SCOTUS Reports

Tag: Constructive Payment

  • Long v. Commissioner, 93 T.C. 352 (1989): Constructive Payment Doctrine Inapplicable to Revenue Procedure 65-17

    Long v. Commissioner, 93 T. C. 352 (1989)

    The doctrine of constructive payment does not apply to satisfy an account receivable established under Revenue Procedure 65-17.

    Summary

    In Long v. Commissioner, the U. S. Tax Court ruled that the doctrine of constructive payment does not apply to an account receivable established between related corporations under Revenue Procedure 65-17. The case involved William R. Long, who sought to apply the doctrine to avoid constructive dividend treatment. The court denied Long’s motion for reconsideration, emphasizing that Rev. Proc. 65-17 requires actual payment in money, not constructive payment, to satisfy the account receivable. The decision clarified that the terms of the closing agreement and the revenue procedure mandate an actual transfer of funds to avoid constructive dividend treatment.

    Facts

    William R. Long, the controlling shareholder, moved for reconsideration of the Tax Court’s opinion in Long v. Commissioner, 93 T. C. 5 (1989). The initial opinion held that an account receivable established between related corporations under Rev. Proc. 65-17, which was not offset by a preexisting account payable or otherwise satisfied within the allowed methods, constituted a constructive dividend to Long and a contribution to the capital of the transferee corporation. Long argued that the doctrine of constructive payment should apply to the transfer of assets required by the revenue procedure.

    Procedural History

    The Tax Court initially ruled in Long v. Commissioner, 93 T. C. 5 (1989), that the unsatisfied portion of the account receivable was a constructive dividend. Long filed a motion for reconsideration under Rule 161 of the Tax Court Rules of Practice and Procedure, which was denied by the court in the supplemental opinion at 93 T. C. 352 (1989).

    Issue(s)

    1. Whether the doctrine of constructive payment applies to the satisfaction of an account receivable established pursuant to Rev. Proc. 65-17.

    Holding

    1. No, because Rev. Proc. 65-17 requires payment “in the form of money,” and the closing agreement required payment in “United States dollars,” which precludes the application of the constructive payment doctrine.

    Court’s Reasoning

    The court’s reasoning focused on the interpretation of Rev. Proc. 65-17 and the closing agreement. The court emphasized that the revenue procedure explicitly required payment in money, and the closing agreement similarly required payment in U. S. dollars. The court rejected Long’s argument that constructive payment could satisfy these requirements, noting that accepting such an interpretation would render the closing agreement futile. The court distinguished this case from prior cases like White v. Commissioner and F. D. Bissette & Son, Inc. v. Commissioner, where the constructive receipt doctrine was applied in different contexts. The court found that the language of Rev. Proc. 65-17 and the closing agreement was unambiguous in requiring actual payment, and thus, the doctrine of constructive payment did not apply.

    Practical Implications

    This decision clarifies that taxpayers cannot use the doctrine of constructive payment to satisfy obligations under Rev. Proc. 65-17. Practitioners should ensure that actual payments are made in accordance with the terms of such agreements to avoid unintended tax consequences like constructive dividends. This ruling impacts how related corporations structure their financial transactions and emphasizes the importance of adhering to the specific payment requirements in revenue procedures. Subsequent cases involving similar revenue procedures will likely cite this decision to support the necessity of actual payment in money.

  • H & H Drilling Co. v. Commissioner, 15 T.C. 961 (1950): Sham Transactions and Constructive Payment of Salary Deductions

    15 T.C. 961 (1950)

    A taxpayer cannot deduct accrued salary expenses to a controlling shareholder if the payment is not actually or constructively made within the taxable year or within two and a half months after the close thereof, and a mere bookkeeping entry does not constitute constructive payment when the funds are not available.

