Memorandum Findings of Fact and Opinion
Respondent determined deficiencies in Federal individual income tax and additions to tax under sections 6651
Additions to Tax ------------------------------------------------------------------------- Sec. Sec. Sec. Sec. Sec. Sec. Year Deficiency 6651 6651(a)(1) 6653(a)(2) 6653(a)(1)(A) 6653(a)(1)(B) 6654 1983 ......... $24,500 $6,125 $1,225
1-- -- $1,499 1984 ......... 30,590 7,648 1,530 1-- -- 1,924 1985 ......... 30,394 7,599 1,520 1-- -- 1,741 1986 ......... 29,566 7,392 -- -- $1,478 11,430 1987 ......... 100,545 25,136 -- -- 5,027 15,430 150 percent of the interest due on the entire deficiency for each year.
Findings of Fact
Some of the facts have been stipulated; the stipulation and the stipulated exhibits are incorporated herein by this reference.
When the petition was filed in the instant case, petitioner resided in Claremore, Oklahoma.
During the years in issue, petitioner resided in the State of Washington. On August 1, 1973, Auvil Investments, Ltd., a Washington partnership (hereinafter sometimes referred to as Auvil-I), was formed. (Auvil was petitioner's parents' surname.) Petitioner was the general partner and also was one of the three limited partners in Auvil-I. In October 1973, Auvil-I bought a 32-unit apartment complex (hereinafter sometimes referred to as the Apartment Complex) in Federal Way, Washington, from Edward L. Crosby and Marilyn D. Crosby (hereinafter sometimes referred to as the Crosbys).
In April 1976, Auvil-I redeemed the interests of the limited partners, other than petitioner, for cash and deferred payments (monthly payments on interest-bearing notes due April 1, 1996). After the limited partners' interests were redeemed, Auvil-I filed a cancellation of its certificate of limited partnership. However, Auvil-I was not to be terminated until the redeemed limited partners were fully paid. Petitioner continued to operate the Apartment Complex under the name of Auvil-I, albeit without partners. The income and expenses of the Apartment Complex were reported on Schedule E of petitioner's individual income tax returns for 1977 through 1980.
On March 31, 1982, petitioner formed the Nancy Lee Trenerry Trust (hereinafter sometimes referred to as the Trenerry Trust), a revocable trust, of which she was both the grantor and the only trustee.
Also on March 31, 1982, Auvil-I's partnership agreement was amended to form Auvil Investments, Ltd., a Washington limited partnership (hereinafter sometimes referred to as Auvil-II). Petitioner was the general partner and also was one of the three limited partners of Auvil-II. Susan and Joan were the other two limited partners. Susan and Joan each agreed to contribute $13,500 to Auvil-II. Petitioner contributed to Auvil-II the Apartment Complex, which was valued at $273,000, after mortgages and encumbrances.
On August 25, 1982, petitioner, Susan, and Joan amended the Auvil-II partnership agreement to provide that any partner could freely assign her partnership interest to the trustee of a trust created for that partner's benefit. On September 16, 1982, petitioner transferred her general and limited partnership interests in Auvil-II to the Trenerry Trust, but (according to the transfer instrument) petitioner remained general manager of Auvil-II.
On May 17, 1984, Zaran Sayre and Shirley Sayre (hereinafter sometimes referred to as the Sayres) agreed to buy, and Auvil-II agreed to sell, the Apartment Complex for $750,000. Shortly thereafter, Susan (on July 20, 1984) and Joan (on July 25, 1984) assigned and transferred their Auvil-II limited partnership interests to petitioner, as trustee of the Trenerry Trust. On July 25, 1984, Auvil-II filed a Cancellation of Certificate of Limited Partnership Agreement, resulting in Auvil-II's dissolution. Nevertheless, petitioner continued to sign documents as general partner of Auvil-II after that date.
