BAILEY v. COMMISSIONER OF INTERNAL REVENUE
T.C. Memo. 2012-96
United States Tax Court.
Filed April 2, 2012.
In Webb, a trustee misrepresented the eligibility of his solely owned Massachusetts business trust for a storm disaster loan from the U.S. Small Business Administration (SBA) and diverted a portion of the loan proceeds from the trust for his personal use. Id. at 204. The IRS determined that the trustee had unreported embezzlement income in the amount of the diverted loan proceeds and the District Court granted summary judgment to the IRS. Id. at 205. On appeal, the trustee argued (i) that the diverted loan proceeds constituted a de facto loan from the SBA to him, and (ii) that loan proceeds are not income under James v. United States, 366 U.S. 213 (1961). Webb, 15 F.3d at 206-207. Although the Court of Appeals for the First Circuit agreed that loan proceeds are not income, it upheld the IRS's determination and affirmed the District Court because it found that the diverted loan proceeds were not a loan under the so-called James "consensual recognition" test. Id. at 207-208. Under the James test, a loan is recognized as such for tax purposes if there is "the consensual recognition, express or implied, of an obligation to repay" the loan. James, 366 U.S. at 219. The Court of Appeals found that the only borrower with a "consensual recognition" of an obligation to repay the SBA was the trust, and further found that there was no proof of any loan or obligation between the trust and the trustee. Webb, 15 F.3d at 207-208.
However, the facts of Webb are very unlike those of the instant cases. There is no dispute (i) that Credit Suisse made directly to Mr. Bailey the loans that were collateralized by the Biochem Pharma stock, (ii) that he was personally liable for those loans, (iii) that he intended to repay Credit Suisse, (iv) that Credit Suisse insisted that he repay the loans—even when he became incarcerated—before it would release the collateral, and (v) that he actually repaid Credit Suisse in 1996. On those facts and in the absence of any evidence to the contrary, we find that there was a "consensual recognition" of Mr. Bailey's obligation to repay the loans to Credit Suisse. Under the James test, the loan proceeds from Credit Suisse were the product of a loan to Mr. Bailey, and thus, are not includible in his gross income.
However, the Commissioner contends that Mr. Bailey must nonetheless recognize the loans from Credit Suisse as income, because he misappropriated the value of the Biochem Pharma stock by using it as collateral for those loans. We disagree. The receipt of a loan is not income to the borrower where the borrower uses another person's property as collateral to obtain that loan—even where the collateral is obtained under false pretenses or is otherwise misappropriated—as long as there is a "consensual recognition" that the borrower will repay the loan. See Kreimer v. Commissioner, T.C. Memo. 1983-672 (holding that loan proceeds were not income to taxpayers who borrowed money through a series of shell companies and fraudulently issued bonds in another corporation's name to secure those loans, because the taxpayers treated the loans as bona fide debt and the facts showed a "consensual recognition" of all parties involved that the loans would be repaid). Even though Mr. Bailey received most of the alleged income as loan proceeds, the Government argues here that it was income to him because his use of the Biochem Pharma stock as collateral was a knowing misappropriation that they criticize in no uncertain terms. It is indeed clear—with the benefit of hindsight—that Mr. Bailey was not entitled to use the Biochem Pharma stock as collateral to secure loans for his personal use, and we certainly do not condone Mr. Bailey's failure to draw clear lines between his personal financial interests and the other interests he was bound to promote; but viewing Mr. Bailey as a taxpayer, we find that the Government entered into a "vague and unusual" agreement with Mr. Bailey under which: he was given the broadest possible discretion to sell the stock or use it as collateral; he and his co-counsel were led to believe that their compensation might amount to as much as $3 million; he and his co-counsel believed (wrongly) that they could take fees as they earned them (subject to a later accounting); he bore the risk (eventually realized) of zero compensation; he performed very substantial services for the Government's benefit35 for which he was never paid; and his belief that he owned the right to any appreciation in the value of the stock, though mistaken, survived two dispositive motions in the Court of Federal Claims36 and was eventually decided only after a nine-day trial, after which the court, though holding against Mr. Bailey, stated that it found him to be one of the three "most consistently credible of the witnesses testifying at the trial." Bailey II, 54 Fed. Cl. at 463. In these cases the Court asked Mr. Kirwin "Why was this arrangement not reflected in a written agreement?", and Mr. Kirwin answered candidly:
Well, I ask myself that question about every three months, your Honor. You know, it should have been. It absolutely should have been. That is a huge mistake that was made. * * * I just don't think anybody thought about the need to put it in writing.
