Caton v. Commissioner
| Decision Date | 23 February 1995 |
| Docket Number | Docket No. 21971-92. |
| Citation | 69 T.C.M. 1937 |
| Parties | Leslie M. Caton v. Commissioner. |
| Court | U.S. Tax Court |
Richard S. Karam, 10812 N. May, Oklahoma City, Okla., for the petitioner. Elizabeth Downs, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined deficiencies in petitioner's Federal income tax and additions to tax for the taxable years 1987 and 1988, as follows:
Additions to Tax
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Sec. Sec. Sec. Sec
Year Deficiency 6653(a)(1)(A) 6653(a)(1)(B) 6653(a)(1) 6661(a)
1987 ..................... 1$65,879 $3,294 2 -- $16,470
1988 ..................... 11,294 -- -- $565 2,824
1 Includes an excess distributions tax under sec. 4980A in the amount of $2,303
2 50 percent of the interest due on $65,879
On brief, respondent conceded the deficiency and additions to tax for 1988.
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years before the Court, and all Rule references are to the Tax Court Rules of Practice and Procedure.
The issues before the Court arise out of the interplay between petitioner's debt to his company's profit-sharing trust and his vested benefit in that profit-sharing trust. Petitioner argues that his debt to his company's profit-sharing trust was discharged in 1987 by the running of the State statute of limitations and thereby constitutes discharge of indebtedness income excludable from income under section 108(a)(1)(B) due to his insolvency that year. Respondent contends that petitioner's debt to his company's profit-sharing trust was offset in 1987 against his vested benefit in that profit-sharing trust and that such offset constitutes a constructive distribution from the profit-sharing trust includable in his taxable income that year under section 402(a) and subject to the excess distributions tax under section 4980A.
Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
At the time the petition was filed in this case, Leslie M. Caton (petitioner) resided in Enid, Oklahoma. Prior to and during the years in issue, petitioner was president of Caton Lumber Co., Inc. (Caton Lumber). Caton Lumber was a closely held family business, established by petitioner's father. During the years at issue, petitioner and his brother, Mac Caton, owned directly or indirectly all of the outstanding shares of Caton Lumber.1
At all times relevant to this case, petitioner and his brother were the administrators and co-trustees of the Caton Lumber Co. Profit-Sharing Plan Trust2 (the profit-sharing trust). The profit-sharing trust was a defined-contribution plan established to operate as a qualified plan described in section 401(a). Petitioner also was an employee of Caton Lumber and a participant in the profit-sharing plan.
The construction, validity, and administration of the profit-sharing trust indenture, the plan, and the adoption agreement are governed by the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, and regulations issued thereunder, and, to the extent not so governed, by the laws of the State of Oklahoma. See supra note 2. Petitioner knew that, as an administrator and trustee of the trust, he had a duty to invest the funds of the trust in a prudent manner. As a trustee of the profit-sharing trust, petitioner was prohibited from entering into any "prohibited transaction" as defined by section 4975 or ERISA section 406, 88 Stat. 879. Also as a trustee, petitioner was required to keep accurate and detailed accounts of all receipts, disbursements, investments, and all other transactions involving the funds of the profit-sharing trust. As a fiduciary of the trust, petitioner was required to prepare and provide all reports required by regulations adopted by the Secretary of the Treasury and the Secretary of Labor. Also in his fiduciary capacity, petitioner was required to maintain records necessary to verify such reports, including vouchers, worksheets, and receipts, for a period of not less than 6 years after the filing date of such reports.
Over the years, the profit-sharing trust made loans to some Caton Lumber employees who were participants in the profit-sharing plan, including petitioner and his brother. As an administrator of the trust, petitioner approved each of the loans made by the profit-sharing trust. The loans were evidenced by demand notes. Each participant's loan balance, including accrued interest, was determined annually. Each participant's vested account balance was treated as collateral or security for his or her outstanding loan balance.3 No lawsuit to collect on a loan from the profit-sharing trust was ever filed against an employee.
