constructive dividend

Transfer of home to closely held shareholders was constructive dividend; penalties imposed
RVJ Cezar Corporation et al, TC Memo 2010 –173
A new Tax Court decision illustrates the need for closely held corporations to be wary of constructive dividends when dealing with their owners. A closely held construction company's transfer of a home to its shareholders resulted in dividend/capital gain income to them, and taxable gain to the corporation. What's more, both the shareholders and the corporation were held liable for accuracy related penalties.
Background. A dividend is a distribution of property from a corporation to its shareholders out of the corporation's earnings and profits. ( Code Sec. 316(a) ) The amount of the distribution equals the fair market value of the distributed property on the distribution date. ( Code Sec. 301(b)(1) , Code Sec. 301(b)(3) ) For dividends received before 2011, qualified dividend income is taxed at the same rates as long-term capital gain. ( Code Sec. 1(h)(11) ) After 2010, unless Congress changes the rules, dividend income will be taxed as ordinary income. The amount of a distribution that exceeds earnings and profits, and is therefore not a dividend, is taxable capital gain to the recipient. ( Code Sec. 301(c)(3) ) Under long-established case law, dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation confers a benefit on a shareholder by distributing available earnings and profits without expectation of repayment.
A corporation that distributes appreciated property to a shareholder recognizes gain as if the property were sold to the shareholder at its fair market value. ( Code Sec. 311(b)(1) ) Gain is recognized to the extent that the property's fair market value exceeds the corporation's adjusted basis in the property.
Taxpayers are liable for an accuracy-related penalty for any portion of an underpayment of income tax attributable to negligence or disregard of rules and regulations, unless they establish that there was reasonable cause for the underpayment and that they acted in good faith. ( Code Sec. 6662(a) , Code Sec. 6662(b)(1) , Code Sec. 6664(c)(1) ) Under Code Sec. 6662(b) , an accuracy related applies for a substantial understatement of income tax, i.e., the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $10,000.
Facts. Mr and Mrs. Cezar were the sole shareholders of RVJ Cezar Corporation, which built “spec” houses that it sold to the public. They paid $500 for their stock. Mr. Cezar, a general contractor, was the sole employee of the corporation. In 2001, Cezar Corp paid $150,000 for a lot, financing part of the purchase price with a mortgage, and spent $502,000 building an amenity-rich home approximately twice the size of its usual spec homes. Cezar Corp was listed as the sole owner of the spec home on the blueprints, permit, and notice of completion. Some of the construction materials were paid with a credit card issued in both Mr. Cezar's name and Cezar Corp, and the Cezars were unable to document most of the labor costs of building the home.
The home was finished in 2004 and was offered for sale, but there were no takers. That year, Cezar Corp transferred the lot and improvements to the Cezars by quitclaim deed; they assumed the outstanding mortgage of $57,227. At the time of the transfer the lot and improvements had a total fair market value of $920,000. The transfer of ownership report filed with the Assessor's Office did not indicate that the property interest transferred to the Cezars was a partial interest. The Cezars did not report the receipt of the lot or the improvements on their return for 2004, nor did the corporation report the distribution of the lot and the improvements on its return for 2004.
On audit, IRS determined that the distribution of the lot and the improvements was a constructive dividend from the corporation. It determined that the Cezars received a qualified dividend up to the amount of the corporation's earnings and profits, and treated the balance of the distribution, less their $500 initial capital contribution, as long-term capital gain. IRS also determined that both the Cezars and their corporation were liable for the accuracy related penalty.
