T.C. Memo. 1996-221
UNITED STATES TAX COURT
PAUL G. GUBBINI, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23708-93. Filed May 7, 1996.
Marie L. DeMarco and J. Paul Raymond, for petitioner.
Francis C. Mucciolo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: Respondent determined a deficiency of $58,883
in petitioner’s 1989 Federal income tax. After concessions, the
issues remaining for decision are: (1) Whether petitioner is
entitled to a business bad debt deduction pursuant to section
166(a)(1) for the worthlessness of certain loans and advances
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made by petitioner to Color Trick, Inc. (Color Trick); and (2)
whether petitioner may claim an ordinary loss pursuant to section
1244 attributable to the worthlessness of his stock in Color
Trick. Unless otherwise noted, all section references are to the
Internal Revenue Code as in effect for the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
FINDINGS OF FACT
Some of the facts and certain exhibits have been stipulated
for trial pursuant to Rule 91. The stipulated facts are
incorporated herein by reference and are found accordingly.
At the time he filed the petition in the instant case,
petitioner resided in Dunedin, Florida.
Beginning in 1978 and during the times relevant to the
instant case, petitioner was an anesthesiologist. During 1980,
petitioner and certain other anesthesiologists formed a
partnership known as Anesthesia Associates of Dunedin (medical
group) that provided services at a local hospital. Petitioner
handled operation of the medical group. Petitioner worked
between 40 and 50 hours per week as an anesthesiologist and took
18 weeks of vacation per year.
From 1980 until 1984 or 1985, petitioner invested with a
builder in the construction and sale of homes on speculation.
Additionally, petitioner and another physician in the medical
group owned an apartment building. Petitioner maintained the
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building, collected rents, and found tenants. Petitioner sold
the building during 1991 to pay expenses connected with his
divorce. During 1986, after being approached by an accountant,
petitioner, together with two other physicians, invested in a
company known as Cinevision. Petitioner expected to reap a
profit if Cinevision’s business was successful. Cinevision
experienced difficulties after purchasing additional equipment to
expand its business. Petitioner was involved in meetings with
Cinevision's management in an attempt to resolve the
difficulties.
A tenant in petitioner's apartment building introduced
petitioner to Leland Prentice, who held a patent for a simple and
inexpensive process of color printing (process). Leland Prentice
had licensed the patent to Prentice Color, which in turn made an
agreement with A.B. Dick, a large printing equipment and process
distributor, to market the process to print shops. Prentice
Color had gone bankrupt, allegedly due to A.B. Dick’s failure to
market the process, and a lawsuit was being pursued against A.B.
Dick to dissolve the agreement to market the process and to
recover damages for A.B. Dick’s alleged failure to market the
process. The litigation was settled in 1991.
Leland Prentice had the right to use the process in two
locations, but could not market it, and had come to Florida to
set up a print shop using the process. Leland Prentice also
hoped to market the process once the lawsuit against A.B. Dick
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was resolved. He, however, did not have the necessary resources
to exploit his rights in the patent. Petitioner was willing to
put money into Leland Prentice’s business in order to share in
the profits when it became successful.
During October or November 1987, Color Trick was organized
pursuant to Florida law. Leland Prentice and his wife, Faye
Prentice, were issued 700 shares of Color Trick’s stock, Leland
Prentice’s son, Stanley Prentice, and his wife were issued 100
shares, and petitioner was issued 200 shares, a 20-percent
interest in the corporation. Petitioner paid $5,000 for the
shares. The directors of the corporation were Leland Prentice,
Faye Prentice, and petitioner. Color Trick was an S corporation.
On January 28, 1988, Leland Prentice assigned the patent to Color
Trick.
From 1987 through 1989, petitioner advanced funds and made
and guaranteed loans to Color Trick. Petitioner continued to
make loans to Color Trick because he believed its business could
be profitable. Petitioner received promissory notes for some of
the advances and loans. Petitioner’s loans and advances to Color
Trick were used to finance its operations and to purchase
equipment. From 1987 through 1989, petitioner devoted time and
effort to Color Trick’s business but received no compensation
from Color Trick. During the period of its operation, Color
Trick experienced continuing difficulties due to lack of sales,
equipment problems, and an excessive number of employees.