    Summary

    H & H Drilling Co. sought to deduct salary accrued to its majority stockholder, Fred Ptak. The company issued a check to Ptak, who endorsed it back to the company for deposit into its account. The Tax Court disallowed the deduction, finding that this was not actual or constructive payment because the company did not have sufficient funds to cover the check, and the transaction was merely a bookkeeping maneuver. Therefore, the court held that the company failed to meet the requirements for deducting accrued expenses under Section 24(c) of the Internal Revenue Code.

    Facts

    H & H Drilling Co. was formed in 1941. Fred Ptak owned 50.4% of the company’s stock but was not an officer or director. On December 30, 1941, the company’s directors resolved to pay Ptak $10,000 for services rendered. On May 13, 1942, the company issued a check to Ptak for $9,970 (salary less social security tax). Ptak endorsed the check back to the company on the same day, and the company deposited it into its own bank account. The company’s books showed a charge and then a credit to Ptak’s account for the check amount. The company lacked sufficient funds in its account to cover the check when it was issued and deposited.

    Procedural History

    H & H Drilling Co. deducted the accrued salary expense on its tax return. The Commissioner of Internal Revenue disallowed the deduction, citing Section 24(c) of the Internal Revenue Code. H & H Drilling Co. then petitioned the Tax Court for review of the Commissioner’s determination.

    Issue(s)

    Whether H & H Drilling Co. is entitled to a deduction for salary accrued to its majority stockholder when a check was issued but immediately endorsed back to the company and deposited into its own account, and when the company lacked sufficient funds to cover the check.

    Holding

    No, because H & H Drilling Co. did not demonstrate that actual or constructive payment was made to Ptak within the taxable year or within two and a half months after its close, as required by Section 24(c) of the Internal Revenue Code. The endorsement and redeposit of the check, combined with the lack of funds, constituted a mere bookkeeping entry rather than a true transfer of funds.

    Court’s Reasoning

    The Tax Court emphasized that the taxpayer bears the burden of proving the inapplicability of Section 24(c) of the Internal Revenue Code, which disallows deductions for unpaid expenses and interest under certain conditions. Specifically, the court focused on the requirement that the expenses be “paid within the taxable year or within two and one half months after the close thereof.” The court found that the issuance of the check, followed by its immediate endorsement back to the company, did not constitute actual or constructive payment. The court stated, “Endorsement of the check by Ptak, and delivery thereof to petitioner for deposit to its credit, was not payment, actual or constructive. Petitioner was in the same financial condition, as respects Ptak, after the completion of the transaction as it was before the issuance of the check and Ptak received nothing. The formality was nothing more than a bookkeeping or paper transaction.” The court distinguished the case from others where notes were issued and accepted as actual payment or where demand notes with a cash value were issued. Since H & H Drilling Co. did not prove that Ptak constructively received the salary or that the company constructively paid it, the deduction was properly disallowed.

    Practical Implications

    This case serves as a cautionary tale for closely held businesses. It highlights the importance of ensuring that payments to related parties are bona fide and not merely accounting maneuvers designed to create tax deductions. The case reinforces the principle that constructive payment requires the unqualified availability of funds to the payee. It clarifies that merely issuing a check that is immediately returned to the issuer does not constitute payment for tax purposes, especially when the issuer lacks sufficient funds to honor the check. Attorneys and tax advisors should counsel clients to avoid such “sham” transactions and to ensure that actual transfers of value occur when claiming deductions for accrued expenses, especially when dealing with controlling shareholders or related parties. Later cases cite this one to disallow deductions taken without actual transfer of funds.

  • Granberg Equipment, Inc. v. Commissioner, 11 T.C. 704 (1948): Disguised Dividends and Constructive Payment

    Granberg Equipment, Inc. v. Commissioner, 11 T.C. 704 (1948)

    Payments labeled as royalties made retroactively to a corporation’s stockholders in proportion to their stockholdings, without arm’s length negotiation or business justification, may be recharacterized as disguised dividends and are therefore not deductible as ordinary and necessary business expenses.