Tax Court sides with IRS. The Cezars conceded that they received the lot as a constructive dividend from the corporation. However, they argued that the improvements were not a constructive dividend because they owned the improvements by having paid for the construction materials and having done all the work to construct the improvements. The Tax Court agreed with IRS's assessment that improvements are built on land that one owns or else there would be an agreement identifying the rights and responsibilities of the parties. The Cezars failed to show that there was an agreement between them and the corporation that would have allowed them to construct a home on the corporation's property. Their ownership argument also was directly contradicted by Mr. Cezar's statements during the audit that the lot and the improvements were both corporate assets. Moreover, there was no credible evidence to support the Cezars' claim that they owned the improvements by paying the construction costs and personally completing the labor. The only records the Cezars produced to establish that they paid the construction costs were insufficient. Furthermore, the corporation was the sole owner of the lot as well as the improvements from the start of construction until the distribution to the Cezars. The corporation received property tax bills for both the lot and the improvements and did not protest that it had been billed for improvements that it did not own. The Tax Court also find it compelling that the corporation, which was in the business of building and selling homes, offered the lot and the improvements for sale without obtaining any transfer of interest from the Cezars. No prospective buyer would buy only the improvements and not the lot or vice versa. The Tax Court also noted that no other spec home that the corporation sold before or since was owned by the Cezars individually. Rather, all the homes and lots were owned and offered for sale by the corporation.
As a result, the Tax Court found that the Cezars didn't establish that they owned the improvements, and sustained IRS's determination that the Cezars must include the distribution of the lot and the improvements in gross income as a constructive dividend from the corporation. The Tax Court also found that treatment of the home as a constructive dividend to the Cezars caused the corporation to recognize taxable income to the extent that the fair market value of the lot and improvement exceeded its adjusted basis.
The Tax Court also hit the Cezars with an accuracy related penalty for the underpayment of income tax attributable to negligence or disregard of rules and regulations. It also hit Cezar Corp with an accuracy related penalty for substantial understatement of its income tax.

reasonable cause case

Wayne Robert Risley and Nanette Risley v. Commissioner., U.S. Tax Court, T.C. Summary Opinion 2009-172, (Nov. 23, 2009)
Docket No. 10857-05S. Filed November 23, 2009.
A married couple who participated in a fraudulent tax shelter was not entitled to the claimed business expense deductions or disabled access credits for any of the tax years at issue. The IRS was not equitably estopped from assessing deficiencies against them. The couple failed to prove that the IRS made any representations to them regarding the tax shelter. In fact, the IRS had no contact with the couple before the returns claiming the dubious expenses and credits were filed. Since the couple invested in the tax shelter separate and apart from any advice from the IRS, equitable estoppel did not apply. In addition, the promoter’s statements regarding the validity of the tax shelter were not imputed to the IRS even though the promoter advertised that it employed enrolled agents and former IRS employees. The IRS was not estopped from challenging the tax shelter merely because an enrolled agent or former IRS employee was affiliated with it. Moreover, the couple was not entitled to deduct their investment in the tax shelter as a theft loss under Code Sec. 165 because they failed to establish that they discovered the "theft" during any of the tax years at issue. Finally, the accuracy-related penalty for negligence was imposed because the couple failed to show that they had reasonable cause or acted in good-faith. The couple could not rely on the tax shelter’s alleged preparation of their returns to show reasonable reliance of a tax professional. Not only did the couple prepare their own returns for two of the tax years at issue, but the tax shelter informed the couple that it was not providing them with legal or tax advice. Moreover, any reliance on the tax shelter promoter would be per se unreasonable.
PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b), THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.
Robert L. Risley, for petitioners; Kevin W. Coy and Kelly R. Morrison-Lee, for respondent.
LARO, Judge: Petitioners petitioned the Court to redetermine respondent's determination of deficiencies in and accuracy-related penalties related to their joint 2001, 2002, and 2003 Federal income tax returns (2001 return, 2002 return, and 2003 return, respectively; collectively, subject returns). Petitioners filed their petition pursuant to the provisions of section 7463. 1
This case is now before the Court on respondent's motion for summary judgment. We hold that respondent is entitled to summary judgment and shall enter a decision accordingly. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.
Background
I. Preliminaries
Petitioners are husband and wife. They resided in California when their petition was filed. They filed the subject returns jointly.
