Estate of Kluener v. C.I.R.

• Court: U.S. Court of Appeals — Sixth Circuit
• Writing for the Court: SILER; WELLFORD
• Citation: Estate of Kluener v. C.I.R., 154 F.3d 630 (6th Cir. 1998)
• Decision Date: 10 November 1998
• Docket Number: No. 97-1201,97-1201
• Parties: -6151, 98-2 USTC P 50,712 Estate of Robert G. KLUENER, Donald E. Hathaway, Co-Executor, Charlotte J. Kluener, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Page 630

154 F.3d 630

82 A.F.T.R.2d 98-6151, 98-2 USTC P 50,712 Estate of Robert G. KLUENER, Donald E. Hathaway Co-Executor, Charlotte J. Kluener, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 97-1201.

United States Court of Appeals Sixth Circuit.

Argued March 20, 1998.

Decided Sept. 9, 1998.

Rehearing Denied Nov. 10, 1998.

David E. Hathaway (argued and briefed), Beckman, Weil, Shepardson & Faller, LLC, Cincinnati, OH, for Petitioners-Appellants.

Stuart L. Brown, Internal Revenue Service, Joan I. Oppenheimer, David I. Pincus (briefed), Patricia Bowman (argued and briefed), U.S. Department of Justice, Appellate Section Tax Division, Washington, DC, for Respondent-Appellee.

Before: WELLFORD, NELSON, and SILER, Circuit Judges.

SILER, J., delivered the opinion of the court, in which NELSON, J., joined. WELLFORD, J. (pp. 640-641), delivered a separate opinion concurring in part and dissenting in part.

OPINION

SILER, Circuit Judge.

This case involves the tax consequences of a horse sale. The petitioners are the estate of Robert Kluener and Kluener's widow, Charlotte ("the taxpayers"). In the late 1980's, Robert Kluener ("Kluener") transferred forty-one horses to his closely-held corporation, sold the horses, then transferred the proceeds back to himself tax-free. Respondent, the Commissioner of Internal Revenue ("IRS"), concluded that Kluener himself sold the horses. It issued a notice of deficiency and a penalty for substantial understatement of taxes. The Tax Court upheld the IRS. We AFFIRM the deficiency judgment and REVERSE the penalty.

I. Background

Kluener controlled four separate lines of investment and used them to avoid taxes. This case centers around the American Power Equipment Company ("APECO"). APECO manufactures paint-spraying products in Harrison, Ohio. In 1989, APECO began to develop a series of "turbo airless sprayers" based on a new type of sprayer mechanism. APECO struggled to perfect this series for several years, and these development problems contributed to its serious financial losses. By the middle of 1989, APECO had a net operating loss ("NOL") exceeding $4.4 million and owed a bank over $5.3 million. These losses directly affected Kluener. He owned all of APECO's stock and served as its Chief Executive Officer, and he normally financed APECO through personally guaranteed loans. Kluener, therefore, was personally liable for APECO's entire debt.

Kluener's other investments were also losing money. Through his sole proprietorship, Robert G. Kluener Enterprises, Kluener owned thoroughbred horses worth about $2.5 million. During the first seven months of 1989, however, Kluener Enterprises lost about $400,000. Finally, Kluener and his wife held two related sets of investments involving their bank. They owned over $12.5 million in securities in the bank. They also owned portions of highly leveraged, interest-generating real estate ventures. They had financed the ventures by borrowing $12.2 million from the bank in personal unsecured loans and then repaying the loans using the interest generated by the ventures. Unfortunately, by 1989 real estate values had plummeted, and their loan repayments began to exceed the interest. In other words, they were losing money on real estate, on APECO, and on the horses.

To help stem the losses, Kluener decided to sell his horses. His two tax advisors, however, cautioned against a direct sale. With a direct sale, any gain would have been taxable as ordinary income or a capital gain. Instead, the advisors recommended that Kluener first transfer the horses to APECO, sell them in APECO's name, and use APECO's NOL to shelter any gain. This procedure would result in little or no tax liability. Kluener took the advice. In August 1989, he transferred the horses to APECO and created a separate division of APECO, APECO Equine, to handle them. Over the next several months, APECO Equine sold the horses at open auction for over $2.5 million, resulting in a gain of over $1.2 million. All proceeds went into the accounts of APECO Equine.

Despite the transfer and sale, APECO never used the funds in APECO Equine. APECO Equine never paid any money to APECO, and Kluener continued to finance APECO through loans. At least two reasons explain this forbearance. In part, an unexpected development reduced APECO's need for these funds. In late 1989, APECO collected $1.6 million on a disputed account receivable. This windfall allowed APECO to operate through the middle of 1990.

