In re Sommers
| Decision Date | 11 March 1997 |
| Docket Number | Bankruptcy No. 89 B 30804,Adversary No. 89 A 3069. |
| Parties | In re James F. SOMMERS, Debtor. James F. SOMMERS, Plaintiff, v. INTERNAL REVENUE SERVICE, Defendant. |
| Court | United States Bankruptcy Courts. Seventh Circuit. U.S. Bankruptcy Court — Northern District of Illinois |
Richard Jones, Woodstock, IL, Scott A. Bentley, McHenry, IL, for plaintiff.
Stacy Hallett, U.S. Dept. of Justice, Washington, DC, for defendant.
This matter came before the Court for trial on October 25 and 26, 1995, on the Complaint of the Debtor, James F. Sommers, to Determine Dischargeability of Debt. To aid the Court in its discussion of the issues, counsel for both parties provided Post-Trial Briefs.1 The Debtor is represented by Attorneys Richard T. Jones and Scott A. Bentley. The United States, by United States Attorney James B. Burns, for and on behalf of the Internal Revenue Service ("IRS") is represented by Attorney Stacy Hallett.
On January 21, 1988, the United States Tax Court held that Mr. Sommers had income tax deficiencies for the tax years 1980 and 1981.2 The 1980 tax deficiency is $39,269.00 and the 1981 tax deficiency is $76,723.00.3 These amounts allegedly arose from royalty income and gain from the sale of stock not reported on Mr. Sommers' personal tax returns.
The path that leads to this litigation is complicated. Several transactions interrelate, adding to the complexity.4 The Court will set forth the facts in specific categories, when appropriate, to achieve some measure of continuity.
Some would say the story began when Mr. Sommers purchased a company called VM Nutri Foods, Inc. in the mid-1970s. VM Nutri Foods is a food supplement manufacturing business. Mr. Sommers had been involved in this industry since 1947. Mr. Sommers' ran a successful business. In 1979, the gross profit exceeded $2.4 million dollars. See IRS Exhibit # 2K.
In October of 1978, Mr. Sommers, through a James F. Sommers Family Trust, sold and assigned 2,000 shares of VM Nutri Foods to Mr. J. Robert Lemon for $80,000.5 At this time, it appeared VM Nutri Foods had 5,000 shares of common stock. The breakdown of shares after this sale and assignment was as follows:
James F. Sommers Family Trust — 1800
J. Robert Lemon — 2000
Kevin Buggy — 200
Non-issued stock — 1000
On September 15, 1979, VM Nutri Foods was transferred into a Wisconsin corporation, VM Nutri, Inc. ("VM Nutri"). An attorney by the name of John M. Couture prepared the documents.6 See IRS Exhibit # 21. The corporate documents indicate that the capital stock consisted of 10,000 shares of common stock with no par value. The corporate documents also indicate that the following entities were shareholders.
9/29/79 Lorelei Investment Trust — 5054
9/29/79 Liberty Investment Trust — 4506
9/29/79 Kevin J. Buggy — 440
A State Court Complaint brought in part by Mr. Sommers reveals that the Lorelei Investment Trust ("Lorelei Trust") was organized on September 26, 1979. See IRS Exhibit # 2T at 3. Attorney Couture testified in the state court proceeding that the Lorelei Trust was created by a lay expert, Mr. Paul Westone. See IRS Exhibit # 14 at 9 (Day One). Attorney Couture reviewed the documents with a view to their validity under state law. Id. Mr. Sommers was the Executive Trustee of the Lorelei Trust. See IRS Exhibit # 2T. Both he and Mrs. Sommers were the Nominee Trustees of the Lorelei Trust. Id. Mr. Sommers is the sole beneficiary. Id. Attorney John Couture described the purpose of the Lorelei Trust as a vehicle to take ownership of Mr. Sommers' stock to gain certain tax advantages and conserve the assets that Mr. Sommers held. See IRS Exhibit # 14 at 9 (Day One).
Mr. Sommers transferred the ownership of his stock in VM Nutri to the Lorelei Trust.7 Lorelei Trust owned a majority of the VM Nutri stock. It does not appear Mr. Sommers received any consideration for this transfer. Mr. Witt testified that the only benefit that might accrue from this transaction would be that the dividends would be paid from VM Nutri to Lorelei Trust. But if Mr. Sommers eventually received the funds, there would be no reduced tax liability. When this transfer occurred Mr. Sommers' right to receive income from VM Nutri was diminished. Thus, he transferred his stock without consideration and would receive less than what he owned prior to the transfer. See R. at 118.
