T.C. Memo. 1999-74
UNITED STATES TAX COURT
AL ZUNI OF ARIZONA, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
NASHAT KHALAF, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 18917-96, 18918-96. Filed March 10, 1999.
Henry W. Tom and Rick Kilfoy, for petitioners.
Rachael J. Zepeda, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: In these consolidated cases, respondent
determined deficiencies in petitioners' Federal income taxes,
additions to tax, and penalties, as follows: - 2 -
Al Zuni of Arizona, Inc.
Addition to Tax Accuracy-Related Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) 1989 $274,514 $68,628 $54,903 1990 194,163 48,541 -- 1991 142,726 35,682 28,545 1992 290,668 72,667 58,134
Nashat Khalaf
Addition to Tax Accuracy-Related Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) 1989 $127,674 $32,041 $25,535 1990 51,682 13,204 10,336 1991 44,038 11,977 8,807 1992 245,164 -- 49,033
After settlement of many issues, the issues for decision
involve the amount of income that is to be charged to petitioner
Al Zuni of Arizona, Inc. (Al Zuni), on transfer of its inventory
of Native American jewelry to Nashat Khalaf (Khalaf), its 100-
percent shareholder, and the amount of capital gain that is to be
charged to Khalaf with regard to receipt from Al Zuni of the
jewelry inventory.
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. - 3 -
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
At the time the petitions were filed, Khalaf’s residence was
located in New Mexico.
Al Zuni was incorporated in 1976 as an Arizona corporation
engaged in the business of buying and selling Native American
jewelry.
Since the early 1980's, Khalaf was the sole shareholder of
Al Zuni. From 1976 and through the years in issue, Khalaf
traveled throughout the Southwestern United States purchasing and
reselling on behalf of Al Zuni Native American jewelry.
Native Americans who live on reservations and who make and
sell jewelry often do not have easy access to banks and typically
would sell jewelry to Khalaf only for cash. Thus, over the
years, Khalaf purchased for cash the items of jewelry that were
added to Al Zuni’s jewelry inventory.
In September of 1992, on Al Zuni’s books and records there
was recorded a debt obligation of Al Zuni to Khalaf in the amount
of $196,510.
In mid-September of 1992, a transaction was entered into
between Al Zuni and Khalaf in which Al Zuni transferred to Khalaf
all of its then extant jewelry inventory.
In minutes of a special meeting of Al Zuni's board of
directors that was held on September 15, 1992, the transfer of a
portion of Al Zuni's jewelry inventory to Khalaf is described as
a transfer in payment of Al Zuni's above-mentioned $196,510 debt - 4 -
obligation to Khalaf. In those same minutes, the transfer of the
balance of Al Zuni’s jewelry inventory to Khalaf is described as
a sale by Al Zuni and as a purchase by Khalaf of the balance of
the jewelry inventory for a total price of $671,413.
A resolution reflected in the September 15, 1992, minutes of
Al Zuni's board of directors’ meeting indicates that Al Zuni’s
purported sale of jewelry to Khalaf for $671,413 was contingent
upon payment by Khalaf to Al Zuni of the $671,413 stated purchase
price.
The evidence establishes that Khalaf did not pay to Al Zuni
any portion of the $671,413 stated purchase price for the
jewelry. The parties herein, however, have stipulated, and we so
find that on September 15, 1992, Al Zuni’s jewelry inventory was
transferred and that Al Zuni’s total cost basis in the jewelry
inventory transferred to Khalaf on September 15, 1992, was
$538,000.
After the transfer to Khalaf of its jewelry inventory, Al
Zuni had no remaining assets and conducted no further business
activity.