In addition, Kluener never gave APECO's officers and directors an opportunity to use the funds. Apart from APECO's vice-president for finance, Kluener never told them that APECO Equine contained almost $2.5 million or that APECO Equine even existed. He recorded neither the horses' transfer nor their sale in APECO's monthly financial statements. Indeed, Kluener actively disguised the existence of APECO Equine. For example, in January 1990, Kluener told APECO's Board of Directors that APECO needed between $1.5 and $2.5 million of capital, but that he knew of no funding sources. In a curious charade, he then solicited funding suggestions despite knowing that APECO Equine contained the needed capital.

Kluener's finances came to a head in the summer of 1990. On June 4, his debts to the bank came due. He owed the bank $12.2 million for the real estate loans, and he had personally guaranteed APECO's loans of almost $4.8 million. Furthermore, Kluener's financial statement showed a negative balance of over $3.8 million, mainly due to the collapsing real estate market. Given this bleak financial outlook, the bank refused to renew the loans and instead forced Kluener to renegotiate. He reluctantly agreed. Under the new terms, he agreed to pay $500,000 immediately and $1 million over the next year. The balance would become due by September 1991.

Faced with this new repayment schedule, Kluener decided to use the horse proceeds to repay the loans. Eleven months after first transferring the horses, Kluener dismissed all other APECO directors and distributed the remaining proceeds, $2,176,000, to himself. Kluener used $1 million to repay the bank and $400,000 to repay a loan from his wife. He loaned the remaining funds back to APECO. APECO reported the sale on its federal income tax return but offset the entire gain against its NOL. The Klueners never reported the gain and never paid any taxes on it. Kluener died in 1991, and APECO eventually was sold for $2.5 million.

After Kluener's death, the IRS concluded that Kluener, not APECO, sold the horses. As a result, it assessed the taxpayers a notice of deficiency of $284,247 and an accuracy-related penalty of $56,093 for substantial understatement of taxes. The taxpayers petitioned the Tax Court for relief. They conceded that tax concerns partially motivated the transfer, but contended that Kluener also transferred the horses for a legitimate business purpose, namely, to provide APECO with capital to develop the new sprayers.

At trial, the taxpayers relied heavily on the testimony of Kluener's two tax advisors, both certified public accountants and partners at Deloitte & Touche. Both advisors testified that Kluener first considered removing the horse proceeds in June 1990, after the bank refused to renew the loans. In other words, they asserted that Kluener originally transferred the horses to APECO for a legitimate business purpose, and that, at the time he was transferring the horses, he had no plan to remove their proceeds for personal use. The advisors stressed that they never researched or developed such a plan, and that Kluener had consulted them on all tax issues for almost forty years. Kluener himself was not a tax expert.

Despite this testimony, the Tax Court ruled in favor of the IRS. Estate of Kluener v. Commissioner, 72 T.C.M. (CCH) 1326 (1996). The court concluded that Kluener transferred the horses for his benefit rather than APECO's benefit. It stressed, among other factors, that APECO never used the funds in APECO Equine, that Kluener hid the funds, and that Kluener used most of the proceeds to satisfy his personal debts. With respect to the accuracy-related penalty, the court held that Kluener lacked substantial authority for his acts. It found his legal sources materially distinguishable. See id.

II. The Deficiency

The main issue on appeal is whether Kluener had a valid, non-tax business purpose for transferring the horses to APECO. If Kluener had such a purpose, the law will recognize the transfer and will deem APECO the horses' seller, thereby letting APECO shelter the gain with its NOL. On the other hand, if Kluener had no such purpose, the law will not recognize the transfer and will deem Kluener the seller, thereby forcing the taxpayers to pay personal taxes on the gain.

A. Standard of Review

We review the Tax Court's factual findings for clear error. Owens v. Commissioner, 568 F.2d 1233, 1237-38 (6th Cir.1977). In a multi-step transaction, the identity of the seller is a factual finding, not a legal conclusion. United States v. Cumberland Public Serv. Co., 338 U.S. 451, 456, 70 S.Ct. 280, 94 L.Ed. 251 (1950). "It is for the trial court, upon consideration of an entire transaction, to determine the factual category in which a particular transaction belongs." Id. Therefore, "[w]hether for tax purposes several acts constitute separate and distinct transactions or are integrated steps in a single transaction is a question of fact." Robino, Inc. Pension Trust v. Commissioner, 894 F.2d 342, 344 (9th Cir.1990) (citation omitted). See also United States v. Bondurant, 245 F.2d 265, 268 (6th Cir.1957). Here, the Tax Court concluded that Kluener sold the horses. We review this finding only for clear error.

B. Discussion

The Internal Revenue Code assesses taxes based on economic reality. Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945). In other words, the Code...