Opinion
15925-21
06-26-2024
Gale Stead, Petitioner, v. Commissioner of Internal Revenue, Respondent
ORDER
Mark V. Holmes, Judge.
Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is
ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the of the trial of the above case before Judge Mark V. Holmes at Saint Paul, Minnesota on May 22, 2024, containing his oral findings of fact and opinion rendered after the conclusion of trial.
In accordance with the oral findings of fact and opinion, a decision for Rule 155 will be entered.
Bench Opinion by Judge Mark V. Holmes
May 22, 2024
Gale Stead v. Commissioner of Internal Revenue
Docket No. 15925-21
THE COURT: In the case of Gale Stead v. Commissioner, docket number 15925-21, the Court has decided to render oral findings of fact and opinion. And the following is the Court's oral findings of fact and opinion.This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code, 1986, as amended, and Rule 152 of the Tax Court's Rules of Practice and Procedure.
Mr. Stead was and remains a resident of Minnesota.
BACKGROUND
In 2018, Dr. Stead was in his 53rd year as an optometrist here in Minneapolis. In his prime, he had a local chain of optometry and vision care stores, but with the increase of competition from the internet and increasing difficulty in seeking reimbursement from insurance companies and other third-party payers, by 2018, he was down to a single store in a mall.
To keep the business afloat, he would draw down on a life insurance policy that he had.
In 2018, he began taking money out of the business for him and his wife, who also worked there only sporadically. I find him to be an honorable man, and I believe his testimony that when the cash flow became difficult, he paid his other employees first, rent second, and then only then he and his wife.
He was also - nobody contests this - timely with his paying over of withholding taxes for his employees and himself. He tried to keep payments from his business regular so that they looked like wages paid to his employees. But by the middle of 2018, these payments had become sporadic and the cash flow of the business apparently became quite difficult and challenging to deal with.
He did regularly write checks and withheld the appropriate amounts, as if they were regular paychecks, for both himself and his wife. Nobody contests that they paid over to the Federal and State governments in a timely fashion the amounts that would be owed if these checks had been signed and cashed. But in many cases, he held onto these checks. And in almost all cases, didn't sign them. And they simply weren't deducted from his corporate bank account at the time in 2018.
Now, the business that he had was a C corporation, and he appears to have deducted the amounts even for the checks that were not cashed. This probably didn't make a difference to the corporation. Its records show that by that time, he had no taxable income. It also had an NOL carryforward from previous years that had accumulated.
Interestingly enough, none of this was in the Notice of Deficiency. The IRS and Dr. Stead settled all the issues that were in the Notice of Deficiency. Which means that what I'm left to decide is whether Dr. Stead overstated is and his wife's income on their joint return, to the extent that they declared income that they never actually received from their own corporation.
DISCUSSION
This is a bit of a puzzle. Let me start with the Code. Section 451(a) states, "The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer". Is income that is not actually received by a taxpayer his income? That's an ambiguous term.
Let's go to the regulation. 26 CFR section 1.451-1 (a) states that "Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received”. Well, what does constructive receipt mean? We turn to 26 CFR section 1.451-2 (a) which states, "Income, although not actually reduced to a taxpayer's possession, is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions."
Well, that's not really helpful here. We know that Dr. Stead and his wife didn't actually receive the income, so we have to ask whether it was constructively received. And that means we have to look at whether there were substantial limitations for restrictions upon their enjoyment of this income represented by checks that they didn't sign.
I want to make two observations here. One is that is money paid to owners of the corporation set aside for them or credited to their account just because they own the corporation and can do with its assets pretty much as they please? The answer is ambiguous. The second is what does it mean for a taxpayer to control receipt but to be subject to substantial limitations or restrictions? These are not defined in the Internal Revenue Code or the regulations, and we have to go to the case law here.
