Scheaf v. U.S. No. C-82-0388-SW (1983)

United States District Court; N.D. California.

K. Laurel Scheaf, Plaintiff

v.

United States of America, Defendant.

No. C-82-0388-SW

9/8/83

MACMAHON, District Judge.

Opinion and Order
Plaintiff seeks a refund of income taxes, claiming that she is entitled to an interest deduction under 26 U. S. C. § 163(a) for a payment of $5,718.00 to Antigua Banking Limited on November 30, 1977. Plaintiff argues simply that the interest payment was made upon a genuine indebtedness. The government argues that no bona fide indebtedness existed between plaintiff and ABL and that the funds used for the interest payment belonged not to plaintiff but rather to a third party.

A bench trial was held on July 25-29, 1983. At the close of plaintiff's case, the government moved for a directed verdict. We reserved judgment, but we now grant the motion. In addition, we have considered the government's evidence and also grant judgment to the government upon all the evidence presented. Our findings of fact and conclusions of law, respectively, are divided into those based upon plaintiff's case and those based upon all the evidence.

Any finding of fact deemed a conclusion of law hereby is concluded as a matter of law; any conclusion of law deemed a finding of fact hereby is found as a fact.

A. Plaintiff's Case.
1. Plaintiff filed a claim for refund. Ex. D-10.

2. Harry Margolis and his law office acted as plaintiff's tax attorney and financial advisor during the years relevant to this lawsuit. T. 74. Also during these years, plaintiff was an officer of "est," now Werner Erhard & Associates. T. 72 "Est" was founded by Erhard, T. 72, and was a client of the Margolis office, T. 30-31.

3. Antigua Banking Limited ("ABL") is a private bank, incorporated in Antigua, managed and operated out of the Margolis office, T. 34. Its purpose is to provide financing for clients of Margolis, T. 35. Margolis is president of ABL and director, his wife is vice president and a director, and his daughter is secretary-treasurer and a director; thus, Margolis is the single individual most in control of ABL's activities, T. 193. ABL has contracted to obtain services from the Margolis office, T. 194. ABL is now owned by Island Bank, a British Virgin Islands corporation, T. 195.

4. Anglo-Dutch Capital Company ("ADC"), now defunct, was a company similar to ABL; its purpose also was to provide financing for clients of the Margolis office, T. 39. ADC was owned by Margolis and Walter Joe, T. 40.

5. Alexia Trust Company ("ATC") is a trust company organized in the Channel Islands, T. 495. It is owned by Evard van Walsum, who is also the managing director of ATC and of Island Bank, T. 218-19.

6. van Walsum travels to the Margolis office, and Margolis employees travel to van Walsum's offices in Panama and Holland, T. 70.

7. Plaintiff borrowed $5,000.00 from ADC by signing a note numbered 2992. This note was dated June 20, 1973; it provided that interest at the rate of 10% per year was payable quarterly and that the principal was due in six months. The proceeds of this loan were a check signed by Margolis. Ex. P-M.

8. Plaintiff borrowed $2,500.00 from ADC by signing a note numbered 3306. This note was dated July 10, 1973; its terms were the same as those of Note 2992. The proceeds check was signed by Margolis. Ex. P-M.

9. These two notes were stamped "Paid" and the date "12-14-73" was handwritten on each below the stamp. A document entitled "Anglo Dutch Capital Company Loan History" indicates that plaintiff paid $265.00 interest on Note 2992, but does not reflect an interest payment on Note 3306. Ex. P-M.

10. Plaintiff borrowed $500.00 from ABL by signing a note numbered 115. This note was dated October 1, 1973; it provided that interest at the rate of 10% per year was payable monthly but had no provision for the repayment of the principal. Ex. P-A(1). The proceeds check was signed by Margolis. Ex. P-C(1).

11. This proceeds check, and the proceeds checks from subsequent ABL loans to plaintiff, were deposited into one or another of plaintiff's bank accounts by someone from the Margolis office. T. 106. Plaintiff received monthly statements showing her balance at ABL. T. 87. 12. Despite the terms of Note 115 and of subsequent notes plaintiff signed with ABL, she never made a payment until she was requested to do so by someone at the Margolis office. It was her understanding that she was not required to pay any money until requested to do so by someone at the Margolis office. T. 92, 143.

