McGrath v. Commissioner, Docket No. 3880-82.

• Decision Date: 16 March 1987
• Docket Number: Docket No. 3880-82.
• Citation: 53 TCM (CCH) 363,1987 TC Memo 139
• Parties: Eugene C. McGrath v. Commissioner.
• Court: U.S. Tax Court

53 T.C.M. (CCH) 363 (1987)

T.C. Memo. 1987-139.

Eugene C. McGrath v. Commissioner.

Docket No. 3880-82.

United States Tax Court.

Filed March 16, 1987.

Bruce I. Hochman, 9100 Wilshire Blvd., Beverly Hills, Calif. and Charles P. Rettig, for the petitioner. Karl D. Zufelt, for the respondent.

Memorandum Findings of Fact and Opinion

NIMS, Judge:

Respondent determined a deficiency in petitioner's income tax for the taxable year 1973 in the amount of $190,407. After concessions, the issues for decision in this case are (1) whether petitioner realized income by reason of a discharge of indebtedness in 1973 and (2) whether the statute of limitations bars the assessment and collection of tax in this case.

Findings of Fact

Some of the facts in this case have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference.

Petitioner, a United States citizen, was a resident of the Republic of Panama at all times relevant to this case. Petitioner filed United States Federal income tax returns for the taxable years 1962 through 1968, inclusive, and for the taxable year 1973.

Petitioner was the founder and one of the original directors of the Panama Insurance Company (Compania Panamania de Seguros, S.A., hereinafter referred to as the Company). The Company began its operations in 1949.

During his employment with the Company, petitioner held various titles, but his responsibilities were primarily those of managing director and chief operating officer of the Company. The Company began its operations with two employees and a minimal amount of annual premiums and grew to become one of the largest insurance companies in the Republic of Panama with approximately 140 employees.

From 1950 until 1957 petitioner's salary from the Company was $1,100 per month, plus 5 percent of the Company's profits. During that time, petitioner paid for all of his business expenses. In 1957 petitioner executed an employment agreement with the Company, for the five-year period beginning July 1, 1957. Under the terms of the agreement, petitioner received $2,200 per month plus 10 percent of the Company's annual net profit. The $2,200 included a monthly salary of $600 plus $1,600 for reimbursement of business expenses. The agreement also provided petitioner with a loan of $175,000 from the Company to purchase 6,500 shares of Company stock.

The 1957 employment agreement between petitioner and the Company was superseded by a new employment agreement dated December 15, 1961. The new agreement increased petitioner's remuneration to $3,000 per month to cover petitioner's salary and reasonable expenses. The new agreement also provided stock options in petitioner's favor and extended the time for repayment of the amounts previously loaned to petitioner for purchasing Company stock.

On January 15, 1962, petitioner and the Company executed an "Annex to Employment Agreement" (hereinafter referred to as the Annex). The Annex provided that petitioner was to be paid, in March, 1962, 10 percent of the Company's profit for 1961. This document also provided for a "special reimbursement:"

2. — The Board of Directors of the Company has indicated a willingness to grant a special reimbursement to McGrath over and above his salaries and bonuses received or earned from January 1, 1949 to December 31, 1961. This special reimbursement would compensate McGrath for his efforts in the guiding of the Company through its thirteen years of growth, and in particular in connection with the salvage of the multimillion dollar INEMSA loss as threatened the Company. It is agreed that this special reimbursement to McGrath is payable by the Company recognizing to McGrath an indebtedness, effective immediately, in the amount of Six Hundred Thousand Dollars ($600,000), payable to McGrath over the period of the next eleven years on either one of the two alternatives spelled out hereafter, with the understanding that said alternative is to be selected by McGrath within thirty days of his acceptance of this annex to the Employment Contract:

Alternative "A": McGrath may elect to receive the $600,000 by a payment of $100,000 prior to December 31, 1963, and $50,000 each year during the ten successive years beginning in 1964 and terminating in 1973. Or,

Alternative "B": McGrath may agree to accept ten percent (10%) of the net profits of the Company for the ten operating years of 1962 to 1971, inclusive, in lieu of the "lump sum" payment of $600,000. In the event that McGrath selects this alternative the Company and McGrath agree that, should the ten percent of the profits over the ten operating years be less than $600,000, then the 10% of the annual net profit shall be payable to McGrath until the Company has paid to McGrath the sum total of the $600,000 indebtedness which is recognized as a credit to McGrath effective this date.

