Underwood v. Comm'r of Internal Revenue
| Decision Date | 27 January 1975 |
| Docket Number | Docket Nos. 2882-73,2883-73. |
| Citation | 63 T.C. 468 |
| Parties | MORRIS G. UNDERWOOD, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTJACKIE UNDERWOOD, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Edward R. Smith, for the petitioners.
D. Derrell Davis, for the respondent.
Petitioners husband and wife, residing in a community property State, owned all the stock of corporation A, an electing small business corporation, and corporation L. A borrowed $110,000 from L. Subsequently, L canceled A's debt to it, Underwood gave his $110,000 note to L, and A gave its $110,000 note to Underwood. Held, A's note to Underwood is not an ‘indebtedness' which increases Underwood's ‘adjusted basis' under sec. 1374(c)(2)(B), I.R.C. 1954, for the purpose of determining the amount of A's net operating loss petitioners may deduct for 1969. Held, further, a settlement of an income tax refund suit for a prior year does not estop respondent from denying the deductibility by petitioners of A's net operating loss for 1969.
In these consolidated cases, respondent determined deficiencies in petitioners' Federal income taxes for 1969 in the following amounts:
+---------------------------------------------+
¦Petitioner ¦Docket No. ¦Deficiency ¦
+-------------------+------------+------------¦
¦ ¦ ¦ ¦
+-------------------+------------+------------¦
¦Morris G. Underwood¦2882-73 ¦$4,286.24 ¦
+-------------------+------------+------------¦
¦Jackie Underwood ¦2883-73 ¦4,302.42 ¦
+---------------------------------------------+
The only issue for decision is whether petitioners, on their Federal income tax returns for 1969, properly deducted their respective shares of the net operating loss incurred by an electing small business corporation. The answer depends upon (1) whether the corporation's execution of a promissory note to petitioners gave them an ‘adjusted basis' in ‘indebtedness' within the meaning of section 1374(c)(2)(B),1 and (2) whether respondent is estopped to contend that it did not.
Morris G. Underwood (hereinafter Underwood) and Jackie Underwood, husband and wife (referred to jointly hereinafter as petitioners), were residents of Lubbock, Tex., at the time they filed the petitions herein. They filed separate individual Federal income tax returns for the calendar year 1969, using the case method of accounting. All of their income, notes, and stock here involved were community property.
During all pertinent years, petitioners were the sole shareholders of Underwood's of Lubbock, Inc. (hereinafter referred to as Lubbock), a corporation engaged in the retail barbecue cafeteria business located in Lubbock, Tex.
In January 1965, petitioners organized another retail barbecue cafeteria business, Underwood's of Albuquerque, Inc. (hereinafter referred to as Albuquerque). As of May 1966, Albuquerque elected to be taxed as a small business corporation under subchapter S of the Internal Revenue Code of 1954, sections 1371-1379. Petitioners became the sole shareholders of Albuquerque as of June 1, 1966, and continued to be so through April 30, 1969.
Lubbock filed its income tax returns using the accrual method of accounting and a fiscal year ending August 31. Albuquerque filed its income tax returns using the accrual method of accounting and a fiscal year ending April 30.
For the period prior to its election to be taxed as a small business corporation, Albuquerque's tax returns reflected the following operating results:
+---------------------------------+
¦FYE Apr. 30— ¦Gain (or loss) ¦
+----------------+----------------¦
¦ ¦ ¦
+----------------+----------------¦
¦1965 ¦0 ¦
+----------------+----------------¦
¦1966 ¦($82.49) ¦
+---------------------------------+
As a small business corporation, Albuquerque's operations reflected the following results:
+---------------------------------+
¦FYE Apr. 30— ¦Gain (or loss) ¦
+----------------+----------------¦
¦ ¦ ¦
+----------------+----------------¦
¦1967 ¦($4,003.05) ¦
+----------------+----------------¦
¦1968 ¦(51,815.94) ¦
+----------------+----------------¦
¦1969 ¦(13,054.74) ¦
+----------------+----------------¦
¦1970 ¦(11,331.62) ¦
+---------------------------------+
Lubbock's operations during its fiscal years ended August 31 of 1965 through 1970 consistently resulted in profits.
During the period January 1965 to October 1966, Lubbock made loans to Albuquerque totaling $110,000, in order to help finance the latter's operations. In return, Albuquerque executed a series of demand promissory notes to Lubbock, each bearing 6-percent interest.
Interest due from Albuquerque on its notes was regularly accrued on Lubbock's books as interest income and was consistently reported as such on its income tax returns. Albuquerque's books similarly reflected accruals for interest expense incurred on the loans extended to it by Lubbock.