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On November 23, 1988, Color Trick reassigned the patent to
Leland Prentice and his wife in exchange for 200 shares of its
stock, which were to be canceled. On that date, two other
investors in Color Trick were each issued 100 shares of Color
Trick. As a condition for advancing more money to Color Trick,
on November 30, 1988, Leland Prentice granted petitioner and
other investors a lien on the patent, and a financing statement
concerning the lien was filed with the Florida secretary of
state. The lien on the patent was the only security petitioner
obtained for all of his loans and advances to Color Trick.
Petitioner also considered any damages that might be awarded in
connection with the lawsuit against A.B. Dick as a possible
source for the repayment of his loans and advances to Color
Trick.
During 1988 and 1989, as petitioner continued to advance
funds to Color Trick, he acquired additional stock in Color Trick
and, by the end of 1989, he had acquired 60 percent of the stock
of Color Trick. During 1989, in order to induce petitioner to
continue to advance funds to Color Trick, Leland Prentice and his
wife returned the remainder of their stock in Color Trick to the
corporation. The stock was reissued to petitioner and other
investors. The transfer of the shares allowed more of Color
Trick’s losses to be passed through to petitioner and the other
investors. Leland Prentice continued to work in Color Trick’s
business after he had given up all of his stock in the
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corporation. Stanley Prentice and his wife also returned their
100 shares of stock in Color Trick to the corporation during
February 1989.
Toward the end of 1989, petitioner concluded that Color
Trick could not generate sufficient income to pay its bills, that
its business could not be turned around, and that he could not
continue advancing money to the business. Petitioner’s efforts
to sell Color Trick around that time were unsuccessful. Except
for activities connected with winding down its business, Color
Trick ceased operations at the end of 1989. Its equipment was
sold or foreclosed upon and available funds were used to repay
certain creditors, not including petitioner.
Leland Prentice had no assets from which petitioner’s loans
could have been repaid. Petitioner did not attempt to foreclose
on or to sell the patent. The process had become obsolete by the
end of 1989 because of the widening availability of digital
printers. Petitioner received no repayment of principal or
payment of interest with respect to the loans and advances he had
made to Color Trick.
On his Federal income tax returns for 1987, 1988, and 1989,
petitioner claimed the following losses with respect to Color
Trick:
Year Loss
1987 $9,053
1988 42,982
1989 78,356
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Petitioner reported the income or loss connected with Cinevision
as passive income or loss on his 1987 through 1989 returns.
On his 1989 Federal income tax return, petitioner claimed a
business bad debt deduction with respect to his loans to Color
Trick in the amount of $269,129. Petitioner’s Federal income tax
returns for taxable years 1987 through 1990 contain no other
reference to any lending activity of petitioner.
OPINION
The first issue we consider is whether petitioner is
entitled to a business bad debt deduction pursuant to section
166(a)(1) for the worthlessness1 of petitioner’s loans and
advances to Color Trick. That section provides, in general, for
the deduction of debts that become wholly worthless during a
taxable year. Section 166(d), however, limits the general rule,
providing that, in the case of a taxpayer other than a
corporation, nonbusiness bad debts are to be treated as short-
term capital losses.2 In general, a nonbusiness bad debt is a
1
Respondent does not contest the fact that petitioner's loans
to Color Trick became worthless during 1989.
2
Sec. 166(d) provides:
SEC. 166(d). Nonbusiness debts.--
(1) General rule.--In the case of a taxpayer other than a
corporation--
(A) subsection (a) shall not apply to any
(continued...)
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debt other than a debt (1) created or acquired in the trade or
business of the taxpayer or (2) the loss from the worthlessness
of which is incurred in a trade or business of the taxpayer.
Sec. 166(d)(2). The question whether a debt is a nonbusiness bad
debt is a question of fact. Sec. 1.166-5(b), Income Tax Regs.
Petitioner has the burden of showing that he was engaged in a
trade or business to which the debts in question are proximately
related. Spillers v. Commissioner, 407 F.2d 530, 534 (5th Cir.
1969), affg. T.C. Memo. 1967-216; United States v. Byck, 325 F.2d
551, 552 (5th Cir. 1963); Deely v. Commissioner, 73 T.C. 1081,
1092 (1980).