13. On November 14, 1973, plaintiff opened a checking account at Barclay's Bank of California ("Barclay's") by signing a signature card and depositing $100.00 which she borrowed from Margolis to open the account. T. 118, Ex. P-D, P-E. The signature card also was signed by Doxie Gore of the Margolis office, Ex. P-E, who subsequently maintained the check register, T. 114, Ex. P-D. All the checks written on this account were typewritten. Ex. P-D, D-4.

14. Plaintiff borrowed $8,500.00 from ABL. Plaintiff first signed an unnumbered note dated December 14, 1973, which provided that interest at the rate of 10% per year was due monthly but which made no provision for the repayment of the principal. This note was marked "cancelled-replaced by note 613." Ex. D-15. Note 613 also is dated December 14, 1973; it also is for $8,500.00, but it provides that interest at the rate of 10% per year was payable quarterly and that the principal was due on demand or within one year if no demand were made. Ex. P-A(2). The proceeds check, dated December 14, was signed by Margolis. Ex. P-C(2). Although the bank statement indicates that this check was deposited in plaintiff's account at Barclay's on December 14, the check register shows November 15, 1973 as the date of the deposit. Ex. P-D.

15. Also on December 14, two checks drawn on plaintiff's Barclay's account cleared the bank. Ex. P-D. These checks were for $100.00 payable to Margolis and $7,765.00 payable to ADC, and both were signed by Doxie Gore. Ex. D-4. Although both checks cleared the bank on December 14, both were dated November 15. Ex. P-D.

16. Plaintiff borrowed $2,300.00 from ABL by signing a note numbered 687. This note was dated January 17, 1974; its terms were the same as those of Note 613. Ex. P-A(3). The proceeds check, signed by Margolis, was deposited in plaintiff's Barclay's account on January 18. Ex. P-C(3). 17. On January 18, 1974, a check for $2,500.00 payable to plaintiff was drawn on plaintiff's Barclay's account and signed by Doxie Gore. Ex. D-4. After this check, there was no activity in plaintiff's Barclay's account until 1977 with the exception of a $100.00 deposit on February 18, 1975, Ex. D-3, explained in the check register as "Werner Erhard-return 100.00 paid on loan," Ex. P-D. However, there are two curious entries in the check register in this period. One is the entry "VOID" for Check No. 101; another is the word "VOID" written over the entry "Nevada Energy and Heating Partnership" for Check No. 102 in the amount of $10,000.00 Ex. P-D.

18. Plaintiff borrowed $2,000.00 from ABL by signing a note numbered 247. This note was dated April 12, 1974; it prvided that interest at the rate of 10% per year was due monthly and that the principal was due on demand but within six months if no demand were made. Ex. P-A(4). The proceeds check was signed by Margolis. Ex. P-C(4).

19. Note 247 was marked "Cancelled-replaced by No. #681." Note 681, signed by plaintiff, was dated April 12, 1974, the same day as Note 247. The terms of this note were the same as those of Note 613. Ex. P-B(4).

20. Note 145, in the amount of $500.00, was replaced by Note 517, also for $500.00. Note 517 was dated October 2, 1974; its terms were the same as those of Note 681. Ex. P-A(1), P-B(1). 21. Plaintiff borrowed $4,000.00 from ABL by signing a note numbered 2103. This note was dated September 2, 1976; its terms were the same as those of Note 613. Ex. P-A(5). The proceeds check, signed by Margolis, was dated August 2, 1976. Ex. P-C(5).

22. By check dated December 29, 1976, plaintiff paid ABL $200.00 pursuant to a request from the Margolis office T. 143. This check was drawn on plaintiff's account at Lloyd's Bank, California. The date and amount on this check are in plaintiff's handwriting, as are the words "loan payment" on the memo line. The name of the payee and the words "Note #2103" on the memo line are not in plaintiff's handwriting. Plaintiff signed the check. Ex. P-L. ABL credited $70.00 of the $200.00 to principal, $130.00 to interest. Ex. P-K.

