Pahl v. C.I.R., No. 96-70402

• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)
• Writing for the Court: BOOCHEVER
• Citation: 82 A.F.T.R.2d 98,150 F.3d 1124
• Docket Number: No. 96-70402
• Decision Date: 29 July 1998
• Parties: -5418, 98-2 USTC P 50,602, 98 Cal. Daily Op. Serv. 5844, 98 Daily Journal D.A.R. 8136 Stephen D. PAHL; Louise A. Pahl, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Page 1124

150 F.3d 1124 82 A.F.T.R.2d 98-5418, 98-2 USTC P 50,602,
98 Cal. Daily Op. Serv. 5844,
98 Daily Journal D.A.R. 8136 Stephen D. PAHL; Louise A. Pahl, Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. No. 96-70402. United States Court of Appeals,
Ninth Circuit. Submitted Feb. 11, 1998.
Decided July 29, 1998.

Page 1125

Stephen D. Pahl, Pro se, San Jose, California; Thomas M. Gosselin, Pahl & Gosselin, San Francisco, California, for petitioners-appellants.

Bruce R. Ellisen and Annette M. Wietecha, United States Department of Justice, Tax Division, Washington, DC, for respondent-appellee.

Appeal from a Decision of the United States Tax Court; James S. Halpern, Judge, Presiding. Tax Ct. No. 7757-94.

Before: D.W. NELSON, BOOCHEVER, and REINHARDT, Circuit Judges.

BOOCHEVER, Circuit Judge:

The Tax Court denied the petition for redetermination of federal income taxes for tax year 1990 filed by Stephen Pahl and his wife, Louise. ¹ The Tax Court concluded that in 1990 Stephen Pahl was a shareholder in the law firm Niesar, Pahl, Cecchini & Gosselin (the "firm"), a subchapter S corporation, and therefore Pahl should have reported a pro rata share of the law firm's 1990 income on his tax returns. The Tax Court also determined that Pahl negligently failed to report as income a $6,500 automobile allowance from the firm, and thus is liable for taxes and a 26 U.S.C. § 6662 negligence penalty. Pahl v. Commissioner, 71 T.C.M. (CCH) 2744, 1996 WL 167967 (1996). Pahl appeals.

I. Facts and procedural history

During the first part of 1989, Stephen Pahl and Thomas Gosselin negotiated with Gerald Niesar and Garrett Cecchini to join their law firm, Niesar & Cecchini. The firm had been organized two years earlier as a Subchapter S corporation, which has the feature of paying no taxes and instead passing through profits and losses pro rata to its shareholders. Pahl and Gosselin agreed to join the firm effective August 9, 1989, and each agreed to become a 25-percent shareholder of the law corporation by purchasing 1000 shares of stock for 25 percent of the audited book value of the corporation as of July 31, 1989.

Pahl and Gosselin joined the firm, but soon were disenchanted. By May 1990, they had informed Niesar and Cecchini of their intention to separate from the firm on June 30, 1990. During Pahl's brief tenure at the firm, some aspects of the initial agreement were fulfilled, but others were not. Some of the corporate and state bar formalities were attended to, but others were not. Resolving the main question on appeal, whether Pahl was a shareholder of the firm during 1990, requires a determination whether his and the other lawyers' acts were sufficient to make him one.

A "Notice of Special Meeting" of the board of directors of Niesar & Cecchini, dated August 3, 1989, described the business to be conducted that same day:

1. Sell Thomas M. Gosselin and Stephen D. Pahl:

Page 1126

1,000 shares at price to be determined by auditor at July 31, 1989.

2. Amend articles to change name to Niesar, Pahl, Cecchini & Gosselin.

3. Effective August 8, 1989

Elect Stephen D. Pahl and Thomas M. Gosselin as directors. (Amend Bylaws to provide for four directors.)

4. Bank Resolutions re 500K loan.

5. Any other legitimate business that may come before the meeting.

The minutes of the August 3, 1989 meeting of the board of directors report that the board (Niesar and Cecchini) determined and resolved as follows:

WHEREAS, this Board of Directors has determined that the issuance of additional stock in the corporation would benefit the corporation; and

WHEREAS, this Board has determined that Thomas M. Gosselin and Stephen D. Pahl are suitable shareholders whose participation would benefit the corporation and each is an active member of the California Bar, and

NOW, THEREFORE, BE IT RESOLVED, that the corporation shall issue and sell to each of Thomas M. Gosselin and Stephen D. Pahl one thousand (1,000) shares of common stock, such action to take effect on August 9, 1989; and

FURTHER RESOLVED, that the price to be paid by Messrs. Pahl and Gosselin for such shares shall be determined by an audit of this corporation's balance sheet as at July 31, 1989; and

FURTHER RESOLVED, that each of Messrs. Pahl and Gosselin shall pay in cash, the amount equal to one-half of the net worth of the corporation as determined by reference to such audited balance sheet as at July 31, 1989, as and for the total purchase price of said purchasers' 1000 shares of common stock.