The question of whether a shareholder’s loans to his
corporation are business or nonbusiness bad debts frequently has
been litigated. A worthless debt resulting from a loan by a
2
(...continued)
nonbusiness debt; and
(B) where any nonbusiness debt becomes worthless
within the taxable year, the loss resulting therefrom
shall be considered a loss from the sale or exchange,
during the taxable year, of a capital asset held for
not more than 1 year.
(2) Nonbusiness debt defined.--For purposes of
paragraph (1), the term “nonbusiness debt” means a debt other
than--
(A) a debt created or acquired (as the case may
be) in connection with a trade or business of the
taxpayer; or
(B) a debt the loss from the worthlessness of
which is incurred in the taxpayer’s trade or business.
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shareholder to his corporation may qualify as a business bad debt
if the shareholder was engaged in the business of promoting,
organizing, financing, and selling corporations. Deely v.
Commissioner, supra at 1092. If a shareholder is only an
investor, the debt will be treated as a nonbusiness bad debt
because the management of one’s investments does not constitute a
trade or business. Id. In Whipple v. Commissioner, 373 U.S.
193, 202-203 (1963), the Supreme Court set forth the following
guidelines for deciding the question:
Devoting one’s time and energies to the affairs of a
corporation is not of itself, and without more, a trade
or business of the person so engaged. Though such
activities may produce income, profit or gain in the
form of dividends or enhancement in the value of an
investment, this return is distinctive to the process
of investing and is generated by the successful
operation of the corporation’s business as
distinguished from the trade or business of the
taxpayer himself. When the only return is that of an
investor, the taxpayer has not satisfied his burden of
demonstrating that he is engaged in a trade or business
since investing is not a trade or business and the
return to the taxpayer, though substantially the
product of his services, legally arises not from his
own trade or business but from that of the corporation.
* * *
If full-time service to one corporation does not
alone amount to a trade or business, which it does not,
it is difficult to understand how the same service to
many corporations would suffice. To be sure, the
presence of more than one corporation might lend
support to a finding that the taxpayer was engaged in a
regular course of promoting corporations for a fee or
commission * * * or for a profit on their sale * * *,
but in such cases there is compensation other than the
normal investor’s return, income received directly for
his own services rather than indirectly through the
corporate enterprise * * *
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In Deely v. Commissioner, supra at 1093, we concluded that, based
on Whipple v. Commissioner, supra at 202-203, a taxpayer claiming
to be in the business of promoting, financing, and/or dealing in
corporations must show that the activity is conducted for a fee
or commission or with the immediate purpose of selling the
corporations at a profit in the ordinary course of that business.
A taxpayer who seeks a return from long-range investment gains
rather than from a quick sale of a corporation after it has
become established is more likely to be considered an investor
rather than a business promoter. Deely v. Commissioner, supra at
1093-1095. Whether petitioner is engaged in the trade or
business of promoting corporations is a question of fact. Smith
v. Commissioner, 62 T.C. 263, 268 (1974); see also Commissioner
v. Groetzinger, 480 U.S. 23, 36 (1987).
Petitioner claims that he was engaged in the trade or
business of a venture capitalist or business promoter and that
the loans and advances that he made to Color Trick were made in
the course of that trade or business. Petitioner, however, has
not established that he was engaged in the trade or business of
promoting corporations in addition to his medical practice. We
note that petitioner's medical practice was his primary
occupation, to which he devoted approximately 40 to 50 hours per
week, excluding vacations. Additionally, petitioner admitted
that he was not in the business of lending money when he began
advancing funds to Color Trick. Moreover, nothing in
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petitioner’s Federal tax returns that are in the record indicates
that he earned income from rendering services as a promoter.
Although petitioner claims that he had a reputation in his
community as a promoter, there is little evidence in the record
to support that claim, and the absence of any indication that
petitioner was separately compensated for his activities renders
that evidence unpersuasive. Deely v. Commissioner, supra at
1096.