II. Tax Shelter
Petitioners participated in a fraudulent tax shelter (tax shelter) promoted and sold by the National Audit Defense Network (NADN). The NADN advertised itself as a conglomerate of former Internal Revenue Service agents, enrolled agents, certified public accountants, and tax attorneys who could help U.S. taxpayers pay no Federal income tax. The NADN informed petitioners that they could qualify for significant tax benefits by forming a Web site and then paying the NADN to modify the Website to comply with the Americans with Disabilities Act of 1990 (ADA), Pub. L. 101-336, sec. 302(a), 104 Stat. 355, codified at 42 U.S.C. sec. 12182(a) (2006). The ADA generally provides that any person who owns, leases, or operates a place of public accommodation shall not discriminate against disabled individuals in the full and equal enjoyment of goods, services, facilities, privileges, advantages, and accommodations of the place of public accommodation.
The NADN informed petitioners that they had to pay the NADN $2,495 and issue to the NADN a $7,980 promissory note as to each year in which they wanted to participate in the tax shelter. Payments on a note were to be made from the revenue generated by the Web site or, if no revenue was generated, 8 years after the note's making. The NADN informed petitioners that they could claim a $5,000 tax credit pursuant to section 44 and deduct at least $5,475 of business expenses pursuant to section 162 for each year that they participated in the tax shelter. The NADN advised petitioners that it was not providing them (nor was it engaged in the rendering of) any legal, accounting, or other professional service and that they should retain a “competent professional” if they wanted any legal advice or other expert assistance with respect to the tax shelter.
Petitioners paid the NADN $2,495 in each subject year to participate in the tax shelter. Petitioners also signed at least one $7,980 promissory note payable to the NADN or to an affiliate thereof.
III. Subject Returns
A. 2001 Return
Petitioners prepared their 2001 return themselves. Petitioners attached a 2001 Schedule C, Profit or Loss From Business (Sole Proprietorship), to their 2001 return reporting that petitioner Wayne R. Risley (Mr. Risley) operated an “Electronic Shipping and Information Service” business during 2001. The only item of income or expense reported on the 2001 Schedule C was a $5,475 expense identified as “Excess expenditures for modifications made for disabled access to business”. Petitioners also attached a 2001 Form 8826, Disabled Access Credit, to their 2001 return. The 2001 Form 8826 reported that petitioners paid $10,475 in total eligible access expenditures during 2001 and were claiming a $5,000 disabled access credit for 2001. Petitioners claimed the $5,000 credit on their 2001 return.
B. 2002 Return
Petitioners prepared their 2002 return themselves. Petitioners attached a 2002 Schedule C to their 2002 return reporting that Mr. Risley operated an “Apple Electronic Shopping & Information” business during 2002. The only item of income or expense reported on the 2002 Schedule C was a $5,475 expense identified as “Excess expenditures for modifications made for [sic]”. Petitioners also attached a 2002 Form 8826 to their 2002 return. The 2002 Form 8826 reported that petitioners paid $10,475 in total eligible access expenditures during 2002, that petitioners had a current year disabled access credit of $5,000, and that petitioners were claiming $611 of the $5,000 as an allowable disabled access credit for 2002. Petitioners claimed the $611 credit on their 2002 return.
C. 2003 Return
Petitioners' 2003 return was prepared by H&R Block. Petitioners' 2003 return did not report any income or deductions as to the tax shelter. Petitioners attached a 2003 Form 8826 to their 2003 return. The 2003 Form 8826 reported that petitioners paid $5,000 in total eligible access expenditures during 2003 and that petitioners were claiming a $2,375 disabled access credit for 2003. Petitioners claimed the $2,375 credit on their 2003 return.
IV. Notice of Deficiency
Respondent issued petitioners a notice of deficiency as to the subject returns. Respondent determined in the notice of deficiency that petitioners were not entitled to any of the deductions or credits claimed as to the tax shelter. For the respective years, respondent determined deficiencies of $6,513, $2,776, and $2,712. 2 Respondent also determined accuracy-related penalties under section 6662(a) and (b) of $1,303, $555, and $542, respectively, for negligence or disregard of rules and regulations.