On March 1, 1980, Lorelei Trust and Liberty Investment Trust entered into an agreement to sell VM Nutri stock to Dr. Paul A. White and Mr. Raleigh Jones. See IRS Exhibit # 2L. The agreement called for the sale of 1120 shares each to Dr. White and Mr. Jones.8 The sale price to be paid to Lorelei Trust was $480,000.9
On March 2, 1980, Lorelei Trust, Liberty Investment Trust, and Kevin J. Buggy entered into an agreement to sell VM Nutri stock to Kelley Research Trust I. See IRS Exhibit # 2M. The agreement called for the sale of 2520 shares for $175,000.10
On March 31, 1980, Lorelei Management Corporation ("Lorelei Management") was incorporated. See IRS Exhibit # 2C. Mr. and Mrs. Sommers were the only two shareholders. Mr. Sommers was also a director and officer. At a Board of Directors' Meeting, held on April 1, 1980, the directors moved to permit Lorelei Management to enter into a twenty-year contract to act as Trust Manager for Lorelei Trust. The "Trust Manager Agency Contract" states, in part, that the "Trust Manager . . . has exclusive authority for conducting and managing the routine day-to-day and accounting affairs of Lorelei Trust." See IRS Exhibit # 2C.
On August 23, 1980, Lorelei Trust and Kevin J. Buggy entered into a Stock Purchase Agreement with Kelley Investments for the sale of 2720 shares of VM Nutri stock for $188,888.88.11 See IRS Exhibit # 20. Kelley Investments would receive 2520 shares from Lorelei Trust for $175,000, and 200 shares from Kevin Buggy for $13,888.88. After the completion of this transaction, Lorelei Trust no longer held any shareholder interest in VM Nutri.
Concurrent with the Stock Purchase Agreement, Mr. Sommers entered into a Stock Agreement with Kelley Investments. See IRS Exhibit # 2N. Mr. Sommers agreed to sell his entire remaining interest in VM Nutri, which would include all assets, books, financial statements and tax returns, for $175,000.12
On September 16, 1980, Mr. Sommers, acting as Trust Manager of Lorelei Management agreed to receive 150 Krugarands13 in lieu of $100,000 due Lorelei Trust for the purchase of VM Nutri stock. See IRS Exhibit # 2S. The document states:
I hereby guarantee that if One Hundred Thousand Dollars ($100,000.00) plus interest at Eight (8) percent per annum is paid to Lorelei Investments within six months of this date, the One Hundred Fifty (150) Krugarands will be returned to Kelley Investments.14
Mr. Sommers testified that he did not cash the Krugarands immediately. See R. at 51. The receipt of the $100,000 in Krugarands was not reported on Mr. Sommers' tax return for 1980. R. at 52-52; see also IRS Exhibit # 2A.
In April of 1980, the existence of two Certificates of Trust indicates that Mr. Sommers transferred his beneficial interest in Lorelei Trust to two separate Cayman Island corporations, namely Andros Island Investments, Ltd. and Young Island Investments, Ltd. Mr. Sommers testified that he was not aware that he or Lorelei Trust transferred anything to the Cayman Islands. See R. at 198-99.
Testimony provided by Mr. Witt indicated that Mr. Sommers expected to receive income from the sale of stock.15 Mr. Witt pointed out that there is no indication of any consideration for the transfers.16
VM Nutri's tax return for the 1979 tax year listed a royalty expense of $686,019.00. See IRS Exhibit # 2K. Mr. Witt's testimony revealed that the IRS concluded that the royalty expense was not a deductible expense and therefore it was disallowed to the corporation. See R. at 97-98. Based on this conclusion, the IRS also determined that Mr. Sommers received the revenue as a constructive dividend. Id. Having this background, a review of the transactions surrounding the royalties is necessary.
On October 1, 1978, the first royalty agreement entered into evidence was the one entered into by Mr. Sommers and Mr. J. Robert Lemon, the Licensors, and VM Nutri Foods and Geneva Bio-Chem, Inc. ("Bio-Chem"), the Licensees. See IRS Exhibit # 2G. The Agreement provides for the payment of royalties.
The second royalty agreement was entered into between Advance Development Investments ("ADI") as Licensor and VM Nutri as Licensee in March of 1980. See IRS Exhibit # 2J. Before addressing the substance of this royalty agreement, it is necessary to provide the background of ADI.
The Declaration of Trust for ADI indicates that Mr. Sommers and Mr. J. Robert Lemon were the creators.18 ADI was created on September 22, 1979. See IRS Exhibit # 2E. Mr. Sommers retains an equitable interest in ADI. He held 50 units of the trust. The trust corpus was listed in the schedules and it consists of the following:
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