Cal-Farm Ins. Co. v. United States, Civ. No. S-84-0157 MLS.

• Decision Date: 05 September 1986
• Docket Number: Civ. No. S-84-0157 MLS.
• Citation: 647 F. Supp. 1083
• Parties: CAL-FARM INSURANCE COMPANY, a California corporation, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Eastern District of California

647 F. Supp. 1083

CAL-FARM INSURANCE COMPANY, a California corporation, Plaintiff, v. UNITED STATES of America, Defendant.

Civ. No. S-84-0157 MLS.

United States District Court, E.D. California.

September 5, 1986.

COPYRIGHT MATERIAL OMITTED

Forrest A. Plant, William B. Shubb, William W. Sumner, Diepenbrock, Wulff, Plant & Hannegan, Thomas F. Olsen, Gen. Counsel (Cal-Farm), Sacramento, Cal., for plaintiff.

Yoshinori H.T. Himel, Asst. U.S. Atty., Sacramento, Cal., Scott A. Milburn, Trial Atty., Tax Div., U.S. Dept. of Justice, Washington, D.C., for defendant.

MEMORANDUM AND ORDER

MILTON L. SCHWARTZ, District Judge.

On November 16, 1984, plaintiff and defendant filed cross-motions for summary judgment. The court took the motions under submission and now renders its decision.

I. Factual Background

In 1975, plaintiff/taxpayer Cal-Farm Insurance Company claimed a deduction of $1,471,635 for a payment to its subsidiary Cal-Farm Life Insurance Company. The two companies were formed by the California Farm Bureau Federation, a non-profit organization, to provide insurance to its members at the lowest possible cost. The payment made in 1975 was for alleged overcharges of shared office expenses for the years 1968 through 1972. The deduction resulted in substantial tax refunds to plaintiff. After auditing plaintiff's 1975 tax return, defendant Internal Revenue Service ("I.R.S.") disallowed the deduction and assessed tax deficiencies against plaintiff. Plaintiff paid the assessments and filed this suit for refund.

The allocation of common expenses between plaintiff and its subsidiary has undergone several changes during their history. Plaintiff was established by the California Farm Bureau Federation in 1948. Cal-Farm Life ("Life") was incorporated in 1950 as an affiliate of plaintiff. Since Life's inception, the companies agreed to share such common expenses as the costs for personnel, home office services, and field office services. No written agreement controlled the allocation of expenses. Minutes from a meeting of plaintiff's board of directors state the companies' original understanding: "insofar as possible, and if fair to both companies and dependent upon work performed, the division of common expenses should be on an equal basis."

The companies each paid half the common expenses until 1954. In that year, the companies' management jointly determined that the field offices were spending more time on plaintiff's business than on Life's. They reallocated common expenses 60 percent to plaintiff, 40 percent to Life. This allocation continued for 14 years. Then, in 1968, the companies' management decided that changes in business practices warranted a reevaluation of the expense allocation. They determined that the time spent on Life's business had increased since the 1954 allocation and thereupon reinstated the equal division of common expenses.

In 1973, the companies replaced the system of estimating the proper allocation of common expenses. They conducted time studies. The studies indicated that expenses for 1973 should be allocated 77 percent to plaintiff, 23 percent to Life. The companies determined that expenses for 1974 also should be allocated 77 percent to plaintiff, 23 percent to Life.

In 1975, the companies reviewed the allocation of expenses for 1968 through 1972. They selected the percentage of premiums, commissions and policies written for each business as valid predictors of the proper allocation of expenses. The 1975 study contradicted the result of the 1968 review. Whereas in 1968 the companies agreed that Life's share of the common expenses should be increased, in 1975 they decided Life had been overcharged. Plaintiff voluntarily reimbursed Life for the $1,471,635 overcharge suggested by the 1975 review.

The reallocation of expenses would have resulted in a tax savings to the two companies of approximately $353,192. Including the deduction for the payment to Life, plaintiff claimed a net operating loss of $2,347,713 for 1975. Plaintiff carried the net operating loss back to 1972, 1973, and 1974. The carryback greatly reduced plaintiff's income for 1972 and 1974,¹ entitling plaintiff to refunds for those years. Plaintiff received the refunds.

The government audited plaintiff's 1975 return. It disallowed the deduction for the payment to plaintiff's subsidiary. The disallowance reduced plaintiff's net operating loss for 1975 to $747,943. This substantial reduction reduced plaintiff's carryback, and resulted in deficiency assessments of $410,702 for 1972 and $41,891 for 1974. Plaintiff paid the assessments in full and filed this suit for reimbursement. It alleges that the deficiency tax was erroneously and illegally assessed. Plaintiff contends that the payment to Life is deductible under section 162(a) of the Internal Revenue Code as an ordinary and necessary business expense and under section 1341 as a repayment of an amount included in gross income in a prior year under a claim of right.