Discussion
I. Standard for Summary Judgment
Summary judgment may be granted with respect to any part of the legal issues in controversy if the record before the Court shows no genuine issue as to any material fact and that a decision may be rendered as a matter of law. See Rule 121(a) and (b); Craig v. Commissioner, 119 T.C. 252, 259-260 (2002). Respondent bears the burden of proving the absence of any genuine issue of material fact, and all facts are viewed in the light most favorable to petitioners. See Craig v. Commissioner, supra at 260. Petitioners, however, must do more than merely allege or deny facts; they must set forth “specific facts showing that there is a genuine issue for trial.” See Rule 121(d); Celotex Corp. v. Catrett, 477 U.S. 317, 324 (1986). Petitioners have failed to raise any genuine issue of material fact under that standard, and this case is ripe for summary judgment.
II. Deficiencies
Petitioners make no claim that sections 44 and 162 actually allow them to deduct or credit the items that they reported as to the tax shelter. Cf. Good v. Commissioner, T.C. Memo. 2008-245 (holding on the merits that the taxpayers were not entitled to the section 162 expenses and disabled business credits reported as to the tax shelter). Petitioners' primary argument in challenging respondent's determination of the deficiencies is that respondent is equitably estopped from assessing against them any amount relating to the tax shelter. We disagree. Equitable estoppel is a judicial doctrine that precludes a party from denying his or her acts or representations which induced another to act to his or her detriment. See Hofstetter v. Commissioner, 98 T.C. 695, 700 (1992). The following requirements must be satisfied where, as here, equitable estoppel is asserted against the Commissioner: (1) A false representation by the Commissioner or his wrongful, misleading silence; (2) an error in a statement of fact and not in an opinion or statement of law; (3) ignorance of the true facts; (4) a taxpayer's reasonable reliance on the Commissioner's acts or statements; and (5) adverse effects of the Commissioner's acts or statement. See Norfolk S. Corp. v. Commissioner, 104 T.C. 13, 59-60 (1995), affd. 140 F.3d 240 (4th Cir. 1998). Petitioners' failure to establish any one of these five requirements means that their claim of equitable estopped must fail as well.
Petitioners have failed to establish on the part of respondent either a false representation or a wrongful, misleading silence as to the tax shelter. 3 To that end, we are unable to find as to the tax shelter that respondent made any representation (let alone any misrepresentation) to petitioners or otherwise wrongfully concealed from petitioners any material fact. Instead, the record establishes (and we so find) that respondent had no contact with petitioners as to the tax shelter before his audit of the subject returns and that petitioners invested in the tax shelter separate and apart from any action taken by respondent.
Petitioners argue that the statements of the the NADN's workforce are imputed to respondent to the extent that those workers were registered with the Internal Revenue Service as enrolled agents or tax preparers. Petitioners also argue that the tax shelter is imputed to respondent because the NADN advertised that it employed those workers as well as former Internal Revenue Service employees. We disagree on both counts. The record does not establish, nor do petitioners claim, that any of the NADN's workers also were working for the Internal Revenue Service at the same time. Moreover, the mere fact that a former employee of the Internal Revenue Service, or an individual registered with the Internal Revenue Service as an enrolled agent or a tax preparer, may have been affiliated with the NADN (and/or the tax shelter) does not estop respondent from challenging the legitimacy of the tax shelter. See Auto. Club of Mich. v. Commissioner, 353 U.S. 180, 183-184 (1957) (holding that the Commissioner is usually not estopped from correcting retroactively a mistake of law); see also Martin's Auto Trimming, Inc. v. Riddell, 283 F.2d 503, 506 (9th Cir. 1960); Schwalbach v. Commissioner, 111 T.C. 215, 228 n.4 (1998); Fortugno v. Commissioner, 41 T.C. 316, 323-324 (1963), affd. 353 F.2d 429 (3d Cir. 1965). Nor do we believe, as petitioners argued, that respondent was sufficiently aware of the impropriety of the tax shelter through petitioners' filing of their 2001 return so that he is estopped from challenging any of the amounts that petitioners later claimed as to the tax shelters for 2002 and 2003.
