MEMORANDUM OF FINDINGS OF FACT AND CONCLUSIONS OF LAW SUPPORTING FINAL JUDGMENT DENYING PLAINTIFF'S OBJECTIONS TO THE ALLOWANCE OF DEFENDANT'S CLAIMS
DENNIS J. STEWART, Chief Judge.
The plaintiff trustee in bankruptcy objects to the allowance of the various claims of the Internal Revenue Service against the above referenced bankruptcy estates. The processing of the objections in extensive pretrial and the trial of them by the bankruptcy court was characterized by a troubled procedural history. It was the intention of the court, an intention which was attempted to be effected by appropriate pretrial orders, that the extensive documentation which was certain to be adduced in support of the objections be made the subject of summaries within the contemplation of Rule 1006 of the Federal Rules of Evidence. It is the announced purpose of that rule, and it was the purpose of this court in invoking the rule, to simplify the evidence before the court and to reduce the volumes of evidence which the court must review before handing down its findings of fact and conclusions of law. "Rule 1006 is based on the common-law rule that a party may prove the contents of voluminous writings which cannot be examined in court without causing inconvenience and waste of time by presenting evidence of their contents in the form of . . . written . . . summaries . . ." 5 Weinstein's Evidence para. 1006(01), pp. 1006-2, 1006-3 (1983). "The admission of summaries of voluminous books, records, or documents offers the only practicable means of making their contents available to judge and jury." Id., p. 1006-2 (Emphasis added.). The method of summarization utilized in this action has delayed trial and decision, rather than promoted it. If summarization had been properly attempted and carried out, the action could have proceeded to trial on a set of summaries whereby the contents of the voluminous documents were refined and placed in juxtaposition to the principal legal decisions which would control the allowance or disallowance of the claims. If that optimum method of summarization had been followed — and the evidence which has been adduced fails to show any reason why it could not have been — then the court could have determined the amounts of each claim which were to be allowed simply by reference to the summary which related to each legal problem.
Further, under the circumstances of this case, it would have seemed advisable for the parties, in briefing the issue of sufficiency of the evidence and that of burden of proof, to summarize the evidence to which they were referring, rather than simply citing the authorities in a virtual vacuum as to their applications. This certainly would have foreshortened the process in which the court has had to involve itself since the conclusion of the trial of the issues in this proceeding. With little hope of making findings of fact which would be at once complete and yet restricted to the material issues, the court has taken it upon itself to wade through the virtual cascade of evidence which the parties insisted on adducing in addition to the summaries. Yet, the entire purpose of the presentation of summaries under Rule 1006 is frustrated when the underlying documents, as well
Not to follow the rules which have been fixed by the Congress and the court system is to invite the result which has come to pass in this proceeding. Congeries of evidence were placed before the court and it became the office of the court to sift through the voluminous evidence before it to see if, perchance, any of the items involved gave rise to legal propositions briefed by the parties — or, more importantly, which of the legal propositions and principles advanced by the parties was applicable to the particular item of evidence. Needless to say, the process has consumed a considerable portion of the court's time since the conclusion of the trial several months ago. The parties may be dissatisfied with the delay which has ensued, but the court can only say that the manner in which the case was presented to it more than justifies the delay.
Burden of Proof and Sufficiency of the Evidence offered in Support of the Trustee's Objections to the claims
The trustee, in support of his several objections to the claims of the Internal Revenue Service, has offered a considerable body of evidence in the form of the testimony of David R. Kane, a debtor and also a principal or "insider" in the other cases, which seeks according to its tenor to supplement certain documents and thereby qualify them to be treated as deductions under the Internal Revenue Code. In the same category, generally speaking, falls the evidence submitted through the testimony of the accountant who reviewed the corporate records for the trustee and who seeks to embellish certain of the entries in those records in order to qualify for deductions under the Internal Revenue Code.