On July 31, 1984, Auvil-II sold the Apartment Complex to the Sayres who, in turn, executed a $750,000 promissory note with wraparound provisions (hereinafter sometimes referred to as the Note) to Auvil-II. On the same day, Auvil-II conveyed the Apartment Complex
On August 15, 1984, petitioner, as grantor, changed the name of the Trenerry Trust to the Jennville Trust. This change in name was made "in memory of the Trustor's parents, Fay Glover Jennings Auvil and Jesse Hubert Auvil." Although the amending document revised various provisions of the trust agreement, Susan and Joan (whose name at that time was Joan Trenerry Crews) continued to hold remainder interests, and also to be possible successor trustees. The last paragraph of the amending document provides as follows:
On September 5, 1984, petitioner, as general partner of Auvil-II, assigned the Note to the Jennville Trust. In the assigning document, the Jennville Trust is consistently referred to (in five places) as "Jennville Charitable Trust", a term that does not appear in the August 15, 1984, amending document. The assignment of the Note was accepted for the Jennville Trust by petitioner and Joan as trustees, but the record does not indicate when Joan became a trustee. The assigning document states that the Note had a then-remaining principal balance of $748,347.21, and that the Sayres acknowledge that they are thereafter to make payments to the Jennville Trust. The assigning document provides that the Jennville Trust is thereafter to make payments on the obligation to the Crosbys, and states that the unpaid principal of this obligation had been reduced to $90,149.51 by September 5, 1984.
Petitioner had control of all income received on the Note until March 12, 1986, and was liable for all income tax associated with this income.
2. Creation of Liberty Holding Co.
Nassau Life Insurance Co., Ltd. (hereinafter sometimes referred to as Nassau Life), was incorporated on January 25, 1978.
On March 12, 1986, Liberty Holding Co. (hereinafter sometimes referred to as Liberty), a common law contractual business trust, was created by a contract (hereinafter sometimes referred to as the Contract) in Grand Turk, Turks and Caicos Islands, British West Indies. The parties to the Contract were Walter R. Simons (hereinafter sometimes referred to as Simons), "the CREATOR", and Cynthia A. Francis (hereinafter sometimes referred to as Francis), "the EXCHANGOR". Under the Contract, Simons appointed Nassau Life as trustee, to "control and administer all assets of the Company [Liberty] to the best of its ability for the Certificate Holders." The Contract was signed by Simons, by Francis, and, on behalf of Nassau Life, by Veronica D. Williams.
Also on March 12, 1986, pursuant to paragraph 6 of the Contract, a certificate for 100 Capital Units (hereinafter sometimes referred to as Units) of Liberty was issued to Francis in exchange for $100; on that same day Francis transferred 99 Units back to Liberty. One Unit was retained by Francis.
Also on March 12, 1986, Nassau Life appointed petitioner and Joan as Liberty's president (agent) and secretary (agent), respectively.
Also on March 12, 1986, a certificate for 74 Units was issued to petitioner and was described in Liberty's minutes as being in exchange for $100 "and other items of value as listed on Schedules A and B hereof." The minutes were signed by Eldon Samuel Anderson, as Nassau Life's executive vice president, and by petitioner and Joan. The record does not show the above-referenced Schedules A and B. The remaining 25 Units of Liberty were never issued.
3. Petitioner's Later Transactions with Liberty
On March 21, 1986, the Jennville Trust assigned the Note to Liberty. Petitioner and Joan signed this assigning document as the Jennville Trust's trustees. (Again, the Jennville Trust is consistently referred to in this assigning document as "Jennville Charitable Trust".) Petitioner and Joan also signed this assigning document as Liberty's president (agent) and secretary (agent), respectively. No one else signed this assigning document on behalf of the Jennville Trust or Liberty. This assigning document states that the Note had a then-remaining principal balance of $745,476.44, and that Liberty is thereafter to make payments on the obligation to the Crosbys. The Note was the
Also on March 21, 1986, the Trenerry Trust borrowed $31,740 from Liberty, pledging as collateral security real property in Texas. The deed of trust, signed by petitioner as trustee for the Trenerry Trust,
4. Replacement of Nassau Life as Trustee
On January 1, 1987, Nassau Life tendered its resignation as Liberty's trustee, to take effect January 31, 1987; and Nassau Life appointed petitioner and Joan as successor, or contingent, trustees of Liberty.
On February 1, 1987, petitioner and Joan, as Liberty's contingent trustees, appointed Century Trust Co. Ltd. (hereinafter sometimes referred to as Century Trust), as trustee for Liberty. On the same day, petitioner and Joan resigned as Liberty's contingent trustees. Century Trust, which had been incorporated under the laws of the Turks and Caicos Islands on April 24, 1986, accepted its appointment, accepted petitioner's and Joan's resignations as contingent trustees, and appointed petitioner and Susan as Liberty's president (agent) and secretary (agent), respectively.