23. Plaintiff refinanced Notes 613, 687, 681 and 517 by signing a note numbered 2567 for $13,300.00. Note 2567 was dated June 1, 1977; its terms were the same as those of Note 517. Ex. P-B(2).

24. Plaintiff refinanced the remaining balance (see FF 22) on Note 2103 by signing Note 2733. This note was dated September 2, 1977; it provided that interest at the rate of 10% per year, and the principal, were due in one year. Ex. P-B(5).

25. Plaintiff paid ABL $6,000.00 upon the request of someone in the Margolis office, T. 100, by check dated "November, 1977" and drawn upon plaintiff's Barclay's account. It is this payment that is at issue in this case. A space appears in the date on the check for the day of the month, but it is blank. Ex. P-D. The check register indicates the check was dated November 29, Ex. P-D; it cleared the bank November 30, creating an overdraft of $5,878.37, Ex. D-3. ABL credited $282.00 of the $6,000.00 to principal, and $5,718.00 to interest. Ex. P-K. This allocation was also made in plaintiff's check register, Ex. P-D, which was maintained by Doxie Gore, a Margolis employee, T. 114.

26. On December 1, 1977, $6,000.00 was deposited in plaintiff's Barclay's account. Ex. D-3. This money was received by Barclay's on November 30 by telephone from "Island Bank/Alexia Trust Co." Ex. D-3. Plaintiff does not know where his money came from. T. 132. Margolis testified that it was a loan from a trust of which ATC was the trustee. T. 444. The check register indicates that it was a loan from ATC. Ex. P-D.

27. Plaintiff refinanced Note 2567 by signing a note numbered 3315 for $13,018.00, the remaining balance on Note 2567 (see FF 24). This note was dated June 1, 1978; its terms were the same as those of Note 2733. Ex. P-B(3).

28. Plaintiff borrowed $7,500.00 from ABL by signing a note numbered 3568. This note was dated October 6, 1978; its terms were the same as those of Note 2567. Ex. P-A(6). The proceeds check was signed by Margolis and Robert Dunnett, Ex. P-C(5), an attorney in the Margolis office, T. 233. The check was deposited in plaintiff's Barclay's account on October 9. Ex. P-C(5), D-3. However, the deposit slip was dated October 6, Ex. D-3, and the check register indicates that the deposit occurred September 22, 1978, Ex. D-5.

29. Also on October 9, 1978, Barclay's paid a check signed by plaintiff made out to MCDM Partnership II for $7,500.00. Ex. D-3. The check was dated October 6, Ex. D-3, but the check register indicates September 22 as the date the check was written, Ex. D-5. Plaintiff invested in MCDM, a real estate partnership, upon Margolis' recommendation. T. 172.

30. Plaintiff borrowed $9,300.00 from ABL by signing a note numbered 4311. This note was dated November 27, 1979; its terms were the same as those of Note 3315. A disclosure statement furnished by plaintiff was signed on behalf of ABL by Margolis as president. Ex. P-A(7). The proceeds check was signed by Margolis and another person whose signature is illegible, Ex. P-C(7), and was deposited to plaintiff's Barclay's account on November 28, Ex. D-3.

31. Also on November 28, Barclay's paid a check signed by plaintiff and drawn on her Barclay's account to the order of Summit, Ltd. for $9,300.00. Ex. D-3. This check represented a real estate investment arranged through the Margolis office. T. 178.


 * 5 32. At trial, plaintiff did not know where the real estate involved in MCDM or Summit was located, who the partners were, whether she is now a partner, or the nature of her investments in these two entities. T. 179.

33. On December 6, 1979, plaintiff deposited $25,000.00 in her Barclay's account. On the same date, Barclay's paid a check signed by Doxie Gore and drawn on plaintiff's account to ABL for $7,500.00. On December 18, Barclay's paid a check signed by Doxie Gore drawn on plaintiff's account to plaintiff for $1,000.00, and on January 10, 1980, the bank paid a check signed by Doxie Gore drawn on plaintiff's account to "R. H. Adolphson Special Account" for $16,500.00. Thus, at the end of the day on January 10, the balance in plaintiff's account was the same as that before the $25,000.00 deposit on December 6. Ex. D-3. R. H. Adolphson was an employee of the Margolis office. T. 28.