In the further treatment of this subject below, the court will make more precise findings respecting the credibility and probative value of this testimony. At the outset, however, it seems to be the position of the trustee that the court is foreclosed from making any finding as to the credibility of this evidence; that the evidence adduced constitutes "some evidence" in support of the objection to the claim; that "some evidence" is all that is necessary to rebut the prima facie evidentiary effect of the proofs of claim; that it then devolves upon the claimant Internal Revenue Service to prove its claim by a preponderance of evidence; and that the testimonial evidence above adverted to is uncontradicted. As the trustee states in his "reply brief" filed December 1, 1986:
Little doubt inheres in the proposition that "the allegations of a proof of claim are taken as true. If those allegations set forth all the necessary facts to establish a claim and are not self-contradictory, they prima facie establish the claim." 3 Collier on Bankruptcy para. 502.02, pp. 502-21, 502-22 (15th ed. 1987). It is also true that:
Id., p. 502-22. (Emphasis added.) In determining whether the evidence adduced by a trustee in support of an objection is "equal to the allegations of the proofs of claims themselves," within the meaning of the foregoing passage, it must be observed that the proofs of claims themselves must be based upon credible evidence. See, e.g., 3 Collier on Bankruptcy para. 57.18(6), p. 300 (14th ed. 1977), to the following effect:
If the proof of claim itself is to be scrutinized with an eye to credibility, so must the evidence which is adduced by the trustee in support of the objection to allowance of a proof of claim. The "some evidence" which is adduced to support the objection must, in view of these fundamental principles, be credible evidence.
With these principles in mind, the court has attempted to assay the evidence which is before it for the purpose of determining (1) the credibility of the oral testimony and (2) whether that testimony, if not credible, was necessary to establish the deduction from the Internal Revenue Service's claims which is sought by the trustee. In undertaking this review over a period of several months and at the hearing itself, this court has concluded that neither the testimony of David R. Kane nor that of the principal accountant presented in support of the trustee's contentions was credible. The court bases its conclusions not only on the basis of the appearance and demeanor of the respective witnesses, but also upon the fact that Mr. Kane had an obvious interest in the outcome of the litigation and his testimony was frequently conclusionary in character and based upon events far in the past, and sometimes his testimony respecting the purpose or recipient of the payment represented by the check or other document contradicted the letter of that document.
The same principles apply with nearly equal force to the testimony of the accountant, a witness who had historically held a position of assisting the debtor organizations
The declination of the court to accredit the testimony of Mr. Kane and that of the trustee's accountant necessitates the denial of the trustee's contentions in all respects, except such as may have been voluntarily agreed to by the Internal Revenue Service. Otherwise, even the uncontradicted testimony of the accountant is not sufficient to sustain the trustee's objections. "The uncontradicted testimony of an expert witness is not conclusive and may be rejected by the trial judge if he finds it to be unconvincing." Petro-Chem Marketing v. United States, 602 F.2d 959, 961, 221 Ct.Cl. 211 (1979). And, in respect of all other contentions, they must, for the reasons stated below, find their evidentiary basis either in the testimony of Mr. Kane or that of the accountant.
(a) Brokerage fee income
The trustee, under this heading, complains that he has acquiesced in certain increases in brokerage fee income with respect to several of the debtor corporations in the years 1977, 1978, 1979, and 1980. He presents the testimony of the accountant to the effect that, as he contends in his posttrial brief, "portions of this income were actually reported in later years." If this were so, it would follow that deductions ought to be allowed for income twice reported. It is readily observable, however, that the accountant has testified to the reporting of wholly different amounts
The transcript of the hearing evidences the accuracy of the government's contention in this regard.
