Court: United States Bankruptcy Court, S.D. Ohio; February 15, 1985; Us Bankruptcy; United States Bankruptcy Court
The Chapter 11 adversary proceeding involves D.H. Baldwin Company seeking recovery for a 1976 income tax deficiency and interest, following removal from the U.S. District Court for the Southern District of Ohio by mutual agreement. The plaintiff's case centers on two key issues regarding reported gross income deficiencies of its wholly-owned subsidiary, Baldwin Piano and Organ Company, for the tax year 1976.
1. **Commissions Issue**: The first issue questions whether Baldwin’s 1976 reported gross income should be increased by $725,614, based on additional commission income to the Piano Company under a contract with the D.H. Baldwin Trust, as per Internal Revenue Code (IRC) Section 482.
2. **Installment Accounts Receivable Issue**: The second issue involves whether an increase of $640,195 in reported gross income is warranted due to 1976 collections on installment sales contracts originally sold to banks and repurchased by a Baldwin affiliate.
The court's findings include:
- Both Baldwin and the Piano Company were Ohio corporations with their principal place of business in Cincinnati, Ohio, and the Piano Company was a wholly-owned subsidiary in 1976, later sold in bankruptcy reorganization.
- They utilized the accrual and, where applicable, the installment method for tax accounting, filing their taxes on a calendar year basis.
- Baldwin filed a consolidated U.S. Corporation Income Tax Return for 1976 on September 15, 1977, reporting a federal tax liability of $1,704,670, which was paid in full.
- On June 18, 1982, the IRS assessed a deficiency of $1,840,969 plus interest, which Baldwin timely paid after a subsequent adjustment reduced the interest amount.
- Baldwin submitted a claim for a refund of $1,293,674 related to the assessed tax deficiency, which the IRS denied on December 30, 1982.
Additionally, the Baldwin Foundation, an Ohio nonprofit corporation formed in 1961 and recognized as a charitable organization by the IRS, shares the same address as Baldwin and the Piano Company.
The IRS ruling from October 25, 1962, remains active. From December 1, 1967, to 1976, the Foundation's trustees included Lucien Wulsin, Jr., Morley P. Thompson, and others who also held positions with Baldwin or the Piano Company. Baldwin and the Piano Company aimed to enter a contract for the sale of finished inventory, seeking off-balance-sheet financing and tax reductions while generating revenue for the Foundation. The D.H. Baldwin Trust was established on December 19, 1967, by the Foundation and three initial trustees, and it remains active. The Foundation appointed all Trust trustees and could remove any with thirty days' notice, but did not do so from 1967 to 1977. The Trust's trustees, including Alan R. Vogeler and J. Leland Brewster, had various professional backgrounds, with some previously employed in relevant positions at Baldwin or its creditors.
On December 19, 1967, the Trust contracted with the Piano Company to purchase inventory, later amended to include consigned inventory. The Trust only engaged in this contract in 1976 and had no employees. A credit agreement with Central Trust Company, established on December 28, 1967, included a favorable interest rate due to Baldwin's status as a major customer and required annual certified audits of the Trust and its affiliates.
Baldwin passed a resolution to guarantee the Piano Company's performance under its contract with the Trust, which required the Trust to purchase inventory at prices outlined in "Schedule B," reflecting the factory billing or cost price. These cost prices, typical for manufacturer-to-wholesaler transactions, could be adjusted by the Piano Company with reasonable notice, while the Trust could change wholesale prices, subject to limitations. In 1976, the Piano Company sold inventory to the Trust for $52,736,956, contributing to total sales of $58,456,111, resulting in a gross profit of $14,965,505 and a net profit of $8,307,982 (14.212% of sales) reported in its tax return.
The Trust did not take physical possession of the inventory; instead, it was consigned to dealers directly from the Piano Company. Dealers purchased inventory from the Trust at the wholesale price and could sell items on an installment plan, leading the Piano Company to repurchase the inventory and create installment contracts with consumers. The Piano Company also acted as a collection agent for the Trust for cash sales.
Additionally, the contract designated the Piano Company as the Trust's servicing agent with several responsibilities: conducting audits of Trust-owned goods, managing dealer relationships, maintaining an accounting system for goods, handling settlements and collections for consigned goods, addressing customer complaints, resolving dealer disputes, retrieving goods from non-compliant dealers, ensuring insurance for consigned goods, and reporting on the security of merchandise.
The contract between the Trust and the Piano Company stipulated that the Trust would pay commissions to the Piano Company based on total collections from dealer cash sales, after deducting specific costs. These deductions included: a) the aggregate cost prices of inventory sold, b) the cost prices of old stock, c) reasonable business expenses incurred by the Trust, and d) a reasonable profit, quantified as one-tenth of one percent of the average aggregate cost prices of all goods held.
