Alondra Industries, Ltd. v. Commissioner of Internal Revenue, 012996 FEDTAX, 10849-91
|Docket Nº:||10849-91, 10851-91, 24777-92|
|Opinion Judge:||BEGHE, Judge|
|Party Name:||ALONDRA INDUSTRIES, LIMITED, d.b.a. ACCENT INSULATION COMPANY AND SUBSIDIARIES, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent|
|Attorney:||Mark D. Pastor and Larry S. Dushkes, for petitioners. Ursula P. Gee, William A. McCarthy, and Linette B. Angelastro, for respondent.|
|Case Date:||January 29, 1996|
|Court:||United States Tax Court|
MEMORANDUM FINDINGS OF FACT AND OPINION
By statutory notices dated March 8, 1991, respondent determined deficiencies in and additions to the Federal corporation income tax of petitioner Alondra Industries, Limited, d.b.a. Accent Insulation Company (Alondra), for its fiscal year ended June 30, 1987 (Alondra's fiscal 1987), and of petitioner Edco Leasing Corporation (Edco) for its fiscal year ended September 30, 1987 (Edco's fiscal 1987). By notice of final partnership administrative adjustment (FPAA) dated July 13, 1992, respondent increased the income reported on the U.S. Partnership Return of Income of petitioner Pertinax, Limited (Pertinax), a partnership whose partners include Alondra and Edco, for the calendar year 1987. The deficiencies, additions, and adjustment in dispute are as follows:
ket No. 10849-91 (Alondra)
Additions to tax
50% of the $209,060 interest due on
Docket No. 10851-91 (Edco)
Additions to tax
50% of the interest due on $21,814
Docket No. 24777-92 (Pertinax)
Adjustment to Income
Petitioners' cases were consolidated for trial, briefing, and opinion.
The issues for decision are (1) whether the burden of proof should be shifted from corporate petitioners to respondent with respect to the issues of substantiation of claimed expenses for rent and management fees; (2) whether disputed amounts of $26,881, $3,721, and $3,136 allegedly paid respectively by Alondra, Edco, and Pertinax to Joel Munro (Mr. Munro) for rent are deductible by petitioners as ordinary and necessary business expenses; (3) whether and to what extent $1,000,112 paid to Mr. Munro is deductible by Pertinax as reasonable compensation; (4) whether disputed amounts of $906,879 and $9,922 allegedly paid respectively by Alondra and Edco to Pertinax as management fees are deductible by Alondra and Edco as reasonable compensation; (5) whether disputed amounts of $884,148 and $35,671 paid respectively by Alondra and Edco to Pertinax for wages paid to employees of Pertinax, some of whom also served as officers of Alondra and Edco, are deductible by Alondra and Edco as ordinary and necessary business expenses; (6) the proper tax treatment of unreasonable compensation routed to Mr. Munro by Alondra and Edco through Pertinax; and (7) whether Alondra and Edco are liable for additions to tax for negligence under section 6653(a)(1)(A) and (B)2 and Alondra is liable to the addition to tax for substantial understatement under section 6661(a).
We hold that: (1) Corporate petitioners' motion to shift the burden of proof is denied as moot; (2) the disputed amounts allegedly paid for rent are not deductible; (3) the disputed amounts paid to Mr. Munro as compensation are deductible by Pertinax only to the extent stated below; (4) the disputed amounts allegedly paid by Alondra and Edco to Pertinax as management fees are not deductible; (5) the disputed amounts paid by Alondra and Edco to Pertinax for wages of its employees are deductible to the extent stated below; (6) the unreasonable compensation routed to Mr. Munro by Alondra and Edco through Pertinax should be treated as unreasonable compensation directly provided to Mr. Munro by Alondra and Edco; and (7) the additions to tax for negligence and for substantial understatement are both sustained to the extent stated below.
FINDINGS OF FACT
The stipulations of fact, the supplemental stipulations of fact, and the exhibits attached thereto are incorporated in our findings by this reference. Unless we state otherwise, these findings concern facts occurring during the relevant taxable period.
Parties and Affiliates
Alondra is a California corporation. Alondra keeps its books and reports its income using the accrual method of accounting on a fiscal year ending June 30. J.B. Ross, a.k.a. Jo Anne Munro (Ms. Ross), is Alondra's sole shareholder and secretary. At the time of filing of Alondra's petition, its principal place of business was at 1001 El Centro Street, South Pasadena, California (the El Centro property).
