OPINION
This case comes before the Court on the defendant’s Motion for Summary Judgment
Factual Background
This case involves the plaintiffs claims for income tax refunds for the 1992, 1993, and 1994 tax years. On March 10,1983, Messrs. Dale Carter, Jess Claiborne, and Dennis Porter, Jr., formed plaintiff Seminole Thrift-way, Inc. (“Thriftway”). Each shareholder contributed $10,000 and loans of $50,000 to Thriftway’s capital. Thriftway issued to each shareholder a third of its authorized 1,000 shares of common stock.
Thriftway owns and operates a supermarket in Seminole, Texas. Soon after incorporation, Thriftway required more capital in order to purchase the necessary land and to pay for the construction and stocking of the store. Thriftway sought out several forms of financing other than taking more capital from its shareholders. On July 6, 1983, Thriftway obtained $1 million in financing from Seminole’s Industrial Corporation Industrial Revenue Bonds (Seminole Thriftway, Inc. Project) Series 1983 (“Bonds”). The Bonds had a 15-year term and were due to mature on July 15, 1998. The Bonds had an annual interest rate equal to the lesser of 80 percent of RepublieBank Dallas’ “prime interest rate,” or 15 percent.
However, Thriftway needed additional third-party help on this financing arrangement because the holders of the Bonds would not have accepted the Bonds without some additional guarantees for their investment. Therefore, as part of the arrangement, Thriftway and the three controlling shareholders executed a guaranty agreement whereby the three shareholders absolutely and unconditionally guaranteed the punctual payment of principal and interest due on the Bonds. The guaranty was irrevocable until all the holders of the Bonds were paid in full with funds not subject to recission or repayment. Although both the plaintiff and the defendant agree that the shareholders guaranteed the Bonds in order to finance the project, to save interest and other costs, and to enhance the marketability of the Bonds, the plaintiff adds that “it was * * * mandatory for them to guarantee the bonds to obtain financing * * (Pl.’s Statement of Genuine Issues at 1110.)
Prior to Thriftway’s decision to pay its shareholders for acting as guarantors, the makeup of the shareholders changed. First, on November 1, 1985, Thriftway hired Mr. John Kildow as general manager of the Seminole store. At this time, each of the three shareholders transferred 70 shares of Thrift-way common stock to Mr. Kildow. Thus, Mr. Kildow owned 210 shares and each controlling shareholder owned 263 and % shares. Second, on October 28, 1987, Mr. Dennis Porter, Jr., transferred all of his shares to his wife, Mrs. Cynthia Porter, because he was a bank director and thought a transfer would more prudently protect their mutual assets.
Three days later, on November 1, 1987, Messrs. Porter, Carter, and Claiborne were elected to serve as Thriftway’s directors for a one-year term. Then, just before the new year, Thriftway, by action of its directors, authorized payments of guarantor fees of 8 percent of the total outstanding indebtedness
During the 1992, 1993, and 1994 tax years, Thriftway did not pay out either dividends to its shareholders or director’s fees. It deducted $70,231 for guarantor fees for 1992, $35,866 for guarantor fees for 1993, and $29,-199 for guarantor fees for 1994. In addition, the record reflects that despite Thriftway’s reporting of a net operating loss for 1992 related to its losing investment in Stamford Thriftway, Inc., Thriftway was profitable for each of these tax years. The Internal Revenue Service (“IRS”) disallowed the deductions, and Thriftway paid the resulting tax liability on September 16,1996. At the same time, the plaintiff also filed a claim with the IRS for a refund for each of the deduction amounts. The IRS disallowed the claims on November 20, 1996. Thereafter, on February 25,1997, Thriftway filed its current Complaint with this Court seeking a tax refund.
Discussion
The Court will grant summary judgment when there are no genuine issues of material fact, and the moving party is entitled to judgment as a matter of law. RCFC 56(c); see also Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247-49,
In a tax refund case, the Commissioner of Internal Revenue’s ruling carries a presumption of correctness. See United States v. Janis,
A. The Ordinary and Necessary Standard Under Section 162(a)
1. Defining the hard-headed businessman test
It is plain that “a taxpayer seeking a deduction must be able to point to an applicable statute and show that he comes within its terms.” New Colonial Ice Co. v. Helvering,
A business expense is ordinary if the expense relates to a transaction “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont,
An item is necessary if appropriate and helpful in the development and maintenance of a taxpayer’s business. See Welch v. Helvering,
This standard has its limits and impracticalities. Judicial deference is given to business practices, not to tax avoidance schemes. Also, the value of the hard-headed businessman standard decreases with the existence of special relationships that can occur between contracting parties, as in the case of a close corporation. See Tulia I,
2. The guarantor fee cases
In Tulia I, a cattle feed cooperative provided feed for cattle owned by its customers. The cooperative required large amounts of credit in order to keep its pens full when regular customers generated insufficient business. See id. at 803. From 1964 to 1970, the principal shareholders would guarantee loans to the corporation in proportion to their stock holdings without receiving compensation. In 1970, the cooperative began paying fees to the guarantors. Tulia, a profitable corporation, did not declare a dividend until 1972. See id.