On September 24, 1992, 9 days after the above transfer,
Khalaf transferred apparently the same jewelry inventory to
American Silver Jewelry Outlet, Inc. (American Silver), a related
corporation of which Khalaf was president and in which Khalaf’s
daughter was the sole shareholder. The nature and specific terms
of the transfer of jewelry from Khalaf to American Silver are not
disclosed in the record. In a special September 24, 1992, - 5 -
meeting of the board of directors of American Silver, the
transfer of the jewelry from Khalaf to American Silver is
referred to as a transfer “for sale by consignment” of jewelry
with “a value of $671,413”.
The trial record does not reflect any further sales or other
disposition by American Silver of the jewelry inventory it
received from Khalaf, nor does it reflect that Khalaf received
any payment from American Silver for the jewelry American Silver
received from Khalaf. The record herein does not contain any
written inventory, documentation, cost records, or other
description or list of the specific items of jewelry that during
the years in issue were bought and sold by Al Zuni, by Khalaf,
and by American Silver, nor of the items of jewelry that were
transferred on September 15 and 24, 1992, respectively, from Al
Zuni to Khalaf and from Khalaf to American Silver.
Twice a year, Khalaf would take a physical inventory of Al
Zuni’s jewelry on hand. Khalaf would provide to Murray Peck
(Peck), the certified public accountant who prepared Al Zuni’s
corporate Federal income tax returns and Khalaf’s individual
Federal income tax returns, information regarding the physical
inventory of Al Zuni’s jewelry that Khalaf had taken and of the
cost of jewelry that each year he had purchased with cash on
behalf of Al Zuni. Each year, Peck would use that information to
compute Al Zuni’s cost of goods sold. - 6 -
Since 1980, Peck has been the preparer of Al Zuni’s
corporate Federal income tax returns and of Khalaf’s individual
Federal income tax returns.
Al Zuni’s corporate Federal income tax returns for 1989,
1991, and 1992 were untimely filed. Al Zuni has not filed a
signed Federal income tax return for 1990.
On Al Zuni’s 1989, 1990 (unsigned), 1991, and 1992 corporate
Federal income tax returns, there were reported each year the
following total costs for jewelry inventory purchased, sold, and
yearend jewelry inventory:
As Reported on Al Zuni's Federal Income Tax Returns Cost of 1989 1990 1991 1992 Jewelry purchased $696,795 $1,242,051 $1,634,220 $1,845,156 Jewelry sold 560,426 985,030 1,536,380 1,908,386* Ending inventory 246,369 503,390 601,230 - 0 -
* After subtraction of jewelry with a reported cost of $538,000 to reflect transfer of the jewelry inventory to Khalaf.
On Al Zuni’s 1992 corporate Federal income tax return, which
was prepared using the accrual method of accounting, the transfer
of jewelry to Khalaf was reflected as a “transfer”. The transfer
is not expressly reflected as either a sale or as a distribution
to Khalaf. On Al Zuni's 1992 corporate Federal income tax
return, no gain or loss was reported with respect to the
September 15, 1992, transfer of Al Zuni’s jewelry inventory to
Khalaf. - 7 -
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T.C. Memo. 1999-74
UNITED STATES TAX COURT
AL ZUNI OF ARIZONA, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
NASHAT KHALAF, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 18917-96, 18918-96. Filed March 10, 1999.
Henry W. Tom and Rick Kilfoy, for petitioners.
Rachael J. Zepeda, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: In these consolidated cases, respondent
determined deficiencies in petitioners' Federal income taxes,
additions to tax, and penalties, as follows: - 2 -
Al Zuni of Arizona, Inc.
Addition to Tax Accuracy-Related Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) 1989 $274,514 $68,628 $54,903 1990 194,163 48,541 -- 1991 142,726 35,682 28,545 1992 290,668 72,667 58,134
Nashat Khalaf
Addition to Tax Accuracy-Related Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) 1989 $127,674 $32,041 $25,535 1990 51,682 13,204 10,336 1991 44,038 11,977 8,807 1992 245,164 -- 49,033
After settlement of many issues, the issues for decision
involve the amount of income that is to be charged to petitioner
Al Zuni of Arizona, Inc. (Al Zuni), on transfer of its inventory
of Native American jewelry to Nashat Khalaf (Khalaf), its 100-
percent shareholder, and the amount of capital gain that is to be
charged to Khalaf with regard to receipt from Al Zuni of the
jewelry inventory.
