Leonard C. Jaques, Sybil J. Jaques v. Commissioner of Internal Revenue
935 F.2d 104 (1991)
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Rule of Law:
Withdrawals by a controlling shareholder from their corporation are treated as taxable constructive dividends, rather than non-taxable loans, when there is no objective evidence demonstrating a contemporaneous intent to repay the funds at the time they were withdrawn.
Facts:
- Leonard C. Jaques, an attorney, was the sole shareholder of his professional corporation, Leonard C. Jaques, P.C.
- From 1983 through 1985, Jaques withdrew a total of $1,219,767 from the corporation for personal living expenses.
- The withdrawals were recorded on the corporation's books as 'Accounts Receivable-Officer' but were not accompanied by any promissory notes.
- There was no maturity date set for repayment, no collateral was pledged as security, and no interest was charged on the amounts withdrawn.
- During the years at issue, the corporation had substantial earnings but did not pay any formal dividends to Jaques.
- In a personal financial statement, Jaques noted the amount owed was to be repaid 'whenever convenience may focus.'
- During the same period, the corporation separately borrowed from its pension plan, and these transactions were formalized with interest-bearing promissory notes and regular interest payments.
Procedural Posture:
- The Commissioner of Internal Revenue determined deficiencies in the income tax of Leonard C. and Sybil J. Jaques for the years 1983, 1984, and 1985.
- The Jaqueses challenged the deficiencies by filing a petition in the United States Tax Court.
- The Tax Court held that the withdrawals were taxable dividends, not loans, and sustained the Commissioner's determination of deficiencies.
- The Jaqueses, as appellants, appealed the decision of the Tax Court to the United States Court of Appeals for the Sixth Circuit.
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Issue:
Do withdrawals of funds by a sole shareholder from his wholly-owned professional corporation constitute non-taxable loans when there is no promissory note, no repayment schedule, no security, no interest charged, and only sporadic, minor repayments have been made?
Opinions:
Majority - Boyce F. Martin, Jr.
No. The withdrawals constitute taxable dividends because the parties' intent at the time of the withdrawal, judged by objective factors, did not establish a bona fide debtor-creditor relationship. The court reasoned that a taxpayer's self-serving testimony of an intent to repay is insufficient without objective evidence. Here, the court pointed to several objective factors indicating the withdrawals were not loans: (1) the absence of promissory notes; (2) the lack of a fixed repayment schedule or maturity date; (3) the failure to pledge collateral; (4) the fact that Jaques made only small, sporadic repayments; (5) the corporation had significant earnings yet paid no formal dividends; and (6) Jaques was the sole shareholder, meaning the transactions were not at arm's length. The court contrasted these informal withdrawals with the properly documented, interest-bearing loans the corporation took from its pension plan, which demonstrated that Jaques knew how to structure a formal loan when he intended one.
Analysis:
This case solidifies the principle that for tax purposes, substance prevails over form, particularly in transactions between a closely-held corporation and its controlling shareholder. It provides a clear, multi-factor framework that courts will use to scrutinize such transactions, emphasizing that merely labeling a withdrawal a 'loan' on corporate books is meaningless without objective evidence of a true debtor-creditor relationship. The decision serves as a significant warning to owners of professional corporations and other closely-held businesses that using corporate funds for personal expenses without observing loan formalities will likely result in the withdrawals being reclassified as taxable constructive dividends.
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