34. Plaintiff's Notes 2733 and 3315 were stamped "PAID," and the date "9-24- 80" handwritten under this stamp. Ex. P-B(5), P-B(3). This payment also is reflected on ABL's ledgers. Ex. P-K. Plaintiff offered no other evidence of these payments.

35. On December 10, 1980, Barclay's paid a check signed by plaintiff and drawn on her account to Phoenix Properties Partnership for $40,000.00. This check created an overdraft in her account of $39,879.23. Ex. D-3.

36. On December 11, 1980, $40,000.00 was deposited to plaintiff's Barclay's account. Ex. D-3. The check register indicates that this was a loan from "Eric BV." Ex. P-D. Plaintiff could not recall whether she had ever borrowed money from Eric, where it was, what it did, or whether she now owes Eric any money. T. 154, 157.

37. On March 30, 1981, $3,961.64 was deposited to plaintiff's Barclay's account. Also on March 30, Barclay's paid a check signed by plaintiff drawn on her Barclay's account to ABL for the peculiar sum of $3,961.64. Ex. D-3. This check was dated March 6, Ex. D-3, and the check register entry was dated March 16, Ex. P-D.

38. In addition to the payments referred to in FF 21, 24 and 33, the following payments on plaintiff's notes are reflected in ABL's ledger: principal, $3,638.00 on December 6, 1979; interest, $300.00 on November 27, 1979, $386.00 on December 6, 1979, $2,242.00 on September 24, 1980. Ex. P-K. No other evidence of these payments was offered.

39. No evidence of payment was offered other than those referred to in FF 21, 24, 33 and 37. B. Government's Case. 40. It was the practice of the Margolis office to arrange numerous telephonic transfers between Barclay's and Barclay's Bank International, Tortola, British Virgin Islands ("Tortola"), to take place on a single day. T. 345-46. Such a series of telephonic transfers took place on November 30, 1977. Ex. D-9.

41. Barclay's was notified of the impeding incoming telephonic transfers and authorized to make the outgoing telephonic transfers of November 30, 1977 by means of the advices of incoming transfer and authorization letters, respectively, in pages 8 to 28 of Ex. D-9. 42. It was the practice of the Margolis office to deliver such advices of incoming transfer and authorization letters to Barclay's in the order the Margolis office wanted the telephonic transfers to take place. T. 373-74, 411.

43. The credit advices and advices of charge, which reflect the consummated transfers, appear in Ex. D-9 in the order the transfers actually took place. T. 301, 302.

44. With the exception of the documents relating to the transfer of $1,000,000.00 from the account "OUr [sic] Ref IN 31023 B/O Barclay's Kol & co [sic] Amsterdam" to the account of Werner Erhard, the advices of incoming transfer and authorization letters are in the same order as the credit advices and advices of charge. Ex. D-9. In addition, the Margolis office often arranged these transfers with the office of van Walsum, the managing director of Island Bank. T. 376-80, 394-95. Such consultation would be necessary in order to ensure that the bank official conducting the telephonic transfers in Tortola also was prepared to process the telephonic transfers in the prearranged order. We find that the Margolis office delivered the advices of incoming transfer and authorization letters to Barclay's in the order the Margolis office wanted the telephonic transfers of November 30, 1977 to take place. T. 373-74, 411. 45. The telephonic transfers that took place accurately are reflected in Ex. D-12, a copy of which is the Appendix to this opinion.

