P.R. Farms, Inc. v. C.I.R.

• Decision Date: 26 June 1987
• Docket Number: 86-7066 and 86-7069,86-7063,Nos. 86-7062,s. 86-7062
• Citation: 820 F.2d 1084
• Parties: -5186, 87-2 USTC P 9393 P.R. FARMS, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1084

820 F.2d 1084

60 A.F.T.R.2d 87-5186, 87-2 USTC P 9393

P.R. FARMS, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.

Nos. 86-7062, 86-7063, 86-7066 and 86-7069.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Dec. 11, 1986.

Decided June 26, 1987.

George W. Beatty, Washington, D.C., for petitioners-appellants.

Michael L. Paup, Jonathan S. Cohen and David M. Moore, Washington, D.C., for respondent-appellee.

Appeal from a Decision of the Tax Court of the United States.

Before NORRIS, BEEZER and BRUNETTI, Circuit Judges.

BEEZER, Circuit Judge:

P.R. Farms, Inc. appeals the Tax Court's determination that 1) interest earned by General Fruit Sales (a fruit broker) on proceeds from sales of P.R. Farms fruit is taxable to P.R. Farms, and 2) Palomate Storage Co. was a mere conduit through which P.R. Farms' fruit was sold. Pat and Frances Ricchiuti, husband and wife and principal shareholders in P.R. Farms appeal the Tax Court's determination that interest retained by General Fruit Sales (GFS) and income retained by Palomate constitute constructive dividends taxable to Pat and Frances Ricchiuti. The findings supporting the judgment are not clearly erroneous. We affirm.

I Background

A. Parties

P.R. Farms owns and operates extensive orchards near Clovis, California. From 1974 through 1977, Ricchiuti held approximately 91% of P.R. Farms' common stock. Ricchiuti served both as president and as a director of P.R. Farms.

GFS brokered P.R. Farms' fruit. Brokerage agreements between P.R. Farms and GFS required GFS to remit proceeds of fruit sales to P.R. Farms the tax year following the year fruit was sold. During the years in question, Ricchiuti served as vice-president of GFS and held 50% of GFS' stock. P.R. Farms paid GFS 12cents a box in brokerage fees to sell P.R. Farms' fruit. Ricchiuti controlled the transfer of funds from GFS to P.R. Farms.

Palomate Packing Company Inc. was incorporated in 1970 for the purpose of assuming responsibility for packing P.R. Farms' fruit. The four Ricchiuti children owned equal shares of Palomate stock. Palomate owns no packing or storage facilities.

B. Transactions

GFS did not consistently defer transfer of proceeds from fruit sales to P.R. Farms until the year following sale. When GFS did defer payment, GFS invested the proceeds in interest-bearing certificates of deposit. GFS retained the interest.

Palomate purchased fruit from P.R. Farms for resale at a later date. All fruit was stored together in P.R. Farms' cold storage facility. Palomate bought only those varieties of fruit that could be kept in cold storage for significant time periods. P.R. Farms and Ricchiuti state that the purpose of the sales to Palomate was to permit the Ricchiuti children to assume risks in late-season marketing that he was unwilling to accept.

Although Palomate had its own trade label, "Alta Sierra," Palomate kept the P.R. Farms label on fruit purchased from P.R. Farms and stored the fruit in P.R. Farms' cold storage facility along with P.R. Farms' own fruit. Like P.R. Farms, Palomate sold fruit through GFS. Palomate did not pay P.R. Farms for fruit until after GFS remitted proceeds of sale to Palomate. During 1974 and early 1975, Palomate paid P.R. Farms for fruit sold by GFS, rather than for fruit P.R. Farms shipped to Palomate. Palomate did not buy fruit from other growers. P.R. Farms did not sell fruit other than through Palomate and GFS. Each year in question, Palomate realized profits exceeding $100,000 from fruit sales.

C. Tax Court Disposition

The IRS assessed P.R. Farms for, inter alia, tax on interest earned on certificates of deposit. The Tax Court determined that 1) GFS was P.R. Farms' agent, 2) Ricchiuti controlled whether GFS retained sales proceeds and how long the proceeds would be retained, 3) interest income on the certificates of deposit was taxable to P.R. Farms.

The Tax Court also determined that Ricchiuti controlled sales of Palomate fruit and that net gains realized by Palomate on fruit sales were taxable to P.R. Farms.

Finally, the Tax Court determined that Ricchiuti, as principal shareholder of P.R. Farms, received constructive dividends equal to interest earned by GFS on certificates of deposit and net income realized by Palomate on fruit sales. The court deemed Ricchiuti to have contributed interest retained by GFS to GFS' capital. The court also determined that net income from fruit sales retained by Palomate constituted a gift from Ricchiuti to his children, by way of Palomate.

II Discussion

The Tax Court had jurisdiction under 26 U.S.C. Secs. 6213, 6214. We have jurisdiction under 26 U.S.C. Sec. 7482.

