2000 Tax Ct. Memo LEXIS 279">*279 Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, JUDGE: Respondent determined deficiencies in petitioners' Federal income tax and accuracy-related penalties under section 6662 for taxable years 1993 and 1995 as follows:
Penalty
Year Deficiency Sec. 6662(a)
____ __________ ____________
1993 $ 49,843 $ 9,969
1995 9,567 1,913
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.
After concessions, 1 the issues for decision are:
1. Whether the notice of deficiency inadequately described the basis for respondent's determinations, so as to justify placing the burden of proof on respondent.
2000 Tax Ct. Memo LEXIS 279">*280 2. Whether advances that petitioner husband (hereinafter petitioner) made to a related corporation are deductible as bad debts under
3. Whether advances that petitioner made to a related corporation are deductible as ordinary losses under
FINDINGS OF FACT
The parties have stipulated some of the facts, which are incorporated in our findings by this reference. When they filed their petition, petitioners were married and resided in Montgomery, Alabama. Subsequent to filing the petition, Caroline R. Sellers died. The Estate of Caroline R. Sellers has been substituted as a party.
PETITIONER'S BACKGROUND
Since 1947, petitioner has been in the investment banking business, making loans to companies and individuals. Since at least 1968, 2000 Tax Ct. Memo LEXIS 279">*281 petitioner has made loans through his sole proprietorship, Continental Mortgage Co. (Continental Mortgage).
Petitioner is also a 75-percent shareholder of Philip A. Sellers & Co., Inc. (PASEL), which engages in investment banking. His son, Philip L. Sellers (Philip), owns the remaining 25 percent of PASEL. PASEL owns all the stock of Merchant Capital Corp. (Merchant Capital), an investment banking business with a concentration in municipal type business.
THE GANDY'S ACQUISITION
In 1987, PASEL acquired a 67-percent ownership interest in Kenneth H. Bauer & Associates, Inc. (KHB), a newly organized Georgia corporation formed for the purpose of acquiring interests in existing businesses, including Gandy's Industries, Inc. (Gandy's), a Georgia corporation that manufactured pool tables and related equipment. PASEL acquired its 67-percent ownership interest in KHB as partial consideration for a $ 544,000 loan that it made to KHB to facilitate KHB's leveraged buy-out of Gandy's. 3 The other 33-percent ownership interest in KHB was held by its president and director, Steven K. Bauer (Bauer). KHB, which had no assets other than its ownership interest in Gandy's, then took Gandy's name. 2000 Tax Ct. Memo LEXIS 279">*282 Consequently, PASEL and Bauer then held ownership interests in Gandy's of 67 percent and 33 percent, respectively.
KHB acquired Gandy's through the issuance of $ 5,040,000 in Macon-Bibb County Industrial Revenue Bonds (the Gandy's bonds). The underwriter of the Gandy's bonds was Merchant Capital, which, as previously described, was a wholly owned subsidiary of PASEL.
In 1988 and 1989, petitioner and PASEL made separate loans to Gandy's totaling over $ 250,000. Bauer, who was then Gandy's president, cosigned for the loans in his individual capacity. The loans were not repaid, and judgments were entered against Bauer, resulting in the transfer to PASEL of Bauer's ownership interest in Gandy's. 2000 Tax Ct. Memo LEXIS 279">*283 4 At some time not specified in the record, Philip became president of Gandy's and remained in that position during the years in issue. 5 Sometime prior to 1993, in a manner not revealed in the record, Merchant Capital became a 50-percent owner of Gandy's.
2000 Tax Ct. Memo LEXIS 279">*284 THE ADVANCES IN QUESTION
Gandy's never produced enough income to pay any of the interest on the $ 5,040,000 Gandy's bonds. After June 1, 1988, Gandy's was delinquent on its bond interest payments. 6 Philip handled most of the negotiations with the bondholders with respect to Gandy's failure to make payments on the bonds.
In 1990, petitioner was aware that because of a nationwide recession and because of Gandy's heavy debt repayment burden relating in part to the bond project, Gandy's was experiencing cash-flow problems and was struggling to survive. Because its assets had already been leveraged, Gandy's was unable to obtain financing from financial institutions. In 1990, petitioner, either directly or through his wholly owned corporation Continental Mortgage, advanced $ 300,000 to Gandy's as follows:
2000 Tax Ct. Memo LEXIS 279">*285 Date Amount
_______ ________
7/30/90 $ 100,000
8/13/90 40,000
8/13/90 60,000
12/11/90 100,000
Each of these four advances (the 1990 advances) was evidenced by a promissory note, each stating an 8-percent interest rate. The July 30, 1990, promissory note indicates a due date of December 31, 1991. 7 The December 11, 1990, promissory note indicates a due date of December 11, 1991. The other two promissory notes were payable on demand.