    Summary

    Granberg Equipment, Inc. sought to deduct royalty payments made to its stockholders, including Granberg, for the use of certain inventions. The Tax Court disallowed the deduction, finding that the payments were not bona fide royalties but disguised dividends intended to reduce the company’s tax liability. The court also held that a bonus payable to Granberg, though credited to his account, was not constructively paid within the meaning of Section 24(c) of the Internal Revenue Code and thus was also not deductible. The court emphasized the lack of arm’s length dealings and the absence of business justification for the royalty agreement.

    Facts

    Granberg and others transferred certain inventions to Granberg Equipment, Inc. (petitioner), a corporation they controlled. The petitioner retroactively agreed to pay royalties to Granberg and other stockholders for the use of these inventions. The royalty payments were made in proportion to the stockholders’ stockholdings. The agreement was executed despite limited sales and uncertainty about the marketability of the inventions. A bonus to Granberg was approved and credited to his account on the company’s books.

    Procedural History

    The Commissioner of Internal Revenue disallowed the petitioner’s deductions for royalty payments and the bonus payment. The Tax Court reviewed the Commissioner’s determination.

    Issue(s)

    1. Whether the retroactive royalty payments made by the petitioner to its stockholders were ordinary and necessary business expenses, or disguised dividends, and therefore not deductible.

    2. Whether the bonus payable to Granberg was constructively paid within two and one-half months after the close of the taxable year, making it deductible under Section 24(c) of the Internal Revenue Code.

    Holding

    1. No, because the payments lacked arm’s length negotiation, business justification, and resembled dividend distributions based on stock ownership.

    2. No, because the crediting of the bonus to Granberg’s account did not constitute constructive payment within the meaning of Section 24(c)(1) of the Internal Revenue Code.

    Court’s Reasoning

    The court reasoned that the substance of the transaction should control over its form. It found a lack of arm’s length dealing between Granberg and the petitioner, evidenced by the timing of the royalty agreement, the high minimum royalty, and the distribution of payments proportional to stock ownership. The court noted that the agreement lacked provisions protecting the petitioner’s interests. Quoting Eskimo Pie Corporation, the court stated, “Surely, [the royalty] is not an ordinary and necessary business expense of carrying on petitioner’s trade or business. Except for the close relationship of the parties, it seems hardly conceivable that such an agreement would ever have been entered into.”

    Regarding the bonus, the court found insufficient evidence that Granberg constructively received the bonus in February 1943. Furthermore, the court held that even if there was constructive receipt, “constructive payment” is not a payment within the meaning of Section 24(c)(1) of the Code, citing P.G. Lake, Inc.

    Practical Implications

    This case highlights the importance of arm’s length transactions, especially between closely held corporations and their stockholders. Payments characterized as business expenses, such as royalties or bonuses, will be scrutinized to determine their true nature. To deduct such payments, a company must demonstrate a legitimate business purpose, fair negotiation, and reasonableness. The case reinforces the principle that the IRS can recharacterize transactions to reflect their economic substance, preventing taxpayers from using artificial arrangements to avoid taxes. It also clarifies that simply crediting an amount to a related party’s account does not necessarily constitute payment for tax deduction purposes, particularly under Section 24(c) (now Section 267) of the Internal Revenue Code.

  • Bemb v. Commissioner, 5 T.C. 1335 (1945): Cash Basis Taxpayer’s Bad Debt Deduction

    5 T.C. 1335 (1945)

    A cash basis taxpayer cannot claim a deduction for a constructive payment of a debt unless the payment is actually made and the funds are irrevocably placed at the disposal of the creditor within the tax year.

    Summary

    Walter Bemb, a cash basis taxpayer, guaranteed obligations of a country club that became insolvent. In 1941, he was sued as a guarantor, and his bank accounts were garnished. On December 13, 1941, a settlement was reached where Bemb would pay $4,000 in cash to discontinue the garnishment. The payment was made on January 12, 1942, when the garnishment was released. Bemb claimed a bad debt deduction for 1941, which the Commissioner disallowed. The Tax Court held that Bemb did not make constructive payment in 1941 and, therefore, could not claim the deduction for that year, as he was a cash basis taxpayer and the payment was not completed until 1942.

