dacor reported that it owned lasercolor lasercolor did not pay dividends during its fiscal_year lasercolor paid the following amounts for officer compensation salaries and wages and management services fiscal_year officer compensation dollar_figure none none e other related corporations management services paid to salaries and wages kadac dollar_figure big_number big_number unknown dollar_figure none during the years in issue mr cummings owned percent of dynagraphics a printing company in portland oregon that was one of petitioner's clients on its return petitioner reported that it was a member of a controlled_group_of_corporations which included dacor lasercolor and visionworks inc on its return petitioner reported that it was a member of a controlled_group_of_corporations which included lasercolor and nevada graphics inc mr cummings was president of those corporations kadac paid mr or mrs cummings about half of their wage and salary income for f oregon income of the cummings mr and mrs cummings reported on their federal and oregon income_tax returns that they earned the following amounts from dacor and kadac year reported on federal tax returns dollar_figure dollar_figure dollar_figure dollar_figure reported as earned in oregon dollar_figure big_number big_number big_number the amounts reported as earned in oregon in and were mr and mrs cummings' earnings the amounts reported as earned in oregon in and were mrs cummings’ earnings mr cummings did not file oregon individual income_tax returns for or deen filed oregon tax returns for tax years to grant cummings did not file oregon income_tax returns for tax years to the state of washington does not have an income_tax g petitioner's lease of the s w corbett street property petitioner is located pincite s w corbett street portland oregon s w corbett st property before moving to s w corbett street petitioner leased buildings pincite and s w corbett street old property petitioner leased the old property from mr cummings doing business as blackstone under an oral month-to-month lease the buildings on the old property had about big_number square feet petitioner paid rent of dollar_figure per month to mr cummings in mr cummings leased the s w corbett st property from the american red cross for years with an option to buy the s w corbett property was a three-story wood frame building with about big_number square feet a detached shop and storage building with big_number to big_number square feet and an annex or residence with about big_number square feet mr cummings paid rent of dollar_figure per month dollar_figure per year to the american red cross he agreed to pay real_estate_taxes maintenance and insurance expenses on the property the lease did not require mr cummings to perform major repairs the s w corbett st property was zoned for high density multifamily residences before mr cummings leased the s w corbett st property from the american red cross mr cummings did business in the name of the blackstone co blackstone before and during the years in issue petitioner obtained a revocable permit to use the property as a photo processing lab as the tenant of the american red cross petitioner paid all the expenses required to obtain the revocable permit mr cummings sublet the s w corbett st property to petitioner before the years in issue petitioner spent about dollar_figure to adapt the property for its use petitioner paid for insurance maintenance utilities and other similar costs petitioner paid rent of dollar_figure to mr cummings for fiscal_year dollar_figure for and dollar_figure for mr and mrs cummings deducted rent of dollar_figure in and and taxes of dollar_figure for and dollar_figure for mrs cummings deducted rent of dollar_figure for and and taxes of dollar_figure for and dollar_figure for in mr cummings paid about dollar_figure to repair the roof and dry rot damage and to remove an oil tank petitioner contends that blackstone paid real_property_taxes for the s w corbett st property petitioner relies on exh which consists of copies of checks written by the blackstone co from date to date and a memo to the file from petitioner's counsel dated date pertaining to tax accounts associated with particular pieces of property petitioner did not provide exh to respondent in the time required by the court's standing_pretrial_order the parties stipulated that the information in the exhibit pertaining to tax accounts for the particular pieces of property is based on inadmissible hearsay thus we do not consider exh opinion a deductions for management fee sec_1 contentions of the parties a taxpayer may deduct payments for management services under sec_162 if the payments are for services actually rendered and are reasonable in amount 56_tc_828 this question is decided based on a consideration of all of the facts and circumstances of the case id pincite petitioner bears the burden of proving that it may deduct the management fees it paid rule a 779_f2d_849 2d cir affg in part and remanding in part mandina v commissioner tcmemo_1982_34 petitioner deducted management fees it paid to dacor and kadac totaling dollar_figure