Bergersen v. Commissioner

• Decision Date: 29 August 1995
• Docket Number: Docket No. 11747-92.
• Citation: 70 T.C.M. 568
• Parties: Earl O. Bergersen and Evelyn K. Bergersen v. Commissioner.
• Court: U.S. Tax Court

70 T.C.M. 568

T.C. Memo. 1995-424

Earl O. Bergersen and Evelyn K. Bergersen v. Commissioner.

Docket No. 11747-92.

United States Tax Court.

Filed August 29, 1995.

James M. O'Brien, Thomas M. Haderlein, Michael J. Wilczynski, Mark A. Oates, and Tamara L. Frantzen, Chicago, Ill., for the petitioners. William T. Derick, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARKER, Judge:

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

                Additions to Tax
                                                         -----------------------------------------------------------------
                Year                        Deficiency   Sec. 6651(a)(1)   Sec. 6653(a)(1)1 Sec. 6653(a)(2)2 Sec. 6661
                1985 ....................   $  460,309       $45,731            $23,015       50% of interest     $115,077
                                                                                              on $460,309
                

                1986 ....................      402,781        60,417             20,139       50% of interest      100.695
                                                                                              on $402,781
                1987 ....................    1,347,642          --               67,382       50% of interest      336,911
                                                                                              on $1,347,642
                1 For 1986 and 1987, sec. 6653(a)(1)(A) applies
                2 For 1986 and 1987, sec. 6653(a)(1)(B) applies
                

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years before the Court, and all Rule references are to the Tax Court Rules of Practice and Procedure.

After concessions,¹ the issues remaining for decision are:

(1) Whether petitioners Earl O. Bergersen and Evelyn K. Bergersen were bona fide residents of Puerto Rico during the entire taxable years 1986 and 1987 and, therefore, were entitled to exclude from gross income all income derived from sources within Puerto Rico under section 933(1);

(2) whether the gain or a portion of the gain realized by petitioners on the sale of their home in Winnetka, Illinois, in November of 1985 is taxable, or whether petitioners may defer gain recognition under section 1034;

(3) whether certain withdrawals made by Earl O. Bergersen from Ortho-Tain, Inc., constitute bona fide loans or constitute constructive dividends or, alternatively, compensation for services, or some combination thereof;

(4) whether petitioners are entitled to deduct the payments made to Ortho-Tain, Inc., during each of the taxable years at issue as interest paid with respect to the purported loans;²

(5) whether petitioners are liable for additions to tax under section 6651(a)(1) for the late filing of their Federal income tax returns for 1985 and 1986;³

(6) whether petitioners are liable for additions to tax under section 6653(a)(1) and (2) or section 6653(a)(1)(A) and (B) for negligence or disregard of rules or regulations for the years at issue; and

(7) whether, except for certain items to which respondent concedes the addition does not apply, petitioners are otherwise liable for additions to tax under section 6661 for substantial understatement of income tax for the years at issue.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, the supplemental stipulation of facts, the second supplemental stipulation of facts, and the exhibits attached thereto are incorporated herein by this reference.

At the time the petition was filed in this case, Earl O. Bergersen and Evelyn K. Bergersen (collectively referred to as petitioners) resided in Dorado Beach, Puerto Rico. Petitioners filed Federal income tax returns for the taxable years 1982 through 1986 at the Internal Revenue Service Center located in Kansas City, Missouri. Petitioners timely filed a Federal income tax return for the 1987 taxable year at the Internal Revenue Service Center located in Philadelphia, Pennsylvania. Petitioners filed State of Illinois income tax returns for the taxable years 1982 through 1986. Petitioners did not file a Commonwealth of Puerto Rico income tax return for the 1986 taxable year. Petitioners filed such income tax returns in Puerto Rico for the 1987 and 1988 taxable years.⁴

Background

Earl O. Bergersen (petitioner) was graduated from the Northwestern University Graduate School in Dentistry (the Northwestern Dental School), with degrees in dentistry (D.D.S.) and in orthodontics (M.S.D.). In 1959, petitioner established an orthodontics practice in Winnetka, Illinois, a northern suburb of Chicago. Petitioner subsequently moved his practice into a commercial office building in Winnetka that he and his wife, Evelyn K. Bergersen (Mrs. Bergersen), purchased.

