Thompson v. Comm'r of Internal Revenue

• Decision Date: 25 February 1980
• Docket Number: 4397-77.,Docket Nos. 4396-77
• Citation: 73 T.C. 878
• Parties: JOHN D. THOMPSON, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENTWESTWARD, INC., PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

73 T.C. 878

JOHN D. THOMPSON, PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENTWESTWARD, INC., PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket Nos. 4396-77

4397-77.

United States Tax Court

Filed February 25, 1980.

1. During 1973 and 1974, petitioner Westward, Inc., purchased tax refund claims from taxpayers filing Form 1040 or 1040A Federal income tax returns. Westward, Inc., would pay a taxpayer an amount equal to two-thirds of the refund due the taxpayer in exchange for the right to receive any refund made by the IRS. Held, the discount income Westward, Inc., derived on the receipt of taxpayers' refund checks does not constitute “interest” within the meaning of sec. 1372(e)(5), I.R.C. 1954. Held, further, Westward, Inc.‘s election under sec. 1372(a) to be treated as a small business corporation remained in effect in 1973 and 1974.

2. During 1974, Cable Vision, Inc., rented recorded video cassettes to cable television stations. In July of 1974, Cable Vision, Inc., entered an agreement with G.E. Corp. under which G.E. Corp. paid Cable Vision, Inc., $3,004.80 for the right to use Cable Vision, Inc.‘s recorded cassettes for one year. Held, the $3,004.80 Cable Vision, Inc., received from G.E. Corp. in 1974 constituted “rent” within the meaning of sec. 1372(e)(5). Held, further, petitioner did not render “significant services” in connection with the receipt of this rental income. Held, further, Cable Vision, Inc.‘s election under sec. 1372(a) to be treated as a small business corporation terminated in 1974 and, therefore, petitioner Thompson is not entitled to deduct the amount he claimed as his share of Cable Vision, Inc.‘s 1974 loss.

3. Held, advances petitioner Thompson made to Cable Vision, Inc., in 1974 constituted contributions to capital and, therefore, petitioner Thompson is not entitled to a bad debt deduction under sec. 166 in 1974 for these advances. George Constable, for the petitioners.

Matthew W. Stanley, for the respondent.

FAY, Judge:

Respondent determined deficiencies in petitioners' Federal income taxes and additions to taxes as follows:

+-------------------------------------------------------------------+
                ¦            ¦                ¦      ¦            ¦Addition to tax  ¦
                +------------+----------------+------+------------+-----------------¦
                ¦Docket No.  ¦Petitioner      ¦Year  ¦Deficiency  ¦sec. 6653(a)1    ¦
                +------------+----------------+------+------------+-----------------¦
                ¦            ¦                ¦      ¦            ¦                 ¦
                +------------+----------------+------+------------+-----------------¦
                ¦4396-77     ¦John D. Thompson¦1973  ¦$5,752      ¦$288             ¦
                +------------+----------------+------+------------+-----------------¦
                ¦            ¦                ¦1974  ¦6,814       ¦341              ¦
                +------------+----------------+------+------------+-----------------¦
                ¦4397-77     ¦Westward, Inc.  ¦1973  ¦11,925      ¦---              ¦
                +------------+----------------+------+------------+-----------------¦
                ¦            ¦                ¦1974  ¦5,338       ¦---              ¦
                +-------------------------------------------------------------------+
                

1. All statutory references are to the Internal Revenue Code of 1954, as amended, and in force during the years in issue.

These cases have been consolidated for purposes of trial, briefing, and opinion.

Concessions having been made,² the remaining issues for decision are:

(1) Whether more than 20 percent of the gross receipts of petitioner Westward, Inc., for its taxable year 1973 was “interest” and therefore passive investment income within the meaning of section 1372(e)(5), so as to terminate its election under section 1372(a) to be treated as a small business corporation for 1973 and 1974.

(2) Whether more than 20 percent of the gross receipts of I-Cable Vision Programmers, Inc., for its taxable year 1974 was “rent” and therefore passive investment income within the meaning of section 1372(e)(5). If so, then I-Cable Vision Programmers, Inc.‘s election under section 1372(a) to be treated as a small business corporation terminated in 1974 with the result that petitioner John Thompson is not entitled to deduct the amount that he claimed as his share of I-Cable Vision Programmers, Inc.‘s 1974 loss.

(3) Whether petitioner John Thompson is entitled to a bad debt deduction under section 166 in 1974 for advances made to I-Cable Vision Programmers, Inc. ³

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

At the time of filing his petition herein, petitioner John D. Thompson resided in Seattle, Wash. Petitioner Westward, Inc., maintained its principal office in Seattle, Wash., at the time of filing its petition herein.