    Facts

    Walter J. Bemb, a cash basis taxpayer, guaranteed certain obligations of the Tam O’Shanter Country Club. The club became insolvent, and other guarantors made payments. In 1935, the guarantors agreed to apportion the debt, assigning $21,770.46 to Bemb. Bemb was unable to pay this amount. In February 1941, a trustee sued Bemb, and his bank accounts were garnished for $4,000. On December 13, 1941, a settlement was agreed upon: Bemb would pay $4,000 cash, and the garnishment would be discontinued. On January 12, 1942, the trustee received the $4,000, and the garnishment was formally released.

    Procedural History

    The Commissioner of Internal Revenue disallowed Bemb’s $4,000 bad debt deduction claimed on his 1941 tax return. Bemb petitioned the Tax Court for a review of the Commissioner’s determination.

    Issue(s)

    Whether a cash basis taxpayer is entitled to a bad debt deduction in 1941 for a payment made in January 1942, based on a settlement agreement reached in December 1941, where the taxpayer’s funds were garnished, and the garnishment was released upon payment in 1942.

    Holding

    No, because the petitioner was a cash basis taxpayer, and the payment was not completed and the funds were not irrevocably placed at the disposal of the creditor until January 12, 1942; therefore, no deduction may be allowed for this amount in 1941.

    Court’s Reasoning

    The court reasoned that constructive payment is a legal fiction applied only in unusual circumstances. Since Bemb was a cash basis taxpayer, the court stated, “It is settled beyond cavil that taxpayers other than insurance companies may not accrue receipts and treat expenditures on a cash basis, or vice versa. Nor may they accrue a portion of income and deal with the remainder on a cash basis, nor take deductions partly on one and partly on the other basis.” The court found that the settlement agreement in 1941 did not discharge Bemb’s obligation because the garnishment proceedings, which tied up the funds, were not discontinued until January 12, 1942. The amount was not subject to the creditor’s “unfettered demand” in 1941 because the discontinuance of the garnishment proceedings was a prerequisite to the payment. The court concluded that no amount was credited to the trustee in 1941, and Bemb’s obligation was not satisfied until the cash payment in 1942.

    Practical Implications

    This case reinforces the principle that cash basis taxpayers can only deduct expenses in the year they are actually paid. The existence of a settlement agreement or the garnishment of funds does not constitute payment until the funds are released and made available to the creditor. This decision is crucial for tax planning, particularly for individuals and small businesses using the cash method of accounting. Taxpayers must ensure actual payment occurs within the desired tax year to claim a deduction. This case highlights the importance of understanding the distinction between cash and accrual accounting methods for tax purposes. Subsequent cases would apply this rule, focusing on when control of funds shifts from the taxpayer to the creditor.

  • Dennison v. Commissioner, 47 B.T.A. 1342 (1943): Cash Basis Taxpayer Deduction Requires Actual Payment, Not Just Obligation

    Dennison v. Commissioner, 47 B.T.A. 1342 (1943)

    For a cash basis taxpayer to deduct an expense, actual payment, not merely the establishment of an obligation or a settlement agreement, must occur within the taxable year; constructive payment is a narrow exception requiring funds to be unequivocally at the creditor’s disposal.

    Summary

    The petitioner, a cash basis taxpayer, sought to deduct a bad debt in 1941 related to a guarantee he made for a country club. Although a settlement agreement was reached in 1941 and his bank account was garnisheed, the actual payment to the creditor occurred in 1942 after the garnishment was formally released. The Board of Tax Appeals held that for a cash basis taxpayer, a deduction requires actual payment, not just an agreement to pay or the restriction of funds. Since the creditor did not receive unfettered access to the funds until 1942, the deduction was not allowed in 1941.