5. Steward Co.
Steward Co. (hereinafter sometimes referred to as Steward) was a company similar to Liberty. Century Trust, Liberty's trustee, was also Steward's trustee. On February 1, 1987, petitioner exchanged her 74 Units of Liberty for 100 units of Steward. Petitioner is the only unit-holder of Steward.
6. Petitioner as President of Liberty
Petitioner acted as president (agent) of Liberty from its inception. As president (agent) of Liberty, petitioner's duties included signing checks; executing real estate deeds; endorsing, buying, selling, signing or otherwise transferring securities, stocks, bonds, notes, or money fund accounts; and signing any other required legal documents. Petitioner set up, maintained, and was signatory for Liberty's U.S. bank accounts. As president (agent) of Liberty, petitioner received and deposited into Liberty bank accounts the payments made by the Sayres on the Note. Petitioner continued to conduct Liberty's affairs throughout 1987 even though she no longer held Units of Liberty. Petitioner signed the checks (dated April 1, 1987, and August 12, 1987) drawn on Liberty's bank accounts to pay the real estate taxes for the Apartment Complex.
7. Sale of the Note
On December 16, 1987, Centrum Financial Services, Inc. (hereinafter sometimes referred to as Centrum), offered to buy the Note from Liberty for $400,000. Under the terms of the offer, Centrum would pay $400,000 cash to the holder of the Note on closing, which was to take place no later than December 31, 1987. Petitioner, as president (agent) of Liberty, accepted Centrum's offer. On December 24, 1987, Centrum sent a letter to the Sayres asking them to verify the balance owed on the Note. The letter, signed "Sent without signature to avoid delay", states as follows:
On December 28, 1987, Liberty assigned to Centrum the Note and the Deed of Trust. The only signatures on this assigning document were those of petitioner and Susan, as Liberty's president (agent) and secretary (agent), respectively.
Also on December 28, 1987, petitioner and Susan, as Liberty's president (agent) and secretary (agent), respectively, notified the Sayres of the assignment and directed the Sayres to make future payments to Centrum. As Liberty's president (agent), petitioner was entitled to compensation by Liberty for her services, but the only payment "of significance" that petitioner remembers is for per diem and expenses on account of her trip to the coast in connection with the sale of the Note.
Apart from the interest and capital gain on the Note, which are in dispute, the parties have agreed to dispose of the 1986 and 1987 notice of deficiency determinations as shown in table 1.
Table 1 Notice of Deficiency Parties' Item Adjustment Agreement 1986 Interest $19,904 $19,904 Annuity 10,596 10,596 Personal exemption (1,080) (1,080) Net rental income -0- (3,188) Itemized deductions -0- (7,003) Capital gains and losses -0- (3,000) 1987 Interest 746 746 Annuity 10,716 10,716 Personal exemption (1,900) (1,900) Itemized deductions (2,540) (7,616) Capital gains and losses -0-
1 1Petitioner has a capital loss carryover available in the amount of $17,526. The amount of this carryover that may be allowable for 1987 depends on our resolution of the dispute on the 1987 sale of the Note.
As grantor and trustee, petitioner did not file fiduciary income tax returns for the Trenerry Trust or the Jennville Trust. As both general and limited partner, petitioner did not file partnership tax returns for Auvil-I or Auvil-II. Petitioner did not file individual income tax returns for any of the years in issue.
Liberty and Steward are shams, the separate existence of which may be disregarded for income tax purposes. The interest income and capital gain on account of the Note, purportedly received by Liberty, are properly attributable to petitioner.
Respondent contends that the interest income (1986 and 1987) and capital gain (1987) from the Note are taxable to petitioner under three alternate theories as follows: (1) Petitioner was the owner of Liberty under the grantor trust rules of sections 671 through 677, (2) petitioner was the owner of Liberty under the foreign grantor trust rules of section 679, or (3) Liberty was a sham entity that should be disregarded for Federal income tax purposes.