Alternatively, should the 10% of the profit for the ten operating years from 1962 to 1971, inclusive, total more than $600,000, McGrath shall be entitled to receive the full amount as is payable from that 10% of the profits annually despite the fact that it shall be more than $600,000.

* * *

The intent of the foregoing two paragraphs is embodied in the Company's desire to see McGrath (as the highest executive of the Company) granted a further initiative, over and above the $600,000 lump sum payment as is recognized to McGrath as a special reimbursement. Further, the Company recognizes that, should McGrath select alternative "B," McGrath may probably require longer than ten years to be paid the $600,000, and should therefore be entitled to receive more than the $600,000 in order to compensate for the length of time required for said payout.

3. — It is specifically agreed that no interest is payable to McGrath on this $600,000 credit.

4. — It is specifically agreed by McGrath that the payment to him of $600,000 (or the 10% of the profits from January 1, 1962 to December 31, 1971) is accepted by McGrath in full payment to him for all services rendered by McGrath for the period of January 1, 1949 to December 31, 1961 inclusive.

5. — It is specifically agreed that in the event of the death of McGrath prior to December 31, 1973, the payments of Alternatives 2-A or 2-B, as selected by McGrath hereafter, shall continue to be paid to his estate until the full amount of the payment involved by that alternative shall have been paid.

Petitioner elected Alternative "B" of the Annex. Petitioner was not paid in cash from the special reimbursement. Instead, payments under the special reimbursement were credited to petitioner's officer's loan account, a running account of personal expenditures the Company paid on petitioner's behalf. Through 1967 petitioner was credited a total of $270,000 pursuant to the special reimbursement resulting in a balance due petitioner in 1968 in the amount of $330,000. Petitioner reported each of the payments from the special reimbursement on his United States Federal income tax returns in the year of receipt.

In 1968 and 1969, petitioner received the remaining balance of the special reimbursement in the amount of $330,000 as a credit to his officer's loan account. Petitioner reported $360,000¹ from the special reimbursement as exempt income on his 1968 United States Federal income tax return.

All the services performed by petitioner on behalf of the Company were performed on the Republic of Panama or in countries outside the United States. All the income received by petitioner from the Company was income from sources outside the United States. On each of petitioner's United States Federal income tax returns for the years 1962 through and including 1968, petitioner reported income received from the Company, claimed to have been exempt under the provisions of sections 1.911-1(c)(1) and 1.911-2(a), Income Tax Regs.²

Between 1963 and 1968 the Company incurred significant losses with respect to bonds held in an entity known as INEMSA. In 1968, the minority shareholders of the Company held several meetings (general and special), designed, in part, to remove petitioner from his office as president of the Company. The dissident shareholders caused the termination of petitioner's employment in 1968. From August, 1968, until 1972, petitioner received no income, property or other assets from the Company.

Under Panamanian law, the minutes of shareholders' and directors' meetings of Panamanian corporations must be protocolized (registered) with the Director of Public Registry in the Republic of Panama to have legal and binding effect. In 1968 the by-laws of the Company required that more than one-half of the total of 114,594 shares of issued and outstanding stock of the Company be represented to constitute a quorum for the transaction of business at shareholder meetings. Only 47,608 shares were represented at the Company's shareholder meetings in 1968. Accordingly, in 1968 petitioner initiated litigation seeking to declare as void the actions taken by the minority shareholders at the meetings and to return petitioner to his position as president of the Company.

Petitioner was successful in obtaining an order dated December 5, 1972, from the Third Circuit Court of Panama instructing the Director General of the Public Registry to annul the registration of the contested minutes. The minority shareholders appealed the order through the Panamanian court system.

While this litigation was pending, the minority shareholders attributed various expenditures of the Company to petitioner's officer's loan account. On August 31, 1968, the minority shareholders contended that petitioner was indebted to the Company in the amount of $728,349.86.

On or about November 19, 1968, in an attempt to prevent collection activities by the Company, petitioner signed a document entitled "Acknowledgment of Debt with Collateral" (hereinafter referred to as the Acknowledgment) in favor of the Company in the amount of...