Albuquerque made no payments of principal or interest on these notes to Lubbock until April 1968, when it paid Lubbock $6,980, which represented the total amount of interest which had accrued on the notes as of January 31, 1967.
Ray Lawrence (hereinafter Lawrence) is and has been the C.P.A. for the Underwood interests since about 1953. Sometime prior to January 31, 1967, Lawrence discussed with Underwood the matter of anticipated losses of Albuquerque for its fiscal year ended April 30, 1967. Lawrence advised Underwood that losses in Albuquerque could well exceed Underwood's adjusted basis in that corporation's stock in the near future and that, therefore, Underwood should consider steps which would increase his basis in Albuquerque's stock or indebtedness, thereby enabling him to deduct such losses for tax purposes.
At the time this discussion was held, Lubbock was not actively engaged in any expansion program for which it needed the funds previously lent to Albuquerque.
As a result of the discussion between Lawrence and Underwood, the following transactions occurred: (1) Lubbock surrendered its Albuquerque notes to Albuquerque, marking them ‘paid’ as of January 31, 1967; (2) Albuquerque issued a demand promissory note to Underwood dated January 31, 1967, in the amount of $110,000, bearing 6-percent interest per annum; (3) Underwood gave his personal demand note to Lubbock dated January 31, 1967, in the amount of $110,000, bearing 6-percent interest per annum.
Thereafter, the books and records of Lubbock and Albuquerque reflected the ownership of the new notes and cancellation of the original notes in conformity with the transactions described above.
Interest due on the note Underwood executed to Lubbock was regularly accrued and reported for income tax purposes by Lubbock from and after January 31, 1967. Actual payments of interest to Lubbock were made by Underwood on April 11, 1968, December 15, 1969, and March 6, 1970. The note was paid in full on March 27, 1970.
On the note Albuquerque issued to Underwood on January 31, 1967, no principal or interest had been actually paid as of April 30, 1972.2
As of April 30, 1967, petitioners' adjusted basis in Albuquerque stock was $13,000. On their joint Federal income tax return for 1967, petitioners claimed a combined total of $3,695.22 of Albuquerque's April 30, 1967, fiscal year loss of $4,003.05,3 which left them a remaining basis of $9,304.78 in Albuquerque stock. On their joint Federal income tax return for 1968, petitioners claimed all of Albuquerque's losses in the amount of $51,815.94 for its fiscal year ended April 30, 1968.
After deducting $9,304.78 of Albuquerque's April 30, 1968, net operating loss on their joint income tax return for 1968, petitioners' adjusted basis in Albuquerque stock was reduced to zero. Petitioners also deducted the remainder of the April 30, 1968, fiscal year net operating loss incurred by Albuquerque. The remainder of the loss deducted exceeded the $22,377.50 directly loaned to Albuquerque by Underwood in April 1968, thereby reducing petitioners' adjusted basis in that indebtedness to zero. The remaining $20,133.66 of Albuquerque's April 30, 1968, net operating loss was also fully deducted by petitioners for 1968. Petitioners' computations treated the $110,000 January 31, 1967, note owed by Albuquerque to Underwood as a bona fide indebtedness of Albuquerque, serving to increase the limitation of their deductible portion of Albuquerque's net operating loss.
Subsequently, petitioners' income tax returns for 1967 and 1968 were audited by respondent. The revenue agent's report was dated February 5, 1970. With respect to 1967, respondent's agent proposed to treat the January 31, 1967, note exchange as a $110,000 dividend from Lubbock to petitioners. For 1968, he proposed (a) to disallow $20,133.66 of the Albuquerque loss to petitioners on the grounds that Lubbock, and not petitioners, had, in fact, advanced the $110,000 to Albuquerque, and (b) to treat the repayment of $12,000 by Albuquerque to petitioners as taxable capital gain instead of tax-free return of capital.
In conference, respondent dropped the proposed disallowance of Albuquerque's April 30, 1968, loss but maintained his positions on both the 1967 dividend receipt and the capital gain treatment for the 1968 repayments by Albuquerque on the April 9, 1968, loan extended by Underwood.4
Early in 1971, as a result of the settlement conference, petitioners were assessed a tax for 1967, which they paid, on the theory that the note they received from Albuquerque for $110,000 on January 31, 1967, was a dividend in that amount from Lubbock. In June 1971, petitioners filed a claim for refund of the tax so assessed and paid, and in January 1972, they filed suit for refund. A pretrial order entered by the United States...
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