Petitioner points to his activities outside his medical
practice to show that he was engaged in the trade or business of
being a business promoter, but the activities do not indicate
that petitioner was in that trade or business. Although
petitioner was involved in building and selling houses on
speculation prior to his dealings with Color Trick, the record
does not indicate how he was compensated for his efforts, that
is, whether he received compensation directly for his services,
or indirectly through the success of the ventures. Moreover,
that activity had ceased in 1984 or 1985, and it therefore does
not indicate that petitioner was involved in a business of
developing properties for quick sale during 1987, when he became
involved with Color Trick. Petitioner’s other activities, such
as his ownership of an apartment building and his investment in
Cinevision, do not indicate that he engaged in promoting
corporations for a fee or commission or for the profit to be
derived from quickly selling them after they were established.
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Rather, petitioner appears to have sought long-term returns from
his ownership interests, which is the hallmark of the investor.
Deely v. Commissioner, supra. Although petitioner was actively
involved in the management of the apartment building, there is no
evidence he was directly compensated for his services. Moreover,
it does not appear that he planned to sell the apartment building
once it became established; rather, he sold it as a result of his
divorce proceedings.
Similarly, petitioner apparently sought a return from
Cinevision in the form of enhanced value of his investment,
rather than from direct compensation for his services to the
corporation. Petitioner, moreover, reported the income or loss
connected with Cinevision as passive income or loss on his 1987
through 1989 returns. Petitioner’s activities with respect to
Cinevision, which consisted of meetings with its management to
discuss its difficulties, appear no different from those of an
investor seeking to protect his investment. As we discuss below,
we reach the same conclusion with respect to petitioner’s
activities in connection with Color Trick.
The record is also devoid of evidence of other indicia of a
business of promoting corporations, such as the active seeking
out of opportunities to promote corporations, advertising, the
maintenance of a separate office or books of account for such a
business, or the preparation of statements of profit and loss
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from corporate promotion activities. United States v. Henderson,
375 F.2d 36, 41 (5th Cir. 1967).
Accordingly, we conclude that petitioner was not in the
trade or business of promoting corporations. Moreover, even if
petitioner were engaged in a promoting business, we would not
conclude that the business encompassed his activities regarding
Color Trick. Petitioner’s activities in connection with Color
Trick were more consistent with those of an investor rather than
those of a business promoter. Petitioner’s loans and advances to
Color Trick were used to finance its operations and to purchase
equipment, which furthered Color Trick’s business. Petitioner’s
rendering of advice and making advances to Color Trick did not in
themselves amount to a promotion of the corporation. United
States v. Clark, 358 F.2d 892, 895 (1st Cir. 1966).
Furthermore, petitioner’s testimony indicates that the only
return he expected for his investments in Color Trick was from
dividends or the long-term enhancement of his share holdings
generated from the profits to be derived from the success of
Color Trick's business. Petitioner may also have hoped to share
in any recovery from a lawsuit against A.B. Dick in connection
with a license it was granted to market the process. Petitioner
further appears to have expected some return from the
exploitation of the patent once A.B. Dick’s licensing agreement
was dissolved in connection with the litigation. Petitioner took
no salary from Color Trick, and there is no evidence that he
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expected or was entitled to any direct compensation for his
services. Although petitioner contended that he did not do so
because of Color Trick’s financial problems, there is no evidence
that he was owed any salary for his services or that he deferred
collecting any salary due him. We conclude from the record as a
whole that petitioner expected only an investor’s return from
Color Trick in the form of dividends or long-term enhanced value
of his shareholdings.
It does not appear that petitioner planned to sell Color
Trick quickly once it became established. Indeed, there is some
question whether the business could have been sold, because
Leland Prentice was allowed to use his process in only two
locations but was not allowed to market it. Rather, an effort
was made to sell the business only after petitioner decided that
it would not be successful and that he could not continue
financing it.
Petitioner also contends that he made advances to Color
Trick in order to protect his business reputation after he had
induced other physicians in the medical group to invest in Color
Trick.3 As noted above, we cannot conclude from the record in
the instant case that petitioner had a reputation as a business
3
Petitioner does not contend that the investments in Color
Trick by other physicians with whom he practiced rendered his
advances to Color Trick proximately related to his medical
practice, or that his medical practice would be in any way
affected by the fate of Color Trick.
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promoter. It appears to us that, in making the advances,
petitioner’s motivation was to protect his reputation as an
investor. Petitioner also contends that he made advances to
Color Trick in an effort to protect the investments of the other
physicians who had loaned money to Color Trick. Advancing money
to a corporation to protect the investments of others, however,
is an indication that the taxpayer is not a promoter. United
States v. Clark, supra at 896.