46. Interlit, Ltd. was formerly Est, International, and the Margolis office is a client of Interlit. T. 391.

47. Island Bank maintains a bank account with Tortola. T. 382.

48. Assume a transfer, which we will call transaction 6A, of $152,379.21 from Island Bank's account to Interlit's account in Tortola immediately before the transfer of that sum from Interlit's account to Finch Partnership's account at Barclay's. In addition, assume a transfer, which we will call transaction 20A, of $1,000,000.00 from Island Bank's account to the account of "OUr [sic] Ref IN 31023 B/O Barclay's Kol & co [sic] Amsterdam" in Tortola immediately before the transfer of that sum from the latter account to Erhard's account at Barclay's. Assume further that the balance in Island Bank's account before these transfers was zero. After each transaction, the balance in Island Bank's account would be as follows:

TABULAR OR GRAPHIC MATERIAL SET AT THIS POINT IS NOT DISPLAYABLE

Thus, under the above assumptions, the balance in the Island Bank account never would have gone below zero.

49. The following on the balances of Finch Partnership's account at Barclay's after transactions affecting that account. Again, assume an initial balance of zero.

TABULAR OR GRAPHIC MATERIAL SET AT THIS POINT IS NOT DISPLAYABLE

Again, the balance in this account never would have gone below zero under the above assumption. 50. Nevada Energy and Heating Partnership is an entity sometimes used in the tax planning of the Margolis office. Ex. D-9. Cf. supra FF 17.

A. On the Motion for Directed Verdict.
1. This court has jurisdiction by virtue of 26 U. S. C. § 7422(a) and 28 U. S. C. § 1346(a)(1). 2. There has been some confusion in this case as to the burden of proof. The burden is on the taxpayer to show that she is entitled to a refund. Lewis v. Reynolds [3 USTC P 856], 284 U. S. 281, 283 (1932). This is the law whether or not the government's theories at trial differ from those advanced in the notice of deficiency. See Roybark v. United States [55-1 USTC P 9122], 218 F. 2d 164, 166 (9th Cir. 1954); King v. United States [81-1 USTC P 9307], 641 F. 2d 253, 259 (5th Cir. 1981).

3. Plaintiff is a cash basis taxpayer.

4. Plaintiff is entitled to a deduction for all interest paid within a given taxable year on indebtedness. 26 U. S. C. § 163(a). Interest is compensation for the use of borrowed money. Deputy v. du Pont [40-1 USTC P 9161], 308 U. S. 488, 498 (1940). Interest is deductible only on genuine indebtedness, i. e., indebtedness in substance and not merely in form. See Knetsch v. United States [60-2 USTC P 9785], 364 U. S. 361 (1960). Documents and bookkeeping entries are not dispositive evidence that a transaction has substance. Commissioner v. Goldwyn [49-1 USTC P 9321], 175 F. 2d 641, 644 (9th Cir. 1949); Yale Avenue Corp. v. Commissioner [CCH Dec. 31,556], 58 T. C. 1062, 1074 (1972).

5. Plaintiff has failed to present a prima facie case of her entitlement to an interest deduction for the payment of Novmber 30, 1977 for two reasons.

6. First, the indebtedness on which the payment was made was not genuine. The following factors lead to this conclusion: (1) there was no arm's length negotiation of the terms of the notes plaintiff signed with ABL, because Margolis was both president of ABL and plaintiff's tax attorney and financial advisor, FF 2, 6, 7, 9, 13, 15, 17, 20, 27, 29; (2) the loans were unsecured; (3) the repayment schedules in the notes were ignored, FF 11, 38; (4) plaintiff understood that she was not required to make any payments until requested to do so by the Margolis office, FF 11, 21, 24; (5) the interest rate remained 10% for the period 1973-79, FF 6, 7, 9, 13, 15, 17, 20, 22, 23, 26, 27, 29; (6) plaintiff's testimony about her use of the loan proceeds was not credible; (7) plaintiff made no payments on the loans for significant periods, FF 28; (8) the payments made were made only because they were requested, FF 11, 21, 24; (9) no direct evidence was offered of the payments referred to in FF 33 and 37 leading to the inference that these entries were fraudulent; (10) the only significant payment for which direct evidence was offered, cf. FF 33, 37, was itself a sham transaction, see infra conclusions of law 7 & 10; and (11) ABL made no attempt to collect when plaintiff failed to make interest and principal payments as called for by the notes.