1. For the years 1993 and 1994, the IRS issued a notice of deficiency to Mr. Bailey and his wife, Patricia S. Bailey, who died in 1999. Mr. Bailey is the personal representative of the Estate of Patricia S. Bailey. For the years 1995 through 2001, the IRS issued a notice of deficiency to Mr. Bailey alone.
2. Unless otherwise indicated, all citations of sections refer to the Internal Revenue Code (26 U.S.C.), and all citations of Rules refer to the Tax Court Rules of Practice and Procedure.
3. Some of the facts pertinent to the Biochem Pharma stock issue were determined in litigation between Mr. Bailey and the Government on two prior occasions: In United States v. Duboc, No. 94-01009 (N.D. Fla. Oct. 23, 1997), aff'd in part, rev'd and remanded in part sub nom. United States v. Bailey 175 F.3d 966, 967-968 (11th Cir. 1999) (Bailey I), a forfeiture proceeding in District Court, the Government successfully claimed the right to Mr. Duboc's 602,000 shares of Biochem Pharma stock, reduced only by expenditures approved by the district court. In Bailey v. United States, 40 Fed. Cl. 449 (1998), 46 Fed. Cl. 187 (2000), 54 Fed. Cl. 459 (2002) (Bailey II), a contract suit in the Court of Federal Claims, Mr. Bailey unsuccessfully claimed a contractual right to the appreciation in value that the Biochem Pharma stock experienced after it was transferred to his Credit Suisse account. The parties are here collaterally estopped from disputing the facts set out in part I.B. below that were found in those prior cases.
4. Mr. Bailey believed that under the agreement he became entitled to any appreciation in the value of the Biochem Pharma stock, see p. 12 below; and that was an additional subjective reason for him to favor the transfer of the stock to himself. However, the Court of Federal Claims held in Bailey II that the unwritten agreement did not entitle him to the appreciation.
5. The parties are collaterally estopped from disputing this finding of the District Court. See pt. I.B.2. below.
6. See Bailey II, 54 Fed. Cl. at 468 ("Mr. Bailey and * * * [his co-counsel] agreed that under the arrangement they could take fees as they were necessary or earned").
7. By eliminating the stock sale proceeds, the Commissioner concludes that the remainder of the transferred funds were borrowings and amounted to $550,041 in 1994 and $2,500,230 in 1995, totaling $3,050,271. Mr. Bailey objects to this analysis only by asserting that "[t]he fees of two other clients were deposited in the Credit Suisse account during 1994 (as the records show) and were included in the transfers as earned". We infer that the "records" must be Exhibit 5-J (Credit Suisse statements) and that the two non-Duboc deposits are for $17,169.96 on October 28 and $19,637.63 on December 21, totaling $36,807.59. We accept the Commissioner's analysis subject to that correction, so that the 1994 loans were $513,233 and the two-year total was $3,013,463. Because we find that loan proceeds are not income to Mr. Bailey, the precise amounts of the loans are not necessary to our decision.
8. From this account Mr. Bailey also made a $57,487 personal purchase of stock. This stock purchase was apparently made from Mr. Bailey's own money in the account, which, according to Arthur Andersen, consisted of an opening balance of $5,526 and non-Duboc-related deposits of $49,006 and $17,170.
9. The parties stipulated that the 1994 transfers from the Credit Suisse account to the Barnett account totaled $725,078. Of this amount, $688,270 was from Duboc-derived funds, and the remaining $36,808 was from fees paid by other clients.
