Thompson Engineering Co., Inc. v. C.I.R.
| Decision Date | 04 January 1985 |
| Docket Number | No. 83-1786,83-1786 |
| Citation | 751 F.2d 191 |
| Parties | -576, 85-1 USTC P 9126 THOMPSON ENGINEERING CO., INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. |
| Court | U.S. Court of Appeals — Sixth Circuit |
Charles R. Hembree, Philip E. Wilson (argued), Kincaid, Wilson, Schaeffer & Hembree, Lexington, Ky., for petitioner-appellant.
Joel Gerber, Acting Chief Counsel, Internal Revenue Service, Washington, D.C., Glenn L. Archer, Jr., Asst. Atty. Gen., Steven Frahm (argued), Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.
Before KENNEDY and KRUPANSKY, Circuit Judges; and DeMASCIO, District Judge. *
Taxpayer, Thompson Engineering Co., Inc. (Thompson Engineering), appealed from a judgment of the tax court concluding that taxpayer permitted its earnings and profits to accumulate beyond the reasonable needs of its business with a purpose to avoid income with respect to its shareholder and imposing liability upon the taxpayer for accumulated earnings pursuant to Sec. 531 of the Internal Revenue Code of 1954 (IRC).
Taxpayer was incorporated in 1959 and, since that time, has been a construction subcontractor primarily engaged in general plumbing, heating, air conditioning, and related sheet metal work. In the mid-1960's, Billy R. Thompson (Thompson) became its sole shareholder. All of taxpayer's officers and directors were members of Thompson's family during the years at issue. As president, Thompson was responsible for taxpayer's operations, including its financial and dividend policies.
The vast majority of taxpayer's projects were performed for government agencies and involved the construction of schools, hospitals, office buildings, utility plants and federally funded housing, for which taxpayer served as a mechanical subcontractor. Taxpayer's contracts were awarded to general contractors pursuant to a procedure whereby the contractor submitted bids to the soliciting government agency which incorporated price quotations of subcontractors such as the taxpayer. The general contractor was not required to accept the lowest bidding subcontractor. In selecting a subcontractor, the general contractor considered the amount of the subcontractors' bid, the subcontractors' financial capability, physical capacity to perform, available personnel, existing workload, and experience in performing the type of work involved. Once a general contractor was awarded a contract, subcontracts were awarded to the selected subcontractors. Taxpayer subcontracted only a small amount of the work it was awarded.
General contractors engaged in public works projects were required to post a performance and bid bond. The general contractor had the option, in turn, to require the subcontractor to provide a performance and payment bond. If the subcontractor was unable to provide a bond, the general contractor, with the government's permission, could substitute the next acceptable contractor. General contractors generally avoid subcontractors who are not bondable.
Russell E. Davis (Davis), taxpayer's insurance underwriter testified that insurance companies generally derive the bondable limits of a subcontractor at a figure computed at 4 to 5 times its net worth or 6 1/2 to 7 times its working capital, as applied to the aggregated value of the subcontractor's outstanding contracts. For example, on an aggregated value of $1 million worth of work in progress, the working capital requirement would be $150,000 or $200,000 to 250,000 on net worth.
Davis testified that, notwithstanding the application of the foregoing criteria, the maximum bonding level of any given contractor was basically a subjective determination. He stated that other factors considered were "the individual, his pay record, his operating capital, his net worth, his reputation, [and] his past experience on jobs," and that "there is a great deal of subjective evaluation within those guidelines." Davis also explained that bonding companies require contractors and subcontractors to have exceptional financial strength before they issue bonds without conditions of personal indemnity.
From its incorporation through at least 1974, taxpayer's volume of business steadily increased, as did its reputation which was excellent. Taxpayer consistently operated at a profit. Beginning in 1972, however, and accelerating during 1973 and 1974, the construction industry in taxpayer's geographical area experienced dramatic price escalations and material shortages. Taxpayer's contracts with general contractors did not incorporate escalator clauses protecting it against such price increases. During the years at issue, taxpayer suffered losses on four or five of its contracts, and many of its competitors went bankrupt. Cash flow difficulties caused many subcontractors to reduce profit margins to remain competitive. Taxpayer sought to avoid the increased competition by bidding only on bigger projects.
