McCoy Enterprises, Inc. v. C.I.R., 93-9014

• Decision Date: 20 June 1995
• Docket Number: No. 93-9014,93-9014
• Citation: 58 F.3d 557
• Parties: -5302, 95-2 USTC P 50,332 McCOY ENTERPRISES, INC., & Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 557

58 F.3d 557

76 A.F.T.R.2d 95-5302, 95-2 USTC P 50,332

McCOY ENTERPRISES, INC., & Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 93-9014.

United States Court of Appeals Tenth Circuit.

June 20, 1995.

Merrill R. Talpers of Olsen & Talpers, Kansas City, MO, for petitioner-appellant.

David English Carmack of U.S. Dept. of Justice, Tax Div. (Loretta C. Argrett, Asst. Atty. Gen., and John A. Nolet, U.S. Dept. of Justice, Tax Div., with him on the briefs) and David L. Jordan, Chief Counsel of I.R.S., Branch 4, Tax Litigation Div., Washington, DC, for respondent-appellee.

Before EBEL, KELLY, Circuit Judges and COOK, ^* District Judge.

EBEL, Circuit Judge.

This case involves the special tax treatment of domestic international sales corporations ("DISCs"). Petitioners-Appellants McCoy Enterprises and Subsidiaries (collectively, "McCoy") created a wholly-owned subsidiary to account for its foreign sales and to take advantage of the tax benefits given to DISCs. The net income of the subsidiary was distributed to its parent as a "loan" each year and carried on the subsidiary's books as an account receivable. McCoy maintains that these amounts were not really loans, but were actually distributions to the parent shareholder company. If the amounts were loans, then the subsidiary would have lost its DISC status because the assets represented by those loans, in the form of accounts receivable, would have resulted in the subsidiary's failure to maintain the required percentage of its assets as qualifying export assets.

The IRS determined that the amounts were loans and that the subsidiary failed to qualify as a DISC for the tax year ending October 31, 1984. As a result, the IRS determined that McCoy owed a tax deficiency. The IRS also imposed a penalty on McCoy for substantial understatement of tax for the year in question. The Tax Court ruled that McCoy owed a tax deficiency and must pay the substantial understatement penalty, and McCoy filed this appeal. We conclude that McCoy is bound by its original characterization of the payments as loans and, therefore, we affirm the Tax Court's ruling on McCoy's liability. While the imposition of the understatement penalty presents a closer question, we affirm the Tax Court on that issue as well.

I. BACKGROUND

During the period at issue in this dispute, McCoy Enterprises was the parent company for the wholly-owned subsidiaries McCoy Company, Orion Industries, and Orion Fittings ("Fittings"). Together, the companies engaged in the manufacture, marketing, and sales of pipe fittings and related products domestically and abroad. In 1982, a new company, Orion International ("International"), was added to this corporate family as a subsidiary of McCoy Company to take advantage of tax benefits extended to DISCs. Qualifying DISCs are exempt from paying federal income taxes under Section 991 of the Internal Revenue Code ("I.R.C."). A portion of a DISC's income (about one-half) is taxable as a "deemed distribution" to the DISC's shareholders and the remaining accumulated DISC income is deferred from taxation to the shareholders until cash is actually distributed, the shareholders dispose of their stock, or the company loses its DISC status.

International existed only as a "paper" or "dummy" company in order to account for McCoy Company's foreign sales and to take advantage of the tax breaks given to DISCs. International was formed with an initial cash investment of $2,500, and it carried that amount as "working capital" on its balance sheet each year. Foreign customers of Fittings were billed by International, but their payments were commingled with Fittings' accounts and used to pay Fittings' expenses. At the end of each year, Fittings segregated the sales and expenses allocable to foreign sales, and independent accountants prepared separate financial statements and tax returns for International. The net income from foreign sales that was deposited in Fittings' bank account was reflected as earnings on International's books with a corresponding amount listed as an asset called "producer's loans." ¹ Interest was then imputed and added to the producer loan account. Since all of International's income was carried as producer's loans, International never reported any cash distributions to its sole shareholder, McCoy Company, and only reported "deemed distributions" as required by I.R.C. Sec. 995(b). International filed tax returns as a DISC.

In 1984, Congress enacted legislation effective for tax years ending after 1984 which limited the tax benefits available to DISCs. As a result, International went out of existence and distributed all of its assets to McCoy Company, filing its final DISC return for the abbreviated period of November 1, 1984 to December 31, 1984.