It is certainly true, as the Government pointed out, that the general rule is that income represented in the form of a check is income as soon as it's delivered. See Kahler v. Commissioner, 18 T.C. 31, 34 (1952), where we ourselves said in Tax Court, "we fail to see where there should be any difference in result just because it might be impossible to cash a check in the year in which it was drawn, where delivery actually was placed in such year.” So the general rule is, it's income in the year in which a check is delivered. But this is a general rule, not a universal rule.
And an even older case called Fischer v. Commissioner, 14 T.C. 792, we were faced with the issue of some similarity to this one where a check was received but the payor of the check had some cashfijflow problems. In Fischer, we found as a matter of fact, "When the client delivered the check to Fischer, he stated that he was short of money at the time and as a matter of accommodation would appreciate it if Fischer would hold the check for a few days. Fisher agreed to hold the check. The client had in the bank account against which the check was drawn a balance of approximately $17,000 on December 31st, 1942. Other checks had been drawn against that account in the amount of approximately $80,000, which were held for release when funds became available.
"When he received the check, Fischer placed it in his desk. Several weeks later, he was asked by the client whether or not the check had been deposited. When he was told by Fischer that it had not, the client stated that it could be deposited at any time. Fischer deposited the check on February 10th, 1943, and it was paid by the bank on which it was drawn." With these facts, we concluded, "The obvious fact is that the check was not income to Fischer in 1942. He could not use the money that year. What he did receive was in 1942 still subject to a very substantial restriction, arising from his agreement that he would not deposit the check until after the first of the year in 1943. Income is not realized until the taxpayer has the funds under his dominion and control, free from any substantial restriction as to the use thereof. This principle of our tax law is now too familiar to require citation." No citation. But of course, in Fischer, the payor of the check was an unrelated third party. The rules can be a bit different on the relationship between corporation and its owners. Consider, for instance, the case of Hooper v. Commissioner. In Hooper, a corporation leased property from its owner. The corporation in Hooper paid rent to the Hoopers at the rate of $3,000 per month. In a board meeting held in June 1989, the directors of the corporation decided that no rental payments would be made for three months in the summer of 1989.
The corporation, in fact, paid no rent to the Hoopers for three months in the summer of 1989. The corporation at the time did have sufficient funds in its account to make the payments.
We concluded in Hooper that the Hoopers had both the right to receive the rental income from the corporation for the period in question, and the power to do so. Furthermore, the corporation had sufficient funds to pay rent for the corporation.
The Hoopers had not presented any evidence suggesting that the use of the rental property by their corporation changed during those months, or that the rental value of the property had declined. Thus, despite petitioner's decision not to be paid rent for those three months, we held that they were entitled to this income and continued to have the right to receive such income until they contributed the property to their corporation.
Thus, the funds for the rental income were unqualifiably available to petitioners and they had to include this rent that they did not actually pay to themselves in their taxable income because they were entitled to it and they had the power at any time to pay it to themselves.
And there's the case of Haack v. Commissioner. In Haack, the taxpayers had a corporation, and the board of directors authorized a bonus to be paid to Mr. Haack. The bonus was authorized to be payable on December 31st, but was not in fact paid to Mr. Haack until the next tax year. We found as a matter of fact that, "The corporation approved each bonus on its books and deducted each bonus as a business expense in the same year in which the bonuses were authorized. The corporation was liable for the payment of all bonuses on December 31st of the year in which the bonuses were authorized. At the time the bonuses were authorized, the corporation had sufficient cash on hand to pay them. Although no written employment agreement existed between petitioner and the corporation, petitioner was authorized to sign all corporate checks on any bank account maintained by the corporation", 41 T.C.M. 708, 709 (1981).
We concluded that the doctrine of constructive receipt applied to this situation to require the inclusion of the bonuses in Mr. Haack's taxable income in the year in which the bonus was authorized. The reason was "petitioner has acknowledged that the corporation was liable for the bonuses upon their authorization.
Moreover, petitioner could sign the checks himself without any additional countersignature or other corporate action. At the dates of the authorizations, the corporation had sufficient funds to pay the bonuses". Id., 41 T.C.M. at 710.