Edco is a California corporation. Edco keeps its books and reports its income using the accrual method of accounting on a fiscal year ending September 30. Mr. Munro, Ms. Ross's father, is Edco's sole shareholder. At the time of filing of Edco's petition, its principal place of business was at the El Centro property.
United California Insulation Company (UCIC) is a wholly owned subsidiary of United California Industries, Inc. (UCII); both of them are California corporations, and their income, deductions, and credits are reported on consolidated corporation income tax returns.3 The principal place of business of both UCIC and UCII is at the El Centro property. Mr. Munro is UCII's sole shareholder. UCII keeps its books and reports its income using the accrual method of accounting and a calendar year. Neither UCIC nor UCII is a petitioner in this Court.4
Pertinax was formed as a California general partnership in January 1978. Pertinax keeps its books and records and reports its income using the accrual method of accounting and a calendar year. At the time of filing of Pertinax's petition, its principal place of business was at the El Centro property. From the time of its formation through 1987, Pertinax always had three general partners that shared equally in income and made equal capital contributions, and those partners are Edco, Alondra, and UCIC.
All three petitioners--Alondra, Edco, and Pertinax--as well as UCIC and UCII, are controlled by Mr. Munro and his family. Mr. Munro's daughter Ms. Ross is the sole shareholder of Alondra. Mr. Munro is the sole shareholder of Edco and UCII. Thus, members of Mr. Munro's family directly or indirectly own all of Pertinax's partners. Pertinax manages Alondra, Edco, and UCIC, and Mr. Munro controls Pertinax's policies.
Alondra and UCIC are insulation contractors, engaged primarily in the sale and installation of insulation material in buildings. Edco is engaged in leasing automobiles and trucks. Pertinax provides marketing, management, and administrative services to its partners.
Alondra employs between 175 and 200 persons. Edco has three employees. Pertinax employs approximately 6 executives (including Mr. Munro and Ms. Ross), 2 to 3 managers, a sales employee, and 20-plus clerical personnel as support staff.
In 1970, when Mr. Munro was in his midsixties, he had approximately 30 years of business experience in banking and finance that included employment with Security Bank, Security Pacific Bank, the Bank of Pasadena, and Wells Fargo Bank. He first became acquainted with UCIC while he was employed at Wells Fargo, when the then owner of UCIC asked him for advice. In September 1970, when Mr. Munro retired from Wells Fargo, UCIC hired him as an adviser. Later, about 1972, Mr. Munro acquired ownership of UCIC5 and was its sole shareholder from about 1972 through 1987. In 1972, Alondra was a newly organized but inactive corporation, and UCIC did all the insulation work of the complex later made up of Alondra, UCIC, Edco, and Pertinax.
David Lee Clearman (Mr. Clearman) joined UCIC at Mr. Munro's invitation in spring 1975, working as assistant to the president. After some 2 years at UCIC, Mr. Clearman became president of Alondra, which was just then beginning active operations.
Prior to beginning employment with UCIC and its affiliates in 1975, Mr. Clearman worked for Wells Fargo Bank, where he had started in 1957 and risen to the rank of vice president and branch manager. In March 1968, while he was assistant manager of the South Pasadena branch, Mr. Clearman first met Mr. Munro, who was manager of that branch. Mr. Clearman and Mr. Munro worked together at the South Pasadena branch for about a year and a half.
By about 1975, UCIC's trade debt with its primary insulation supplier, Owens-Corning Fiberglass, was delinquent. Because of Owens-Corning's importance to UCIC, UCIC could not remain in business unless it avoided default on this debt. Mr. Munro persuaded Owens-Corning to restructure the payment terms on the debt. Then, by reducing overhead, returning some leased equipment, and closing unprofitable branch locations, he cut UCIC's expenses and increased its cash-flow. In this and other ways, Mr. Munro succeeded in having the Owens-Corning trade debt repaid in full and in putting UCIC on a sound operating footing.
Mr. Munro was UCIC's and Alondra's primary spokesman for purchasing fiberglass insulation material and for negotiating prices and terms with Owens-Corning. This was because the president of Owens-Corning personally held him in high esteem. Whereas the industry payment term was generally 30 days, and 60 days for a large contractor, Owens-Corning's terms with Alondra and UCIC were 90 days with a 2-percent discount. Mr. Munro's good relations with Owens-Corning were a critical reason for Owens-Corning's granting such favorable terms. The 90-day- payment terms allowed Alondra and UCIC to buy and warehouse the insulation, sell and install the...
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