Prior to 1974, both entities utilized the First-In-First-Out (FIFO) method for inventory valuation, which treats sales as drawn from the oldest inventory. In 1974, they switched to the Last-In-First-Out (LIFO) method, which accounts for sales as drawn from the newest inventory. This change in methodology results in increased reported costs of goods sold and reduced taxable profits during periods of rising inventory prices. Both the Piano Company and the Trust filed the required IRS forms to adopt LIFO in a timely manner.
For tax years using LIFO, an adjustment known as a LIFO reserve is necessary to reflect the valuation difference compared to FIFO. For 1976, the Trust's LIFO inventory reserve adjustment amounted to $725,614. Testimony indicated that the adoption of LIFO was discussed among representatives from both entities and the Trust's accountants, with a memorandum recommending the change due to minimal income impact and improved cash flow. It was also agreed that commissions to the Piano Company would be calculated based on the Trust's LIFO cost of goods sold, although the actual payment for inventory remained unchanged.
The written contract between the parties was not amended to reflect a new method for calculating commissions. Despite the reduction in commissions, the services provided by the Piano Company to the Trust remained unchanged. Mr. Lewis indicated that the Piano Company accepted reduced commissions due to the Trust’s adoption of the LIFO accounting method, which would theoretically allow the Trust to have more cash for inventory purchases or debt repayment, although he was unsure if these benefits materialized.
Monthly settlement statements summarized transactions between the Trust and the Piano Company, with the December 1976 statement showing a deduction for a "LIFO reserve" of $725,614.89. The parties agreed that the Trust received a credit of this amount against its debt to the Piano Company. The accounting records indicated gross commissions of $6,194,330.88 for the Piano Company, which were adjusted to a net commission of $5,468,715.99 after the LIFO reserve deduction. The Piano Company reported a total commission income of $5,841,616.29 for its 1976 tax year, which was affected by an IRS adjustment that increased its gross income by $725,614, resulting in a higher tax liability.
During 1976, the Trust reported net earnings of $15,722 and paid $16,300 to the Foundation. However, due to the IRS adjustment, the Trust faced a net operating loss of approximately $710,000 for the year. The Trust sold inventory items back to the Piano Company under installment contracts, which were later assigned to Baldwin Finance Company. In 1974, the Piano Company sought to sell its installment contracts to adopt the installment method of accounting without incurring tax disadvantages.
On December 17, 1974, the Piano Company received an IRS private letter ruling confirming that the proposed sale of installment contracts would be considered a bona fide sale, allowing the company to elect the installment method of accounting and defer tax on collections from sold contracts. The ruling was based on a contract with a group of banks, led by Continental Illinois National Bank and Trust Company, which specified that the Piano Company would serve as the agent for collections on these installment contracts. Prior to this sale, Baldwin Finance Company had transferred its portion of the contracts to the Piano Company.
On December 31, 1974, the Piano Company finalized an agreement with Continental to sell installment contracts valued at $18,385,311.42, with an additional future interest of $4,793,094.81, for a total sale price of $21,091,422, of which 10% was withheld as a reserve. The Piano Company reported the principal and accrued interest from the installment contracts in its gross income for 1973 and 1974, alongside a gross profit of $2,706,111 from the sale.
Beginning January 1, 1975, the Piano Company opted to account for inventory sales using the installment method. The agreement with Continental allowed the Piano Company to repurchase any defaulted installment contracts at the unpaid contract balance, defined as any contract with overdue payments exceeding 90 days. If repurchased, collections on these contracts would be included in the Piano Company's gross income as received, despite prior inclusion of the full amounts in 1974.
If the Piano Company did not repurchase a defaulted contract, Continental could utilize the 10% reserve to cover the unpaid balance, with future collections added to the reserve. The Piano Company expressed concerns about potential double taxation on amounts added to the reserve and the impact of defaulted contracts on its credit relationship with Continental, especially given the existing defaults at the time of the transfer. A potential solution considered was for a third party to acquire the defaulted contracts from Continental.
National Farmer’s Union Service Corporation (NFU) is a Delaware insurance holding company, wholly owned by the Farmers Educational and Cooperative Union of America, a Texas nonprofit corporation. On December 12, 1973, Baldwin acquired convertible preferred stock in NFU, allowing conversion into 90% of NFU's common stock, with a mandatory conversion date extended to after 1976. This preferred stock entitled Baldwin to 90% of NFU's net earnings. The conversion to common stock occurred in January 1978.
Baldwin's 1976 Form 10-K indicated that although the Farmers Educational and Cooperative Union owned NFU, Baldwin controlled it through the preferred stock. There were no allegations of connections between NFU's directors or officers and Baldwin or the Piano Company during the relevant period; NFU's directors were associated with state farmers unions.