Gandy's used the 1990 advances for working capital and to meet daily operating expenses.
During 1991 or 1992, Gandy's made no repayments of the 19902000 Tax Ct. Memo LEXIS 279">*286 advances. During 1991 and 1992, neither petitioner nor any other party made any additional advances to Gandy's.
On January 7, 1993, and January 27, 1993, petitioner made two additional advances to Gandy's of $ 25,000 each. Neither advance is evidenced by a note.
On December 2, 1993, petitioner wired an additional $ 10,483 to a broker to pay shipping charges on slate from Italy that Gandy's had ordered for use in the manufacture of pool tables. This advance is evidenced by a demand note bearing 8 percent interest.
Although Gandy's was in default on two of petitioner's advances after December 31, 1991, petitioner did not sue Gandy's for collection or otherwise demand payment of principal or interest with respect to any of the advances.
Petitioner's advances to Gandy's from 1990 through 1993 were all unsecured, because Gandy's had pledged all its assets to other lenders. Petitioner's advances to Gandy's were subordinated to the Gandy's bonds.
Gandy's treated all the advances in question (with the possible exception of the $ 10,483 advance of December 2, 1993) as shareholder debt and accrued interest thereon. 8 It was Gandy's intention to repay the advances as soon as Gandy's started2000 Tax Ct. Memo LEXIS 279">*287 producing positive cash-flow. This never happened. On its September 30, 1991, and September 30, 1992, Forms 1120, U.S. Corporate Income Tax Return, Gandy's reported net losses of $ 1,205,578 and $ 1,412,516. Near the end of 1993, Gandy's had retained earnings deficits of approximately $ 4 to $ 5 million.
On December 23, 1993, Gandy's repaid $ 5,000 of petitioner's advances. 9 Otherwise, Gandy's repaid neither principal nor interest on any of the advances made by petitioner from 1990 through 1993.
DEFAULT ON THE GANDY'S BONDS AND FORECLOSURE
Gandy's never made any interest or principal payments on2000 Tax Ct. Memo LEXIS 279">*288 the Gandy's bonds. On February 1, 1994, the Gandy's bonds trustee declared Gandy's in default of its bond obligations and foreclosed on Gandy's assets. Philip purchased Gandy's assets from the foreclosure, and Gandy's has continued to operate under the name Macon Manufacturing. In 1994 and 1995, petitioner advanced additional, undisclosed sums to Macon Manufacturing.
PETITIONERS' RETURN POSITIONS AND RESPONDENT'S DETERMINATIONS
On their 1993 joint Federal income tax return, petitioners deducted $ 355,483 as a bad debt deduction and reported a net operating loss of $ 169,331. 10 On their 1995 joint Federal income tax return, petitioners claimed a net operating loss of $ 177,794, of which $ 169,331 represented a carryover of the 1993 net operating loss.
In the notice of deficiency for taxable year 1993, respondent disallowed petitioners' claimed bad debt2000 Tax Ct. Memo LEXIS 279">*289 deduction "because it has not been established that any amount of bad debts existed in fact and in law." Similarly, for taxable year 1995, respondent disallowed the $ 169,331 claimed net operating loss carryover "because it has been determined that a net operating loss did not exist in the year that caused the carryforward."
OPINION
Petitioners argue that the advances to Gandy's were loans that petitioner made in the course of his lending business, that the loans became worthless in 1993, and that they are properly deductible either under
Respondent agrees that petitioner was in the business of lending money but argues that the advances in issue represent contributions to Gandy's capital rather than debt. At trial and on brief, respondent concedes that petitioners are entitled to deduct the losses under
Under generally applicable principles, petitioners bear the burden of proving entitlement to a deduction resulting from petitioner's advances to Gandy's. 2000 Tax Ct. Memo LEXIS 279">*290 See Rule 142(a);
Petitioners argue that the notice of deficiency failed to set forth the reasons for respondent's determinations with sufficient specificity to satisfy the requirements of
The purpose of
A taxpayer generally may deduct a debt that becomes worthless within the taxable year. See
The identified factors are not equally significant, nor is any one factor determinative. See
1. NAMES GIVEN TO THE CERTIFICATES
The issuance of a note may be indicative of bona fide debt. See
Two of petitioner's 1993 advances, of $ 25,000 each, were not evidenced by any kind of debt instrument. As applied to these two advances, this factor weighs toward equity.