10. These expenditures and transfers of Biochem Pharma-derived funds from the Credit Suisse advance account total only $4,672,671, whereas the gross totals of Biochem Pharma-derived funds credited to the Credit Suisse advance account (from sales and loans) was $5,414,318. The difference of $741,647 apparently consists of amounts paid back to Credit Suisse from time to time during 1994 and 1995.
11. As we have found, Mr. Bailey had paid Duboc-related expenses from the Biochem Pharma proceeds totaling $1,269,857 (i.e., from the advance account, $931,698 in 1994 and $302,454 in 1995; and from the personal checking account, $35,705 in 1995).
12. The $1,100,000 in settlement payments from Mr. Broder consisted of (i) a $100,000 check to Michael Armstrong for legal fees, (ii) a $485,000 check to Wayne Smith for loan repayment, (iii) a $50,000 check to Fishman, Ankner & Horstmann for legal fees, (iv) a $270,360.99 check to Mr. Bailey, and a wire transfer of $194,639.01 to Truman Bank for loan repayment, totaling $465,000.
13. In his response to a request for admissions, Mr. Bailey admitted that he did not include the $700,000 payment from Mr. Broder to the trustees, the $485,000 payment from Mr. Broder to Mr. Smith, and the $194,639.01 payment from Mr. Broder to Truman Bank in the income he reported on his tax returns. In that response, Mr. Bailey denied that he failed to include the $270,360.99 payment from Mr. Broder to himself. However, the IRS included that amount as unreported income for 1998 in the notice of deficiency, and Mr. Bailey had the burden to prove that he reported that amount on his tax returns. Since Mr. Bailey failed to do so, we find that he did not include any of the $1,650,000 in the income he reported on his tax returns.
14. The court orders concerning Mr. Bailey's disbarment are, of course, public records. See In re Bailey, 2005 WL 2901885 (D. Mass. No v. 1, 2005), aff'd, 450 F.3d 71 (1st Cir. 2006); Florida Bar v. Bailey, 803 So.2d 683 (2001); In re Bailey, 786 N.E.2d 337 (Mass. 2003). However, the Commissioner did not attempt to bind Mr. Bailey to any findings reflected therein, and we do not derive facts from them nor attempt to reconcile our findings with them.
15. See note 42 below.
16. See Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, sec. 13161, 107 Stat. at 449 (repealing the luxury tax on the first retail sale of boats). Mr. Bailey testified that the luxury tax was important to his idea of selling refurbished used yachts. He said he began the venture believing that the 10 percent tax that was imposed by section 4002 on sales of new yachts would work to his advantage by increasing the prices of new yachts as compared to used yachts, but that the repeal frustrated his original plan. However, the tax was enacted in 1990, after he purchased the Spellbound. See Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, sec. 11221(a), 104 Stat. at 1388-438 (imposing a 10% luxury tax, effective January 1, 1991, on the first retail sale of passenger vehicles, boats, aircraft, and furs and jewelry). His trial testimony was sincere but evidently mistaken about this almost 20-year-old sequence.
17. Despite the fact that PBR exited the yacht refurbishing business in 1993 and never intended to enter the yacht rental business, it purchased a 22-foot ski boat in 1995, which Mr. Bailey christened the Glacier Bay. Mr. Bailey kept the Glacier Bay docked at his personal residence, and concedes that the principal use of PBR's ski boat was personal.
18. The record does not include any copies of timesheets kept by the crew of the Spellbound for other years.
19. The FAA is charged by Congress with promoting air safety. See 49 U.S.C. sec. 106(g)(1)(A) (1994). When the FAA approves an aircraft design, the FAA issues a type certificate. See id. sec. 44704(a). Modifications to an FAA-approved aircraft design must also be FAA approved. Id. The FAA may issue a field approval to approve a minor modification to one serial numbered aircraft, see FAA Order 8900.1 (2009), or a supplemental type certificate to approve a modification to an aircraft design, see 14 C.F.R. sec. 21.113 (1995). As Mr. Vasco testified, the process for obtaining a "multi-use" supplemental type certificate to modify an aircraft design is considerably more difficult and expensive than obtaining a "one-off" field approval to modify a single aircraft.