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. - 3 -
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
At the time the petitions were filed, Khalaf’s residence was
located in New Mexico.
Al Zuni was incorporated in 1976 as an Arizona corporation
engaged in the business of buying and selling Native American
jewelry.
Since the early 1980's, Khalaf was the sole shareholder of
Al Zuni. From 1976 and through the years in issue, Khalaf
traveled throughout the Southwestern United States purchasing and
reselling on behalf of Al Zuni Native American jewelry.
Native Americans who live on reservations and who make and
sell jewelry often do not have easy access to banks and typically
would sell jewelry to Khalaf only for cash. Thus, over the
years, Khalaf purchased for cash the items of jewelry that were
added to Al Zuni’s jewelry inventory.
In September of 1992, on Al Zuni’s books and records there
was recorded a debt obligation of Al Zuni to Khalaf in the amount
of $196,510.
In mid-September of 1992, a transaction was entered into
between Al Zuni and Khalaf in which Al Zuni transferred to Khalaf
all of its then extant jewelry inventory.
In minutes of a special meeting of Al Zuni's board of
directors that was held on September 15, 1992, the transfer of a
portion of Al Zuni's jewelry inventory to Khalaf is described as
a transfer in payment of Al Zuni's above-mentioned $196,510 debt - 4 -
obligation to Khalaf. In those same minutes, the transfer of the
balance of Al Zuni’s jewelry inventory to Khalaf is described as
a sale by Al Zuni and as a purchase by Khalaf of the balance of
the jewelry inventory for a total price of $671,413.
A resolution reflected in the September 15, 1992, minutes of
Al Zuni's board of directors’ meeting indicates that Al Zuni’s
purported sale of jewelry to Khalaf for $671,413 was contingent
upon payment by Khalaf to Al Zuni of the $671,413 stated purchase
price.
The evidence establishes that Khalaf did not pay to Al Zuni
any portion of the $671,413 stated purchase price for the
jewelry. The parties herein, however, have stipulated, and we so
find that on September 15, 1992, Al Zuni’s jewelry inventory was
transferred and that Al Zuni’s total cost basis in the jewelry
inventory transferred to Khalaf on September 15, 1992, was
$538,000.
After the transfer to Khalaf of its jewelry inventory, Al
Zuni had no remaining assets and conducted no further business
activity.
On September 24, 1992, 9 days after the above transfer,
Khalaf transferred apparently the same jewelry inventory to
American Silver Jewelry Outlet, Inc. (American Silver), a related
corporation of which Khalaf was president and in which Khalaf’s
daughter was the sole shareholder. The nature and specific terms
of the transfer of jewelry from Khalaf to American Silver are not
disclosed in the record. In a special September 24, 1992, - 5 -
meeting of the board of directors of American Silver, the
transfer of the jewelry from Khalaf to American Silver is
referred to as a transfer “for sale by consignment” of jewelry
with “a value of $671,413”.
The trial record does not reflect any further sales or other
disposition by American Silver of the jewelry inventory it
received from Khalaf, nor does it reflect that Khalaf received
any payment from American Silver for the jewelry American Silver
received from Khalaf. The record herein does not contain any
written inventory, documentation, cost records, or other
description or list of the specific items of jewelry that during
the years in issue were bought and sold by Al Zuni, by Khalaf,
and by American Silver, nor of the items of jewelry that were
transferred on September 15 and 24, 1992, respectively, from Al
Zuni to Khalaf and from Khalaf to American Silver.