The four 1990 advances were each evidenced by promissory notes, 11 as was the December 2, 1993, advance of $ 10,483. All the notes were unsecured. Apart from the $ 5,000 repayment made in late 1993, which was not allocated specifically to any of the notes, there were no repayments. When petitioner made the advances, either he singly, or else he and Philip together, owned all the interest in Gandy's, either directly or through their wholly owned corporations PASEL or Merchant Capital, which was also underwriter of the Gandy's bonds. 12 Throughout this period, Philip was president of Gandy's. Where a transaction involves a closely held corporation, the form and labels used may signify little, because the parties can mold the transaction to their will. See
2. THE PRESENCE OR ABSENCE OF A FIXED MATURITY DATE
The presence of a fixed maturity date is indicative of debt but is not dispositive. See
Five out of seven of petitioner's advances to Gandy's had no fixed maturity date and no repayment schedule. The notes reflecting the other two advances had 1-year maturity dates, but the significance of this factor is diminished by Gandy's failure to make repayments in accordance with the maturity dates and petitioner's failure to make any efforts to collect.
This factor weighs against a bona fide debtor-creditor relationship.
3. SOURCE OF THE PAYMENTS
Repayment that depends on corporate earnings has the appearance of a contribution to capital. See
This factor weighs toward equity.
4. RIGHT TO ENFORCE PAYMENT
A definite obligation to repay principal and interest weighs2000 Tax Ct. Memo LEXIS 279">*296 toward debt. See
As far as the record reveals, Gandy's had no fixed obligation to repay the two 1993 advances of $ 25,000 each. With regard to the other five advances, even if we were to assume arguendo that petitioner had a basic right to enforce payment, petitioner made no effort to do so and failed to take customary steps to ensure payment. The advances were unsecured. There is no evidence that any sinking fund was established by which the principal and interest could be paid. In short, the record does not establish that the parties expected Gandy's to repay the advances.
This factor weighs toward equity.
5. INCREASED PARTICIPATION IN MANAGEMENT
An increase in the nominal creditor's participation in management of the nominal debtor2000 Tax Ct. Memo LEXIS 279">*297 as a result of the advance weighs toward equity. See
This factor is neutral, and we give it no weight.
6. STATUS OF THE CONTRIBUTIONS IN RELATION TO REGULAR CORPORATE
CREDITORS
Subordination of repayment of an advance to other indebtedness weighs toward equity. See
This factor weighs toward equity.
7. THE PARTIES' INTENT
Although the parties' intent is relevant, the "subjective intent on the part of an actor will not alter the relationship or duties created by an otherwise objectively indicated intent."
Petitioner argues that he intended to make the loans in furtherance of his trade or business of lending money, in order to make Gandy's profitable so as to help his investment banking business prosper. The objective facts in the record, however, do not support the conclusion that these advances were made in a manner consistent with normal lending practices or consistent with petitioner's own practices in making loans to other, unrelated borrowers. Although petitioner testified that he intended the advances to be repaid, the record does not reveal that he made any efforts to collect principal or interest on the advances over a period of 2 to 3 years. Petitioner was aware of Gandy's perilous financial situation when he first made the advances in issue and could not realistically have expected to be repaid, especially in light of Gandy's delinquency on the Gandy's bonds, to which his advances were subordinated. He acknowledged that he made the 1990 advances2000 Tax Ct. Memo LEXIS 279">*299 on an unsecured basis at a time when Gandy's needed the advances to operate. He made three further unsecured advances in 1993, without having received or requested repayment of the overdue 1990 advances, and in two instances without receiving any kind of debt instrument.
This factor weighs toward equity.
8. THIN OR ADEQUATE CAPITALIZATION
Advances to corporations are generally indicative of equity where the corporation is thinly capitalized (i.e., has a high ratio of debt to equity). See
This factor weighs toward equity.
9. IDENTITY OF INTERESTS BETWEEN CREDITOR AND SHAREHOLDER
If stockholders make advances in proportion to their stock ownership, a capital contribution is indicated. See
This factor is neutral, and we give it no weight. 13
10. SOURCE OF INTEREST PAYMENTS
"[A] true lender is concerned with interest."
This factor weighs toward equity.
11. ABILITY TO OBTAIN FUNDS FROM OUTSIDE LENDERS
If a party receiving an advance can borrow funds from another lender in an arm's-length transaction on similar terms, the advance may appear to be debt. See
This factor weighs toward equity.
12. EXTENT2000 Tax Ct. Memo LEXIS 279">*303 TO WHICH THE ADVANCES WERE USED TO ACQUIRE CAPITAL
ASSETS
The use of a shareholder's advances to pay day-to-day operating expenses, rather than to acquire capital assets, tends to indicate that the advances are bona fide indebtedness. See
This factor weighs toward debt.