The Fifth Circuit held that Tulia’s guarantor fees were not ordinary and necessary business expenses but instead were distributions of property (i.e., constructive dividends) payments to shareholders pursuant to I.R.C. § 316. See id. at 803-04; infra. The court denied the deduction because Tulia failed to demonstrate that the cattle feedlot industry businesses customarily paid shareholders a guarantor fee. See id. at 805-06. Without such evidence, the court “could not be sufficiently informed as to the economic realities of the transaction.” Id. at 806. In addition, Tulia had failed to provide any evidence that the amount of the fees was reasonable. See id.
In Olton Feed Yard, Inc. v. United States,
The Fifth Circuit determined that it was not necessary for Olton to pay the shareholders a fee to induce them to sign guarantees for the loan. See id. at 275-76. The court noted that Olton was profitable and did not pay out dividends. See id. at 275. Olton did not present evidence establishing that industry businesses customarily paid guarantor fees to their shareholders, and the court noted that the absence of such custom would disallow the deduction. See id. at 276. The
Four years later, the United States Claims Court heard Tulia Feedlot, Inc. v. United States,
In Fong v. Commissioner,
These cases provide a valuable legal framework for defining when payments of guarantor fees made to shareholders should be considered ordinary and necessary and when those same payments should be considered as constructive dividend transactions. The framework includes several factors. First, the fees must be reasonable. See Tulia I,
Second, businesses of the same type and size as the payor corporation must customarily pay guarantor fees to their shareholders. See Tulia I,
Third, shareholders must demand compensation in exchange for signing on as guarantors. If the shareholders had provided the guarantees without compensation, then the payment of guarantor fees is gratuitous, and the courts will not label such a transaction as “necessary.” See Olton Feed Yard,
Fourth, the payment of guarantor fees suggests a constructive dividend if the corporation’s profitability enabled it to pay a dividend, and yet no dividends were paid out during the relevant tax year. See Olton Feed Yard,
Fifth, the courts give consideration to the proportional relationship between the amount of the payments and the shareholders’ stock ownership. See Tulia III,
One of the key lessons derived from these cases is that a guarantor fee transaction that does not fit the definition of an ordinary and necessary business expense will likely be used by a close corporation to distribute dividend-like profits to its shareholders. The Court will closely scrutinize payments made by close-corporations where shareholders also act as directors. See Charles McCandless Tile Serv. v. United States,
(1) out of its earnings and profits accumulated after February 28,1913, or
(2) out of its earnings and profits of the taxable year * * *.
* * * To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.
I.R.C. § 301, 26 U.S.C. § 301 (1994), states in pertinent part that distributions of property made by a corporation to its shareholder shall be treated in accordance with section 301(c). This section provides that dividend distributions as defined by section 316(a) shall be included in the shareholders’ gross income. A corporate taxpayer may not normally deduct those dividends. See Hillsboro Nat’l Bank v. Commissioner,
Thus, in a constructive dividend transaction, the corporation attempts to avoid the tax consequences of nondeductible dividends. Proportionality and dividend history matter in the ordinary and necessary test because they tend to show the true nature of the transaction as a dividend payout, and federal tax law relies on the substance of a transaction, not the form. See generally Holiday Village Shopping Ctr. v. United States,
B. Analysis of the Factors
1. Disposing with the custom and reasonableness factors
For the purposes of this Motion for Summary Judgment, the Court infers that the plaintiff paid out reasonable fees and that the plaintiffs type of business customarily pays guarantor fees. The Government states with respect to custom that “[w]hether such fees are customary in plaintiffs type of business (i.e., the grocery business) is a disputed factual issue as to which summary judgment is not appropriate.” (Def.’s Mot. for Summ. J. at 13, n. 10.) The Government also assumes as true, for the purposes of this motion, that the plaintiff paid reasonable fees to the shareholders in the tax years of 1992, 1993, and 1994. “Whether guarantor fees of 10% of plaintiffs outstanding indebtedness were reasonable expenses * * * is a disputed factual issue as to which summary judgment is not appropriate.” (Def.’s Mot. for Summ. J. at 13, n. 14.) Therefore, the remaining
2. Guarantees without promises of compensation
Previous courts have indicated that shareholders must demand compensation in exchange for the guarantees in order to satisfy section 162(a)’s ordinary and necessary standard. If the shareholders had, in the past, provided the guarantees without compensation, there can be no necessity for paying the guarantor fees. See Olton Feed Yard,
a. Fees for past consideration
First, the plaintiff claims, and the Court accepts this claim as true for the purposes of defendant’s motion, that but for the personal guarantees of the shareholders, the plaintiff would have been unable to obtain financing. (Pl.’s Br. at 11.) The plaintiff analogizes its case to A.A. and E.B. Jones Co. v. Commissioner,
The Bonds were necessary to buy land, construct a building and buy inventory. Without the financing provided by the Bonds, Plaintiff would not have had the necessary capital to be in business. It was “appropriate and helpful” to pay the guarantor fees to compensate the guarantors for the risk incurred in guarantying the Bonds.
