Gideon L. and Corazon P. Medina v. Commissioner

112 T.C. No. 6

• Court: United States Tax Court
• Decided: February 22, 1999
• Docket: 18999-97
• Status: Unknown

Opinion

112 T.C. No. 6

UNITED STATES TAX COURT

GIDEON L. MEDINA AND CORAZON P. MEDINA, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 18999-97. Filed February 22, 1999.

H and W, who were both disqualified persons within the meaning of sec. 4975, I.R.C., borrowed $340,000 from the qualified pension plan of H's wholly owned corporation. H and W did not make any payments of interest or principal relating to the loan and did not file excise tax returns. 1. Held: Sec. 4975, I.R.C., applies to a loan, even though such loan, pursuant to sec. 72(p), I.R.C., was treated as a distribution. 2. Held, further, H and W did not correct, within the meaning of sec. 4975, I.R.C., the prohibited transaction and, pursuant to sec. 4975(a) and (b), I.R.C., are liable for both tiers of excise taxes. 3. Held, further, the "amount involved", on which the sec. 4975 excise taxes are based, is equal to the greater of interest paid or fair market interest relating to the loan. Because H and W did not make any payments of interest, the amount involved is the fair market interest. - 2 -

4. Held, further, in determining the amount involved, the fair market interest rate is 10.5 percent.

5. Held, further, H and W, pursuant to sec. 6651(a)(1), I.R.C., are liable for additions to tax for failing to file excise tax returns.

Michael E. Dumke, for petitioners.

Mark L. Hulse and Roberta M. Amos, for respondent.

OPINION

FOLEY, Judge: By notices dated June 25, 1997, respondent

determined deficiencies in, and an addition to, petitioners'

Federal excise taxes as follows:

Gideon L. Medina Excise Taxes Addition to Tax Year Sec. 4975(a) Sec. 4975(b) Sec. 6651(a)(1)

1991 $2,685 -- $671 1992 5,652 -- 1,413 1993 8,930 -- 2,233 1994 12,553 -- 3,138 1995 16,556 -- 4,139 1996 20,979 -- -- 19971 -- $468,469 -- 1 For the taxable period ending June 30, 1997.

Corazon P. Medina Excise Taxes Addition to Tax Year Sec. 4975(a) Sec. 4975(b) Sec. 6651(a)(1)

1992 $2,967 -- $742 1993 6,245 -- 1,561 1994 9,868 -- 2,467 1995 13,871 -- 3,468 1996 18,294 -- -- 19971 -- $414,769 -- 1 For the taxable period ending June 30, 1997. - 3 -

Unless otherwise indicated, 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. The issues for decision are as follows:

1. Does section 4975 apply to a loan even though such loan,

pursuant to section 72(p), was treated as a distribution? We

hold that it does.

2. Did petitioners, within the meaning of section

4975(f)(5), correct the prohibited transaction? We hold that

they did not.

3. What is the "amount involved" relating to a loan that is

subject to section 4975 excise taxes? We hold that the "amount

involved" is the greater of the interest paid or the fair market

interest.

4. In determining the "amount involved" relating to

petitioners' loan, what is the fair market interest rate? We

hold that the fair market interest rate is 10.5 percent.

5. Are petitioners, pursuant to section 6651(a), liable for

additions to tax for failing to file excise tax returns? We hold

that they are.

Background

The parties submitted this case fully stipulated pursuant to

Rule 122. At the time the petition was filed, petitioners

resided in Niles, Michigan. - 4 -

Gideon Medina was an employee, the sole shareholder, and

president of Gideon L. Medina, M.D., P.C., a Michigan

professional corporation (corporation). Corazon Medina was

secretary of the corporation. The corporation established a

qualified employees' pension plan and trust (plan), which met the

requirements of section 401. During the years in issue,

petitioners were participants in the plan.

On December 1, 1986, petitioners borrowed $340,000 (loan)

from the plan to acquire Sunshine Villa Apartments. Petitioners

executed a promissory note with the following terms: (1)

Interest at the rate of 10.5 percent per annum is payable

annually; (2) any unpaid interest is added to the principal

amount; and (3) the entire principal amount is due 8 years from

the date of the note or, if sooner, upon the sale of Sunshine

Villa Apartments. On August 15, 1991, Mr. Medina executed a

document providing that "Building C of Sunshine Villa Apartments

* * * [is] assigned to * * * [the plan]. * * * to ensure that

the loan is paid if and when the Sunshine Villa is sold."