II. Summary Judgment Standard

Rule 56(c) of the Federal Rules of Civil Procedure specifies that summary judgment is proper when there is no genuine issue as to any material fact and the moving party is entitled to judgment as a matter of law. Aydin Corp. v. Loral Corp., 718 F.2d 897, 901-02 (9th Cir.1983). The general rule is that the burden of showing the absence of a genuine issue of triable fact is on the moving party. International Union of Bricklayers and Allied Craftsman Local Union No. 20, AFL-CIO v. Martin Jaska, Inc., 752 F.2d 1401, 1405 (9th Cir.1985).² Once that burden has been met, the burden then shifts to the opponent of the motion to set forth specific facts indicating that there is a genuine issue for trial. Fed.R.Civ.Proc. 56(e); Lowe v. City of Monrovia, 775 F.2d 998, 1008 (9th Cir. 1985), opinion amended at 784 F.2d 1407 (9th Cir.1986). Union of Bricklayers, 752 F.2d at 1405, Turner v. Local Union No. 302, International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America, 604 F.2d 1219, 1228 (9th Cir.1979). A party opposing summary judgment must therefore present some significant probative evidence to support his position. Compton v. Ide, 732 F.2d 1429, 1434 (9th Cir.1984), Ruffin v. Los Angeles County, 607 F.2d 1276, 1280 (9th Cir.1979), cert. denied, 445 U.S. 951, 100 S.Ct. 1600, 63 L.Ed.2d 786 (1980).

In actions challenging the assessment of a deficiency, the I.R.S.'s determination is presumed correct and the taxpayer bears the burden of proving otherwise. Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933); Long v. C.I.R., 757 F.2d 957, 959 (8th Cir.1985); Foster v. C.I.R., 756 F.2d 1430, 1439 (9th Cir.1985), cert. denied, ___ U.S. ___, 106 S.Ct. 793, 88 L.Ed.2d 770 (1986). The government is entitled to the benefit of that presumption in moving for summary judgment. Long, 757 F.2d at 959 (citing Coca-Cola Co. v. Overland, Inc., 692 F.2d 1250, 1254 (9th Cir.1982)); see also, Jones v. Wike, 654 F.2d 1129 (5th Cir.1981), Engl v. Aetna Life Insurance Co., 139 F.2d 469, 472-73 (2d Cir.1943), 6 Moore's Federal Practice, ¶ 56.153. The presumption permits summary judgment in the I.R.S.'s favor unless the taxpayer produces substantial evidence overcoming it. Long, 757 F.2d at 959.

Furthermore, the inquiry involved in a ruling on a motion for summary judgment necessarily implicates the substantive evidentiary standard of proof which would apply at the trial on the merits. Anderson v. Liberty Lobby, Inc., ___ U.S. ___, ___, 106 S.Ct. 2505, 2515, 91 L.Ed.2d 202 (1986). When determining whether a genuine issue of fact exists, a trial judge must bear in mind the actual quantum and quality of proof necessary to find for plaintiff. Id. at ___, 106 S.Ct. at 2514. The issue is whether the evidence presented is such that a rational fact finder, applying the applicable evidentiary standard, could reasonably find for either side. If not, summary judgment is appropriate. Id.

III. Analysis

The court has jurisdiction over this case under 28 U.S.C. § 1346(a)(1).

The issues presented³ by these motions for summary judgment are:

1. Whether defendant may rely on section 482 of the Internal Revenue Code, which imposes a heavier than normal burden of proof on a taxpayer in challenging the I.R.S.'s determinations;

2. Whether the payments made by plaintiff in this case are deductible as ordinary and necessary business expenses under 26 U.S.C. § 162; and

3. Whether plaintiff is entitled to deduct the payment as a repayment of monies previously included in income under claim of right under 26 U.S.C. § 1341.

The court will address each issue in turn.

A. Applicability of Section 482

Section 482 of Title 26 provides:

In any case of two or more organizations, trades, or businesses whether or not incorporated, whether or not organized in the United States, and whether or not affiliated, owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

Section 482 gives defendant broad discretion to place controlled taxpayers in the same position as uncontrolled taxpayers dealing at arm's length. Peck v. C.I.R., 752 F.2d 469, 472 (9th Cir.1985). The burden of persuasion is upon plaintiff to show error in the defendant's allocation, and the allocation must be sustained unless it is unreasonable, arbitrary or capricious. Id.

Because of the heavier than normal burden of proving arbitrariness, plaintiff is entitled to notice that defendant intends to rely on section 482. Foster v. Commissioner, 80 T.C. 34, 143 (1983), aff'd in part, vacated in part, 756 F.2d 1430 (9th Cir. 1985) (appellate discussion did not...