Twice a year, Khalaf would take a physical inventory of Al
Zuni’s jewelry on hand. Khalaf would provide to Murray Peck
(Peck), the certified public accountant who prepared Al Zuni’s
corporate Federal income tax returns and Khalaf’s individual
Federal income tax returns, information regarding the physical
inventory of Al Zuni’s jewelry that Khalaf had taken and of the
cost of jewelry that each year he had purchased with cash on
behalf of Al Zuni. Each year, Peck would use that information to
compute Al Zuni’s cost of goods sold. - 6 -
Since 1980, Peck has been the preparer of Al Zuni’s
corporate Federal income tax returns and of Khalaf’s individual
Federal income tax returns.
Al Zuni’s corporate Federal income tax returns for 1989,
1991, and 1992 were untimely filed. Al Zuni has not filed a
signed Federal income tax return for 1990.
On Al Zuni’s 1989, 1990 (unsigned), 1991, and 1992 corporate
Federal income tax returns, there were reported each year the
following total costs for jewelry inventory purchased, sold, and
yearend jewelry inventory:
As Reported on Al Zuni's Federal Income Tax Returns Cost of 1989 1990 1991 1992 Jewelry purchased $696,795 $1,242,051 $1,634,220 $1,845,156 Jewelry sold 560,426 985,030 1,536,380 1,908,386* Ending inventory 246,369 503,390 601,230 - 0 -
* After subtraction of jewelry with a reported cost of $538,000 to reflect transfer of the jewelry inventory to Khalaf.
On Al Zuni’s 1992 corporate Federal income tax return, which
was prepared using the accrual method of accounting, the transfer
of jewelry to Khalaf was reflected as a “transfer”. The transfer
is not expressly reflected as either a sale or as a distribution
to Khalaf. On Al Zuni's 1992 corporate Federal income tax
return, no gain or loss was reported with respect to the
September 15, 1992, transfer of Al Zuni’s jewelry inventory to
Khalaf. - 7 -
There was reflected on Al Zuni’s 1992 corporate Federal
income tax return a loan to Khalaf in the amount of $460,600.
This $460,600 purported loan apparently related to the $671,413
stated total purchase price for the jewelry transferred to
Khalaf, less the $196,510 loan that Al Zuni owed to Khalaf and
that was treated by Al Zuni and Khalaf as paid off upon transfer
to Khalaf of the jewelry inventory.
The purported $460,600 loan from Al Zuni to Khalaf in
connection with the transfer of jewelry inventory to Khalaf was
not reflected by a promissory note or by any other loan
documentation. No payments of principal or interest were ever
made by Khalaf on the $460,600 purported loan owed to Al Zuni.
On Al Zuni’s corporate Federal income tax returns for 1983
and subsequent years, the amount of Khalaf’s capital investment
in his shares of stock in Al Zuni was reflected as $486,000.
On his 1992 Federal income tax return, Khalaf did not report
income or gain with respect to his receipt of jewelry from Al
Zuni.
On American Silver’s corporate Federal income tax return for
its taxable year ending September 30, 1993, a loan payable to
Khalaf in the total amount of $671,412 was reflected relating to
American Silver’s receipt on September 24, 1992, of the jewelry
inventory from Khalaf.
On audit of Al Zuni, respondent determined that on
September 15, 1992, Al Zuni distributed, rather than sold, all of
its extant jewelry inventory to Khalaf, that the September 15, - 8 -
1992, transaction between Al Zuni and Khalaf constituted a
distribution to Khalaf in complete liquidation of Al Zuni, that
the jewelry inventory Al Zuni transferred to Khalaf had a cost
basis to Al Zuni of $538,000, a total fair market value upon
distribution of $671,413, and that Al Zuni therefore realized on
the distribution business income of $133,413.