dollar_figure and dollar_figure for fiscal years and respectively petitioner contends that it paid the management fees exclusively for personal services and that the fees are reasonable ordinary and necessary under sec_162 respondent contends that the management fees were excessive respondent contends that part of the payments was for something other than services such as disguised dividends a transfer of wealth from mr cummings to members of his family without gift_tax consequences or a means of evading oregon income_tax respondent contends that petitioner may deduct only dollar_figure dollar_figure and dollar_figure for those years respondent determined these amounts based on the amount dacor's and kadac's employees reported on their oregon income_tax returns increased by percent for taxes and benefits whether the amount of management fees that petitioner paid was reasonable the parties agree that we should apply the legal standards which govern whether compensation is reasonable to decide whether the management fees at issue here were reasonable more specifically the parties agree that we should apply the factors in 716_f2d_1241 9th cir revg and remanding tcmemo_1980_282 the factors are the importance of the employees who perform services to the success of the business the character and condition of the company the hypothetical investor's viewpoint the consistency of payments for similar services within petitioner’s business and a comparison of amounts paid_by other similar businesses for similar services we also consider petitioner's contention that comparing the management fees to petitioner's gross_receipts shows that the management fees were reasonable no single factor determines whether the fees at issue were reasonable 399_f2d_603 9th cir affg tcmemo_1967_7 178_f2d_115 6th cir revg and remanding a memorandum opinion of this court whether the amount of management fees was reasonable is a question of fact american sav bank v commissioner supra see elliotts inc v commissioner supra petitioner bears the burden of proving that the amount of management fees was reasonable rule a we evaluate the case by considering the total amount of management fees petitioner seeks to deduct not the smaller amounts that dacor and kadac paid to various members of the cummings family if the employee controls the employer we closely scrutinize the reasonableness of compensation to see if it was paid for something other than the employee's services 819_f2d_1315 5th cir affg tcmemo_1985_267 elliotts inc v commissioner supra pincite 500_f2d_148 8th cir affg tcmemo_1973_130 see also 57_tc_587 an exploitable relationship may exist if the employees are the controlling shareholders or if a family relationship suggests that the compensation plan was not the result of a free bargain elliotts inc v commissioner supra pincite see pacific grains inc v commissioner supra pincite 340_f2d_861 9th cir affg tcmemo_1963_198 petitioner and the cummings did not deal at arm's-length and the cummings controlled dacor kadac and petitioner thus we will closely scrutinize the reasonableness of the management fees petitioner paid application of the factors a importance of dacor and kadac employees to petitioner the positions that dacor and kadac employees held with petitioner their hours and duties and their importance to the success of petitioner are relevant to deciding whether management fees for their services are reasonable elliotts inc v commissioner supra pincite 536_f2d_289 9th cir affg in part and revg in part 59_tc_231 73_tc_1142 mr and mrs cummings and other members of their family built petitioner from a small prepress company to a successful firm mr cummings testified that petitioner is ranked in the top of big_number prepress companies in the nation mr and mrs cummings deen and to a lesser extent other dacor and kadac employees contributed to petitioner's success however there are no billing records for those services or records showing how much time dacor and kadac employees spent providing services to petitioner oregon income_tax returns filed by members of the cummings family suggest that the cummings did not provide services to petitioner in oregon to the extent they claim oregon income_tax law requires nonresident taxpayers who earned_income from personal services rendered in oregon to apportion their oregon income based on the ratio of the number of days worked in oregon for a business over the number of days worked in and out of oregon for that business or rev stat sec_316 or admin r a a a mr cummings and two employees testified that mr cummings spent a little more than day a week in portland however mr cummings did not file oregon income_tax returns in and that suggests that he did not perform services for petitioner in oregon during those years mrs cummings testified that she worked in oregon most of the time during the years in issue she reported in her oregon income_tax returns that she earned dollar_figure in and dollar_figure in dacor or kadac paid her dollar_figure in oregon in and dollar_figure in this suggests that mrs cummings worked full time for dacor or kadac