20. Mr. Olcott currently serves as president of General Aero Co., Inc., a business aviation consulting firm. From 1992 to 2003, he served as president of the National Business Aircraft Association, a trade organization for corporate aviation. From 1973 to 1992, he served as an editor for two aviation magazines—FLYING and Business & Commercial Aviation—published by Ziff Davis Publishing Co. From 1974 to 1986, Mr. Olcott served on advisory committees for the National Aeronautics and Space Administration. He is a licensed transport pilot and holds a bachelor's and a master's degree in aeronautical engineering from Princeton University and a master's degree in business administration from Rutgers University.
21. For 1994, when both the yacht activity and the airplane remanufacturing activity were underway, PBR's reported cost of goods sold ($427,166) and deductions ($200,657) totaled $627,823, of which the yacht-related expenses totaled $203,036, leaving the difference—$424,787—attributable to Project 288.
22. PBR purchased three Twin Comanches in 1994; and if we assume that PBR's entire increase in capital in that year ($180,599) is allocated among the three planes that PBR acquired, then $60,186 was the capital cost of acquiring the plane that PBR then remanufactured. The remainder of the Bailey Bullet's $400,000 presumed cost and value (i.e., $400,000-$60,186=$339,814) was therefore incurred by PBR in 1994 and 1995 (i.e., $169,907 in each year). The imprecision of these assumptions is obvious; but as we explain below, the Commissioner has the burden of proof on alternative contentions for which the amounts attributable to the plane itself are relevant, and in the absence of such proof we therefore make assumptions favorable to Mr. Bailey.
23. The record does not show whether BEI filed a Form 1120S for 1993 or 1994, but it does show that PBR failed to file Forms 1120S for 2000 and 2001.
24. These miscellaneous items are discussed in part VII below.
25. By stipulation and on brief, both parties have resolved several of the issues raised in the notices of deficiency. Mr. Bailey concedes that he had additional interest income of $207 under section 61(a)(4) from Barnett Bank of Palm Beach County in 1993. The Commissioner concedes that Mr. Bailey is entitled to an additional depreciation deduction under section 167 in the amount of $273 in 1994 with respect to the cost of two computers. The Commissioner also concedes the adjustment to Mr. Bailey's 1996 Form 1040 with respect to a $365,000 malpractice insurance policy payment made by the Home Insurance Co. on his behalf. Although this payment is includible in income under section 61(a), the Commissioner agrees that Mr. Bailey is entitled to a corresponding deduction in the same amount pursuant to section 162(a).
26. During trial and on brief the parties collectively referred to the miscellaneous adjustments as "Issue C" or "the `C' issues".
27. The record does not show the type or quality of records that Mr. Bailey kept in the hangar, and the Commissioner disputes Mr. Bailey's contention that those records were sufficient to substantiate his profit motive.
28. The record contradicts Mr. Bailey's contention that he was given no notice that the IRS might challenge his profit motive. Revenue Agent Tabor issued five IDRs to Mr. Bailey in April 2002 that each made requests with respect to the profitability of his activities—well before June 2002, when Mr. Bailey gave the IRS a final opportunity to review and copy his records before he discarded them.
29. The period of limitations for assessment was open with respect to all seven of the tax years at issue on November 6, 2007, when the IRS issued the notices of deficiency to Mr. Bailey, because he signed Forms 872, Consent to Extend the Time to Assess Tax, by which he agreed to extend the period of limitations on assessment. See sec. 6501(c)(4). The period of limitations for assessment will remain open for a minimum of 60 days after the decision of this Court becomes final. See secs. 6213(a), 6503(a).
30. Although these alternative contentions were not pleaded in the Commissioner's answer, they were addressed at trial without objection by Mr. Bailey and were therefore tried by consent. We therefore treat them as pleaded and do not require the Commissioner to file a motion to amend his answer, which motion we would grant.