Petitioner also contends that his advances and loans to
Color Trick exceeded his initial investment in its stock by 60
times and that this circumstance indicates the lack of an
investment motive for the loans and advances. We do not consider
the circumstance pointed to by petitioner indicative of the lack
of an investment motive given that petitioner (1) acquired
additional stock in Color Trick during 1988 and 1989, (2) held 60
percent of its stock by the end of 1989 and (3) was not entitled
to compensation for his services to Color Trick. It seems quite
plausible to us that petitioner’s loans and advances were made to
protect his increasing and substantial equity stake in the
corporation.
Based on our consideration of the entire record in the
instant case, we hold that petitioner’s loans and advances to
Color Trick, which became worthless in 1989, are nonbusiness bad
debts. Whipple v. Commissioner, 373 U.S. at 203-204; United
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States v. Byck, 325 F.2d at 554-555; Deely v. Commissioner, 73
T.C. at 1092-1093.
Petitioner alternatively contends that he is entitled to
claim, pursuant to section 1244, an ordinary loss of $50,000 due
to the worthlessness of his stock in Color Trick.4 Section
165(g) provides generally that the loss resulting from the
worthlessness of a security (including stock) that is a capital
asset is capital in nature, and the allowability of such a loss
consequently is governed by the provisions of section 1211(b).
The allowable amount of the loss is the adjusted basis of the
security provided in section 1011 for purposes of determining the
loss from the sale or other disposition of property. Sec.
165(b).
Section 1244(a), however, allows an individual taxpayer to
treat a loss from “section 1244 stock” as an ordinary loss where
it would otherwise be treated as a loss from the sale or exchange
of a capital asset. As relevant to the instant case, the
aggregate amount of the loss that may be treated as an ordinary
4
Respondent contends that petitioner raised this issue too
late in the course of the instant case for us to consider it.
Respondent points out that the issue was not raised in the
petition, any amendment thereto, or in petitioner’s trial
memorandum, and contends that it would be unfair and prejudicial
to respondent for us to consider the issue, which respondent
asserts was raised for the first time at trial. Because we
decide below that petitioner has not established his entitlement
to claim a loss pursuant to sec. 1244, we need not consider
whether respondent was surprised and prejudiced by the raising of
the issue at trial.
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loss pursuant to section 1244 cannot exceed $50,000. Sec.
1244(b). The term “section 1244 stock” is defined to mean stock
of a domestic corporation where: (1) At the time of the stock's
issuance, the corporation had not received money or other
property in excess of $1 million for its stock, as a contribution
to capital, or as paid-in surplus; (2) the stock was issued for
money or other property (other than stock or securities); and (3)
the corporation during its most recent 5 taxable years (or, if
less, the period during which the corporation has been in
existence) derived more than 50 percent of its aggregate gross
income from sources other than royalties, rents, dividends,
interest, annuities, and sales or exchanges of stocks or
securities. The third test, however, does not apply where the
amount of deductions allowed exceeds the amount of the
corporation’s gross income. Sec. 1244(c). The Commissioner is
empowered to prescribe the regulations necessary to carry out the
purposes of section 1244. Sec. 1244(e). Pursuant to that
authority, the Commissioner has issued regulations requiring a
taxpayer to have records sufficient to establish that the
taxpayer is entitled to the loss and satisfies the requirements
of section 1244.5 Sec. 1.1244(e)-1(b), Income Tax Regs. We have
5
The Commissioner’s regulations previously required taxpayers
claiming a loss pursuant to sec. 1244 to attach an information
report to the return in which the loss was claimed showing the
address of the corporation issuing the stock, the manner in which
(continued...)
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held that strict compliance with the requirements of section 1244
and the regulations issued pursuant to it is necessary to obtain
the benefits of the section. Mogab v. Commissioner, 70 T.C. 208,
212 (1978); Morgan v. Commissioner, 46 T.C. 878, 889 (1966).
