Dietrick v. Commissioner, Docket No. 13616-84

• Decision Date: 28 April 1988
• Docket Number: Docket No. 13616-84,42129-84.
• Parties: Gerald Patrick Dietrick and Anita Lea Dietrick v. Commissioner.
• Court: U.S. Tax Court

55 T.C.M. (CCH) 706 (1988)

T.C. Memo. 1988-180.

Gerald Patrick Dietrick and Anita Lea Dietrick v. Commissioner.

Docket Nos. 13616-84, 42129-84.

United States Tax Court.

Filed April 28, 1988.

Stephen A. Kappers, Florence, Ky., for the petitioners.¹ Genevieve K. Murtaugh, for the respondent.

Memorandum Findings of Fact and Opinion

PARKER, Judge:

In these consolidated cases, respondent determined deficiencies in petitioners' Federal income tax for the calendar years 1980 and 1982 as follows:

                Docket No. Year Deficiency
                  13616-84           1980         $70,864.55
                  42129-84           1982          38,490.19
                

After a concession by petitioners, the issues for decision are:

(1) Whether the taxpayer, who incurs and pays expenses for his closely held corporation from which his sole proprietorship possibly may later derive income, is protecting or promoting his sole proprietorship and so may deduct the corporation's expenses on his Schedule C.

(2) If the taxpayer is found to be protecting or promoting his sole proprietorship, whether he may deduct the corporation's expenses when the corporation has transferred funds to him. This depends upon whether the corporation's transfers of funds to him are loans or reimbursements for the corporate expenses he has paid.

(3) Whether the taxpayer may deduct under section 162² a certain percentage of the wages paid to an employee of a corporation if the employee did work for the taxpayer's sole proprietorship as an agent of the corporation.

Findings of Fact

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

Petitioners Gerald Patrick Dietrick and Anita Lea Dietrick resided in Florence, Kentucky at the time of the filing of their petitions. Petitioners filed their joint Federal income tax returns (Forms 1040) for the taxable years 1980, 1981, and 1982, and an amended individual income tax return (Form 1040X) for the taxable year 1982 with the Internal Revenue Service Center in Memphis, Tennessee. Petitioner Anita Lea Dietrick is a party in this case solely because she filed joint income tax returns with her husband for each of the years in issue. All further references to "petitioner" are to Gerald Patrick Dietrick.

In approximately 1959 petitioner began operating a sole proprietorship known as Dietrick Sales and Service. This business provided a wide variety of engineering services, which primarily included the sales and service of filtration equipment, water waste treatment, tramp oil systems and oil water separators, generally referred to as the filtration operation.

Petitioner became interested in the Windecker Eagle airplane (hereinafter referred to as the Eagle) in 1973 when he bought an Eagle from Windecker Industries, Inc. The Eagle is a single engine, high performance aircraft constructed of a composite material known as NUF, or nonwoven, unidirectional fiberglass material. The Eagle was first conceived by Dr. Leo J. Windecker, a dentist who devoted substantial time to aircraft research and development. Dr. Windecker incorporated Windecker Industries, Inc. in 1967 primarily for the purpose of developing, manufacturing, and marketing the Eagle.

Petitioner had no experience in the aircraft industry other than as a private pilot. Petitioner became convinced that the Eagle could be commercially successful and proceeded to acquire certain indebtedness of the financially troubled Windecker Industries, Inc. The indebtedness petitioner acquired was secured by various assets of Windecker Industries, Inc. that were required to manufacture the Eagle. Windecker Industries, Inc. had obtained a Federal Aviation Administration (FAA) Type Certificate on the Eagle and had manufactured seven of the aircraft before it defaulted on its indebtedness. Petitioner then foreclosed on his security interests and obtained machine tools, production molds, the FAA Type Certificate on the Eagle, aircraft tooling, the machine that manufactured NUF, trademarks and registered trade names, and engineering specifications. Petitioner then purchased substantial aircraft inventory that Windecker Industries, Inc. had on hand. Petitioner sold most of the machine tools, but retained the FAA Type Certificate and aircraft tooling, unique machine tools and production molds, as well as the machine that manufactured NUF.