(b) Uncollected brokerage fee income as bad debts
The trustee next asserts that he should have the right to deduct uncollected brokerage fee income as bad debts when the Internal Revenue Service has previously required that all brokerage fees be reported as income at the time they are earned — regardless of whether they are then collected. The trustee contends that "(n)o taxpayer should be required to pay taxes on income that it can never collect. That is especially true in this case where there are deserving creditors who have had to wait patiently in line while the blatantly
Income Reported under the Rule of 78's
Prior to the hearing held in this proceeding, the Internal Revenue Service disallowed some $70,501 in interest deductions because those interest deductions were calculated under the Rule of 78's, which the Service disallowed, under certain circumstances, in Revenue Ruling 83-84. The trustee agreed to the disallowances. But he now points out that the necessary concomitant of use of the Rule of 78's method of interest calculation was that, not only was more interest reported on income tax returns in the early years of a loan term, the corporation would also report more income than normal in those years. The trustee contends that a total of $799,270 in "artificial" income was reported by debtor entities in the years 1978, 1979, 1980, and 1981. But there is really no evidence to establish that, as a fact, as much artificial income was reported beyond the suppositions of the accountant who was produced to testify on the subject.
"Management Fee Income"
The Internal Revenue Service, with respect to some of the debtor entities, for the years 1978, 1979, and 1980, assessed a total of $141,524 as partnership income
The trustee, seizing upon the proviso above emphasized, contends that the value given must be regarded as a share in partnership profits and therefore not as income to the partner receiving the value. In the absence of evidence supporting this position, the trustee asks the court to accept this contention as exiomatic because the "corporation's capital ownership percentage is exactly equal to the percentage of capital which it had actually contributed."
Internal Revenue Service "Errors"
Again, on the basis of his accountant's uncontradicted testimony, the
But it is the duty of the court, even though the testimony was uncontradicted, to determine whether that testimony is sufficient to establish the proposition contended for. This court concludes that the testimony is not sufficient to establish an error in any of the particulars contended by the trustee. As in the above instances, the testimony of the accountant was only derivative and secondary. It was primarily based upon suppositions as to what was done when the tax returns and the documents underlying them were prepared, not what was actually done.
Accordingly, this court declines to honor the trustee's contention in this regard.
Bad Debt and Commission and Sales Expense
The trustee next contends that certain payments made by and between the debtor entities were loans instead of capital contributions, as they have been characterized by the Internal Revenue Service. The evidentiary support for the contention that the payments of monies were intended as loans rather than capital contributions is the testimony of David R. Kane. As found above, it is neither sufficiently credible nor sufficiently detailed to support the deduction. Without Mr. Kane's testimony, there is no evidence to establish the intention that the payments were intended as loans rather than capital contributions
In this category, the trustee contends that a second category of payment constitutes a lawful deduction under the provisions of section 162, Title 26, United States Code. That is a series of payments to salesmen and commission employees
The debtor entities also seek a deduction for interest expense in the sum of $1,639,210.36 allegedly paid on various note repayments. There can be little question that interest payments are deductible. See section 163(a) of the Internal Revenue Code. But, in making the determination, the courts must insist on minimal evidence that the amounts paid were, in reality, interest. In this action, the only evidence which identified the payments sought to be deducted as actual interest payments was the self-serving testimony of David R. Kane, a sample of which is set out in the marginal note.
It appears to be the position of the trustee that the court must — or may — infer from the fact that the Internal Revenue Service has granted some interest deductions that those which are now asserted are equally meritorious. "In the Amended Answer," the trustee states in his "post trial memorandum of law," "the IRS accepted $950.410 of the interest deductions. Acceptance of such a large figure highlights the fact that the IRS adjustment was arbitrary and without justification." This court believes the consideration to be irrelevant, particularly in the absence of reliable evidence as to the amounts which are now sought to be deducted. The court has no doubt that some interest deductions were proper, but it cannot make a reasonable judgment as to the amount on such speculative evidence as is adduced in this case.
It can hardly be said, for the same reasons, that the position of the Internal Revenue Service has been arbitrary. The Internal Revenue Service, in fact, has acceded to more of the interest deduction during the course of these proceedings.
This court accordingly denies the trustee's claim of deductions in this regard.