Petitioners also argue that the Government should bear the loss of any Federal income taxes owed by them as to the tax shelter because respondent failed to inform petitioners that the tax shelter was a “fraud” and is in a better position than they to recover the $7,485 that they paid to the NADN. We disagree. While petitioners consider it inequitable that they have to pay taxes as to the tax shelter when they have paid $7,485 to the NADN for what they now consider to be a worthless investment, we know of no reason the Government should act as an insurer of that investment. Nor do we agree with petitioners that they are entitled for the subject years to deduct the $7,485 as a theft loss under section 165. While section 165 lets an individual deduct a theft loss in the year during which the individual discovers the loss, see sec. 165(a), (c)(3), (e), the record does not establish that petitioners discovered any such theft loss during the subject years.
We hold that respondent is not estopped from disallowing the claimed amounts. Accordingly, we sustain respondent's determination of the deficiencies.
III. Accuracy-Related Penalties
Respondent determined that petitioners are liable for accuracy-related penalties under section 6662(a) and (b)(1). Section 6662(a) and (b)(1) imposes a penalty equal to 20 percent of the portion of an underpayment of tax attributable to a taxpayer's negligence or disregard of rules or regulations. Negligence connotes a lack of due care or failure to do what a reasonable and prudent person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348 (9th Cir. 1991). An accuracy-related penalty is not applicable to any portion of an underpayment to the extent that the taxpayer had reasonable cause for that portion and acted in good faith with respect thereto. See sec. 6664(c)(1).
Respondent bears the burden of production with respect to the applicability of the accuracy-related penalties. See sec. 7491(c). That burden requires that respondent produce sufficient evidence that it is appropriate to impose the accuracy-related penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once respondent meets this burden, the burden of proof falls upon petitioners. See id. at 447. Petitioners may carry their burden by proving that they were not negligent; i.e., that they made a reasonable attempt to comply with the provisions of the Internal Revenue Code and were not careless, reckless, or in intentional disregard of rules or regulations. See sec. 6662(c). Alternatively, petitioners may establish that their underpayment was attributable to reasonable cause and their acting in good faith. See sec. 6664(c)(1).
We conclude that respondent has met his burden of production and that petitioners have failed to carry their burden of proof. The record establishes that petitioners claimed significant amounts of tax benefits to which they neither were entitled nor had a reasonable claim. The record does not establish that petitioners made a reasonable attempt to comply with the provisions of the Internal Revenue Code, that petitioners' underpayment was attributable to reasonable cause, or that petitioners acted in good faith as to the underpayment. Petitioners claim that the subject returns were prepared and reviewed by the NADN and that they reasonably relied on the NADN to prepare those returns correctly. We reject that claim as factually and legally incorrect. As a point of fact, petitioners prepared their 2001 and 2002 returns themselves; H&R Block prepared their 2003 return; and the NADN informed petitioners that it was not providing them with any legal or other professional service and that they should retain a competent professional if they wanted any legal advice or other expert assistance with respect to the tax shelter. As a point of law, any such claimed reliance upon the NADN (if it in fact had occurred) would not be reasonable in the setting of this case given that the NADN was the tax shelter's promoter. See Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), affd. 299 F.3d 221 (3d Cir. 2002).
We hold that petitioners are liable for the accuracy-related penalties respondent determined. Accordingly, we sustain respondent's determination as to those penalties.
IV. Conclusion
We have considered all of petitioners' contentions and have concluded that those contentions not discussed herein are without merit. To reflect the foregoing,
An appropriate order and decision will be entered for respondent.

Footnotes


1
Section references are to the applicable versions of the Internal Revenue Code. Rule references are to the Tax Court Rules of Practice and Procedure.
2
These deficiencies total $11,664, and petitioners' cash expenditures as to the tax shelter total $7,485 ($2,495 × 3). Petitioners reportedly realized an economic gain of $4,179 from the tax shelter ($11,664—$7,485 = $4,179).
3
Given this failure, we need not and do not address any of the other four requirements of equitable estoppel.