NFU did not file a consolidated federal income tax return with Baldwin or the Piano Company for 1976 or any prior year. In January 1975, Baldwin's treasurer, James Schwab, inquired about NFU purchasing defaulted installment contracts, leading to NFU acquiring these contracts on a month-to-month basis. The Piano Company informed NFU of the total purchase price, and NFU made direct payments to Continental for the contracts.
NFU was reimbursed by the Piano Company for unearned interest on the contracts at the time of purchase. NFU's profits stemmed from interest and late charges collected on these contracts. Additionally, the Piano Company acted as NFU's collection agent for these contracts, charging a monthly fee per contract.
In 1976, NFU received $1,129,576 from the Piano Company for collections on installment contracts purchased from Continental. Mr. Huff indicated that acquiring defaulted contracts yielded NFU a profit with a 14 to 16 percent return, based on the principal amounts invested against income from interest and late charges. The agreement between the Piano Company and NFU regarding these contracts was not formalized in writing until 1977, primarily for compliance with Utah insurance examiners. NFU reported profits from these contracts in its 1976 tax return, while the Piano Company did not include collections from defaulted installments in its gross income for the same year.
The IRS subsequently adjusted the Piano Company’s gross income for 1976, adding $640,195 from these collections, which increased the tax liability by $265,512 and incurred interest of $263,099. The IRS also increased reported commission income by $725,614, citing Internal Revenue Code (IRC) § 482, which allows income allocation between controlled organizations to prevent tax evasion. The determination of control was supported by the interrelationship of the Trust, Foundation, and Piano Company, all under Baldwin's influence, despite the Foundation's intermediary role.
The Trust was created to facilitate inventory sales for the Piano Company, and its sole business activity was its contract with the Piano Company. The IRS found insufficient evidence for the Trust’s adoption of LIFO and its subsequent reduction in commissions to meet arm's length standards, as unrelated taxpayers would not typically engage in such an arrangement. The Trust's substantial loss from adopting LIFO without reducing commissions further undermined the rationale for the arrangement. The IRS's determinations are generally presumed correct, placing the burden of proof on the taxpayer to demonstrate otherwise.
The plaintiff failed to prove that the defendant improperly allocated an additional $725,614 in commission income for 1976. According to the contract, the Piano Company was entitled to commissions based on "cost prices" in Schedule B, which continued to apply in 1976. Although the Piano Company recorded commissions from dealer sales, it agreed to receive $725,614.89 less than owed, effectively waiving its right to those commissions. Citing case law, including Mensik v. Commissioner, the court determined that the Piano Company's acceptance of reduced commissions did not change tax implications, and thus, the plaintiff is not entitled to a tax refund related to this income.
On the issue of installment accounts receivable, the IRS claimed that NFU's purchase of defaulted installment contracts was a sham and aimed at tax evasion, implying that income should be allocated back to the Piano Company. The court disagreed, finding that the plaintiff provided credible evidence, including testimony and exhibits, showing that NFU legitimately purchased the contracts. The Piano Company's role as a collection agent for a fee was part of a valid business purpose, justifying the sale of the accounts receivable. Legal precedent supports the taxpayer's right to minimize tax liabilities through lawful means, and the court upheld that the installment sales were bona fide, rejecting the IRS's assertions.
The IRS will adhere to the precedent set in City Stores, allowing taxpayers using the installment method to exclude amounts from gross income for installment obligations sold in the previous year. The sale of defaulted installment contracts from Continental to NFU is deemed to meet the arm's length test, regardless of Baldwin's control over NFU. This sale benefited Baldwin for tax purposes and maintained its creditor relationship with Continental, while NFU found it an appealing investment yielding a high return, facilitated by The Piano Company's reimbursement of interest on the contracts.
Defendant's post-trial brief acknowledges that payments to NFU were lower than the additional tax Baldwin would incur if it had directly repurchased the contracts. The taxpayer must provide credible evidence to refute the IRS's deficiency assessment; if the IRS fails to support its claim, uncontroverted evidence in favor of the taxpayer suffices to meet its burden. Here, the IRS did not present evidence for its deficiency claim, and its assertion that Continental had no dealings with NFU was discredited by plaintiff witnesses.
The court concludes that the plaintiff is entitled to a refund of $528,611. Jurisdiction is established under 28 U.S.C. 157. The defendant's allocation of $725,614 in commission income for 1976 is upheld, while the additional allocation of $640,195 in income from installment accounts receivable is deemed incorrect. The refund awarded relates to taxes and interest from the installment accounts receivable deficiency. The court notes that while double taxation is prevented under Section 453(c), Baldwin faces increased tax liabilities due to higher consolidated taxable income in 1976 compared to prior years. Additionally, a significant portion of the installment accounts receivable in 1975 and 1976 consisted of defaulted contracts. The excerpt also mentions control relationships in charitable organizations based on trustee appointments, referencing Treas. Reg. 1.509(a)-4(g)(1)(i).