7. Second, the payment of $6,000.00 to ABL on November 30, 1977 was a sham transaction. The following factors point to this conclusion: (1) plaintiff did not know where the deposit which covered the overdraft caused by the payment to ABL came from, FF 25; (2) the deposit came from an overseas entity beyond the subpoena power of this court, FF 25, leading to the inference that this entity was used in order to evade taxation; (3) the payments and the deposit which covered the overdraft occurred in the space of two days in an account which was dormant for long periods of time, FF 16, 24, 25; (4) the space for the exact date of the check was left blank, FF 24, leading to the inference that the check was prepared well in advance to await the movement of funds from another Margolis-controlled property; and (5) the loan on which the payment was made was not a genuine indebtedness, see conclusion of law 6.

8. Although the evidence that the $6,000.00 payment on November 30, 1977 was a sham is not overwhelming, the only evidence plaintiff offered which contradicts this conclusion is the testimony of Margolis that the deposit which covered the payment to ABL was the proceeds of a loan from the "Bessie Clausen trust," a trust administered by ATC, and the check register of the Barclay's account, which indicates that the deposit was a loan from ATC. FF 25. This evidence is unpersuasive for four reasons: First, it is contradictory; Margolis testified that the loan was from a specific trust, while the register indicates it was from ATC itself. Second, no direct evidence of a loan, such as a promissory note, was offered. Third, the alleged loan was unsecured and was interest-free. T. 503. Finally, the testimony of Margolis was not credible. Margolis has an interest in this case because it is his tax planning that is at issue, and, indeed, he is financing the litigation for plaintiff. T. 516-17. More importantly, his demeanor while testifying, especially his claimed sudden recollection on the stand, T. 503-04, was unconvincing.

B. Upon All the Evidence.
9. First, the indebtedness upon which the $6,000.00 payment was made was not genuine. See conclusion of law 7.

10. Second, the government's evidence strengthens the conclusion, No. 7 above, that the $6,000.00 payment on November 30, 1977 was a sham transaction. The additional factors leading to this conclusion are: (1) the Margolis office on occasion would transfer large amounts of money among Margolis-controlled entities on a single day ("money movement"), FF 39; (2) the Margolis office would deliver advices of incoming transfer and authorization letters to Barclay's in the order the office wanted the transfers to take place, FF 41, and did so for the transfers of November 30, 1977, FF 43, leading to the inference that the bank accounts involved in the money movements had little or no money in them and the office had to be careful not to create overdrafts; (3) the beginning balances on November 30, 1977 in the accounts of Island Bank and Finch Partnership could have been zero, FF 46, 47, leading to the inference that these entities were merely shells; (4) plaintiff's Barclay's checking account, through which money passed in the money movement of November 30, 1977, was effectively controlled by the Margolis office, FF 10, 12, 21, and almost all the transactions in this account involved back-to-back deposits from and payments to Margolis-controlled entities, FF 12, 13 & 14, 15 & 16, 24 & 25, 27 & 28, 29 & 30, 32, 34 & 35, 36, leading to the inference that plaintiff's Barclay's account was merely a conduit for money movements among Margolis-controlled entities; (5) the several variances between dates in the check, register and on checks, on the one hand, and in the bank statements of plaintiff's Barclay's account, on the other, FF 13, 14, 27, 28, lead to the conclusion that transactions affecting plaintiff's account were prepared well in advance of their actual completion but were postponed to coincide with a money movement; and (6) certain entities in the check register, FF 16, 48, could indicate aborted money movements.

11. Although the government's evidence is entirely circumstantial, plaintiff has offered absolutely no evidence tending to show that the transactions, or the entities involved, in the November 30, 1977 money movement had economic substance. Indeed, plaintiff's testimony about Summit, Ltd. and MCDM Partnership II, FF 31, two entities which received funds from her checking account, revealed a stunning ignorance of these entities which also leads to the inference that money passed through her checking account solely for the purpose of creating income tax benefits.


 * 10 Accordingly, the government's motion for a directed verdict is granted, and the government also is granted judgment upon all the evidence presented at trial. The Clerk is directed to enter final judgment in favor of the United States on plaintiff's remaining claim.

So ordered.

Scheaf v. Com.