13. THE FAILURE OF THE DEBTOR TO REPAY ON THE DUE DATE
This factor is the most telling of the Mixon factors. See
This factor weighs strongly toward equity.
CONCLUSION
In light of the foregoing, we conclude and hold that petitioner's advances to Gandy's were capital contributions and not bona fide debt. Therefore, petitioner may not deduct the advances2000 Tax Ct. Memo LEXIS 279">*304 as bad debts under
D. CHARACTERIZATION OF PETITIONER'S LOSSES AS ORDINARY OR CAPITAL
Petitioners argue that even if petitioner's advances to Gandy's constituted capital contributions rather than bona fide indebtedness, they are nevertheless entitled to claim ordinary losses under
A loss from the sale or exchange of a capital asset is generally subject to
Petitioners do not argue, and the facts do not indicate, that petitioner's ownership interest in Gandy's qualifies for any of the
Accordingly, we conclude, pursuant to respondent's concession, that petitioner's advances to Gandy's resulted in long- term capital losses, deductible pursuant to the limitations of
To reflect the foregoing and concessions by the parties,
Decision will be entered under Rule 155.
1. Respondent concedes that petitioners' losses from the advances at issue are long-term capital losses that are deductible under
2. Respondent's disallowance of petitioners' net operating loss carryover deduction for 1995 appears to be a computational matter, depending entirely on our resolution of the proper income tax treatment of petitioner's advances to the related corporation.↩
3. On Dec. 17, 1987, Philip A. Sellers & Co., Inc. (PASEL), lent $ 544,000 to Kenneth H. Bauer & Associates (KHB), pursuant to a promissory note, bearing 11 percent interest, with principal and accrued interest payable in two installments on Mar. 17, 1988, and Dec. 17, 1988. On July 1, 1988, this loan was repaid in full.↩
4. On June 24, 1988, petitioner lent $ 150,000 to Gandy's Industries, Inc. (Gandy's) pursuant to a promissory note, payable in 60 days with 11 percent interest. The note is signed by Steven K. Bauer (Bauer) both in his capacity as president of Gandy's and in his individual capacity. The note was not repaid, and petitioner sued Bauer. On Feb. 20, 1990, judgment was entered for petitioner.
On Mar. 22, 1989, PASEL lent $ 104,000 to Gandy's pursuant to a promissory note payable in monthly installments of $ 10,000 plus accrued interest, beginning Apr. 1, 1989. The note was cosigned by Bauer in his individual capacity. The note was not repaid. PASEL sued Bauer and obtained a judgment that included the transfer of Gandy's stock.↩
5. It is unclear from the record what continuing involvement, if any, Bauer had in Gandy's during the years in issue.↩
6. The Gandy's project bonds bore interest from Dec. 1, 1987, at a per annum rate of 11 percent, payable semiannually on Dec. 1, 1987, and June 1 of each year, commencing June 1, 1988.↩
7. The note in the record regarding the July 30, 1990, advance is dated Dec. 31, 1990, and bears a handwritten notation that it "covers wire of 7/30/90".↩
8. The record does not reveal how Gandy's treated the December 1993 advance of $ 10,483.↩
9. The record does not reveal specifically to which advance this repayment related. Petitioner testified that the repayment was allocated "to principal."↩
10. This amount represents the total amount of money that petitioner advanced to Gandy's in 1990 and 1993, less the $ 5,000 that Gandy's repaid in Dec. 1993.↩
11. One of these notes indicates on its face that it was made some 6 months after petitioner had wired the principal amount to Gandy's, suggesting the absence of a "businesslike, arm's length transaction."
12. The record is unclear about the exact configuration over time of ownership interests in Gandy's among petitioner, Philip, and their corporations. Petitioners state in their reply brief that petitioner "eventually held all the [Gandy's] stock".↩
13. To the extent that petitioner, as majority shareholder and father of the sole minority shareholder, controlled the corporations that held ownership interests in Gandy's (and there is no evidence to the contrary), we could also conclude that there was identity of interest between petitioner and the other shareholders -- a factor that would weigh strongly toward treating the advances as equity. Cf.
14. In support of its argument that Gandy's could obtain financing from other sources, petitioner cites the controller's testimony that during 1991 and 1992, Gandy's factored its accounts receivable with a factoring company. This testimony does not establish, however, that the factoring company would have made unsecured loans to Gandy's on terms similar to those that pertained to petitioner's advances.↩