1997 Tax Ct. Memo LEXIS 442">*442 Decisions will be entered for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY,
William L. McCurley and Victoria J. McCurley, docket No. 10499-94 | ||
Addition to Tax | ||
Year | Deficiency | Sec. 6661 |
1988 | $ 43,612 | $ 10,903 |
1989 | 9,900 | -- |
1990 | 5,600 | -- |
Robert D. Hall and Gayle E. Hall, docket No. 10500-94 | ||
Penalty | ||
Year | Deficiency | Sec. 6662 |
1989 | $ 11,247 | $ 2,249 |
1990 | 11,200 | 2,240 |
1991 | 18,468 | 3,694 |
William L. McCurley and Victoria J. McCurley, docket No. 6557-95 | ||
Penalty | ||
Year | Deficiency | Sec. 6662 |
1991 | $ 12,664 | $ 2,533 |
1992 | 4,473 | 895 |
1997 Tax Ct. Memo LEXIS 442">*444 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue.
The issues for decision are as follows:
1. Whether certain payments made by a corporation to petitioners are loans or constructive dividends. We hold that they are constructive dividends.
2. Whether petitioners, pursuant to
3. Whether petitioners William and Victoria McCurley, pursuant to
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. William and Victoria McCurley, husband and wife, resided in Kennewick, Washington, at the time their petitions were filed. Robert and Gayle Hall, husband and wife, resided in Yakima, Washington, at the time their petition was filed. Messrs. McCurley and Hall each owned automobile dealerships at all relevant times. Mr. McCurley owned 100 percent of Bill McCurley Chevrolet, 1997 Tax Ct. Memo LEXIS 442">*445 Inc., and McCurley Pontiac, Inc. Mr. Hall owned 100 percent of Sunfair Chevrolet, Inc., and 75 percent of Greenway Auto Plaza, Inc.
Each dealership offered financing to prospective customers. The dealership, as an agent for an insurance company, offered credit life and/or credit health insurance policies to customers who financed their purchases through the dealership. The dealership retained as compensation a portion of the premium due. The policies provided that the insurer would make payments on the dealership loan in the event the insured became disabled and would repay the balance outstanding on the loan in the event the insured died.
Southwestern Dealers Insurance Co. (SDI) was formed by a group of automobile dealership owners whose dealerships issued policies similar to those issued through Messrs. McCurley's and Hall's dealerships. In February of 1982, SDI was incorporated in Grand Cayman under the laws of the Cayman Islands, British West Indies. Mr. McCurley became an SDI shareholder in 1982 and served as chairman of SDI's board of directors from that year forward. Mr. Hall became an SDI shareholder in 1984. Prior to becoming shareholders, Messrs. McCurley and Hall reviewed1997 Tax Ct. Memo LEXIS 442">*446 letters prepared by Peat, Marwick, Mitchell & Co., outlining issues relating to the formation of SDI and the availability of interest-free loans. The letter cautioned that adverse tax consequences would result if the loans were not bona fide loans.
SDI reinsured credit insurance policies issued through dealerships (i.e., the dealerships served as agents of the insurance companies) owned by SDI shareholders. As described below, reinsurance profits from policies attributable to a particular shareholder's dealership were then allocated to that shareholder. Seventy-five percent of the allocated profits was readily accessible to the shareholder through interest-free loans.
SDI's articles of association (Articles) set forth the rules governing the corporation. They authorized the issuance of ordinary shares, which carried one vote per share, and preferred shares, which carried no voting rights. During the relevant years, SDI had between 16 and 24 shareholders and each held one ordinary share and 340 preferred shares.
SDI maintained a redemption account for each shareholder. Pursuant to the Articles, the amount of a shareholder's redemption account: (1) Represented the price at which 1997 Tax Ct. Memo LEXIS 442">*447 SDI would redeem that shareholder's preferred shares, (2) formed a basis for allocating dividends to that shareholder, and (3) served as a point of reference for determining the maximum amount of funds that SDI could advance that shareholder.
Preferred shares were redeemable for a price based on a formula. The formula provided that preferred shares could be redeemed for an amount equal to (1) the shareholder's capital contributions and share of SDI's profits (e.g., profits attributable to policies issued by the shareholder's dealerships) and investment income, less (2) his share of SDI's losses and dividends paid with respect to the shares. Negative redemption accounts reduced other redemption accounts pro rata.
SDI did not pay dividends. It did, however, advance interest-free funds to its shareholders. The Articles authorized the board to approve an advance to a shareholder if such advance and all previous advances for that shareholder did not exceed 75 percent of that shareholder's redemption account. If a shareholder's redemption account declined in value such that the total advances to the shareholder exceeded 75 percent of his redemption account, the board of directors would1997 Tax Ct. Memo LEXIS 442">*448 demand repayment to the extent of the excess. The board demanded repayment of two of the more than 70 advances to shareholders. In each case, repayment was demanded because, after a decline in the value of the shareholder's redemption account, advances to the shareholder exceeded 75 percent of the account.