(PL’s Br. at 10.) As an example of this risk, the plaintiff points to the failure of the Stamford Thriftway, an asset of the plaintiffs.
However, the plaintiffs logic skips a step. The plaintiff contends that because the financing was necessary, and because the low-cost financing
Looking at the circumstances here, the controlling shareholders signed the guarantee agreement without agreeing to compensation from the plaintiff for risking their personal assets on behalf of the corporation. In the A.A. and E.B. Jones case, shareholders only agreed to provide the guarantees in exchange for the compensation. See id. at 1562. The plaintiff here has not offered any evidence that the shareholders entered into the agreement because they expected to receive any guarantee fees later. Had the plaintiff and the shareholders written up such an agreement, this case might come out differently. See Tulia III,
b. Fees in exchange for shareholders providing future consideration
The plaintiff also contends that it had to pay the fees in order “to assure the availability of future guarantees.” (Pl.’s Br. at 7.) The Court assumes this assertion refers to promises by the shareholders to act as guarantors for the plaintiff in the future for other similar financial arrangements. However, the plaintiff has made no showing that the shareholders made any commitment to provide future guarantees in exchange for the fees paid. Without such commitment, the shareholders have no obligation to help the plaintiff in the future as guarantors, and any promise made is an empty one. A guarantor fee paid to any of these shareholders for this reason is, therefore, at best a gratuity, even if one full of hopeful expectations, and, therefore, not deductible under section 162(a).
3. Relationship between stock ownership and fees paid.
The relationship between the guarantee fees paid and the amount of the stock the stockholder owns may also indicate whether or not the corporation masked a dividend as an ordinary and necessary business expense. See Olton Feed Yard,
It might appear that the plaintiff made disproportionate contributions to its shareholders. By the time the plaintiff had paid out the fees, some shares had been transferred to a fourth individual, Mr. Kildow, and one of the original shareholders, Mr. Porter had given his shares to his wife, Mrs. Porter. New shareholders Mr. Kildow and Mrs. Porter received no fees, while a nonshareholder, Mr. Porter, did receive fees. None of these events, however, prevent the Court from viewing the payment of fees as a proportional transaction.
a. Stock owned by a spouse attributable to other spouse.
Beneficial ownership is marked by command over property or enjoyment of its economic benefits. See Cepeda v. Commissioner,
In addition to Mr. Porter’s control over the corporation, the fact that he transferred the stock to his wife also suggests a continuity of ownership. Congress intended to prohibit tax avoidance through transfer of ownership within families. See H.R.Rep. No. 8-1337, at 36, reprinted in 1954 U.S.C.C.A.N. 4017, 4060; S.Rep. No. 83-162, at 45 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4675. Although Congress has not indicated its intentions on the effect of family transfers on the proportionality test, it has made itself clear in other statutes in other situations. In I.R.C. § 318(a)(1), 26 U.S.C. § 318(a)(1) (1994), for example, the Code provision dealing with constructive ownership rules for stock deems stock owned by one spouse to be owned by the other spouse. In sum, the Court imputes the distribution made to Mrs. Porter under these circumstances to her husband, Mr. Porter.