    Facts

    Prior to 1941, the petitioner guaranteed certain obligations of the Tam O’Shanter Country Club.

    The country club became insolvent.

    On February 11, 1941, a lawsuit was filed against the petitioner to enforce his guarantor liability.

    The petitioner’s bank accounts were garnisheed, and $4,000 was withheld.

    On December 13, 1941, the petitioner and the trustee for the country club reached a settlement agreement where the petitioner would pay $4,000, and the garnishment would be released.

    On the same day, the petitioner confessed judgment and authorized his attorney to allow the trustee to receive the garnished funds.

    On January 12, 1942, the garnishment proceedings were formally released.

    In January 1942, the trustee received $4,000 in cash from the petitioner’s accounts.

    The petitioner was a cash basis taxpayer and claimed a bad debt deduction for $4,000 in 1941.

    Procedural History

    The petitioner claimed a bad debt deduction on his 1941 tax return.

    The Commissioner of Internal Revenue disallowed the deduction for 1941.

    The petitioner appealed to the Board of Tax Appeals (now Tax Court).

    Issue(s)

    1. Whether a cash basis taxpayer constructively paid a debt in 1941, and is entitled to a bad debt deduction in that year, when funds were garnisheed and a settlement agreement was reached in 1941, but actual payment occurred in 1942 after the garnishment was formally released.

    Holding

    1. No, because for a cash basis taxpayer, a deduction requires actual payment or constructive payment where the funds are unequivocally at the disposal of the creditor, neither of which occurred in 1941.

    Court’s Reasoning

    The court emphasized that the petitioner was a cash basis taxpayer. For cash basis taxpayers, income is recognized when cash or its equivalent is actually or constructively received, and expenses are deductible when actually paid.

    The court acknowledged the general rule that a guarantor who makes payment on a guarantee creates a debt with the principal obligor, and a bad debt deduction is allowed in the year of payment if the principal obligor cannot repay. However, the dispute was not about the deductibility of the bad debt itself, but the timing of the payment.

    The court stated, “Constructive payment is a fiction and is to be applied only under unusual circumstances.” It is rarely applied for cash basis taxpayers claiming deductions because it presupposes an expenditure by the taxpayer.

    Citing Massachusetts Mutual Life Insurance Co. v. United States, 288 U.S. 269, the court reiterated that cash basis taxpayers must consistently treat expenditures on a cash basis and cannot mix cash and accrual methods.

    The settlement agreement in 1941 was deemed merely a basis for future payment, not payment itself. The garnishment proceedings were not discontinued until 1942, meaning “it can not be said that everything necessary for the payment of the money was completed in 1941 or that such amount was placed completely at the disposal of the trustee in that year.”

    The court concluded, “Here, the amount in dispute was not subject to the creditor’s unfettered demand in 1941. Something remained to be done before he was entitled to receive the money, namely, the discontinuance of the garnishment proceedings. Since this was not done until 1942, there was no constructive receipt of the $4,000 in 1941.”

    Therefore, actual payment in cash in 1942, not the 1941 agreement or garnishment, determined the year of deduction.

    Practical Implications

    This case reinforces the fundamental principle of cash basis accounting: deductions are generally taken in the year of actual cash disbursement. It clarifies that merely reaching a settlement or having funds restricted (like in a garnishment) does not constitute payment for a cash basis taxpayer.

    For legal practitioners, this case serves as a reminder that for cash basis clients seeking deductions, it is crucial to ensure actual payment occurs within the desired tax year. Agreements to pay, even if legally binding, are insufficient for deduction purposes until the cash changes hands or is unequivocally available to the creditor.

    This ruling highlights that “constructive payment” is a very narrow exception, not easily invoked by cash basis taxpayers seeking to accelerate deductions. The creditor must have unfettered access to the funds in the tax year for constructive payment to apply. Pending legal procedures, like the release of a garnishment, prevent a finding of constructive payment.

