Felt v. Commissioner of Internal Revenue, 102809 FEDTAX, 3735-06
|Opinion Judge:||HOLMES, Judge|
|Party Name:||DAVID J. FELT AND SHARON A. FELT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent|
|Attorney:||George W. Connolly and Habeeb Gnaim, for petitioners. Randy Durfee and Gordon Sanz, for respondent.|
|Case Date:||October 28, 2009|
|Court:||United States Tax Court|
MEMORANDUM FINDINGS OF FACT AND OPINION
David Felt, a real-estate broker and mortgage banker, bought a Texas savings-and-loan association in 1983. It was failing, and regulators wanted him to sell. To make matters worse, David and his wife Sharon failed to file their tax returns for 1986-87, 1989, and 1994-98. The Commissioner says their failure to file concealed massive amounts of income, including:
! $4 million in capital gains from the sale of the S&L,
! $2 million in cancellation-of-indebtedness income from a different business that David also ran, and
! a small river of money streaming to the Felts through accounts held by David's aged mother and flowing from indistinct sources offshore.
The Commissioner also asserts various additions to tax, and resists Sharon Felt's request for innocent-spouse relief.
FINDINGS OF FACT
I. Beginnings: Reliance Savings Association
David Felt bought Bowie County Savings & Loan Association in 1983. He financed the deal with $1.4 million borrowed from the Texas Investment Bank and from an entity called American Guaranty Inc. (AGI), which he himself owned. Felt moved Bowie to Houston and renamed it Reliance Savings Association. Reliance was a state-chartered, federally insured S&L regulated by the Federal Home Loan Bank Board (FHLBB).
S&Ls became popular in the early twentieth century as a way to promote home ownership. Kendall, The Savings and Loan Business 1 (1962). They offered slightly higher interest rates on savings accounts than could some banks, and then used the savings to fund residential mortgages. For much of the century, S&Ls enjoyed tax benefits but also shouldered a heavy regulatory weight–-for instance, a majority of their assets had to be residential real- estate loans. In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. 96-221, sec. 401, 94 Stat. 151, which loosened restrictions on consumer lending and broadened the types of investments thrifts could make. Volatile interest rates, a mismatch of short-term government-insured liabilities and long-term risky investments--plus some outright thievery--led to a financial crisis in the industry when borrowers defaulted at staggering rates. Hundreds of S&Ls failed, and Texas was especially hard hit, partly due to sagging real estate prices; Felt himself estimated that nearly 75% of the S&Ls in the state failed or disappeared in the 1980s.
Reliance was one of them. In 1986, the FHLBB came after Felt for regulatory violations, and threatened him with removal and a cease-and-desist order. Felt took the hint and, in August 1986, agreed to sell his entire interest in Reliance. The Bank Board gave him six months, and warned him to come to the Board for approval of any deal that he worked out.
Felt quickly found a consortium of buyers. They fell into three groups. The first were people who had lent money to AGI and gotten notes back; Felt traded 60 percent of his Reliance stock for the return of these notes. The second group paid him $500,000 in cash for 7 percent of the Reliance stock, but borrowed the money from a bank which required Felt to personally guarantee the loan. And a third group bought the remaining 33 percent with notes from yet another of Felt's business entities, called Specialty Finance Company, which held the shares as collateral.
The deal was trouble from the start. Felt's offering material included unaudited financial statements and failed to include some information that it should have. The deal also depended on anticipated sales to affiliates that were less than certain to occur. Felt didn't fix these problems and the FHLBB never approved the sale.
But Felt went ahead with the deal anyway. The FHLBB's response was swift and harsh. It seized Reliance, and in 1990 it got a judgment against Felt requiring him to rescind the sale. This left him to pay a judgment for $4.2 million plus costs and interest. The Felts declared bankruptcy in 1992, but even bankruptcy turned sour in 1997 when the Office of Thrift Supervision, the FHLBB's successor agency, won a court order declaring the $4.2 million judgment nondischargeable because it arose from Felt's willful defalcation and breach of fiduciary duty.