Petitioner contends that the income from the Note is not taxable to her because: (1) She relinquished ownership of the Note to Liberty on March 12, 1986, (2) Liberty was a valid, legal entity which acquired legal and equitable title to the Note, and (3) the income derived from the Note is attributable to Liberty. Petitioner contends that her actions were as agent of Liberty and that they do not cause Liberty's income to be attributable to her.
We agree with respondent that the disputed income is taxable to petitioner because Liberty was a sham entity that is to be disregarded for tax purposes.
Respondent's notice of deficiency determinations as to matters of fact are presumed to be correct. Petitioner has the burden of proving that the interest income and capital gain are not taxable to her.
We must decide whether the interest income and capital gain generated by the Note are attributable to Liberty or to petitioner. We shall treat respondent's third argument first because if Liberty is a sham, then it is unnecessary to consider the other arguments. If Liberty is a sham to be disregarded for income tax purposes, then income tax liability will be determined as though Liberty had never been created.
We conclude that, under Zmuda, Liberty's separate existence will be disregarded for tax purposes. This conclusion is based on the combined effect of the following elements:
(a) Petitioner testified that she entered into the arrangement with Liberty and Nassau Life in order to relieve herself of responsibility for the management and control of the Note. When petitioner was reminded about the parties' stipulation as to her role for Liberty, the following colloquy occurred:
The record does not show that Liberty, Nassau Life, or Century Trust did or decided anything with regard to the Note, other than what petitioner did or decided. The Note was held in trust by Liberty through late 1987, until it was sold to Centrum. Thus, we conclude that petitioner's "response" to respondents' last question was carefully designed to be a misleading nonresponse.
(b) In form, Liberty sold the Note to Centrum and received about $400,000 in cash. When respondent asked petitioner what happened to the cash, petitioner stated that she did not know, that "you need to go to the trustee of Liberty", i.e., Century Trust. Century Trust also was Steward's trustee. Petitioner also denied knowing whether anyone other than she owned units in Steward. Later, petitioner and the Court engaged in the following colloquy:
We do not believe that petitioner really took so cavalier an attitude to the $400,000. We do not believe that she constructed all this gingerbread, took so active a role as Liberty's president (agent), took the trouble to change Liberty's trustee, specified a desire to have the Note sold before the end of 1987, took a trip to the coast in connection with the sale of the Note (the only expense for which she was reimbursed), and then walled herself off from control over, and even knowledge of, what happened to the cash.
(c) The following colloquy took place as to petitioner's income tax returns for 1986 and 1987:
We are convinced that petitioner answered questions as a witness only to the extent she believed it was necessary to do so in order to avoid appearing absurd. We believe she misjudged the extent that was necessary.
(6) Based on an analysis of the additions to tax, adjustments to income, and petitioner's testimony (see supra (5)(c)), we conclude that petitioner failed to file individual tax returns for each of the years in issue (1983-1987). By conceding the additions to tax under section 6651(a) for each of the years in issue, petitioner has conceded that she did not file timely individual tax returns. The nature of the adjustments to income to which the parties have agreed, see supra table 1, makes it clear that the adjustments are not modifications of amounts that petitioner had reported. In addition to her failure to file individual income tax returns, petitioner testified that no income tax returns had ever been filed for the Trenerry Trust or the Jennville Trust.
From the foregoing, we conclude (1) that there was no nontax purpose for the creations of Liberty and Steward, and for the arrangements made with Nassau Life and Century Trust, (2) that no nontax functions were served by those creations and arrangements, and (3) that petitioner's purpose in so creating and so arranging was to use paper and distance in order to reduce the likelihood that respondent would realize that income subject to tax was not being reported. In accordance with Zmuda v. Commissioner [Dec. 39,468], 79 T.C. 714 (1982), affd. [84-1 USTC ¶ 9442] 731 F.2d 1417 (9th Cir. 1984), and the numerous opinions relying thereon, we conclude that Liberty's separate existence is to be disregarded for tax purposes
Petitioner relies on two legal opinion letters of Joe Alfred Izen, Jr. (hereinafter sometimes referred to as Izen)
We hold for respondent. Our holding on the sham entities issue makes moot respondent's alternative grantor trust contentions.
To take account of the parties' agreements on other issues,
Decision will be entered under Rule 155.
SEC. 61. GROSS INCOME DEFINED.
(a) General Definition. — Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
* * *
(3) Gains derived from dealings in property;