Pfluger v. C.I.R.

• Citation: 840 F.2d 1379
• Decision Date: 07 March 1988
• Docket Number: No. 87-1503,87-1503
• Parties: -857, 88-1 USTC P 9221 Robert A. PFLUGER and Elaine M. Pfluger, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 1379

840 F.2d 1379

61 A.F.T.R.2d 88-857, 88-1 USTC P 9221

Robert A. PFLUGER and Elaine M. Pfluger, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 87-1503.

United States Court of Appeals Seventh Circuit.

Argued Jan. 8, 1988.

Decided March 7, 1988.

Joseph W. Weigel, Milwaukee, Wis., for petitioners-appellants.

Steven W. Parks, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.

Before CUMMINGS, CUDAHY and POSNER, Circuit Judges.

CUDAHY, Circuit Judge.

Six years ago this court attempted to thwart the proliferation of "family trusts," tax avoidance devices that have as their central feature the anticipatory assignment of income to a trust controlled by the taxpayer. See Schulz v. Commissioner, 686 F.2d 490 (7th Cir.1982). In that opinion, Judge Cummings said:

Given the deeply rooted instinct not to pay more taxes than the law requires and the endless changes that can be rung on trust draftsmanship, we do not suppose that any single opinion can put a definitive end to ... family trusts.

Id. at 497. This case involves an altered version of the family trust device disallowed in Schulz. We find that the new version leads to the same legal conclusions. We also find petitioners' other contentions meritless and affirm the Tax Court's decision upholding a deficiency and negligence penalty.

I.

Petitioner Robert Pfluger, ¹ a dentist, became disillusioned with the federal income tax system after having to borrow money to pay his 1979 taxes. He undertook extensive research into the tax system and concluded that the federal income tax was an unconstitutional "leveling" device. ² He also attended meetings of individuals interested in reducing their tax burden; at one such meeting he learned about "family trusts."

Dr. Pfluger was intrigued by the potential tax benefits that the family trust arrangement seemed to provide. He was, however, aware that similar devices had been struck down by the courts and the Internal Revenue Service (the "IRS"). Nonetheless, after a brief consultation with his attorney and numerous conversations with the provider of the trust documents, Dr. Pfluger decided to forge ahead.

On February 23, 1980, Dr. Pfluger executed the "Family Trust Indenture of the Robert A. Pfluger Family Trust." Dr. Pfluger was the grantor of the trust. In return for the entire beneficial interest he assigned "the exclusive use of his lifetime services" and certain specified property to the trust. See Petitioners' Exhibit 4 at 3. His wife and brother-in-law were the initial trustees, but within two days of the indenture's execution Dr. Pfluger had replaced his brother-in-law as co-trustee. See Petitioners' Exhibit 5 at 2. Thus, Dr. Pfluger was grantor, co-trustee and sole beneficiary of the family trust. ³

Up to this point, the case before us resembled a "typical" family trust case, in which the taxpayer "assigns" his income to the trust and the trust funds are used to cover his personal expenditures, purportedly allowing deduction of those expenditures. See, e.g., Schulz, 686 F.2d at 492-93. This court in Schulz, and every other court to consider the issue in cases too numerous to catalogue, has held that this family trust arrangement is an invalid anticipatory assignment of income under Lucas v. Earl, 281 U.S. 111, 50 S.Ct. 241, 74 L.Ed. 731 (1930). See, e.g., Schulz, 686 F.2d at 493. ⁴ Dr. Pfluger did not follow a straight assignment of income path, however; in fact, he did not attempt to assign his professional receipts directly to the trust. Instead, on February 25, 1980, two days after executing the indenture, he entered into a contract with the trust. The trust was represented in the "negotiations" by Dr. Pfluger and his wife. Under the contract the trust agreed to manage Dr. Pfluger's dental practice ⁵ in return for a management fee, expressed as a percentage of Dr. Pfluger's gross income. The percentage was left blank, to be filled in later by Dr. Pfluger.

After purportedly researching the average business expenses of dentists nationwide, Dr. Pfluger set the management fee at approximately sixty percent of his gross income. ⁶ On their 1980 tax return, the Pflugers reported $159,091 in gross income from the dental practice; they then deducted a "management fee" of $95,000 allegedly paid to the trust. ⁷ They also claimed deductions for office expenses and wages paid directly by Dr. Pfluger, all of which were to be paid by the trust under the February 25 contract. The trust in turn reported income of $95,000 and deductions of $61,280.