in oregon in but only about half time in petitioner did not adequately explain these apparent inconsistencies mr and mrs cummings testified that they worked only for kadac in however kadac paid mr or mrs cummings only about half of the wage and salary income they received in mr and mrs cummings did not explain this apparent inconsistency this factor favors petitioner somewhat b character and condition of the company a company's size as indicated by its sales net_income or capital value the complexities of the business and general economic conditions is relevant in deciding whether management fees are reasonable elliotts inc v commissioner f 2d pincite see 93_f2d_816 9th cir 42_f2d_419 9th cir affg 14_bta_4 petitioner's performance improved during the years in issue petitioner's gross_sales increased dollar_figure percent in fiscal_year and dollar_figure percent in fiscal_year its total assets increased dollar_figure percent in fiscal_year and percent in fiscal_year its taxable_income increased dollar_figure percent in fiscal_year and dollar_figure percent in fiscal_year this factor favors petitioner c the hypothetical investor's viewpoint it is appropriate to consider whether the amount_paid for management service is reasonable from the perspective of a hypothetical independent investor elliotts inc v commissioner supra pincite to calculate the return on investment we divide taxable_income before net operating losses by the shareholder's equity for each fiscal_year see universal manufacturing co v commissioner tcmemo_1994_367 citing elliotts inc v commissioner supra pincite petitioner reported the following fiscal_year taxable_income shareholder's before nol’s equity dollar_figure big_number big_number dollar_figure big_number big_number return on investment petitioner's rate of return would satisfy a hypothetical investor see elliotts inc v commissioner supra pincite an average return on equity of percent would satisfy an independent investor this factor favors petitioner d comparison of amounts paid_by similar businesses for similar services evidence that similar companies pay comparable amounts for similar work may indicate that compensation is reasonable elliotts inc v commissioner supra pincite see 177_f2d_264 9th cir e wagner son inc v commissioner supra pincite neither party offered any evidence of the compensation that similar corporations pay for services similar to those performed by dacor and kadac because petitioner bears the burden_of_proof rule a this factor favors respondent e consistency of payments for similar services within petitioner evidence that a company pays controlling shareholders the same that it pays other employees for similar work may indicate that compensation is reasonable elliotts inc v commissioner supra pincite 84_f2d_453 9th cir affg in part and revg in part 31_bta_758 petitioner provided no convincing analysis whether management fees it paid to dacor and kadac were reasonable in relation to salaries it paid to its employees petitioner contends that this factor favors petitioner because the amounts dacor and kadac paid to their employees were generally less or equal to the amounts petitioner paid to its department managers during the years in issue we disagree petitioner's argument does not explain why the full amount of the management fee petitioner paid to dacor and kadac is reasonable petitioner does not adequately explain why it is reasonable for management fees to substantially exceed dacor's and kadac's payments to the individuals if petitioner's payments to kadac and kadac's payments to its employees in occurred ratably throughout the year then for the period date to date petitioner's management fees paid to dacor and kadac totaled dollar_figure and dacor and kadac's payments to their employees totaled dollar_figure it is difficult to compare the management fee and employee salary data in our record because some of it is based on fiscal years and some is based on calendar years see footnote sec_1 and and accompanying text at par c-3 however it seems that the management fees were substantially larger than the total amount of salaries dacor and kadac paid to their employees f comparison of management fees to gross_receipts courts have compared gross_receipts to compensation in deciding whether compensation is reasonable elliotts inc v commissioner supra pincite mayson manufacturing co v commissioner f 2d pincite here the management fees were dollar_figure percent dollar_figure percent and dollar_figure percent of gross_sales in fiscal years to respectively mr cummings' compensation wa sec_1 percent percent and percent of gross_sales in fiscal years to petitioner contends that compensation of the key individual in a company is reasonable if it falls between and percent of gross_sales petitioner cites rapco inc v commissioner tcmemo_1995_128 donald palmer co v commissioner tcmemo_1995_65 compensation wa sec_31 percent of gross_sales for palmer we allowed percent acme constr co v commissioner tcmemo_1995_6 compensation was percent of gross_sales for horth boca constr inc v commissioner tcmemo_1995_5 compensation