Parfrey v. Commissioner
| Decision Date | 19 December 1983 |
| Docket Number | Docket No. 7627-82. |
| Citation | 47 TCM (CCH) 689,1983 TC Memo 756 |
| Parties | James A. Parfrey and Patricia Parfrey v. Commissioner. |
| Court | U.S. Tax Court |
Thomas J. Renner, 204 W. Pennsylvania Ave., Towson, Md. 21204, for the petitioners. Clare J. Brooks, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined a deficiency of $18,041 in petitioners' 1979 Federal income tax. The issues are: (1) whether a distribution by petitioner James A. Parfrey's solely owned corporation was a dividend or a loan; (2) whether interest earned on the proceeds of that distribution is taxable to petitioners or to their children.
Some of the facts have been stipulated and are found accordingly.
Petitioners resided in Bel Air, Md., when they filed their petition herein. All further references to petitioner (in the singular form) shall be to James A. Parfrey.
Petitioner is president and sole shareholder of J.A. Parfrey Company, Inc. (the corporation). Patricia Parfrey, petitioner's wife, is the corporation's secretary and bookkeeper. The corporation's net earnings after taxes and its retained earnings since its incorporation on January 1, 1973, are as follows:
Retained
Year ended Net income earnings
4/30/73 .......... $ 3,873 $ 3,873
4/30/74 .......... 18,066 21,939
4/30/75 .......... 10,144 32,053
4/30/76 .......... 13,754 45,807
4/30/77 .......... 8,888 54,695
4/30/78 .......... 25,800 80,495
4/30/79 .......... 70,989 $151,283
No dividends were paid by the corporation prior to its fiscal year ending April 30, 1979 (fiscal year 1979); in that year, the company paid a $200 dividend. The corporation's officers (the petitioners) received salaries in fiscal year 1979 totaling $82,281; petitioner's salary was $74,925, while Patricia Parfrey's salary was $7,356.
The corporation is engaged as a subcontractor in the concrete construction business. To maintain a good credit rating, and thus stay in business, the corporation had to maintain significant liquid reserves to meet its obligations in the face of delinquent payments by its creditors. The corporation's net income rose substantially in fiscal year 1979 and consequently its retained earnings nearly doubled.
After reading an article in a business periodical and consulting his accountant, Donald A. Hiltner (Hiltner), as to the tax consequences, petitioner decided to have the corporation loan $20,000 to each of his two children, James A. Parfrey, Jr. (James, Jr.), then age 12, and Jon M. Parfrey (Jon), then age 11. His purpose in having these loans made was to generate income for the college education of his children, which income he believed would be that of the children and taxed at a lower rate.
On December 22, 1978, at petitioner's direction, James, Jr., signed a promissory note in the amount of $20,000, payable without interest to the corporation on or before July 31, 1983. Jon, also at petitioner's direction, signed a similar note, with the same terms, on the same day. No security was provided for either of the notes.
On January 5, 1979, the corporation issued a check for $60,000 to the Equitable Trust Company (Equitable). On January 8, 1979, Equitable issued two six-month certificates of deposit (CDs), bearing interest at 9.55 percent, as follows: one $20,000 CD in the names of petitioner and Jon, minor; one $20,000 CD in the names of petitioner and James, Jr., minor; and two $10,000 CDs in the corporation's name.1 The signature cards corresponding to the two $20,000 CDs state that petitioner held the proceeds "in trust for" his children.2 Equitable required petitioner to set up the account in trust form because the children were minors. No other trust instruments were executed.
Initially, because of a misunderstanding on the part of Hiltner, the corporation carried the $40,000 representing the notes of James, Jr., and Jon on its books in its general ledger account as "Loan Receivable Employees & Officers."3 On April 30, 1980, a new general ledger account, "Notes Receivable," was opened and a $40,000 debit was entered thereon, with an adjusting transfer made to the "Loans Receivable Employees & Officers" account. The corporation's balance sheets for 1979, 1980, and 1981 listed the loans as "current assets."
As the two $20,000 CDs matured, the principal plus interest was rolled over into new six-month CDs.
James, Jr., was killed on May 19, 1980. The CD in his name that expired on July 8, 1980, was rolled over by petitioner, acting as personal representative for the Estate of James A. Parfrey, Jr. (the estate), for another six-month term. On February 10, 1981, the estate paid the corporation $20,000 in settlement of the corporation's "claim" filed against the estate.