Petitioner received loans and executed promissory notes payable on demand to the profit-sharing trust, with interest at the rate of 7.5 percent per annum, on the following dates and in the principal amounts indicated:4
Date Principal Amount
4/30/74 ....................... $ 3,000.00
4/14/78 ....................... 12,000.00
6/15/78 ....................... 20,217.58
4/09/79 ....................... 22,217.31
4/20/79 ....................... 27,217.31
6/07/79 ....................... 200.00
8/07/79 ....................... 52,997.90
10/08/79 ....................... 8,500.00
4/10/80 ....................... 10,000.00
4/15/82 ....................... 9,000.00
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Total ...................... $165,350.10
The amounts of these loans, including unpaid accrued interest, were carried on the books of the profit-sharing trust as loans due from petitioner. During the years petitioner received the loans from the trust, his accrued benefit in the profit-sharing trust was fully vested.
In addition to the loans made to participants in the trust, the profit-sharing trust made loans to third parties who were not Caton Lumber employees. The trust made several loans to Larry Richey (Richey), a certified public accountant (C.P.A.) who prepared the books and records of Caton Lumber and the profit-sharing trust from 1980 until June 30, 1987. Richey was not an employee of Caton Lumber or the profit-sharing trust.
In 1987, Caton Lumber's business was failing. The profit-sharing trust was terminated as of June 30, 1987, and Caton Lumber ceased operating in 1988. In the event of the termination of the trust, all funds in the trust vested immediately in the participants in accordance with their respective interests therein.
On or about June 30, 1987, Richey prepared a written computation that showed the account balances of the trust participants as well as the loan balances of participants and nonparticipants who had debts owing to the trust as of that date. Richey's computation accurately reflected the status of the accounts and loans of the trust at that time. Richey's computation, however, did not reflect the fact that all accounts became fully vested upon termination of the trust.5
For purposes of winding up the business of the company and the profit-sharing trust, the books and records of Caton Lumber were given to Richard S. Karam (Karam), petitioner's counsel in this case. Richey's computation of the profit-sharing trust accounts was included in the records furnished to Karam.
Petitioner relied upon Karam to determine the amount each participant was to receive upon liquidation of the profit-sharing trust. None of the participants who had loans outstanding repaid the loans, except through reduction of or offset against his or her vested balances.6 Instead, each participant's distribution was computed by reducing the vested interest of the participant by the amount of any loans outstanding from the trust to the participant. Petitioner's trust account was treated in a consistent manner with those of the other participants, and his vested interest was reduced by the amount of his outstanding loan balance at the time that the trust was terminated. Final distributions of these net amounts from the profit-sharing trust to participants were made in May or June of 1988.
As of June 30, 1987, petitioner owed the profit-sharing trust $181,225.41 in principal and unpaid accrued interest on the loans. As of that date, petitioner had a fully vested interest in the profit-sharing trust in the amount of $221,468.93. After the offset of petitioner's debt in the amount of $181,225.41, petitioner had a vested interest in the amount of $40,243.52.
After reviewing the documents, Karam told petitioner in 1988 that the notes petitioner had signed for the loans from the profit-sharing trust became unenforceable because the Oklahoma statute of limitations had run. Petitioner was not aware that the statute of limitations might be an issue until Karam discussed it with petitioner in 1988. At the time the profit-sharing trust was terminated in 1987, petitioner believed that he owed the trust a debt in the amount of $181,225.41 for the outstanding loans. With his 1987 return, which was received by the Internal Revenue Service (IRS) on August 8, 1988, petitioner attached a financial statement that noted that he had $181,225.41 discharge of indebtedness from the profit-sharing trust in 1987 that he claimed was excluded from income due to his insolvency.
In January of 1989, an IRS agent began an audit of the profit-sharing trust. The IRS agent concluded the audit by September of 1989. Karam had a power of attorney and...
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