totaled percent and percent of gross_sales for and and comtec sys inc v commissioner tcmemo_1995_4 compensation wa sec_28 percent of gross_sales for vernon beard and percent for reda beard we disagree with petitioner's reliance on those cases we did not calculate or consider compensation as a percent of gross_sales or gross_receipts in any of these cases except for boca constr inc v commissioner supra we calculated those percentages based on facts found in those cases in those cases we considered compensation as a percent of net sales net profit or gross_profit but not compensation as a percent of gross_sales rapco inc v commissioner supra donald palmer co v commissioner supra acme constr co v commissioner supra and comtec sys inc v commissioner supra in donald palmer co v commissioner supra we concluded that a salary equal to percent of gross_profit was reasonable because that percentage was similar to what the taxpayer had paid in prior years here we have no evidence of management fees as a percent of gross_profit that petitioner paid in prior years acme constr co v commissioner supra and comtec sys inc v commissioner supra are unlike this case because some pay during the years in issue in those cases was catchup pay for prior years acme constr co v commissioner supra is unlike this case because the executive there personally guaranteed all of the taxpayer's debt the taxpayers in acme constr co v commissioner supra and comtec sys inc v commissioner supra also provided evidence comparing the compensation at issue with that paid_by similar companies there is no such evidence here in boca constr inc v commissioner supra and rapco inc v commissioner supra the taxpayer applied a longstanding bonus formula or compensation plan there is no similar formula or plan in this case in comtec sys inc v commissioner supra the taxpayer provided evidence which compared the compensation at issue with compensation in a similar company there is no similar evidence here petitioner contends that this case is similar to mortex manufacturing co v commissioner tcmemo_1994_110 in that case we found that it was important that the company had a longstanding compensation plan for its officer-stockholders that was well within industry norms petitioner did not make this showing the taxpayer in mortex provided evidence comparing the compensation at issue to various published surveys petitioner has submitted no such evidence petitioner cites universal manufacturing co v commissioner tcmemo_1994_367 to show that mr cummings' compensation from dacor and kadac was reasonable because it was dollar_figure percent of net sales universal manufacturing co v commissioner supra is similar to boca constr inc v commissioner supra in that it states that compensation as a percentage of gross_sales is one of the factors we may consider we disagree with petitioner's reliance on universal manufacturing co v commissioner supra the issue here is not whether mr cummings' compensation is reasonable it is whether the management fees petitioner paid to dacor and kadac were reasonable further in that case unlike here part of the pay during the year in issue was catchup pay for prior years the taxpayer in that case introduced evidence comparing the compensation at issue with that paid_by other companies petitioner did not do so here the executive in that case guaranteed the taxpayer's dollar_figure million debt there is no similar guarantee in this case the cases petitioner cites do not show that the management fees at issue in this case are reasonable this factor favors petitioner conclusion about management fees we conclude that petitioner is entitled to deduct more management fees than respondent allowed for each year in issue but that part of the management fees that petitioner paid during the years in issue was not reasonable considering the above discussion and the entire record we hold that petitioner may deduct management fees of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively this amount i sec_75 percent of the management fee rounded to the nearest thousand dollars b whether petitioner may deduct its rent payments to mr cummings in excess of the rent he paid to the american red cro sec_1 contentions of the parties mr cummings paid rent of dollar_figure per year dollar_figure for years to the american red cross for the s w corbett st property mr cummings sublet that property to petitioner petitioner paid rent to mr cummings of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively dollar_figure for years respondent contends that petitioner may not deduct more for rent than mr cummings paid to the american red cross petitioner contends that it may deduct all the rent it paid to mr cummings in those years background a taxpayer generally may deduct reasonable rents paid for property used in a trade_or_business sec_162 165_f2d_483 5th cir affg 7_tc_1129 a taxpayer who rents property from a related_person may not deduct more than he or she would have paid if the parties had dealt at arm’s-length 458_f2d_631 9th cir affg tcmemo_1970_74 67_tc_694 a taxpayer may deduct only the fair rental value