Petitioner and Mrs. Bergersen have three children: Leslie (born December 9, 1960), Lauren (born January 14, 1964), and Brian (born June 18, 1965). Petitioner and Mrs. Bergersen for much of their married life resided at 840 Lamson Drive in Winnetka, Illinois (the Winnetka house). In the early part of their marriage, Mrs. Bergersen was a homemaker rearing the children.

In addition to his orthodontics practice, petitioner conducted research, published articles, and lectured extensively on orthodontics. Petitioner also taught for some 22 years as an adjunct professor at the Northwestern Dental School and appeared as a guest lecturer at other dental schools. Petitioner did not accept remuneration for his teaching activities because he enjoyed teaching and viewed it as a contribution to his profession.

In the 1960's and 1970's, petitioner conducted research for the purpose of identifying and creating new orthodontic products. Petitioner invented and patented the Positioner and the Occlus-o-Guide, which are designed to obviate the need for children to wear braces. In 1968, petitioner organized Ortho-Tain Enterprises, Inc. (OTE), through which he sought to market these products by essentially operating a family-run mail order business out of the family home.⁵

OTE purchased its finished inventory from unrelated manufacturer/suppliers which produced the orthodontic appliances using molds provided by OTE. The family would sit around the kitchen table in the evenings and inspect the appliances for symmetry, coloration, and other quality traits. Petitioners stored the inventory in the basements of their Winnetka house and their Winnetka office building.

During the early 1970's, OTE experienced a dramatic decline in the quality of the contract-manufactured appliances. OTE's rejection rate of the appliances increased from 10 percent to 50 percent. Moreover, OTE was experiencing difficulty in obtaining a sufficient supply of products on a timely basis to satisfy its customer demand. Petitioner decided that the only way to overcome these problems was to undertake manufacturing the products himself rather than subcontracting the work to unrelated manufacturers.

On October 2, 1974, petitioner and Mrs. Bergersen incorporated Ortho-Tain, Inc. (Ortho-Tain or the corporation), under the laws of the State of Delaware to manufacture and sell petitioner's inventions. Petitioner served as the president of the corporation, and Mrs. Bergersen served as the secretary of the corporation. Petitioners were at all relevant times the only members of Ortho-Tain's board of directors. Petitioner and Mrs. Bergersen did not receive any salary from Ortho-Tain during the calendar years 1978 through 1987. See supra note 5.

Ortho-Tain's stock was owned by the following individuals during the years at issue:

                Stockholder                           Class of Stock             Number of Shares
                Earl O. Bergersen .................   Class A voting common             56
                Evelyn K. Bergersen ...............   Class A voting common             56
                Leslie A. Bergersen ...............   Class B voting common              5
                                                      Class C nonvoting common         271
                Lauren M. Bergersen ...............   Class B voting common              5
                                                      Class C nonvoting common         177
                Brian E. Bergersen ................   Class B voting common              5
                                                      Class C nonvoting common         115
                Santos Ortiz ......................   Class D nonvoting common         200
                

                Thomas Sedwick ....................   Class E nonvoting common         190
                

Although Ortho-Tain was authorized to issue shares of class F and class G nonvoting common stock, there were no shares of class F or class G nonvoting common stock outstanding.

The corporation initially operated a facility in Winnetka, Illinois, but, soon after establishing Ortho-Tain, petitioners began considering relocating the business to Puerto Rico. Petitioners considered the tax savings available by doing business overseas, particularly in Puerto Rico. Petitioners considered Puerto Rico most appealing because it was a possession of the United States, and petitioners eventually could live there and retain all the benefits of their U.S. citizenship. They also believed that Puerto Rico offers telephone and postal services, a sanitation system, and other amenities comparable to those in the United States. Petitioners were also aware that if they became residents of Puerto Rico, their income from Puerto Rican sources would be exempt from U.S. income tax.

The Puerto Rican Economic Development Administration (the EDA) encouraged petitioner to locate his manufacturing operation in Puerto Rico. An official with the EDA escorted petitioners around the island over a 2-week period, showing them the various potential areas where they could establish a facility.

Petitioners decided to locate their business in Toa Alta, a suburb of San Juan, Puerto Rico. In 1976, petitioners moved Ortho-Tain's plant operations to Puerto Rico, and the corporation elected under section 936 to be treated as a possessions corporation for U.S. income tax purposes. Ortho-Tain received a 15-year grant...