Petitioners did not file Form 5330, Return of Excise Taxes

Related to Employee Benefit Plans, for any of the years in issue,

nor did they make any payments to the plan pursuant to the terms

of the promissory note. - 5 -

Discussion

Section 4975 imposes two tiers of excise taxes on a

prohibited transaction. The first tier is 5 percent of the

"amount involved" relating to a prohibited transaction for each

year, or part thereof, in the "taxable period". Sec. 4975(a).

If the first-tier excise tax applies and the transaction is not

corrected within the "taxable period", a 100-percent second-tier

tax is imposed on the "amount involved" relating to the

prohibited transaction. Sec. 4975(b).

I. Application of Section 4975 to a Loan Subject to

Section 72(p)

The lending of money between a plan and a disqualified

person generally is a prohibited transaction. See sec.

4975(c)(1)(B). Respondent determined that petitioners are

disqualified persons who participated in a prohibited transaction

(i.e., the loan) and, thus, are liable for section 4975 excise

taxes. Petitioners do not contest respondent's contention that

petitioners are disqualified persons. Petitioners contend,

however, that they did not participate in a prohibited

transaction during the years in issue (i.e., 1991 through 1997)

because, pursuant to section 72(p), the loan was a taxable

distribution in an earlier year (i.e., 1986). As a result,

petitioners contend, section 4975 excise taxes are not

applicable. Respondent contends that the loan was subject to - 6 -

section 4975 during the years in issue even though the loan,

pursuant to section 72(p), was treated as a distribution in an

earlier year.

To resolve this issue, we need not look beyond the plain and

ordinary meaning of the words used in section 72(p). See United

States v. Locke, 471 U.S. 84, 93 (1985); Phillips Petroleum Co.

v. Commissioner, 101 T.C. 78, 97 (1993). Section 72(p)(1)(A)

provides that a loan from a qualified employer plan to a plan

participant "shall be treated as having been received by such

individual as a distribution under such plan." The loan is

"treated" as a distribution only for purposes of section 72,

which determines the amount of a distribution subject to income

tax. See sec. 72(p). The characterization of the loan for

section 72 purposes does not change its inherent character for

section 4975 excise tax purposes. Accordingly, section 4975 may

apply to a loan even though such loan, pursuant to section 72(p),

was treated as a distribution. Section 4975 is applicable to

petitioners' loan transaction.

II. Correction of the Prohibited Transaction

Petitioners contend, in the alternative, that they are not

liable for section 4975 excise taxes because they "corrected" the

prohibited transaction on August 15, 1991, the date Mr. Medina

executed the document that assigned to the plan the proceeds from

a future sale of Sunshine Villa Apartments. Respondent contends - 7 -

that the prohibited transaction was not "corrected" within the

meaning of section 4975.

Disqualified persons are subject to the first-tier excise

tax only for years, or portions of years, within the "taxable

period." Sec. 4975(a). The second-tier excise tax does not

apply if the prohibited transaction was corrected within the

"taxable period". Sec. 4975(b). The "taxable period" is the

period beginning on the date the prohibited transaction occurs

(i.e., December 1, 1986) and ending on the earliest of three

dates: (1) The date of mailing the notice of deficiency (i.e.,

June 25, 1997); (2) the date on which the section 4975(a) excise

tax is assessed (no assessment has been made); or (3) the date on

which correction of the prohibited transaction is completed.

Sec. 4975(f)(2).

A prohibited transaction is corrected by "undoing the

transaction to the extent possible, but in any case placing the

plan in a financial position not worse than that in which it

would be if the disqualified person were acting under the highest

fiduciary standards." Sec. 4975(f)(5). Where the prohibited

transaction is the lending of money, the disqualified person

corrects the transaction by repaying the principal plus

reasonable interest. See Kadivar v. Commissioner, T.C. Memo.

1989-404; sec. 53.4941(e)-1(c)(4), Foundation Excise Tax Regs.

Mr. Medina's assignment to the plan of future sales proceeds did - 8 -

not result in the repayment of principal or interest. Therefore,

petitioners did not correct the prohibited transaction, and the

taxable period ended on June 25, 1997, the date respondent mailed

the notice of deficiency. Accordingly, petitioners are liable

for both tiers of section 4975 excise taxes.

III. Amount Involved

Section 4975 excise taxes are imposed on the "amount

involved" relating to the prohibited transaction. Sec. 4975(a)

and (b). This section states that the "amount involved" is the

"greater of the amount of money and the fair market value of the

other property given or the amount of money and the fair market

value of the other property received". Sec. 4975(f)(4). Where

the use of money is involved (i.e., a loan), the regulations

define the "amount involved" as the "greater of the amount paid

for such use or the fair market value of such use". Sec.