Additional deductions are sought with respect to professional fees allegedly rendered for the benefit of the debtor entities. Again, the evidence of deductibility is sparse. As the trustee states in his posttrial brief, "(t)he deductions for professional fees are based upon checks which have been written to non-related third parties." But it is not established that these were ordinary and necessary expenses incurred in carrying on its trade or business. See E.I. duPont de Nemours and Company v. United States, 432 F.2d 1052, 1059 (3d Cir.1970) ("(T)he burden was on the taxpayer
Travel and Entertainment
Again, the sparse evidence before the court is simply the checks purporting to have been written for legitimate travel and entertainment expenses, none of which contains a memorandum or any notation made of the purpose of the expenditure. Rather, the brief and conclusionary testimony of the witness David R. Kane are relied upon to establish the nature of the expenditures evidenced by the checks. The checks do not, as the trustee suggests, show on their face that the expenditures were for deductible travel and entertainment. It was incumbent upon the proponent of the objection to demonstrate by documentation and credible testimony the legitimate business purpose of the deductions. He had "the burden of proving the validity of his Section 162 deductions for . . . travel expenses." Coussement v. C.I.R., 391 F.2d 227, 229 (6th Cir.1968). This he attempted to do through the checks, supplemented only by the very brief testimony of Mr. Kane, which, for the foregoing reasons, was neither sufficient nor credible. The court accordingly denies the trustee's claims for deductions in this regard.
Adjustments to tax liabilities of real estate partnerships
The trustee next attacks the action taken by the Internal Revenue Service in disallowing all deductions claimed by certain "real estate partnerships" related to the debtors on the grounds that the organizations were sham organizations having no substance. The action taken by the Internal Revenue Service was based on Tax Court determinations that at least some of the organizations were without organizational substance.
See also Weimerskirch v. C.I.R., 596 F.2d 358, 360 (9th Cir.1979), to the effect that the Internal Revenue Service cannot lawfully rely upon `a "naked" assessment without any foundation whatsoever.'"
But, in this case, the action of the Internal Revenue Service is reasonably explained. It is clearly contended that the organizations were not genuine for the same reasons as are stated in the Tax Court adjudications. It was clear to the trustee, therefore, what evidence he would have to produce in order to rebut the presumption of correctness of the Internal Revenue Service's claim or adjustment — it was necessary to produce, in accordance with the general principles stated at the beginning of this memorandum, some credible evidence of the genuineness of the organizations. Having failed to produce such evidence, the trustee must be held to have failed to carry his burden of rebutting the presumption in favor of the claimant's action.
Campbell Management Corporation's net operating loss
The trustee contends in his posttrial briefs that "Campbell Management Corp. had certain net operating losses from years prior to its consolidation with the Debtors. That NOL can be carried forward 15 years to offset against other income. Internal Revenue Code section 172." Again, however, the problem has been that of adducing such evidence as will bring about an entitlement to the deduction. In its posttrial brief, the Government has accurately analyzed the situation with respect to this issue as follows:
This court therefore accordingly denies the trustee's assertion in this regard.
Scranton Coal Partnership
The same is true of the trustee's allegations that the Internal Revenue Service is taxing "phantom" income in making its assessments against that entity. The Government has adduced evidence to support its position.
The manner in which the evidence has been presented in this case and in which
Among the uncertainties now faced by the court is the question of whether the Internal Revenue Service is still resisting all of the trustee's assertions that certain "mistakes" were made by the Internal Revenue Service. The trustee, in his initial posttrial brief, asserted four such "mistakes." As has been observed above, on page 12 of this memorandum, the Internal Revenue Service opposed one of these allegations of "mistake" and this court has held in its favor in that instance.
The Internal Revenue Service does not, however, appear to oppose the following additional assertions of "mistake":
Nevertheless, this court cannot find from its review of the record before it that the Internal Revenue Service has conceded those issues. Therefore, the court proposes to rule on the merits of these issues insofar as the record before it will permit. The assertions of error appear to have been made much like the other assertions of deduction — on the basis of suppositions made by the officers of the estate in viewing the records in retrospect. The trustee did not produce the preparer of the returns to demonstrate that the adjustments constituted the same amounts as were reported and taxed in other years. Nor was there evidence of any error in the other respects mentioned. The court, therefore, denies these assertions of the trustee.