Westward

Westward, Inc. (Westward), was incorporated on January 1, 1971. John D. Thompson (John) and his brother, Robert M. Thompson (Robert), each owned 49.5 percent of Westward's stock, and their mother, Ethyle M. Thompson, owned the remaining 1 percent. Robert was president and John was secretary-treasurer of Westward.

John and Robert each operated an income tax consulting and return preparation service in Seattle. John's office was in a building located at 5215 Ballard Ave., N.W. Westward's office was located in this same building across the hall from John's office. Robert's office was approximately one-half mile away from the offices of John and Westward in a building located at 1141 Northwest Market St.

On December 1, 1970, John, on behalf of Westward, filed an election to be taxed pursuant to the provisions of subchapter S of the Internal Revenue Code. The election was effective for Westward's first taxable year beginning January 1, 1971.

During 1973 and 1974, Westward was in the business of acquiring tax refund claims at a discount from taxpayers filing Form 1040 and Form 1040A Federal income tax returns. Beginning in January of each of these years, Westward would circulate flyers in various taverns advertising that it would provide an immediate cash refund to taxpayers who filed Form 1040A returns. The advertisements instructed the taxpayer to bring his or her W-2 Form into Westward's office in Seattle.

When a taxpayer would come into Westward's office, one of the three Westward employees would prepare the taxpayer's 1040A return and calculate the amount of any refund due.⁴ If the taxpayer was entitled to a refund, a Westward employee would fill out one of Westward's forms labeled “Tax Claim Refund & Sale Computation.” The purpose of the form was to compute the amount of cash Westward would pay for the taxpayer's refund claim. The amount of cash to be paid to the taxpayer was calculated on this form by reducing the refund due the taxpayer by a “discount charge” of 331;3 percent. Thus, Westward would acquire the right to receive a taxpayer's entire refund in exchange for two-thirds of the total amount of the refund due the taxpayer.

In addition, the taxpayer was required to fill out a form provided by Westward labeled “Refund Application.” On this “Refund Application,” the taxpayer was asked to provide the following information: various biographical data, the amount of any tax refund received the previous year, whether returns were filed, and whether taxes were owed for the years 1967 through 1972. This form also included a statement to be signed by the taxpayer authorizing the Internal Revenue Service (IRS) to mail the taxpayer's refund check to Westward's office in Seattle.

Westward also required the taxpayer to sign two power of attorney forms. The first was a form prepared by Westward labeled “General Power of Attorney” which gave John and Robert the power to receive, endorse, and collect the taxpayer's refund check. The second was IRS Form 2848 which gave John and Robert the power to act as attorneys in fact for the taxpayer and to receive the taxpayer's refund check.

When the taxpayer's return had been prepared and all the other forms completed, the Westward employee would take these documents, and a check made out to the taxpayer for two-thirds the amount of the refund, across the hall to John's office for approval. John would then review the documents in an effort to determine the validity of the taxpayer's W-2 Form and to make sure the refund was computed correctly. If John approved the transaction, he would sign the check which would then be given to the taxpayer.

John reviewed each transaction to ensure that Westward did not acquire refund claims based on false or fraudulent W-2 Forms. Although the taxpayer was required to sign an affidavit stating under penalty of perjury that the information on the W-2 Form was accurate, once Westward paid a taxpayer for his refund claim, the taxpayer had no obligation to repay Westward even if the IRS did not honor the taxpayer's refund claim. Hence, when a refund was not made by the IRS, Westward sustained a loss on the transaction. For this reason, Westward refused to acquire the refund claims of all taxpayers who brought W-2 Forms into its office. Westward rejected approximately 15 percent of the 600 applications it received from taxpayers each year.

During 1973 and 1974, Westward began acquiring tax refund claims on January 15 and ceased acquiring refund claims on April 15. As refund checks were received, they were endorsed and deposited in Westward's bank account. All of Westward's gross receipts in 1973 and 1974 were derived from its business of acquiring and processing customers' tax refund claims. In 1973, Westward reported $224,122 as gross receipts, $179,737 as cost of operations, and $64,385 as gross income. In 1974, Westward reported $152,854 as gross receipts, $113,478 as cost of operations, and $39,376 as gross income.

Although John conducted his own tax consulting business, he spent several hours a day supervising Westward's activities. John also prepared Westward's income tax returns each year and arranged for Westward to borrow $80,000 from private investors in January of 1...