Petitioner contends that he received certain stock in Color
Trick that previously had been held by each of Leland Prentice
and his wife and/or Stanley Prentice and his wife in exchange for
repaying a $110,000 debt of Color Trick.6 Petitioner bases his
claim of a section 1244 loss on that transaction. Petitioner,
however, has not established his basis in his Color Trick stock
for purposes of computing the amount of his loss pursuant to
5
(...continued)
the stock was acquired, the nature and amount of the
consideration paid, and, if the stock was acquired in a
nontaxable transaction in exchange for property other than money,
the type of property transferred, its fair market value on the
date of transfer to the corporation, and its adjusted basis on
that date. Sec. 1.1244(e)-1(b)(1), (2), and (3), Income Tax
Regs., amended by T.D. 8594, 1995-1 C.B. 146. Petitioner did not
file such an information report with his 1989 return. In 1995,
however, the Commissioner eliminated the requirement of an
information report, amending the regulation to require only that
taxpayers maintain adequate records to establish their
entitlement to claim a loss pursuant to that section. T.D. 8594,
1995-1 C.B. at 147; see also Notice 94-89, 1994-2 C.B. 560. The
amendment is effective for all open taxable years beginning after
Dec. 31, 1953. T.D. 8594, 1995-1 C.B. at 147. Consequently,
petitioner’s failure to file an information report is not fatal
to his claim of entitlement to a loss pursuant to sec. 1244.
6
In view of the circumstances discussed below and our holding
that petitioner has not otherwise established his entitlement to
the benefits of sec. 1244, we need not address whether that stock
was "issued" to petitioner in the manner required by sec.
1244(c)(1)(A).
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section 1244. Petitioner testified that he did not receive
additional stock in Color Trick for the money he advanced to it,
but that the shares were “kickers”. Elsewhere on brief,
petitioner treats only his $5,000 payment for his initial
purchase of Color Trick’s stock as the amount of his investment
in its stock. Petitioner has not attempted to reconcile the
inconsistency of his positions at trial and on brief with his
section 1244 claim.
Furthermore, Color Trick was an S corporation, and,
consequently, the losses that were passed through to petitioner
reduced his basis in its stock. Sec. 1367(a)(2). The basis-
adjustment rules of section 1367 are applied before application
of sections 165(g) and 166(d) in a taxable year of the
shareholder in which a security or debt becomes worthless.
Petitioner does not dispute that, on its 1987, 1988, and 1989
returns, Color Trick reported losses of $45,263, $214,910, and
$138,267, respectively. On his returns for 1987 through 1989,
petitioner claimed losses in connection with Color Trick totaling
$130,391. Petitioner has not shown that there was any basis
remaining in his Color Trick stock after taking into account the
foregoing losses claimed on his returns that would enable him to
claim a loss with respect to its worthlessness.
Additionally, petitioner contends that many records
pertaining to Color Trick were dispersed after Color Trick ceased
operations. We note, however, that the loss of records does not
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alter petitioner’s burden of proof, but, in such a case, we shall
consider credible secondary evidence. Malinowski v.
Commissioner, 71 T.C. 1120, 1125 (1979). Petitioner relies on
certain documents of Color Trick (viz, its articles of
incorporation and minutes of shareholders’ meetings), certain
testimony, and certain of his Federal income tax returns to
establish his entitlement to a section 1244 loss. Certain other
records, however, have not been offered by petitioner, such as
his stock certificates or the stock transfer records of Color
Trick. We do not accept the statements in petitioner’s Federal
income tax returns as proof of the facts asserted by petitioner.
A tax return is merely a statement of the taxpayer’s claim and
does not establish the truth of the matters set forth therein.
Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979); Roberts v.
Commissioner, 62 T.C. 834, 837 (1974); Halle v. Commissioner, 7
T.C. 245, 247-248 (1946), affd. 175 F.2d 500 (2d Cir. 1949).
Accordingly, we hold that the evidence on which petitioner relies
is insufficient to establish his entitlement to the benefits of
section 1244. Moreover, petitioner has failed to maintain
records sufficient to establish that he is entitled to the loss
claimed with respect to his stock in Color Trick and that he
satisfies the requirements of section 1244. Sec. 1.1244(e)-1(b),
Income Tax Regs.
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Accordingly, we hold that petitioner is not entitled to
claim an ordinary loss pursuant to section 1244 in connection
with the worthlessness of his stock in Color Trick.
To reflect the foregoing and concessions,
Decision will be entered
for respondent.