of premises it rents from related_persons 34_tc_549 we closely scrutinize whether rents exceed fair rental value if the lessor and lessee are related 453_f2d_1144 2d cir affg in part and revg in part 54_tc_912 sparks nugget inc v commissioner supra limericks inc v commissioner supra fair rental value is a question of fact 225_f2d_870 9th cir affg a memorandum opinion of this court mark r switz inc v commissioner tcmemo_1979_162 petitioner bears the burden_of_proof rule a 290_us_111 rental from american red cross by mr cummings a price chosen after arm’s-length bargaining close to the time of the valuation_date is the best evidence of value estate in 225_f2d_870 9th cir affg a memorandum opinion of this court the controlling stockholder leased the premises from a third party the taxpayer corporation then sublet the premises and paid rent to the controlling stockholder that was three to four times as much as the controlling stockholder paid to the third party lessor we held that the taxpayer corporation may not deduct the increased amount of rent because there was no business_purpose for paying increased rent the u s court_of_appeals for the ninth circuit affirmed our decision in mark r switz inc v commissioner tcmemo_1979_ mark switz switz controlled the taxpayer-corporation he leased property from a third party at a reasonable rental rate he sublet the property to the taxpayer-corporation for more than twice that rate we disallowed the deduction for rent to the extent it exceeded the rent switz paid to the third party of spruill v commissioner 88_tc_1197 utter-mckinley mortuaries v commissioner supra mark r switz inc v commissioner supra there is no indication in the record that the lease from the american red cross to mr cummings was not negotiated at arm's-length thus the lease payment dollar_figure is highly probative evidence of rental value of these premises during the years in issue respondent's expert respondent's expert steve pietka pietka concluded that the fair rental values of the s w corbett st property were dollar_figure dollar_figure and dollar_figure for fiscal years and respectively petitioner criticizes pietka's comparables because they are not located near s w corbett street we disagree because there are no similar leased properties in that area petitioner points out that its experts said that the fair rental values of pietka’s comparables in north portland and beaverton are generally lower than those in the s w corbett street area we disagree for reasons stated in par below we believe pietka's comparables are more like the s w corbett st property than comparables considered by petitioner's experts petitioner contends that pietka did not consider the fact that petitioner could gradually move from the old property to s w corbett street petitioner did not state how much value to attribute to this fact we are not convinced that it added more than a minimal amount if any petitioner criticizes pietka's assumption that petitioner paid all of the expenses including real_estate_taxes however petitioner did not prove otherwise mr cummings' testimony that he paid the real_estate_taxes differs from his testimony in a prior unrelated case before the oregon tax_court in the oregon tax_court case mr cummings testified that petitioner paid the real_estate_taxes on the s w corbett st property we make no finding as to who paid those taxes petitioner offered documents showing that mr cummings spent about dollar_figure for repairs in the spring of the documents were not admitted because they were exchanged too late week before trial about months before this case was calendared for trial we sent a copy of the court’s standing_pretrial_order to the parties the standing_pretrial_order stated in part any documents or materials which a party expects to utilize in the event of trial except for impeachment but which are not stipulated shall be identified in writing and exchanged by the parties at least days before the first day of the trial session materials not provided in compliance with our pretrial orders are not admitted into evidence rule c see see supra note 565_f2d_954 5th cir affg 65_tc_333 and 67_tc_931 76_tc_1027 affd 696_f2d_1234 9th cir even if petitioner's documents had been admitted we would give them very little weight because they apply to periods much later than the years in issue petitioner contends that pietka did not consider that mr cummings made repairs petitioner points out that mr cummings paid about dollar_figure to repair the roof and dry rot in we make no findings about who paid for repairs during the years in issue we would give little weight to evidence of who paid for repairs in because it occurred so long after the years in issue petitioner contends that pietka considered an incorrect amount of square footage for the s w corbett st property the parties agree that the s w corbett st property included a big_number square-foot production facility they disagree about the size of the other areas petitioner contends that the shop has big_number rather than big_number square feet and that the annex or residence has big_number rather