Petitioner initially attempted to market the Eagle on his own through his sole proprietorship, Dietrick Sales and Service. Petitioner later decided to set up a corporation for the manufacture and sale of the Eagle. Petitioner decided to incorporate for several reasons, including his belief that his Schedule C operation had become too complex and his desire to separate his various enterprises. Other reasons were his belief that the best way to finance the production of the Eagle was through contributing shareholders and his desire for an entity that would continue even if something were to happen to him. Thus, petitioner hired an engineer to take over the Dietrick Sales and Service filtration operation so petitioner could incorporate a company, Composite Aircraft Corporation, to produce the Eagle aircraft and devote his full time to the aircraft business.

On April 1, 1979, Composite Aircraft Corporation (hereinafter referred to as Composite) was organized under the laws of the State of Delaware. Composite filed a corporation income tax return (Form 1120) for the taxable years 1980, 1981, and 1982, with the Memphis Service Center. In addition, Composite filed Employer's Quarterly Federal Tax Returns (Forms 941) for the four quarters of the calendar year 1980 with the Memphis Service Center.

At the time Composite was organized petitioner transferred to Composite all of the assets required for the production of the Eagle, except the NUF machine, that he had acquired from Windecker Industries, Inc., as well as know-how and engineering data in exchange for 310 shares of common stock in Composite. Under the FAA Type Certificate, Composite had the right to use the name "Windecker" in connection with the Eagle. Petitioner retained ownership of the NUF machine. The NUF machine was kept at the Dietrick Sales and Service plant in Midland, Texas. However, petitioner entered into a contract with Composite to supply Composite with its requirements of NUF "at his cost."³

In addition to the assets transferred to Composite by petitioner, Composite sold a few shares of stock through three private offerings on April 1, 1979, March 1, 1980, and January 20, 1981, to obtain financing for the Eagle project. Each of the three offering circulars warned potential investors that "If Windecker Industries, which was larger and better capitalized than Composite, was unable to manufacture and market the Eagle on a commercially successful basis, there can be no assurance that Composite will be able to manufacture and market the Eagle successfully." Petitioner was the controlling shareholder of Composite, owning over 90 percent of the issued and outstanding stock at all times. Moreover, the purchasers of the stock were required to execute a Voting Trust Agreement authorizing petitioner to act as voting trustee and to vote all of their shares subject to the voting trust. These three offerings resulted in capital contributions to Composite from shareholders of $75,000 (12 shares × $6,250 per share) as of September of 1979, $85,800 (11 shares × $7,800 per share) as of June of 1980, and $9,750 (one share × $9,750 per share) as of February of 1981, for a total capital contribution of $170,550. These contributions fell far short of the $1.25 million that Composite had set as its original goal. Composite placed these funds in interest-bearing accounts and Treasury bills so the funds could earn interest. Petitioner used his own funds to pay the corporation's expenses, using Account 22 of Dietrick Sales and Service for that purpose.

Petitioner believed that the only way the Eagle could become commercially feasible was if the wing of the Eagle that Windecker Industries, Inc., had originally manufactured was redesigned. In September of 1979, Composite hired a full-time aeronautical engineer and hired the original designer, Dr. Leo J. Windecker, as a consultant. Composite hired George Alther (hereinafter referred to as Alther) as its aeronautical engineer. Alther had once been the chief engineer on the Eagle's original design team at Windecker Industries, Inc. Due to the risky nature of the new enterprise, petitioner and Alther orally agreed to a contingency plan under which Alther could switch to the filtration operation at the Dietrick Sales and Service plant in Midland, Texas, if Composite could not attract sufficient financing for the Eagle project.

Since petitioner and Alther wanted to promote the Composite name, in early 1980 they decided to operate only under the Composite name in Midland, Texas and to close out any reference to Dietrick Sales and Service in Midland. By 1981 all references made to the Midland, Texas plant referred to Composite only.

In 1980, petitioner paid Alther to perform services for Dietrick Sales and Service.⁴ Petitioner drew twelve checks on his Dietrick Sales and Service account to Alther, each of which was for $2,864.35 with the notation "payroll," for a total of $34,372.20. Petitioner deducted these payments on his Schedule C as part of his cost of goods sold. In addition, petitioner drew a check on the Dietrick Sales and Service account in the amount of $1,650 with the notation "Fed. Tax Deposit for Composite Aircraft" for withholding taxes relative to Alther's salary. See n.4, supra. Petitioner also deducted this expenditure on his Schedule C as part of his cost of goods sold. Petitioner also recorded Alther's salary payments in Account 22, which was the account petitioner used to record the amounts he spent to pay Composite's expenses. The total...