On audit of Khalaf, respondent determined that Khalaf had a
cost basis of zero in his shares of stock in Al Zuni, that the
value of the jewelry inventory Khalaf received from Al Zuni on
September 15, 1992, was $671,413, that a portion of the jewelry
inventory Khalaf received represented a repayment to Khalaf of
the $196,510 purported loan obligation Al Zuni owed to Khalaf,
and that the balance of the jewelry inventory Khalaf received
with a value of $474,903 represented taxable capital gain income
to Khalaf received in exchange for his shares of stock in Al
OPINION
Nature of Transaction
Respondent treats the September 15, 1992, transfer of
jewelry inventory from Al Zuni to Khalaf as a distribution under
section 331 in complete liquidation of Al Zuni, which treatment
petitioners do not seriously challenge. Rather, primarily
petitioners challenge respondent’s determination of the fair
market value of the jewelry inventory transferred to Khalaf, of
Al Zuni’s cost basis in the jewelry inventory, and of Khalaf’s
cost basis in his shares of stock in Al Zuni. - 9 -
Generally, in analyzing the factual issue of whether a
transfer of property to shareholders constitutes a distribution
under section 331 in complete liquidation of a closely held
corporation, it is the intent to shut down and liquidate the
corporation that is controlling, not whether a plan of
liquidation was formally adopted. See Genecov v. United States,
412 F.2d 556, 561-562 (5th Cir. 1969); Kennemer v. Commissioner,
96 F.2d 177, 178 (5th Cir. 1938), affg. 35 B.T.A. 415 (1937).
The transfer on September 15, 1992, to Khalaf of all of
Al Zuni’s extant jewelry inventory, the termination of any
further business activity of Al Zuni, and the failure of Khalaf
to make any payments on the $460,600 loan purportedly owed to
Al Zuni relating to the transfer constitute strong evidence that
the transfer of Al Zuni’s jewelry inventory to Khalaf constituted
a liquidation of Al Zuni and a distribution to Khalaf, not a
sale. We so hold.
Income of $133,413 Charged to Al Zuni
Section 336(a) provides generally that gain or loss is to be
recognized by a corporation on distribution of its property in
complete liquidation. The gain is to be computed based on the
fair market value of the property distributed over the
corporation’s cost basis in the property.
Fair market value is defined as the price at which property
would change hands between willing buyers and sellers, neither
being under any compulsion to buy or to sell and both having
reasonable knowledge of relevant facts. See United States v. - 10 -
Cartwright, 411 U.S. 546, 551 (1973); Collins v. Commissioner,
3 F.3d 625, 633 (2d Cir. 1993), affg. T.C. Memo. 1992-478; Estate
of Hall v. Commissioner, 92 T.C. 312, 335 (1989).
On the evidence before us in these cases, the best
indication of the fair market value of the jewelry inventory
transferred to Khalaf is found in the representations of value
set forth in Al Zuni's and in American Silver’s documentation
relating to the transaction at issue in these cases, particularly
the minutes of Al Zuni’s September 15, 1992, board of directors’
meeting which reflect a value for the jewelry inventory
transferred to Khalaf of $671,413.
At trial, Khalaf opined generally as to the decline during
the 1980's in the value of Native American jewelry to the effect
that such jewelry purchased in the early to mid-1980's would, in
1998 (at the time of the trial), be worth only 10 to 30 percent
of what it had cost. Khalaf did not opine as to the general
value of such jewelry in 1992.
We note that at trial neither party provided timely
independent expert witnesses as to the value of the jewelry
transferred to Khalaf. Even if experts had been called, due to
Al Zuni’s and Khalaf’s failure to have available a written
inventory, books and records, or other documentation describing
the specific items of jewelry transferred to Khalaf, such experts
would not have had sufficient information to make professional
valuations of the jewelry inventory transferred to Khalaf, and
their testimony would not have been helpful. - 11 -
On the limited evidence before us (including petitioners'
and American Silver's written contemporaneous representations as
to the value of the jewelry, the evidence reflected on Al Zuni's
tax returns as to the cost of the jewelry inventory that Khalaf
purchased for Al Zuni in 1990, 1991, and 1992 in the $1 million
plus range and regarding the cost of the jewelry inventory Al
Zuni had on hand at yearend 1990 and 1991 in the one-half million
dollar range), we conclude that the value of the jewelry
$671,413.
