48 T.C.M. (CCH) 931
JAMES A. MILLER and MAXINE S. MILLER, Petitioners
COMMISSIONER OF INTERNAL REVENUE, Respondent
Nos. 23026-80, 23027-80, 29530-81, 29531-81.
United States Tax Court
August 27, 1984
Dr. M, an orthopedic surgeon, was the sole shareholder of PC, his professional corporation. In 1971, he as an individual and four others formed G.A.B. Corp. to operate a hospital. Dr. M was a shareholder and officer of G.A.B. In 1971, G.A.B. borrowed $172,500 from a bank, which required the shareholders to personally guarantee the loan. In 1972, Dr. M pledged the assets of his medical practice to the bank. Also in 1972, WW provided stenographic services to G.A.B. In 1973, G.A.B. defaulted on the loan to the bank, which then sued G.A.B. and its shareholders. The case was settled in 1976, and a judgment of almost $146,000 was entered against the defendants. WW also sued G.A.B. for its fee on account of the 1972 stenographic services. In 1973, it received a judgment against G.A.B., which proved uncollectible; it then secured a judgment against Dr. M individually on an " alter ego" theory. In 1976, Dr. M personally paid $3,600 on the bank judgment and $1,800 on the WW judgment; thereafter, PC took over the payments on such judgment and paid $6,600 in its 1977 taxable year and $7,200 in its 1978 taxable year. During 1976, 1977, and 1978, PC also paid $4,500 in legal fees arising out of the bank lawsuit and $1,500 in legal fees arising out of the WW lawsuit.
(1) PC may not deduct the judgment payments and legal fees as ordinary and necessary business expenses. Sec. 162, I.R.C. 1954.
(2) Dr. M received constructive dividends by reason of PC's payments of the bank judgment and of the $4,500 in legal fees attributable to the bank lawsuit.
(3) Dr. M may deduct the judgment payments made by him or on his behalf as business bad debts. Sec. 166(a), (d), I.R.C. 1954.
Michael W. Frye and Robert A. Housman, for the petitioners.
Steven M. Roth, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
The Commissioner determined the following deficiencies in the petitioners' Federal income taxes:
| Docket No.
|| Taxable Year Ended
|| James and Maxine Miller
|| James and Maxine
|| James A. Miller,
|| James A. Miller, M.D., Inc.
After concessions by the parties, the issues remaining for decision are: (1) Whether the professional corporation owned and operated by Dr. Miller, an orthopedic surgeon, may deduct, as ordinary and necessary business expenses under section 162 of the Internal Revenue Code of 1954,
its payments on a judgment against Dr. Miller arising from his guarantee of a loan to a corporate hospital and its payments of the legal fees incurred in two lawsuits arising from the operation of such hospital; (2) whether Dr. and Mrs. Miller received constructive dividends by virtue of the payment by the professional corporation of such judgment and legal fees; (3) whether Dr. and Mrs. Miller may deduct the judgment payments made by him or on his behalf as business bad debts (section 166(a), (d)); and (4) in the alternative, whether Dr. and Mrs. Miller may deduct such judgment payments as interest (section 163(d)). FINDINGS OF FACT Most of the facts have been stipulated, and those facts are so found. The petitioners Dr. James A. Miller and Maxine S. Miller are husband and wife who maintained their legal residence in Los Angeles, Calif., at the time they filed their petitions. They filed their joint Federal income tax returns for 1976, 1977, and 1978 with the Internal Revenue Service Center, Fresno, Calif. The petitioner James A. Miller, M.D., Inc. (the professional corporation), is a professional corporation with its principal place of business in Los Angeles, Calif., when it filed its petitions. It filed its U.S. Corporation Income Tax Returns for its taxable years ended September 30, 1976, September 30, 1977, and September 30, 1978, with the Internal Revenue Service Center, Fresno, Calif. We shall refer to the taxable year of the corporate petitioner by the calendar year in which it ended. Dr. Miller has been an orthopedic surgeon since 1958. The professional corporation was incorporated on July 1, 1971. During the years in issue, Dr. Miller was the president and sole shareholder of the professional corporation. Mrs. Miller was the corporate secretary during the years in issue. Prior