    Later cases applying this principle often involve disputes over the timing of payments made near year-end or situations where control over funds is restricted. This case remains relevant in tax law for illustrating the strict application of the cash basis method and the limited scope of the constructive payment doctrine in deduction timing.

  • Lake Geneva Ice Cream Co. v. Commissioner, 21 T.C. 87 (1953): Disallowing Deductions for Unpaid Expenses to Related Parties

    Lake Geneva Ice Cream Co. v. Commissioner, 21 T.C. 87 (1953)

    Section 267 of the Internal Revenue Code disallows deductions for accrued expenses, including interest, owed to related parties if payment is not made within a specified timeframe and other conditions are met, even if the expense is otherwise deductible.

    Summary

    Lake Geneva Ice Cream Co. sought to deduct accrued interest owed to its controlling shareholder, Lake. The Commissioner disallowed the deduction under Section 24(c) (now Section 267) of the Internal Revenue Code, arguing that the interest was not actually paid within the taxable year or within two and one-half months after the close thereof, and that the other conditions of the statute were met. The Tax Court upheld the Commissioner’s determination, finding that no actual or constructive payment occurred within the statutory period, despite advances made to Lake during that time. The court emphasized the need for actual payment to satisfy the statute’s requirements.

    Facts

    Lake Geneva Ice Cream Co. accrued interest on amounts owed to Lake, its controlling shareholder. The company used the accrual method of accounting, while Lake used the cash method. Lake did not report the accrued interest as income in his 1939 tax return. The company claimed a deduction for the accrued interest on its 1939 tax return. Advances were made to Lake within two and one-half months after the close of 1939, but these advances were treated separately from the accrued interest. The accrued interest was eventually paid by check on May 17, at which point Lake paid the company by check for amounts owed. The Commissioner disallowed the deduction.

    Procedural History

    The Commissioner of Internal Revenue disallowed the deduction claimed by Lake Geneva Ice Cream Co. for accrued interest. The Tax Court reviewed the Commissioner’s determination.

    Issue(s)

    Whether the deduction of accrued interest, otherwise allowable under Section 23(b) of the Internal Revenue Code, is barred by the provisions of Section 24(c) (now Section 267), because the interest was not actually paid within the taxable year or within two and one-half months after the close thereof.

    Holding

    No, because Section 24(c) requires actual payment, and neither actual nor constructive payment of the accrued interest occurred within the specified timeframe. Advances to the creditor were treated as separate transactions and did not constitute payment of the accrued interest.

    Court’s Reasoning

    The court emphasized the plain language of the statute, which requires that the amount must be “paid” within the specified period. The court found nothing in the statute or its legislative history to suggest that anything less than actual payment is sufficient. The purpose of the statute is to prevent the deduction of accrued but unpaid amounts owed to a controlling party. The court rejected the argument that a constructive payment occurred, noting that constructive payment is a fiction applied only under unusual circumstances. Here, the mere accrual of the amount due, without any action to put the amount beyond the company’s control and within Lake’s control, did not constitute constructive payment. The advances made to Lake were considered separate transactions and did not offset the accrued interest. The court explicitly stated that the consistent policy in the treatment of the two accounts showed this to be the case. “The whole course of dealings show that he intended that one account would off-set the other to the extent of the smaller account.’ We think the whole course of dealing shows clearly the exact opposite.”

    Practical Implications

    This case clarifies that Section 267 requires actual payment of accrued expenses, including interest, to related parties within the specified timeframe to allow for a deduction. Accrual alone is insufficient, even if the creditor is in control of the debtor. Taxpayers must ensure that actual payment occurs within the statutory period, or the deduction will be disallowed. The case also highlights that advances or other transactions must be clearly designated as payments of the accrued expense to qualify as such. This decision affects how businesses manage transactions with related parties to ensure compliance with tax law and maximize allowable deductions. Subsequent cases have reinforced the importance of actual payment and scrutinized arrangements between related parties to prevent tax avoidance.