31. The IRS determined that the $5.9 million was income in 1994 when Mr. Bailey received the stock and allowed subsequent deductions for his reimbursement of sale proceeds and his return of the unsold stock. Since Mr. Bailey fully reimbursed and repaid those amounts, the Commissioner acknowledges that his income in 1994 is fully offset by deductions in later years; but under the Commissioner's approach Mr. Bailey still may be liable for interest, additions to tax, and penalties for tax year 1994.
32. Because the IRS treated the receipt of the $5.9 million of stock as income, it allowed, in subsequent years, deductions for the return of the stock and the reimbursement of the sale proceeds. To the extent we hold that Mr. Bailey did not realize income from the Biochem Pharma stock, the corresponding deductions are not allowable and the adjustments therefor in the notice of deficiency must be reversed. However, under section 1341 Mr. Bailey may deduct his repayment of amounts of Biochem Pharma stock sale proceeds that we conclude were income to Mr. Bailey.
33. Mr. Bailey did not actually spend any of the sale proceeds on personal expenditures until 1995, but we hold that he nonetheless realized the income when he appropriated the funds by transferring them to an account on which he acknowledged no restrictions.
34. Under section 7482(b)(1)(A), an appeal from a decision in these cases would be made to the Court of Appeals for the First Circuit.
35. The Court asked U.S. Attorney Thomas Kirwin, "How many of your criminal defense attorneys end up taking on responsibilities of the sort that Mr. Bailey took on?" Mr. Kirwin answered, "in my experience, almost none. But, this case is different than many of our cases." Mr. Kirwin acknowledged that he has never heard of any other case in which a criminal defense attorney agreed with the Government to manage assets, to postpone for years any payment of his fees, and to risk complete nonpayment of fees if the assets' value declined.
36. See Bailey II, 40 Fed. Cl. 449 (denying motion to dismiss for lack of jurisdiction); Bailey II, 46 Fed. Cl. 187 (denying motion to dismiss for lack of jurisdiction and for failure to state a claim).
37. In our prior order dated April 29, 2009, denying the parties' cross-motions for summary judgment, we overstated the significance of the Biochem Pharma stock as collateral, suggesting that "here `the borrower's legal obligation to repay' was overwhelmed by the fact that the lender held highly marketable collateral— collateral that did not belong to the borrower—which would satisfy the unpaid loan." In so saying we implied a standard not acknowledged in Webb or James and contradicted in Kreimer. The existence of collateral (to protect the lender), whether rightly obtained or wrongly obtained, does not undermine the borrower's obligation.
38. Mr. Bailey also seems to invoke the takings clause of the Fifth Amendment ("nor shall private property be taken for public use, without just compensation") when he asserts, "There is no question but what the government `took'" the Broder payments. However, when the Government takes a person's property not "for public use" but rather to pay the person's private debt, that is not a Fifth Amendment "taking". See Skillo v. United States, 68 Fed. Cl. 734, 743 (2005) ("`This Court and other courts have routinely held that the lawful exercise of the Government's collection powers does not amount to a prohibited Fifth Amendment "taking".'") (quoting Kerrigan v. United States, 1997 WL 685275, at *5 (Fed. Cl. Apr. 30, 1997)). Moreover, this Court has not been granted jurisdiction to adjudicate a Fifth Amendment "taking" claim. Rather, such claims must be litigated in the Court of Federal Claims (under 28 U.S.C. sec. 1491(a)(1) (2006)) or in Federal District Court (under 28 U.S.C. sec. 1346(a)(2) (2006)).
39. Specifically, Mr. Bailey alleges that in Bailey I he was wrongly denied the ownership of the Biochem Pharma stock; that he was denied compensation for his labor in repatriating Duboc's assets; that by misrepresentations the Department of Justice induced the Federal District Court to demand immediate return of the Biochem Pharma stock in 1996; that the Federal District judge refused to hear some of his arguments and evidence and refused to recuse himself though he ought to have been a witness; that Mr. Bailey was unjustly jailed until he could come up with $2.3 million; that the appellate court "missed or avoided the central argument"; and that the Department of Justice held up the renomination of the Court of Federal Claims judge who was handling Bailey II, thereby prompting an adverse outcome that denied him the appreciation on the Biochem Pharma stock.