With regard to Al Zuni’s cost basis in the jewelry inventory
transferred to Khalaf on September 15, 1992, the parties
stipulated that the jewelry inventory had a cost basis to Al Zuni
of $538,000. Subtracting the $538,000 cost from the $671,413
value of the jewelry inventory transferred from Al Zuni to Khalaf
produces income to Al Zuni of $133,413.
Petitioners contend that certain checks totaling $133,000
written during 1992 by Khalaf on Al Zuni’s bank account in favor
of Khalaf, Khalaf’s daughter and son, and cash should be treated
as additional purchases of jewelry on behalf of Al Zuni, and
should be treated as increasing Al Zuni’s cost basis in the
jewelry inventory by at least $133,000 and as eliminating
essentially all gain on the transfer of the jewelry inventory to
Khalaf. No credible evidence indicates that these checks
constitute purchases of jewelry inventory. Petitioners' attempt - 12 -
to violate the stipulation of facts as to Al Zuni’s cost basis in
the jewelry inventory is rejected.
We sustain respondent’s adjustment charging Al Zuni with
income in the amount of $133,413 with regard to the September 15,
1992, transfer of jewelry inventory from Al Zuni to Khalaf.
Capital Gain Income of $474,903 Charged to Khalaf
Section 331 provides that amounts received by shareholders
in liquidation of a corporation shall be treated as full payment
in exchange for the shareholders' shares of stock in the
corporation. Under section 1001, a gain or loss realized by
shareholders upon receipt of property in complete liquidation of
a corporation is determined by comparing the value of the
property distributed with the cost basis the shareholders had in
their shares of stock.
We have concluded that the jewelry inventory Khalaf received
from Al Zuni in September of 1992 had a value of $671,413.
Respondent reduced this amount by the $196,510 principal amount
of the loan that Al Zuni apparently owed to Khalaf. As
explained, respondent treated Khalaf as having a zero basis in
his stock in Al Zuni, and respondent calculated that Khalaf
realized $474,903 in capital gain income on receipt from Al Zuni
of the jewelry inventory. The only issue remaining with regard
to this income adjustment is the amount of Khalaf’s cost basis in
his shares of stock in Al Zuni.
Respondent contends that Khalaf has not established that he
had any cost basis in his shares of stock in Al Zuni and that the - 13 -
full $474,903 constitutes taxable capital gain income to Khalaf.
Petitioners contend that Khalaf’s cost basis in his shares of
stock in Al Zuni was at least $486,000.
At trial, Khalaf and Peck testified that Al Zuni was
incorporated in 1976 with a capital contribution of property of
$360,000 and that in 1983 Khalaf made an additional cash
contribution to Al Zuni of $126,000. Khalaf thus contends that
his total cost basis in his stock in Al Zuni was $486,000, an
amount that fully offsets the $474,903 capital gain income that
respondent charges to Khalaf.
The trial record is not complete with regard to Khalaf’s
capital investment in Al Zuni. No stock record book or canceled
checks were offered into evidence that provide verification of
Khalaf’s basis in his shares of stock in Al Zuni. In evidence,
however, are copies of Al Zuni’s corporate Federal income tax
returns for 1983 and later years in which Khalaf’s capital
investment in his shares of stock in Al Zuni is consistently
reflected as $486,000.
Based on the limited evidence before us on this issue and in
light of Khalaf’s testimony and the invested capital reflected on
Al Zuni’s corporate Federal income tax returns, we conclude that
on September 15, 1992, Khalaf’s cost basis in his shares of stock - 14 -
in Al Zuni was $486,000, and we conclude that Khalaf realized no
capital gain income on the distribution from Al Zuni to him of
Al Zuni's jewelry inventory.
Decisions will be entered
under Rule 155.