than big_number square feet these differences are de_minimis petitioner contends that pietka did not consider all of the property that was subject_to the lease petitioner argues that it leased property other than the s w corbett st property including a square foot storage_facility and big_number square feet from the old property petitioner bases this on mr cummings' testimony that by petitioner rented about big_number square feet in the old building and an additional square feet from another building that mr cummings doing business as blackstone owns petitioner has not convinced us that its position about the rental area is correct petitioner's position is inconsistent with its expert's report petitioner's experts did not include a rental value for the square-foot storage space or the big_number square feet in the old building we believe pietka considered all of the property that was subject_to the lease petitioner's experts petitioner relied on the expert testimony of john vissotzky vissotzky petitioner also called steve zenker george marandas and bruce korter as expert witnesses essentially to corroborate vissotzky we believe vissotzky overestimated the fair rental value he based his opinion on nine leases that he said were comparable most of the properties that he evaluated were buildings with several tenants which had offices up to big_number square feet those spaces are considerably smaller than the s w corbett st property vissotzky’s comparable properties were used as offices for professionals such as lawyers doctors and securities brokers only part of the property leased by petitioner is used for offices much of it is used for production and storage it also includes a residence vissotzky only evaluated leases under which the landlord pays for insurance maintenance real_estate_taxes and other similar costs petitioner admits that it paid insurance maintenance and utilities thus vissotzky's comparables are not like petitioner's facilities vissotzky’s fair rental value estimate includes the value added to the property by the dollar_figure million petitioner spent to improve it we agree with pietka's view that it is unreasonable to expect a tenant to pay for the rental value of improvements that the tenant made petitioner's claim that it had business reasons for paying more rent to mr cummings than he paid to the red cross petitioner contends that it had substantial business reasons for paying more rent to mr cummings than mr cummings paid to the american red cross unlike the taxpayers in 225_f2d_870 9th cir and mark r switz inc v commissioner tcmemo_1979_162 petitioner contends that it had a business_purpose in having a month-to-month rental instead of a 12-year lease mr cummings testified that a 12-year obligation on petitioner’s balance_sheet would give petitioner a poor debt to equity ratio and hurt petitioner's banking relationships we are not convinced that petitioner's banking relationships would have been hurt if petitioner had signed a 12-year lease for each of the years in issue petitioner had retained earnings_of from dollar_figure million to dollar_figure million petitioner contends that it paid more rent to mr cummings than mr cummings paid to the red cross because petitioner had a month-to-month lease instead of a 12-year lease mr cummings also testified that binding petitioner to one location for years would hurt its ability to grow and move we believe that petitioner overstates the value of having a month-to-month lease especially considering that petitioner had spent dollar_figure million to adapt the property to its own needs petitioner contends that a business reason for renting from mr cummings is that it could pay rent late if necessary however petitioner had no right to pay rent late petitioner in fact paid rent on time petitioner's claim that mr cummings might give it a break is entirely speculative the points cited by petitioner are far outweighed by the fact that it paid rent of dollar_figure for the years in issue instead of the dollar_figure mr cummings paid to the american red cross petitioner contends that w h braum family_partnership v commissioner tcmemo_1993_434 is strikingly similar to the instant case we disagree that case did not involve a lease between a controlling shareholder and a third party followed by a sublease by the controlling shareholder to the taxpayer corporation for substantially more rent in w h braum family_partnership v commissioner supra the braum family owned the properties that they leased to the taxpayer corporation we found that the rent was not excessive conclusion petitioner has not shown that mr cummings did not pay fair rental value to the american red cross and has shown little or no business_purpose to increase the rent the facts of this case are similar to those in utter-mckinley mortuaries v commissioner supra and mark r switz inc v commissioner supra and the reasoning of those cases applies here to account for the points described above in pars b-4 b-5 and b-6 we accept pietka's conclusion of the fair rental value we conclude that the petitioner may deduct rental payments of dollar_figure dollar_figure and dollar_figure for fiscal years and respectively to reflect concessions and the foregoing decision will be entered under rule