For the year ending September 30, 1985, McCoy Enterprises filed a consolidated federal income tax return as the common parent company for McCoy Industries, McCoy Company and Fittings. McCoy Enterprises reported the $412,894 previously carried by International as producer's loans (i.e. accumulated DISC earnings) as a nontaxable distribution received upon International's dissolution. ² On that return, McCoy Enterprises did not include the deemed distribution reported by International to McCoy Company on its DISC return for the year ending October 31, 1984.

The Commissioner of the Internal Revenue Service ("the Commissioner") then conducted an audit and determined that International did not qualify as a DISC during its year ending October 31, 1984 and that, therefore, the $123,913 earned by International for that year was taxable. ³ The Commissioner asserted that the income should be allocable to Fittings, and thus, taxable to the consolidated McCoy group. The Commissioner also found that McCoy Company (as International's sole shareholder) effectively received the previously untaxed $140,632 accumulated DISC earnings of International as a dividend once International was found not to qualify as a DISC, and that the consolidated McCoy group also owed taxes on that amount. In sum, a tax deficiency of $121,691 was asserted against McCoy Enterprises, as well as a penalty for a negligent filing under I.R.C. Sec. 6653(a) in the amount of $6,085 plus 50-percent of the interest due on the deficiency. Furthermore, the Commissioner assessed an additional penalty of $30,423 for substantial understatement of tax liability pursuant to I.R.C. Sec. 6661.

McCoy contested the Commissioner's determinations by filing a petition with the United States Tax Court requesting a redetermination of its tax liability. The Commissioner argued that International did not qualify as a DISC for the year ending October 31, 1984 because it failed to meet the 95 percent "qualified export assets" test of I.R.C. Sec. 992(a)(1)(B). Specifically, the Commissioner explained that International's claimed "producer's loans" did not meet the statutory definition for such loans under I.R.C. Sec. 993(d), and that the so-called loans were not, therefore, export assets. Once the "producer's loans" were treated as non-qualifying assets, the Commissioner continued, International was left with less than 95 percent of its assets comprising qualified export assets, and, as such, International no longer qualified as a DISC.

McCoy did not argue that the loans were qualified export assets, but rather, maintained that the "loans" were not really loans, and thus, the producer loans account was not really an asset. McCoy explained that the "loans" advanced to the parent McCoy Company really were distributions and were mislabelled as "loans" by the accountants even though no one ever intended that those sums would be repaid. McCoy concluded that International's only asset was the $2,500 carried as working capital, which was a qualified export asset because it was reasonably necessary to meet the working capital requirements of International's export business.

The Commissioner responded that the "producer's loans" were in fact loans, even if they were not producer's loans within the definition of Sec. 993(d), and that McCoy could not recast its own previous characterization of the loans. Furthermore, the Commissioner asserted that the McCoy Company did not declare any of the purported distributions as income on its previous tax returns, and the IRS would now be precluded by the statute of limitations from taxing the McCoy Company for any such unreported income.

The Tax Court ruled in favor of the Commissioner and held that McCoy owed unpaid taxes as well as an understatement penalty. See McCoy Enterprises, Inc. v. Commissioner, 64 T.C.M. (CCH) 1449, 1992 WL 359140 (1992). Specifically, the court ruled that the "producer loans" were loans rather than distributions and that they did not qualify as export assets. Therefore, the court concluded that the income earned for the year ending October 31, 1984 by International was taxable, the income should be allocated to Fittings, and it was taxable to the consolidated group. The court also upheld the Commissioner's assessment of a penalty for McCoy's substantial understatement of its tax liability. However, the court found that McCoy was not negligent in understating its liability because it concluded that McCoy reasonably relied on the incorrect tax advice of its accountants. McCoy now appeals the Tax Court's decision.

II. DISCUSSION

A. International's DISC Status

For International to have retained its DISC status for the tax year in question, it needed to satisfy the qualified export assets test of I.R.C. Sec. 992(a)(1)(B). That test specifies that at least 95 percent of a company's assets must be qualified export assets. Producer's loans can constitute qualified export assets if they meet the definition outlined in I.R.C. Sec. 993(d), but neither party in this action contends that the amounts listed as "producer's loans" on International's books satisfied that statutory...