Gaddis v. United States

• Decision Date: 18 June 1971
• Docket Number: Civ. A. No. 4420,4421.
• Citation: 330 F. Supp. 741
• Parties: Fred L. GADDIS and Mary F. Gaddis, Plaintiffs, v. UNITED STATES of America, Defendant. GADDIS BREEDER FARMS, INC., Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Southern District of Mississippi

330 F. Supp. 741

Fred L. GADDIS and Mary F. Gaddis, Plaintiffs, v. UNITED STATES of America, Defendant.

GADDIS BREEDER FARMS, INC., Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. Nos. 4420, 4421.

United States District Court, S. D. Mississippi, Jackson Division.

June 18, 1971.

James P. Knight, Jr., Louis H. Watson, Jackson, Miss., for plaintiffs.

Jack Warren, Tax Division, Department of Justice, Washington, D. C., for defendant.

NIXON, District Judge.

MEMORANDUM OPINION

The above styled and numbered income tax recovery cases filed pursuant to Title 28 U.S.C. § 1346(a) were consolidated by this Court pursuant to the agreement of all parties hereto inasmuch as the parties plaintiff are related through stock ownership, all issues arise from examination of income tax returns of the corporate plaintiff in Civil Action No. 4421.

These cases were tried to the Court on May 17, 1971 at Jackson, Mississippi and pursuant to the pleadings filed herein, all evidence adduced, the contents of the agreed Pre-Trial Order submitted and filed herein and the memoranda of authorities filed by the parties, the Court in this Memorandum Opinion makes its following Findings of Fact and reaches its Conclusions of Law as required by Rule 52(a), F.R.Civ.P.

Civil Action No. 4420 was instituted by Fred L. Gaddis and wife, Mary F. Gaddis, against the defendant, The United States of America, for the recovery of income taxes paid in the fiscal taxable years 1965 and 1966 in the total amount of $1,885.20 plus interest and costs. In Civil Action No. 4421 the corporate plaintiff, Gaddis Breeder Farms, Inc., sues for recovery of income taxes paid to the defendant for the fiscal year 1966-1967 in the amount of $132,243.16, plus interest and costs. All legal prerequisites to the institution of these actions have been complied with and these actions are, as a procedural matter, properly before this Court.

I.

The basis of the individual plaintiffs' refund claims in Civil Action No. 4420, is as follows: during 1965 and 1966, the plaintiff in Civil Action No. 4421, Gaddis Breeder Farms, Inc., whose sole and only stockholders were the plaintiffs in Civil Action No. 4420, Fred L. Gaddis and Mary F. Gaddis and trusts set up for their children, were the recipients or beneficiaries of the amounts of $280.20 and $1,605.00, respectively, which were paid by the corporation in the fiscal years ending April 30, 1965 and 1966, respectively, to liquidate personal debts of Mr. and Mrs. Gaddis, its principal stockholders. The Commissioner of Internal Revenue determined that these amounts represented personal expenses of Mr. and Mrs. Gaddis and were not deductible corporate expenses, which fact is not disputed; therefore, the Commissioner determined that such amounts represented informal dividends to Fred L. and Mary F. Gaddis, and as a result of this determination additional taxes were assessed and collected from them for 1965 and 1966 which they now seek to recover in view of the fact that on November 13, 1968, pursuant to the following resolution which had been adopted by the Board of Directors of Gaddis Breeder Farms, Inc. on June 8, 1959, the Gaddises repaid Gaddis Breeder Farms, Inc. the $1,885.20 which it had paid out to liquidate the above debts. The above resolution reads as follows:¹

"It is hereby agreed between this corporation and its officers that in the event any expense made to or by any officer is declared to be a nondeductible item, then the officers shall repay the corporation from his or her personal funds."

The defendant maintains that the $1,885.20 payment constituted informal dividends to the individual plaintiffs and thus disallowed these items as capital expenses of the corporation and taxed them as income to the stockholders. The individual plaintiffs contend that these payments were not intended as and did not constitute dividends but were merely erroneous payments made by the corporation which the individual taxpayers were contractually obligated to repay pursuant to the above resolution which had been signed by them as President and Secretary of the corporation and which they repayed on November 19, 1968.

Thus, in Civil Action No. 4420 the only issue for decision is whether the amounts reclassified from corporate expense to dividends by the Internal Revenue Service constitute taxable income to the individual majority stockholders despite their obligation to repay these amounts pursuant to the above resolution adopted several years before.