to the formation of the professional corporation, 80 percent of Dr. Miller's work in a hospital was spent at Morningside Hospital, which is located 1- 1/2 miles from his office. He also practiced at the City View Hospital, the UCLA Dominguez Valley Hospital, and the Temple Hospital, all of which are located 10 to 17 miles from his office. In November 1971, Dr. Miller formed G.A.B. Corporation (G.A.B.) with two other doctors, a pharmacist, and an attorney. G.A.B. was formed to operate the Manchester Hospital (the hospital), which was to be located one-half block from Dr. Miller's office. Dr. Miller contributed $1,600 to G.A.B.'s capital in 1971. Dr. Miller was the president of G.A.B. from 1971 through 1973, and he also served as the hospital's medical director. Notwithstanding Dr. Miller's responsibilities in connection with G.A.B., he maintained a full-time medical practice. G.A.B. did not own the property on which the hospital was located. Dr. Miller believed that being the medical director of a hospital located near his office would benefit his practice in several ways and also increase his income. Dr. Miller believed that if he worked at one hospital located near his office instead of traveling among four hospitals, he could triple or quadruple his patient load. As medical director of the hospital, Dr. Miller had authority over all aspects of its business, including treatment, equipment, and personnel. Dr. Miller hoped that through his control of the hospital, he could minimize the problems that he had observed in other hospitals, including insufficient or poorly trained staff, delays in treatment, equipment shortages, and reluctance in treating medicare and mediCal patients. Finally, Dr. Miller expected to earn an annual salary of between $25,000 and $45,000 as the hospital's medical director. However, he did not, in fact, receive a salary from G.A.B. On November 12, 1971, G.A.B. borrowed $172,500 from Manufacturer's Bank (the bank). As a condition for making the loan, the bank required that each shareholder and his wife sign a continuing guaranty. Dr. Miller and his wife personally guaranteed loans to G.A.B. up to $250,000. Dr. Miller could not have been the medical director of the hospital had he not signed the guaranty. On November 12, 1971, Dr. and Mrs. Miller assigned a life insurance policy to the bank as collateral. The Millers also pledged various stocks that they owned to the bank. On July 14, 1972, Dr. and Mrs. Miller executed a security agreement granting the bank a security interest in the assets of " the Medical Practice of James A. Miller, M.D." Dr. Miller was shown as the borrower on both the security agreement and the financing statement, and he and his wife signed both documents as individuals. Such documents did not mention the professional corporation. The security agreement provided that the security interest " secures payment of any and all of Borrower's Indebtedness (including all debts, obligations, or liabilities now or hereafter existing, absolute or contingent, and future advances) to Bank." The financing statement was filed in February 1973 with the California Secretary of State. During 1972, World Wide Dictation (World Wide) provided stenographic services to the hospital. Such services included recording the details of operations. On or about April 11, 1973, G.A.B. defaulted on its loan payments. On August 30, 1973, the bank's representatives filed a complaint against G.A.B., its five shareholders and their wives, among others. The complaint alleged a cause of action against G.A.B. on the note and a separate cause of action against the shareholders and their wives on their guaranties; in each cause of action, the plaintiff sought $94,727.64 in unpaid principal, in addition to interest, late charges, and attorney's fees. In March 1976, G.A.B. was adjudicated bankrupt. In the same month, a stipulation for entry of judgment was entered in the bank's lawsuit against G.A.B. and the guarantors. The stipulation provided that judgment would be entered against G.A.B. and each of the shareholders and his wife jointly as individuals, in the amount of $145,935, consisting of $94,728 of principal, $30,662 of interest, $2,432 of late charges, and $18,714 for attorney's fees. The stipulation further provided that the bank would not levy...