Gerald Wayne Wheeler and the IRS seemed to be playing a game of “Who’s the True Earner?” – and Wheeler lost.
The U.S. Tax Court recently settled sales proceeds, inventory basis, rental payment and income questions raised by the IRS in Gerald Wayne Wheeler v. Commissioner, U.S. Tax Court, T.C. Memo 2014-204.
In this case, Wheeler had owned Specific Enterprises, an S corporation. The company was a cabinet door business during the late 1980s through 2002.
Specific Enterprises was operated at a commercial building, which Wheeler owned. During 2002, the business was liquidated and closed. The business assets were equipment and inventory.
A separate entity called Cabinet Door Shop, LLC, was now operating out of the commercial building owned by Wheeler. Cabinet Door Shop was managed by one of Wheeler’s three daughters. The assets of Cabinet Door Shop were the equipment and inventory originally owned by Specific Enterprises.
Wheeler received the assets of Specific Enterprises in liquidation. He held those assets personally.
Wheeler created a trust called RCC Capital Group. Wheeler transferred ownership of the assets and inventory received from Specific Enterprises to RCC. He also transferred ownership of his commercial building and land to RCC.
RCC exchanged two promissory notes valued at a total of $1.65 million in consideration of the assets, inventory, land and commercial building received. RCC then leased these assets to Cabinet Door Shop.
Wheeler drafted the rental agreement and determined the amount of the rental payments. The contract was for two years starting in January 2003 and running through the end of December 2004. The representatives of RCC and Cabinet Door Shop were not involved in the contract negotiations.
Cabinet Door Shop made rental payments to RCC of $273,000 for 2003 and $126,000 for 2004. RCC did not exercise its right to buy the building from Wheeler until March 2004.
After receiving the rental payments from Cabinet Door Shop, RCC turned around and remitted exactly the same amounts to Wheeler. So, Wheeler received $273,000 and $126,000 for 2003 and 2004, respectively.
In a separate deal between Wheeler and Cabinet Door Shop, inventory was sold to Cabinet Door Shop in the amount of $80,798.
Cabinet Door Shop ceased rental payments to RCC in June 2004. RCC in turn stopped paying Wheeler. Wheeler stated that the remaining payments owed to him by RCC were a gift to RCC.
Wheeler failed to file 1040 returns for 2003 and 2004. The IRS prepared those returns on his behalf.
The first issue that the U.S. Tax Court addressed was the sale of the inventory between Wheeler and Cabinet Door Shop. Wheeler’s position was that, because his basis in the inventory exceeded the sales price of the inventory, he had no income from the transaction.
Wheeler was unable to prove the amount of his cost or basis in his inventory. The information Wheeler provided the IRS was deemed not sufficient to establish his basis, so it was disregarded.
If the taxpayer provides some reasonable evidentiary basis, the court can estimate the basis. Wheeler did not provide any facts or details that permitted the court to estimate the basis of his inventory. Therefore, the court ruled that the inventory had no basis, and the entire sales proceeds amount of $80,798 was included in income.
The second issue that the Tax Court addressed was regarding the sale of the land, building and equipment to RCC. The court held that this was a sham transaction. The “true earner” of income is the person or entity that controls the earning of such income – not necessarily the entity that receives it.
Wheeler is the true earner of the income for three reasons:
1. Wheeler personally owned the assets that were being rented to Cabinet Door Shop – at least he did for the first 14 months of the lease. The assets were not transferred to RCC until March 15, 2004. The lease with Cabinet Door Shop started in January 2003.
2. RCC was merely a conduit for the income. RCC received the rental payments from Cabinet Door Shop and sent that exact same amount to Wheeler.
3. There was no separation of trust administration from the operation of Cabinet Door Shop. In essence, Wheeler maintained control over RCC even though he didn’t technically own it. This was evidenced by the fact that Wheeler negotiated and set the price for the asset lease between RCC and Cabinet Door Shop. Wheeler also convinced RCC not to file any trust tax returns for the applicable time period.
For these three reasons, the court concluded that the rental payments were actually taxable income to Wheeler, not to RCC.