The decision to bid on bigger jobs increased taxpayer's bonding needs. In 1972, taxpayer transferred its bonding business to Progressive Insurance Company (Progressive), of which Davis was the president and majority shareholder. Taxpayer sought to have Progressive write bonds at preferred rates and without personal indemnity. Initially, Davis placed taxpayer's bonds with the United States Fidelity and Guaranty Company, but was not able to do so as preferred rates or without personal indemnity clauses. During 1972, Davis began placing taxpayer's bonds with the American States Insurance Agency (States). Although it charged standard rates, it's subsidiary, American Economy Insurance Company (Economy) authorized preferred rates.
In July 1972, States authorized Progressive to write bonds for the taxpayer without home office referral. This authority applied to contracts of not more than $250,000, and only upon the condition that taxpayer's total contracts in progress at the time of application did not exceed $2,500,000. Subsequently, Progressive was authorized to write bonds for taxpayer with Economy at preferred rates and without personal indemnity. This was due to Progressive's experience with taxpayer, taxpayer's increased net worth and working capital, and taxpayer's greater work experience. In February, 1972, Progressive was authorized by Economy to write bonds for taxpayer without home office referral on contracts up to $750,000 so long as the total number of contracts in progress did not exceed $3,000,000. Thompson testified that it was his understanding that taxpayer could be bonded based on a ratio of five or six times working capital and "about" four times net worth.
When submitting bids, taxpayer was required to disclose if it had ever been refused a performance bond. To avoid such embarrassment, Thompson, on occasion, conferred with Davis before submitting bids. If Davis questioned the bidding on a particular job, or if a project would exceed Davis' underwriting authority, Thompson would forego the project. As a result, taxpayer was never denied a bond and Davis made no requests to the home office for approval of amounts in excess of his underwriting authority.
In 1972 and 1973, taxpayer was typically awarded about 20 percent of the contracts upon which it submitted bids. Taxpayer's balance sheets reflected that its net assets for 1972 and 1973 were $759,830 and $896,457, respectively. Taxpayer had accumulated earnings and profits and retained current earnings and profits for the years 1971 through 1973 as follows:
Accumulated Earnings Retained Current 1
Fiscal Year and Profits Earnings and Profits
----------- -------------------- ----------------------
1971 $535,601 ________
1972 $727,507 $191,979
1973 $864,583 $137,257
Taxpayer never paid a dividend from the date of its incorporation through fiscal year 1973, but it made a number of loans to its sole shareholder, Thompson, the outstanding balance of which reached $164,200 by late 1973. 2 The loans were reflected as "notes receivable-officers" on taxpayer's balance sheet and were evidenced by demand notes. All but two of the notes specified the interest rate payable at six percent. Thompson used all but $55,000 of the amounts loaned to him to purchase his house, a farm, and a residential lot. The remainder of the proceeds was used by Thompson to launch a new business venture.
Davis informed Thompson that the loans the company advanced to him would be taken into account in determining taxpayer's net worth but would reduce the amount of taxpayer's working capital for bonding purposes. Davis also advised Thompson that it would become necessary at some time in the future to subordinate to the bonding company the notes evidencing Thompson's personal liability to taxpayer so that the notes would not be subject to taxpayer's general creditors. Thompson testified that his loans were merely shortterm investments, replacing taxpayer's prior unsuccessful venture into the stock market. Thompson had been assured by his bank that he could obtain a personal loan on short notice if it became necessary to immediately repay his loans to taxpayer.
In September 1974, taxpayer elected to be taxed as a small business corporation under Subchapter S, IRC Sec. 1371 et seq. On November 15, 1974, taxpayer declared a dividend to Thompson of $112,986.63. On the same date, Thompson repaid his loans from taxpayer through July 6, 1972, in the total amount of $112,700.
Thompson's compensation as taxpayer's president was $69,665 in fiscal year 1972 and $73,268 in fiscal year 1973. He and his wife reported taxable income on their joint federal income tax returns for 1972 and 1973 of $53,485.50 and $50,571,34. Their marginal rates of federal taxation in those years were 53 and 50 percent, respectively.
The Commissioner of Internal Revenue (the...
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