40. In Bailey I, decisions of the District Court for the Northern District of Florida had to be appealed to the U.S. Court of Appeals for the Fifth Circuit, 28 U.S.C. secs. 1291, 1294(1), and decisions of the Court of Appeals for the Fifth Circuit had to be appealed to the U.S. Supreme Court, 28 U.S.C. sec. 1254. In Bailey II, decisions of the Court of Federal Claims had to be appealed to the U.S. Court of Appeals for the Federal Circuit. 28 U.S.C. sec. 1295(a)(3).
41. Mr. Bailey also alleges that the Department of Justice violated due process by engineering his disbarment. Of course, the Tax Court does not have (and Mr. Bailey does not suggest that we have) jurisdiction to review his disbarment proceedings or the power to reinstate his license to practice law. And even if we could determine that he had been unjustly disbarred, we could not remedy that wrong by excusing him from tax liability on income that we find he did receive.
42. The regulations provide that "all the facts and circumstances" must be taken into account to determine the activity or activities of the taxpayer. 26 C.F.R. sec. 1.183-1(d)(1), Income Tax Regs. On the basis of all the facts and circumstances, we find that Mr. Bailey conducted the airplane rental activity, yacht rental activity, and airplane remanufacturing activity as (three) separate activities for purposes of section 183. See Keanini v. Commissioner, 94 T.C. 41, 46 (1990). Mr. Bailey conducted the three activities as separate activities for accounting purposes. He also hired a different set of employees to manage and carry out each activity.
43. Mr. Bailey contends that he is entitled to deduct "yacht-based expenses" from 1993 until PBR sold the Spellbound in 1998. We find that the yacht rental activity was not engaged in for profit. See pt. V.C. below. In addition, we find that the record provides even less support for Mr. Bailey's contention that his attempts to sell the Spellbound during the 1996 through 1998 tax years constitute an activity that was engaged in for profit. Accordingly, we hold that Mr. Bailey lacked the requisite profit motive for the yacht rental and sale activities during all of the tax years at issue.
44. See Helmick v. Commissioner, T.C. Memo. 2009-220, slip op. at 27-28 (after "a catastrophic loss that could never be recouped," a taxpayer who "thereafter expected to generate an overall prospective profit * * * could not be said to lack a profit objective after the disaster merely because he would never recoup the prior loss").
45. Mr. Bailey testified that he deducted only 90 percent of the expenses of the Spellbound, because he operated under the assumption that 10 percent of the total use of the Spellbound was personal. However, in his reply brief, Mr. Bailey requests this Court to find that 20 percent of the total use of the Spellbound was personal.
46. The Commissioner concedes that PBR incurred in connection with Project 288 research expenditures of $30,635 in 1994 and $21,774 in 1995 that would be currently deductible if the activity was entered into for profit.
47. "A taxpayer is not carrying on a trade or business under section 162(a) until the business is functioning as a going concern and performing the activities for which it was organized." Glotov v. Commissioner, T.C. Memo. 2007-147. Until that time, expenses related to that activity are not "ordinary and necessary" expenses currently deductible under section 162 (nor are they deductible under section 212) but rather are "start-up" or "pre-opening" expenses. Hardy v. Commissioner, 93 T.C. 684, 687-688 (1989).
48. One can even say "that `start-up' or `pre-opening' expenses are capital in nature, given that they spring from the taxpayer's efforts to create or acquire a capital asset." Sorrell v. Commissioner, 882 F.2d 484, 488 (11th Cir. 1989) (emphasis added), rev'g T.C. Memo. 1987-351.
49. Section 6662(a) and (b)(2) also imposes the accuracy-related penalty where the taxpayer's return reflects a "substantial understatement of income tax". An understatement is substantial if it exceeds the greater of: (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000. Sec. 6662(d)(1)(A). After the parties have recomputed the deficiencies pursuant to Rule 155, we will be able to tell whether Mr. Bailey's returns, in addition to reflecting negligence, also reflected substantial understatements of income tax.