b. Nonpayment of fee to Mr. John Kildow
At the time of the payment of fees, Mr. Kildow, who owned 210 shares of stock, received nothing. Again, one could argue that, because of this lack of proportionality, the corporation did not pay out constructive dividends. Here, however, the plaintiff had reasons not to pay Mr. Kildow. Because Mr. Kildow came to the plaintiff several years after the incorporation, he had no role in the original agreement to be a guarantor, and he did not originally infuse the corporation with capital. To the extent that the controlling shareholders signed the guarantor agreement in order to protect and enhance their investment, the fees represented a return on that investment. See, e.g., In re Lane,
Alternatively, the plaintiff contends that “[t]he Board of Directors was bound by state law as all shareholders would have been entitled to share in dividends * * (Pl.’s Br. at 12.) It notes that the corporate laws of Texas require all shareholders to receive dividends under a dividend distribution plan. Since Mr. Kildow did not receive payments, the plaintiff argues, the payments cannot be dividend payments. The Supreme Court ruled long ago, however, that state law will control “only when the federal taxing act, by express language or necessary implication, makes its own operation dependent upon state law.” Burnet v. Harmel,
As for federal law, it does not require the corporation to make its dividend payouts in proportion to stockholdings, or require all shareholders to participate in the payouts, in order to consider the payouts as constructive dividends. See Simon v. Commissioner,
Thus, although at first glance the corporation appeared not to pay out the fees based on stock ownership, the payouts tightly tie
4. Dividend and profitability history
Where a closely-held corporation has the ability to pay dividends but instead issues shareholders guarantor fees, courts may classify these payments as constructive dividends. See Olton Feed Yard,
Here the dividend and profitability history of the plaintiff leads the Court to conclude that the payments were constructive dividends and not ordinary and necessary business expenses. The plaintiff did not pay dividends to its shareholders during its 1992, 1993, or 1994 tax years. It earned profits during each of these years, even when it reported a net operating loss for 1992 because of the failure of its investment in Stamford Thriftway. In addition, plaintiff paid the fees out of its current or accumulated earnings.
Under all of the circumstances discussed above, the Court does not find the relationship between the dividend history and the payment of the guarantor fees coincidental. Therefore, this factor also weighs heavily in favor of calling the payment of guarantor fees to the shareholders, under these circumstances, a distribution of property in the form of constructive dividends.
In final summary, even though the defendant concedes for the purposes of this summary judgment motion that the guarantor fees paid were both reasonable in amount and customary in the plaintiffs type of business, other factors lead the Court to find in favor of the defendant. The corporation had no valid business reason to grant the shareholders the guarantor fees several years after the shareholders had already personally guaranteed the bonds for free for the plaintiff. The shareholders received fees that were directly proportional to their ownership interests in the corporation, and thus the same amounts they would have received had the corporation declared a dividend. Finally, the dividend and profitability history of the corporation placed the directors in a position to provide a dividend when instead they paid out the guarantor fees. These factors lead to a finding of a constructive dividend, not an ordinary and necessary business expense in this case.
CONCLUSION
For the reasons set forth above, this Court holds that the plaintiff may not deduct the guarantor fees it paid to its shareholders and that a transaction of the same circumstances is a constructive dividend paid out by the corporation. As such, the defendant’s Motion for Summary Judgment is granted. Accordingly, the Clerk shall enter judgment dismissing the plaintiffs Complaint.
Each party is to bear its own costs.
Notes
. Although the defendant has requested oral argument in this matter, the Court deems oral argument on these issues unnecessary.
. In Tulia Feedlot, Inc. v. United States,
. In fact, the plaintiff’s reasoning for why it sought the guarantees is undercut by arguing that the fees were necessary. If the plaintiff sought the guarantees in order to obtain low-interest financing in 1983, the payment of additional fees of 8 percent in 1987 and 10 percent thereafter would add significant costs to the finance plan.
. One might ask why, if the plaintiff did not promise to pay the shareholders, the shareholders would incur risk. As the plaintiff itself notes, the financing from the Bonds enabled the plaintiff to build its supermarket and to begin operating its business. (Pl.’s Br. at 5-6.) In return for their signatures, the shareholders received the protection of their investment and any profits reaped from the supermarket.
. There is some dispute between the parties about how much weight the court should give to proportionality. The plaintiff cites Tulia III for the proposition that where guarantor fees are based on the amounts of the guarantees, not on the amounts of stock owned by the guarantors, the defendant’s argument that the fees are constructive dividends is discredited. (Pl.’s Br. at 13.) Tulia III did not indicate, however, that the presence or absence of proportionality ends the discussion. See Tulia III,