internal_revenue_service number release date index number --------------------------------- ------------------------------------------------- ----------------------------- ---------------------------- department of the treasury washington dc person to contact ----------- id no ------------- telephone number --------------------- refer reply to cc psi b01 - plr-126704-04 date june legend legend x --------------------------------- ----------------------- -------------------- --------------------------- state d1 dear ------------------ correspondence written on behalf of x requesting an extension of time under sec_301_9100-3 of the procedure and administration regulations to file a form_8832 entity classification election electing under sec_301_7701-3 to treat x as an association_taxable_as_a_corporation and under sec_1362 of the internal_revenue_code to file a late form_2553 electing to treat x as an s_corporation this letter responds to your letter dated date and related facts the information submitted discloses that x was formed as a limited_liability_company under the laws of the state on d1 x intended to be an s_corporation from d1 but the elections form and form were not filed law and analysis sec_301_7701-3 provides that a business_entity not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes sec_301_7701-3 provides that except as provided in sec_301_7701-3 relating to eligible entities existing prior to the effective date of this section unless the entity elects otherwise a domestic eligible_entity is classified as a partnership if it has two or more members and is disregarded as an entity separate from its owner if it has a single owner classified other than as provided under ' b by filing form_8832 entity classification election with the appropriate service_center under ' c iii this election will be effective on the date specified by the entity on form_8832 or on the date filed if no such date is specified the date specified on form_8832 cannot be more than days prior to the date on which the election is filed sec_301_7701-3 provides that an eligible_entity may elect to be under sec_301_9100-1 the commissioner may grant a reasonable sec_301_9100-2 and sec_301_9100-3 provide the standards the commissioner extension of time to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the code except e g h and i sec_301_9100-1 defines the term regulatory election as including an election whose deadline is prescribed by a regulation published in the internal_revenue_bulletin will use to determine whether to grant an extension of time to make an election sec_301_9100-2 provides automatic extensions of time for making certain elections sec_301_9100-3 provides extensions of time for making elections that do not meet the requirements of sec_301_9100-2 requests for relief under sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interests of the government sec_1362 provides that a small_business_corporation may elect to be an s_corporation sec_1362 provides the rule on when an s election will be effective if an s election is made within the first two and one-half months of a corporation s taxable_year then the corporation will be treated as an s_corporation for the year in which the election is made if the election is made after the first two and one-half months of a corporation s taxable_year then the corporation will not be treated as an s_corporation until the taxable_year after the year in which the s election is made sec_1362 provides that if no election is made pursuant to ' a or if made the election is made after the date prescribed for making such an election and the secretary determines there was reasonable_cause for the failure to timely make the election then the secretary may treat such an election as timely made for such taxable_year and effective as of the first day of that tax_year conclusion based solely on the facts submitted and representations made we conclude that the requirements of sec_301_9100-3 are satisfied as a result x is granted an extension of time of days from the date of this letter to make an entity classification election by filing a form_8832 effective d1 with the appropriate service_center a copy of this letter should be attached to the election a copy of this letter is attached for this purpose further we conclude that x will be recognized as an s_corporation effective d1 provided that x otherwise qualifies as a subchapter_s_corporation and within days from the date of this letter x submits a properly completed form_2553 with a copy of this letter attached to the relevant service_center except as specifically set forth above we express or imply no opinion concerning the federal tax consequences of the facts described above under any other provision of the code this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent sincerely s heather c maloy heather c maloy associate chief_counsel passthroughs and special industries enclosures copy of this letter copy for ' purposes