This Court is of the opinion and finds that the resolved obligations to return or repay these funds was binding on the plaintiffs in Civil Action No. 4420 inasmuch as the stockholders signed the minutes in question as Directors of the corporation and therefore were in no position to deny the existence or validity thereof and which they did honor by reimbursing Gaddis Breeder Farms, Inc., the plaintiff in Civil Action No. 4421, in the amount of its disallowed expense. Because of the fact that the corporation was quite large and growing and its activities were diversified and the financial interest of the individual plaintiffs were complicated, it was reasonably foreseeable either that inadvertent errors might be made in accounting for expenditures made by the above named various business entities, comprising "Gaddis Industries", or that judgmental factors might be questioned to the extent that income tax deductions might be subsequently disallowed.

In Healy v. Commissioner of Internal Revenue, 345 U.S. 278, 73 S.Ct. 671, 97 L.Ed. 1007 (1953), an individual taxpayer received a salary from a closely held corporation and reported it in full in his income tax return for the year in which it was received. In a subsequent year it was determined that the salary was excessive and the taxpayer was required as transferee to make payments on tax deficiencies of the corporation for prior years. The Supreme Court, in holding that the taxpayer's income tax for the year in which he received the excessive salary may not be recomputed so as to exclude from his income that year the part of his salary held to be excessive and which resulted in his transferee liability inasmuch as he received the salary under a "Claim of Right", and was required to report it as income and to pay a tax thereon, stated:

"One of the basic aspects of the federal income tax is that there be an annual accounting of income (cases cited in footnote 6). Each item of income must be reported in the year in which it is properly reportable and in no other. For a cash basis taxpayer, as these three are, the correct year is the year in which received (cases cited in footnote 7).

"Not infrequently, an adverse claimant will contest the right of the recipient to retain money or property, either in the year of receipt or subsequently. In North American Oil Consolidated v. Burnet, 1932, 286 U.S. 417, 52 S.Ct. 613, 76 L.Ed. 1197, we considered whether such uncertainty would result in an amount otherwise includible in income being deferred as reportable income beyond the annual period in which received. That decision established the claim of right doctrine `now deeply rooted in the feder tax system.' The usual statement of the rule is that by Mr. Justice Brandeis in the North American Oil opinion: `If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.' 286 U.S., at page 424, 52 S.Ct. at page 615.

"* * * There is a claim of right when funds are received and treated by a taxpayer as belonging to him. The fact that subsequently the claim is found to be invalid by a court does not change the fact that the claim did exist. A mistaken claim is nonetheless a claim, United States v. Lewis, 1951, 340 U.S. 590, 71 S.Ct. 522, 95 L.Ed. 560.

* * * * * *

"* * * The Government concedes that each of these taxpayers is entitled to a deduction for a loss in the year of repayment of the amount earlier included in income * * * Congress has enacted an annual accounting system under which income is counted up at the end of each year. It would be disruptive of an orderly collection of the revenue to rule that the accounting must be done over again to reflect events occurring after the year for which the accounting is made, and would violate the spirit of the annual accounting system. This basic principle cannot be changed simply because it is of advantage to a taxpayer or to the Government in a particular case that a different rule be followed." 345 U.S. 281-282, 284-285, 73 S.Ct. 673-674, 675.

This "claim of right" doctrine has also been discussed by the United States Court of Appeals for the Ninth Circuit in Noble v. C. I. R., 368 F.2d 439 (C.A. 9, 1966), in which the Court affirmed the Tax Court which had disallowed as business expenses for income tax purposes certain payments made to the sole shareholders of a corporation which were found to be of a personal nature rather than a corporate expense. Subsequent to this determination the corporation passed a resolution requiring the shareholders to reimburse it for these admitted nondeductible payments. The Court stated:

"Dividends may be formally declared or they may be constructive. The fact that no dividends are formally declared does not foreclose the finding of a dividend-in-fact. (Cases cited are omitted).

* * * * * *

"Clearly, the payments in question here are of the type that would fall in the category of constructive dividends * * * The question then arises whether after a determination that payments to the sole stockholders were for personal expenses, a subsequent act of the petitioners can convert what would then have been a taxable dividend into a repayment of a prior valid or outstanding loan from the sole shareholders to the

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