At the same meeting, Pahl and Gosselin were elected directors of the corporation. Pahl was elected President of the board, Gosselin and Cecchini became Vice-Presidents, and Niesar remained Secretary. The board authorized Pahl to negotiate a half-million dollar line of credit with Silicon Valley Bank, which Pahl and Gosselin personally guaranteed because Niesar and Cecchini were rated poor credit risks.

On August 9, Niesar and Cecchini executed a Certificate of Amendment of Articles of Incorporation changing the firm name to "Niesar, Pahl, Cecchini & Gosselin, A Professional Corporation." The Amendment was filed with the Secretary of State on August 29, 1989, and included a two-page declaration by Cecchini listing four shareholders of the corporation as Gerald V. Niesar, Stephen D. Pahl, Garrett L. Cecchini, and Thomas M. Gosselin. The Declaration lists 17 "[e]mployees ... engaged in the practice of law," including all of the named partners. The Amendment is accompanied by a "Guarantee" of payment by the corporation for errors and omissions related to law practice. That document begins "We, the undersigned, as the shareholders of Niesar, Pahl, Cecchini and Gosselin, a Professional Corporation, hereby guarantee ..." and it is signed by all four named partners, including Stephen Pahl. ²

Pahl took over as managing partner of the firm, managed the books, and hired and fired employees. The Commissioner and Pahl agree that the intended audit of the balance sheets to determine book value of the corporation was never conducted, and Pahl never paid for any shares. Pahl claims that he did not pay for the shares because he discovered the book value of the firm was inflated.

In March 1990, Niesar filed a law corporation annual report listing Pahl as a shareholder of the firm, which Niesar signed and thereby declared under penalty of perjury to be true and correct.

Pahl and his law partners entered a separation agreement that was made effective June 30, 1990. Pahl and Gosselin agreed to

Page 1127

assume the corporation's $500,000 credit line, which they had guaranteed. In exchange, they received physical assets and accounts receivable roughly equal to the balance on the credit line and paid the firm $8,000. Paragraph 7 of the agreement provides that the firm "will promptly amend its registration with the California State Bar to reflect that neither Pahl nor Gosselin is a shareholder, officer, director or employee of the Firm as of July 1, 1990."

After the separation, the firm issued Pahl an IRS form K-1 reflecting a 25-percent pro rata share of the firm's losses in 1989. Pahl did not claim the loss on his 1989 tax return, and instead advised the IRS that the K-1 was issued in error. In 1991, he received a K-1 reflecting a 25 percent pro rata share of the firm's profits for 1990 and a form 1099 reflecting $6,500 of nonemployee compensation. Pahl failed to report the 25 percent share of the firm's 1990 profits, but he alleges that the $6,500 was included on his Schedule C (Profit or Loss from Business) under an $8,530 item described as "Attorney Legal Service-Leasing."

STANDARD OF REVIEW

The Tax Court's "factual determinations are reviewed for clear error, but the correctness of the legal standards applied by the Tax Court, and the application of the legal standards to the facts found, are reviewed de novo." Sacks v. Commissioner, 69 F.3d 982, 986 (9th Cir.1995). The "Tax Court's opinions bearing on the Internal Revenue Code are entitled to respect because of its special expertise in the field," but "[w]e owe no deference to the ... Tax Court on issues of state law." Harbor Bancorp v. Commissioner, 115 F.3d 722, 727 (9th Cir.1997) (as amended) (quotations omitted), cert. denied, --- U.S. ----, 118 S.Ct. 1035, 140 L.Ed.2d 102 (1998).

DISCUSSION

I. Pahl's shareholder status

A. Controlling law

The parties dispute whether state or federal law controls our determination whether Pahl was a shareholder of the firm. Pahl claims that state law controls, citing Swenson v. Commissioner, in which the Tax Court held that "[i]n determining when petitioner acquired the stock in question, we must look to the applicable State law." 37 T.C. 124, 131, 1961 WL 1314 (1961), rev'd on other grounds, 309 F.2d 672 (8th Cir.1962). The Commissioner quotes this court's holding that "[t]he question of who is a shareholder as the term is used in Subchapter S must be determined by federal rather than state law." Kean v. Commissioner, 469 F.2d 1183, 1186 (9th Cir.1972).

This apparent discrepancy is addressed in Cabintaxi Corp. v. Commissioner, 63 F.3d 614 (7th Cir.1995), in which the Seventh Circuit had to decide "whether a person was a shareholder on the date of the election to be taxed under Subchapter S," which it deemed "equivalent to the question whether, had there been a valid election [to be taxed under Subchapter S], he would have been required to report as personal income profits earned by the corporation on that date." Id. at 616. Because Pahl's law firm was a valid Subchapter S corporation, the question here is thus similar to the one addressed in Cabintaxi, i.e. whether Pahl was a shareholder of the Subchapter S corporation.

The Cabintaxi court reasoned that the common answer to these questions "depends on whether [the taxpayer] would have been deemed a beneficial owner of shares in the corporation...." Id. at 616. Writing for the court, Chief Judge Posner...