The IRS audited the Pflugers. It first determined that the trust should be disregarded for tax purposes. The government therefore sought to redetermine the Pflugers' tax by allowing the couple to directly deduct all substantiated business expenses, ignoring the management fee and treating expenses paid by the trust as expenses paid by the taxpayers. The Pflugers, however, refused to turn over any documents to the IRS. The Service was left with no choice; it disallowed the $95,000 deduction and all other deductions and assessed a deficiency of $42,762 and a negligence penalty under Internal Revenue Code section 6653(a), 26 U.S.C. Sec. 6653(a), of $2,138.

The Pflugers petitioned the Tax Court for a redetermination of the deficiency. They then refused the government's repeated discovery requests, turning over only the trust indenture and the February 25 contract. The IRS moved for an order compelling compliance with discovery requests and for sanctions if the Pflugers continued their obstinate conduct. The Pflugers continued to refuse cooperation.

After a hearing on the sanctions motion, the court entered an order that states in part:

[T]he petitioners are prohibited from introducing any of the documents which had been requested by the respondent in his request for production of documents and which had been ordered to be produced by the Court's order of May 25, 1984. The petitioners are also prohibited from attempting to prove the matters contained in any such documents by oral testimony or otherwise.

Pfluger v. Commissioner, No. 30209-82 (T.C. June 25, 1984) (order on sanctions motion). The initial oral order excluded only documents, but the court soon realized that such a limited order would "let [the taxpayers] prove that matter indirectly which [they] couldn't prove directly." Transcript at 30 (June 26, 1984). It would also give the taxpayers an unfair advantage, since they could testify as to documents not reviewed by the IRS. Id. Judge Simpson modified the order to preclude oral testimony about the documents; he still permitted third-party testimony (mostly by suppliers) based on third-party records introduced into evidence.

After trial, the Tax Court rejected the Pflugers' argument that the income tax is unconstitutional. It also disallowed the "management fee" deduction, finding that the fee was never paid to the trust and that the trust device was an invalid anticipatory assignment of income. The court allowed $32,824 in deductions substantiated by third-party records and reduced the section 6653(a) negligence penalty to $1,193.

The taxpayers appeal, raising five issues. First, they allege that the burden of proof should shift to the IRS because the initial deficiency notice was "arbitrary." Second, they contend that the court abused its discretion in excluding certain testimony under the sanctions order. Third, they argue that the court erred in disallowing the management fee deduction. Fourth, even if the court correctly disregarded the trust, the Pflugers assert that they proved certain other deductions through testimony and third-party records. Finally, petitioners say the negligence penalty was not justified. These claims are all meritless and we therefore affirm.

II.

The threshold issue concerns the burden of proof. The general rule is that a presumption of correctness attaches to the Commissioner's deficiency determination; the taxpayer has the burden of disproving it. See Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933); see also Ruth v. United States, 823 F.2d 1091, 1094 (7th Cir.1987). A narrow exception exists where the determination is arbitrary and erroneous or without rational foundation. Ruth, 823 F.2d at 1094; see United States v. Janis, 428 U.S. 433, 441-42, 96 S.Ct. 3021, 3025-26, 49 L.Ed.2d 1046 (1976); Helvering v. Taylor, 293 U.S. 507, 514-15, 55 S.Ct. 287, 290-91, 79 L.Ed. 623 (1935).

The Pflugers argue that the IRS arbitrarily denied all of their claimed deductions. They say the IRS was required to guess the amount they could have deducted, perhaps by allowing average dental business deductions. But they cite no authority for this contention; nor do they point us to any analogous uses of averaging by the IRS.

The Pflugers' argument is clearly wrong when viewed in context. They willfully refused to cooperate with the audit. They cannot thereby force the Commissioner to resort to "averages" to estimate the deductions that they could have taken. If that were the case, nobody would cooperate with an audit. The use of estimates could often result in allowance of more deductions than the taxpayer was actually entitled to take; if it did not, the taxpayer would simply petition for a redetermination and substantiate greater deductions. The Tax Court has correctly rejected such a rule in prior cases. See, e.g., Roberts v. Commissioner, 62 T.C. 834, 836 (1974). We agree with the Tax Court that the deficiency notice was not arbitrary.

III.

A second tangential question is whether the Tax Court abused its discretion by excluding certain testimony. The argument, as stated in Petitioners' Brief at 27-30, begins with the true statement that the sanctions order only foreclosed use of documents not given to the IRS and testimony about those documents. The IRS had the trust's tax return, which noted numerous deductions. Therefore, because the return itself was...