53.4941(e)-1(b)(2)(ii), Foundation Excise Tax Regs.; see also id.

subpar. (4), Example (2). See generally sec. 141.4975-13,

Temporary Excise Tax Regs., 41 Fed. Reg. 32890 (Aug. 5, 1976) and

51 Fed. Reg. 16305 (May 2, 1986) (providing that the Foundation

Excise Tax Regulations define the term "amount involved" for

purposes of section 4975 until permanent regulations under

section 4975 are promulgated).

Petitioners contend that the "amount involved" relating to a

loan is the greater of the interest paid or the fair market - 9 -

interest. Respondent contends that the amount involved is the

greater of the "interest actually charged" (i.e., the 10.5-

percent stated interest rate) or the fair market interest.

Respondent relies on Thoburn v. Commissioner, 95 T.C. 132, 139

(1990), and Janpol v. Commissioner, 101 T.C. 518, 529 (1993), as

support for this contention. In Thoburn, the Court paraphrased

the regulations' "amount paid" language as "interest actually

charged". See Thoburn v. Commissioner, supra at 139. The

Court's statement is dicta. In Janpol, the Court repeated this

statement without discussion or necessity. See Janpol v.

Commissioner, supra at 529. In these cases, it is not clear

whether "interest actually charged" means interest stated,

billed, or paid.

We hold that, in the case of a loan, the "amount involved"

is the greater of the interest paid or the fair market value of

the use of the loan proceeds. Our holding and the Treasury

regulations are consistent with the statute's express language.

The statute refers to the greater of "money and * * * other

property given" or "money and * * * other property received".

See sec. 4975(f)(4). In the case of a loan, the money "given"

and "received" is the interest paid by one party and received by

the other. "Interest actually charged" can be interpreted as the

stated or billed interest, and such interest is not, necessarily,

"given" or "received". - 10 -

IV. Value of the Use of Loan Proceeds

Petitioners paid no interest on the loan. As a result, the

"amount involved" is the fair market value of the use of the loan

proceeds (i.e., as reflected by the interest rate). Petitioners

contend that the loan violates Michigan's usury laws, which

prevent a lender from recovering any interest on loans that

provide for interest at a rate that exceeds 7 percent. See Mich.

Comp. Laws Ann. sec. 438.31 and .32 (1978). Petitioners further

contend that the fair market value of the use of the loan

proceeds is zero. Respondent contends that the Court should

conclude that the Employee Retirement Income Security Act of 1974

(ERISA), Pub. L. 93-406, 88 Stat. 829, preempts Michigan's usury

laws and that the "amount involved" should be calculated using a

10.5-percent interest rate.

We reject petitioners' contentions. Petitioners contend

that the fair market value of the use of the loan proceeds equals

what a third-party buyer of the usurious loan would assign to the

loan's stated interest. This value should be based, however, on

a hypothetical loan between a willing lender and a willing

borrower rather than a hypothetical sale of the loan to a third-

party buyer.

We agree with respondent that the fair market interest rate

is 10.5 percent, but we reject his reasoning. A hypothetical

lender would not lend money to a hypothetical borrower at a rate

less than the fair market interest rate. The usury laws, - 11 -

however, do not necessarily establish the fair market rate. See

Estate of Arbury v. Commissioner, 93 T.C. 136, 143 (1989)

(stating that the maximum rates set by usury laws do not

necessarily reflect the economic value of the use of borrowed

funds). Therefore, we need not decide whether ERISA preempts

Michigan's usury laws. Respondent determined that the fair

market interest rate is 10.5 percent and petitioners have not

established that this rate is erroneous. See Welch v. Helvering,

290 U.S. 111, 115 (1933). Accordingly, we hold that, in

determining the "amount involved" relating to petitioners' loan,

10.5 percent is the fair market interest rate.

V. Addition to Tax

Each disqualified person liable for section 4975 excise

taxes with respect to a prohibited transaction is required to

file Form 5330 for each taxable year, or portion thereof, in the

taxable period. Sec. 6011; sec. 54.6011-1(b), Pension Excise Tax

Regs. Section 6651(a)(1) imposes an addition to tax for the

failure to file a required return, unless petitioners establish

that such failure is due to reasonable cause and not due to

willful neglect. Petitioners failed to file excise tax returns

for the years in issue and have failed to establish that they had

reasonable cause not to file such returns. Accordingly,

petitioners are liable for the section 6651(a)(1) additions to

tax.

Decision will be entered

for respondent.