But then we have the case of Kahn v. Commissioner, 1981 U.S. Dist. LEXIS 10858 (Western District of North Carolina 1981). And this case also involved bonuses authorized by a corporation to its owners. In this case, the bonuses were authorized, again, at the end of each calendar year but not actually paid until the beginning of the next calendar year. The court in that case also faced the question of whether the bonuses in this situation were constructively received in the year in which they were authorized or in the year in which they were actually received by the corporation's owner.
Again, as in the Haack case, the bonuses were deducted by the corporation in the year in which they were authorized, not the year in which they were paid. That court concluded that the Government's argument that Mr. Kahn had unrestricted control of the bonuses' amounts because all he had to do was draw a check for the amount was not borne out by the record.
In that case, in the Kahn case, salaries authorized by a corporation to be paid by its officers and credited on its books are unqualifiably set apart from the account of such officer would constitute payment by the corporation and constructive receipt by the officer. But mere authorization of the amount of salary or compensation to be drawn by an officer of the corporation does not constitute payment or constructive receipt even though the officer may at all times have the power to effect the payment of such salary or compensation in virtue of his control of the corporation.
The reason that the Kahn court came out differently from the Haack court is that there's nothing in the record to show that the taxpayer ever exercised his legal authority as majority stockholder, president, and director, to obtain any payment from the corporation contrary to the policy of its being paid in the year after it was authorized.
These cases are a little bit hard to all put together to come up with a result, but here's the lesson that I draw from them. I begin with the proposition that there's no requirement for a C corporation to pay wages to its shareholder or owner. There are exceptions, of course, to recharacterizations of dividends as compensation if they're excessive, of loans as compensation if they don't have the characteristics of loans to third parties, excess accumulated income and the like, but those are merely concerns for successful corporations with monies that their owners want to give out.
What we have here with Dr. Stead's corporation is one that has fallen on hard times. In the case of a corporation looking at hard times, I look to see if there's an obligation by the corporation to the owner. For instance, as in Hooper, rent under a lease previously agreed to, a declared dividend recorded on the corporation's books, or perhaps a binding employment contract. I find that there were none of those here. Maybe the Steads wanted to take regular compensation from their business, but they didn't want to do so when the corporation's business was imperiled by poor cash flow, so they didn't pay themselves regularly in 2018. You normally don't get taxed on phantom income that isn't paid.
One test I can think of to align these cases and make them cohere is whether an owner has constructively received income from a corporation depends on what would happen if a third party came into possession of the rights of that corporation's owner. Take, for instance, a trustee in bankruptcy, or somebody who inherits the rights of an owner by debt, or because of a levy on the owner's assets by a judgment creditor.
This helps reconcile the cases that I've just described. The third party could enforce the rental agreement in Hooper; the corporation owed periodic rent. A third party could enforce a dividend payment once declared if that third party came into possession of a stock. And I think here, that the third party could cash one of the signed checks that the Steads had in their possession but did not in fact deposit. And here, I assume that it is - and I find that it's more likely than not the Steads' corporation was ailing, but not, at the time that signed checks were written, insolvent. But I'm equally sure that a third party could not just take a bunch of blank checks and sign them for whatever amounts they wanted.
So my conclusion is that I need to reduce the amount of the Steads' income by the net of the uncashed, unsigned checks, but continue to include in their income the difference in the gross net pay reflected on those checks that was paid over to the Government with all the other employee withholding and include in their income the signed checks that they chose not to cash.
Specifically, I will exclude the amounts represented by checks 90215, 90205, 90195, 90235, 90225, 90255, 90245, 90223, 90264, 90310, 90331, 90362, 90155, and 90236. I know that this decision is not entirely in the Steads' favor. Portions of their pay were withheld and were presumably paid over for their benefit to the IRS long ago, with albeit other withholding from their employees. Thus, a calculation under Rule 155 will be necessary.
This concludes the Court's oral findings of fact and opinion in this case. (Whereupon, at 10:30 a.m., the above-entitled matter was concluded.)