II. Life After Bankruptcy
The Felts both testified that life became grim. David said they had had an A+ lifestyle before mid-1987, which gradually became an F lifestyle. Sharon credibly testified that she and her husband could no longer afford a housekeeper or a landscaping company after 1992. We also believed her testimony that they could no longer afford new furniture and began instead to accept used furniture handed down from her elderly mother-in-law, Birdie Felt.
It wasn't just furniture that Birdie was giving the Felts. By 1994, and until her death in 2000, many of the Felts' ordinary household expenses came to be paid from Birdie Felt's checking account. Tens of thousands, and perhaps hundreds of thousands, of dollars a year for rent, summer camp, college expenses, and credit-card bills came to the Felts from her account. She also deposited money into several of David's business accounts.
The source of her plentiful wealth is unclear. But whatever its ultimate origins, it flowed from offshore accounts back to the United States in regular $7,500 wire transfers. These wire transfers continued uninterruptedly until March 2000, several months before Birdie died. We specifically find that at least some of her wealth came from her son; for 1995 through 2000, the bank records of Tower Resources (yet another of David's many businesses) show almost $40,000 flowing to Birdie.
III. AGI and AGI-Nev
Reliance was only one province of Felt's empire in the '80s. Another was AGI, a Texas corporation that Felt had formed in 1978, and which later was to become entangled in the Reliance sale. As Felt's troubles grew, he began to fail to pay AGI's franchise tax, and its registration lapsed in November 1989. Before then, though, AGI was in the consumer and residential loan business, which it funded by borrowing money from investors. AGI's importance to this case lies in the notes with a face value of $2,510,740 that some of its investors exchanged for Reliance stock in 1986.
But there was also another AGI. In 1998, Felt applied for an Employer Identification Number for "American Guaranty, Inc." in Las Vegas, Nevada (we'll limit our use of the abbreviation AGI to the Texas corporation, and call this one AGI-Nev). Felt listed his aged mother as AGI-Nev's principal officer. He described it as a "holding company" and indicated that "American Guaranty, Inc." had never applied for an EIN before. (AGI-Nev is also defunct, Nevada having permanently revoked its registration.)
AGI-Nev is important to the case because David and Birdie opened at least two bank accounts in its name. The first was a checking account, into which they deposited $50,000. The second was a money-market account, into which they deposited $250,000. Felt explained this by saying that he had given some old AGI (that's the by-then-defunct Texas AGI, not AGI-Nev) receivables to a collections company, and that he formed the new company to handle the money it remitted. Felt testified that, despite the corporate facade, he and Birdie used the AGI-Nev money personally and may have split it equally. There are several checks bearing Birdie's signature from the AGI-Nev accounts. One check, written in February 1999, is for $17,048.39 and was endorsed by David Felt. The others, from 1998, total $55,000 and were endorsed for deposit into Birdie's Wells Fargo account.
A third entity important here is J&N (the initials of the Felt children). J&N was not a corporation; Felt described J&N as "effectively a d/b/a that just held some rental properties and a couple of notes or something." It did, however, have a bank account in its own name, and at least $153,000 somehow stumbled into this account in 1997. The source of the money is also mysterious--Felt says that J&N took in only $80,000 that year by collecting an old debt, and after expenses it netted only $73,118.
V. Notices of Deficiency
In 2005, the Commissioner issued notices of deficiency to the Felts. They showed the following deficiencies in tax:1
The Commissioner also asserted additions to tax under sections 6651(a)(1) and (2) and 6654.2 We tried the case in Houston, as the Felts were Texans when they filed their petition.
The parties settled many issues, but these remain:
! Whether David and Sharon Felt should have reported capital gains for 1986 from the sale of Reliance;
! whether they should have reported $2 million in cancellation-of-indebtedness income for 1989;
! whether they should have reported income from Birdie Felt for 1996, 1997, and 1998;
! whether they should have reported $153,118 in income from J&N for 1997;
! whether they should recognize $300,000 in income from AGI-Nev for 1998;
! whether Sharon Felt is entitled to relief from community property liability rules under section 66; and
! whether the Commissioner properly asserted additions to tax and a penalty against her. I. Income from the Sale...
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