Another matter respecting which the parties' positions appear to be uncertain is that of the claimed deduction for "abandoned project expense." The court cannot find that the trustee has briefed this issue in his posttrial briefs. The Government opposes allowance of the deduction on the familiar ground of absence of sufficient evidence. This court agrees with the Government's position. The only evidence which connected the checks, which were written to a variety of persons, with any abandoned projects or with the trade and business of the debtor entities is the unreliable testimony of Mr. Kane, which this court has elected not to believe. It is simply too fertile a field for the practice of fraud for the court to find in accordance with naked and conclusionary testimony that certain expenditures, which on their face had nothing to do with the projects, really were connected expenditures. Further, to find that they were expenditures which were connected with the ordinary trade or business of the debtor entities is another step removed, a further inference which the court cannot in good conscience make.
And so, as it seems to the court, for failure to abide the pretrial orders and instructions of the court, the trustee has been unable to meet the burden of proving his entitlement to the deductions. It seems unlikely in retrospect that, had the evidence been summarized as suggested by the court, under the headings of the relevant and controlling legal propositions, there could have been the failure of proof on this wide and catastrophic of a scale. For, then, the trustee would have had to match his proof against the letter of the statutes and the case decisions thereunder. Such proof as was required, if it existed,
As an example of what has happened in this action, the presentation of the evidence on travel and entertainment expenses might be mentioned. Such evidence as was presented seems to have been presented in total obliviousness of the rather strict types of proof required by the governing case law and the rules of the Internal Revenue Service. See, e.g., Hughes v. C.I.R., 451 F.2d 975, 976, 977 (2nd Cir.1971), to the following effect:
Yet, the trustee, in his posttrial brief, contended that certain checks, on their face, should be sufficient to establish entitlement to the deductions. See page 15 of the "post trial memorandum of law" filed October 16, 1986, to the effect that, "(f)rom the face of the check summaries themselves, these items should properly be deductible." No authority was cited for that proposition. Later, in the reply brief filed by the trustee in December of 1986, the trustee stated that "the Court may lessen the degree of exactitude required for substantiation if the circumstances so warrant. Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2nd Cir.1930)." But a brief attention to the later decisions would have revealed that this is no longer good law. "Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2d Cir.1930), first enunciated the rule that if a taxpayer could prove that he had incurred travel or entertainment expense of an inexact amount, the Revenue Service must make `as close an approximation as it can' of the amount spent, since `to allow nothing at all appears . . . inconsistent with saying that something was spent.' 39 F.2d at 544. The Cohan doctrine gave rise to such extensive expense account abuses that Congress in the Revenue Act of 1962 expressly rejected it, holding taxpayers to considerably more rigid requirements vis-a-vis the proof of substantiation of business entertainment and related expenses." Hughes v. C.I.R., supra, at 976. See also Berkley Mach. Works & Foundry Co. v. C.I.R., 623 F.2d 898, 902 (4th Cir.1980) ("The substantiation requirements of section 274(d) were intended to abolish the Cohan rule and require the taxpayer to prove the exact amount and circumstances of the deduction; otherwise it would be disallowed entirely.") Thus, it seems that only a sciolistic attention to the cases which govern the submission of proof would have saved a great measure of time and effort.
Entity Year Amount DFSI 1977 $ 45,716 DFS America 1977 267,427 Realty Consultants 1980 89,250 STC 1978 377,359 STC 1979 53,686 STC 1980 91,680 ________ Total $925,118
The amounts now sought to be excluded from income are as follows:
Entity Year Amount STC 1977 $ 13,390 STC 1978 81,046 STC 1979 60,645 35,767 STC 1980 39,850 49,991 23,772 STM 1981 7,240 22,313 31,535 10,157 35,518 STM 1982 3,757 32,131 10,192 19,772 ________ Total $477,676