All advances were recorded on SDI's certified financial statements as loans receivable. To obtain an advance, a shareholder was required to execute an application. The applications generally stated the amount of the advance requested and provided that: (1) No interest would accrue; (2) the board would demand repayment if the shareholder's total advances exceeded 75 percent of that shareholder's redemption account; and (3) the shareholder's redemption account could be used to satisfy any outstanding advances. These applications were routinely approved by SDI's board of directors. SDI denied only two applications. These applications were denied because the future profitability of the respective applicant's redemption account was questionable.
SDI advanced funds to Messrs. McCurley and Hall. Each time Messrs. McCurley and Hall requested funds, they executed an application and submitted1997 Tax Ct. Memo LEXIS 442">*449 it to SDI's board of directors. The board approved, by resolution, each advance. Messrs. McCurley and Hall each tendered noninterest-bearing demand notes in the amount of the funds received. During the years in issue, SDI advanced a total of $ 275,661 to Mr. McCurley and $ 138,596 to Mr. Hall. SDI did not demand repayment of, and Messrs. McCurley and Hall did not repay, any of the advances.
During the years in issue, the McCurleys and Halls filed joint Federal income tax returns. On those returns, they did not report their advances from SDI as income. For each of the years in issue, certified public accountants prepared the McCurleys' and Halls' tax returns.
Respondent issued notices of deficiency to the McCurleys relating to their 1988, 1989, 1990, 1991, and 1992 returns. Respondent also issued a notice of deficiency to the Halls relating to their 1989, 1990, and 1991 returns. Respondent determined that Messrs. McCurley and Hall had income equal to the amounts SDI advanced to them. In the alternative, respondent determined that 75 percent of the annual increases in Messrs. McCurley's and Hall's redemption accounts was taxable to them as income constructively received. For the McCurleys' 1997 Tax Ct. Memo LEXIS 442">*450 1992 tax year, respondent determined a deficiency based solely on the constructive receipt theory. Respondent concedes that if we conclude petitioners received income when advances were made to them, there will be no deficiency in the McCurleys' 1992 income tax. Respondent also determined an addition to tax and accuracy-related penalties.
OPINION
I.
A distribution of cash or property from a foreign corporation to a domestic shareholder with respect to the corporation's stock generally is, to the extent of the corporation's earnings and profits, taxable to the shareholder as a dividend. See
A dividend need not be formally declared, but may be constructive.
Several factors support our conclusion. First, SDI never paid formal dividends to its shareholders. Second, petitioners did not establish that SDI demanded, or that Messrs. McCurley or Hall volunteered, repayment of the advances. See
In essence, SDI was designed and intended to capture each shareholder's insurance-related profits and to provide the shareholder with tax-free and interest-free1997 Tax Ct. Memo LEXIS 442">*453 access to profits attributable to policies issued through the shareholder's dealership. Messrs. McCurley and Hall would not repay their advances unless it was in their economic interests to do so. Petitioners have not persuaded us that it would ever be in their economic interests to repay these advances. Mr. McCurley, Mr. Hall, and SDI viewed the advances as permanent distributions with the understanding that there was a remote possibility that SDI would demand repayment. Accordingly, we hold that the advances to Messrs. McCurley and Hall were constructive dividends.
II.
A.
Petitioners contend that they exercised due care in reporting the advances as loans. Petitioners also contend that they reasonably relied on professional advice and that, as a result, their underpayments were attributable to reasonable cause. Messrs. McCurley and Hall did not unconditionally intend to repay the advances, and they knew or reasonably should have known that there was only a remote possibility that SDI would demand repayment of their advances. As a result, we reject petitioners' contentions and hold that they are liable for the accuracy-related penalties for negligence. Because we have held that the McCurleys did not understate their income in 1992, however, they are not liable for the negligence penalty for 1997 Tax Ct. Memo LEXIS 442">*455 that year.
B.
The McCurleys contend that they have not understated their income within the meaning of
The McCurleys also contend that the understatement was due to reasonable cause and that, as a result, respondent should have waived the penalty. See
We have 1997 Tax Ct. Memo LEXIS 442">*457 considered all other arguments made by the parties and found them to be either irrelevant or without merit.
To reflect the foregoing,
1. Cases of the following petitioners are consolidated herewith: Robert D. Hall and Gayle E. Hall, docket No. 10500-94; William L. McCurley and Victoria J. McCurley, docket No. 6557-95.↩