A. Interest Earned by GFS on Certificates of Deposit

P.R. Farms contends that GFS retained proceeds from sales of P.R. Farms' fruit pursuant to a compensation-related loan agreement. Whether an arrangement constitutes a compensation-related loan is a question of fact. We review the Tax Court's factual determinations for clear error. Stern v. C.I.R., 747 F.2d 555, 557 (9th Cir.1984). "A finding is 'clearly erroneous' when although there is evidence to support it, the reviewing court on the entire record is left with the definite and firm conviction that a mistake has been committed." United States v. United States Gypsum Co., 333 U.S. 364, 395, 68 S.Ct. 525, 542, 92 L.Ed. 746 (1948); see also Anderson v. City of Bessemer City, 470 U.S. 564, 573, 105 S.Ct. 1504, 1511, 84 L.Ed.2d 518 (1985).

P.R. Farms claims that it realized no income from interest earned on certificates of deposit, or, in the alternative, that any income P.R. Farms realized from investment of sales proceeds was offset by a deduction for cost of brokerage services furnished by GFS. Generally, interest earned on investment is taxable to the person who controls the principal. Helvering v. Horst, 311 U.S. 112, 116-17, 61 S.Ct. 144, 146-47, 85 L.Ed. 75 (1940). In Horst, the Supreme Court deemed interest on bonds taxable to a bond holder even though he transferred the right to receive interest (coupons) to a third party before the interest obligation matured.

The record supports the Tax Court's determination that P.R. Farms and Ricchiuti controlled proceeds from fruit sales and, accordingly, any income earned on investment of the proceeds. First, GFS often remitted sales proceeds to P.R. Farms within the same year as fruit was sold, contrary to the parties' brokerage agreements. Second, although P.R. Farms contends that GFS retained proceeds in order to defray operating expenses, the amount of interest income retained by GFS decreased when GFS lowered brokerage fees from 12 cents to 10 cents per box, rather than increasing to compensate for lost revenue. Third, GFS' bookkeepers testified that they paid out or retained sales proceeds at Ricchiuti's direction. Finally, Ricchiuti signed checks from GFS to P.R. Farms. In short, the record indicates that Ricchiuti had authority to direct GFS to transfer all proceeds to P.R. Farms immediately for investment in certificates of deposit.

P.R. Farms relies on dicta in Dean v. Commissioner, 35 T.C. 1083 (1961), to the effect that interest-free loans result in no interest income to the lender. Dean, 35 T.C. at 1090. The lenders in Dean, and cases cited therein, exercised substantially less control over debt principal than P.R. Farms and Ricchiuti exercised over proceeds from sales of P.R. Farms' fruit. See Combs Lumber Co., 41 B.T.A. 339, 342-43 (1940); Society Brand Clothes, Inc., 18 T.C. 304, 320-21 (1952). The facts of Horst more closely resemble the facts of this case.

P.R. Farms argues that, in the absence of an obligation to allow GFS to retain sales proceeds, Ricchiuti would not have allowed GFS to retain sales proceeds because Ricchiuti held only 50% of GFS's stock while he owned 90% of P.R. Farms. P.R. Farms argues that Ricchiuti would not voluntarily donate 50% of the interest earned on P.R. Farms' income to an unrelated 50% shareholder in GFS. However, Ricchiuti was not the only contributor to GFS. The record does not reflect the extent of similar contributions made by the other 50% shareholder in GFS. These contributions, combined with salary paid to Ricchiuti as vice-president of GFS, may have offset any interest lost by Ricchiuti.

P.R. Farms had no legal obligation to allow GFS to retain sales proceeds. The Tax Court properly held that interest on the certificates of deposit was taxable to P.R. Farms.

B. Net Proceeds From Palomate Fruit Sales

The Tax Court determined that Palomate Storage Inc. was a mere conduit through which P.R. Farms marketed fruit. We will not reverse the Tax Court's determination that Palomate was a mere conduit in the absence of clear error. Stewart v. C.I.R., 714 F.2d 977, 992 & n. 17 (9th Cir.1983).

"The incidence of taxation depends upon the substance of a transaction.... A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title." Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945). We will not treat an entity as a conduit if 1) parties to transactions respect formal distinctions between the entity and others, 2) the entity exists for a valid business purpose, and 3) the transaction in question is incident to the entity's business. Stewart, 714 F.2d at 988. Transfers of income within a family warrant special scrutiny. See Helvering v. Clifford, 309 U.S. 331, 335, 60 S.Ct. 554, 556, 84 L.Ed. 788 (1940); Royster v. C.I.R., 1985 T.C.M. 258.

The record amply supports the Tax Court's characterization of Palomate as a conduit for P.R. Farms' income. Palomate served no real economic function in the storage and marketing of P.R. Farms' fruit. We now review the evidence supporting the Tax Court's characterization of Palomate...