OpinionThe first issue for decision is whether the $40,000 withdrawal from the corporation was a loan, either to petitioner or to his children, or a dividend taxable to petitioners under sections 301 and 316.4
Respondent contends that the withdrawal was a dividend because petitioner controlled the corporation, no interest was charged, no security was given for the loans, and no dividends had yet been declared by the corporation. Petitioner argues, on the other hand, that the withdrawal was a bona fide loan because promissory notes were issued, the withdrawal was consistently treated on the corporation's books and records as a loan, the children had a continuing ability to repay the loan, petitioner designed the transaction to shift income to lower-bracket taxpayers, and the loan to James, Jr., was repaid after his death.
It is clear that where a closely held family corporation is involved, particularly where a sole shareholder is in complete control, the transaction must be closely scrutinized. Baird v. Commissioner Dec. 21,363, 25 T.C. 387 (1955). On the other hand, it is equally clear that the presence of sole-shareholder control is not, in and of itself, sufficient to justify a refusal to find that a bona fide loan existed. White v. Commissioner Dec. 18,856, 17 T.C. 1562 (1952); Faitoute v. Commissioner Dec. 10,079, 38 B.T.A. 32 (1938); Wiese v. Commissioner Dec. 9606, 35 B.T.A. 701 (1937), affd. 93 F. 2d 921 (8th Cir. 1938). The form of the transaction is not determinative, although the presence or absence of such elements as notes, interest, and security are elements to be taken into account. Miele v. Commissioner Dec. 30,841, 56 T.C. 556, 567-569 (1971), affd. without published opinion 73-1 USTC ¶ 9379, 474 F. 2d 1338 (3d Cir. 1973). The controlling factor is whether, at the time the withdrawal was made, it was intended that the amount withdrawn would be repaid.5Pierce v. Commissioner Dec. 32,402, 61 T.C. 424, 430 (1974). See also 1 Mertens, Law of Federal Income Taxation, sec. 9.21, p. 64 (1981), and cases cited therein. Intent is determined from all the facts and circumstances. Dean v. Commissioner Dec. 31,024, 57 T.C. 32 (1971). The burden of proof is on petitioners. Miele v. Commissioner, supra; Rule 142(a). On the record before us, we think petitioners have carried their burden.
The fact of the matter is that the formalities were scrupulously observed. The amounts were always treated as loans on the books and records of the corporation, although there was initially some confusion as to who was the borrower. See pp. 4-5, supra. There were notes. They had a fixed due date. To be sure, that date was subsequent to the time of trial herein, so that the element of actual payment or payments on account (which is an important element in the decided cases) is not present. On the other hand, the due date was not picked out of thin air but was keyed to the time when each of the children would be nearing college entrance age. Moreover, there was evidence of repayment of James, Jr.'s loan after his death (when the need for the funds for his education no longer existed) and shortly after the normal time for creditors to file claims against his estate had expired.6
The fact that the proceeds were put in six-month certificates of deposit provided a ready means of earlier repayment of the notes if the corporation needed the money. We attach no significance to the fact that the CDs were not formally used to collateralize the notes. Given petitioner's control over both sides of the transaction and its future implementation, we think that, as a practical matter, the notes were secured by the CDs whose value would remain constant at face.
Nor do we think we should speculate that, because the cost of each child's education would likely be in excess of the accumulated income on the CDs, the petitioner would see to it that the notes were not enforced so that the principal of the CDs could be used. The accumulated income over a five-year period would have exceeded $10,000 for each child — a not insignificant amount to be applied toward his education.
The long and short of the matter is that there are sufficient objective elements in this record to support petitioner's testimony that he clearly intended that the notes be repaid.7 We found petitioner to be a forth-right and credible witness. Under these circumstances, if we were not to accept his testimony, we think we would be violating the rule that control by a sole shareholder per se is not determinative that a distribution is a dividend and not a loan (a rule long ago established, see Faitoute v. Commissioner, supra; Wiese v. Commissioner, supra) and would be concluding that the presence of a tax minimization objective in and of itself precludes the possibility of a loan even though there was also a legitimate non-tax purpose, i.e., accumulation of income for the education of petitioner's children. This we are not prepared to do, see Goldstein v. Commissioner 66-2 USTC ¶ 9561, 364 F. 2d 734, 738-740 (2d Cir. 1966), although we are constrained to observe that,...
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