T.C. Memo. 1997-491
UNITED STATES TAX COURT
KENT JENSEN AND CAROL JENSEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20121-94. Filed October 29, 1997.
J. Craig Carman, for petitioners.
Richard W. Kennedy, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: Respondent determined deficiencies in
petitioners’ joint Federal income taxes, an addition to tax, and
an accuracy-related penalty, as follows:
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Accuracy-Related
Addition to Tax Penalty
Year Deficiency Sec. 6651(a) Sec. 6662(a)
1988 $ 502 -- --
1989 4,148 $1,058 --
1990 9,335 -- $1,871
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. All references to petitioner are to Kent Jensen.
The issue for decision is whether petitioners are entitled
either to a section 166 business bad debt deduction with respect
to $128,841 that was transferred to petitioners’ closely held
corporation or to a section 1244 ordinary loss deduction in the
same amount with respect to the stock of petitioners’ closely
held corporation.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
When the petition was filed, petitioners resided in Centerville,
Utah.
On July 23, 1984, petitioners organized K&C Industries (K&C)
as a corporation to market and sell artificial fingernails.
Petitioner served as president and treasurer of K&C, and Carol
Jensen served as vice president and secretary of K&C.
At the time of K&C's formation, petitioners contributed to
K&C $5,882 in cash, office furniture, and a computer system.
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Petitioners each received 5,000 shares of the common stock of
K&C, representing a 50-percent ownership interest in K&C for each
petitioner.
From 1984 through 1987, petitioners transferred to K&C an
additional $38,538 in small cash denominations from their
personal funds and $94,000 obtained from petitioner's father.
The following schedule reflects for 1984 through 1987 the
above funds transferred to K&C:
Funds Obtained Funds Obtained From
Year From Petitioners Petitioner’s Father
1984 $11,740 $17,500
1985 22,748 29,000
1986 4,050 44,000
1987 -- 3,500
Total $38,538 $94,000 $132,538
During 1984, 1985, and 1986, petitioners received from K&C
documents designated as promissory notes in favor of petitioners,
as follows:
Date Of Promissory Note Amount
July 23, 1984 $ 7,341
July 23, 1984 7,341
Mar. 21, 1985 85,000
Feb. 12, 1986 30,000
Total $129,682
On August 5, 1986, 40,000 shares of K&C stock were issued in
the name of petitioner's father and provided to petitioner’s
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father in connection with the $94,000 that petitioner’s father
had provided for transfer to K&C.
On their 1987 joint Federal income tax return, petitioners
claimed a business bad debt deduction with respect to $128,841
that had been transferred to K&C. After mathematical
modifications required by Schedule A, Form 1045, petitioners
claimed on their 1987 joint Federal income tax return a net
operating loss (NOL) of $127,533 based upon the above $128,841
claimed business bad debt deduction. The claimed net operating
loss of $127,533 was carried forward to petitioners’ joint
Federal income tax returns for 1988, 1989, and 1990.
Petitioners untimely filed their 1989 joint Federal income
tax return in September of 1991.
Respondent disallowed petitioners' claimed $128,841 business
bad debt deduction for 1987 and the related $127,533 NOL that
petitioners carried forward to 1988, 1989, and 1990. Respondent
also determined for 1989 an addition to tax with respect to the
late filing of petitioners’ 1989 joint Federal income tax return
under section 6651(a) and for 1990 an accuracy-related penalty
under section 6662(a).
OPINION
Generally, taxpayers are allowed deductions for bona fide
debts owed to them that become worthless during a year. Sec.
166(a). Bona fide debts generally arise from valid debtor-
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creditor relationships reflecting enforceable and unconditional
obligations to repay fixed sums of money. Sec. 1.166-1(c),
Income Tax Regs. Contributions to the capital of corporations
and other equity investments in corporations do not constitute or
qualify as bona fide debts. Kean v. Commissioner, 91 T.C. 575,
594 (1988).
The question of whether transfers of funds to closely held
corporations constitute debt or equity must be decided on the
basis of all the relevant facts and circumstances, and taxpayers
generally bear the burden of proving that the transfers
constituted loans by the taxpayers to the corporations and not
equity investments. Rule 142(a); Dixie Dairies Corp. v.
Commissioner, 74 T.C. 476, 493 (1980).
Various factors are often used to analyze whether funds
transferred to closely held corporations are to be treated as
debt or equity: (1) The treatment of the funds on documents
prepared by the parties to the transaction; (2) the presence or
absence of fixed due dates for repayment of the funds; (3) the
likely source of repayment of the funds; (4) efforts to enforce
repayment of the funds; (5) participation by the transferor of
the funds in management of the corporation; (6) whether the
transferor subordinated right of repayment to the corporation’s
other creditors; (7) the intent of the parties; (8) whether the
transferor of the funds was also a shareholder of the
corporation; (9) the capitalization of the corporation;
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(10) availability to the corporation of outside financing;
(11) use of the funds by the corporation; (12) repayment history;
and (13) the risks involved in making the transfers. Calumet
Indus., Inc. v. Commissioner, 95 T.C. 257, 285 (1990); Dixie
Dairies Corp. v. Commissioner, supra at 493. No single factor is
controlling. Dixie Dairies Corp. v. Commissioner, supra at 493.
Transfers by controlling shareholders to closely held
corporations are subject to heightened scrutiny, and labels
attached to such transfers by controlling shareholders through
bookkeeping entries or testimony have limited significance unless
the labels are supported by objective evidence. Fin Hay Realty
Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968); Dixie
Dairies Corp. v. Commissioner, supra at 495.
Petitioners argue that the $128,841 claimed business bad
debt deduction constituted bona fide business loans by them to
K&C and that the loans became worthless in 1987. Alternatively,
if the funds they transferred to K&C are to be treated as equity,
petitioners argue that a section 1244 ordinary loss deduction
should be allowed with regard thereto.
Respondent argues that the funds petitioners transferred to
K&C should be treated as contributions to the capital of K&C and
that petitioners therefore should not be allowed the claimed
$128,841 business bad debt deduction under section 166. With
regard to the alternatively claimed section 1244 loss, respondent
argues that that section would apply only to the 10,000 shares of
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stock that petitioners owned and not to the 40,000 shares of K&C
stock that were issued in the name of petitioner’s father and
that related to the $94,000 provided by petitioner’s father that
was contributed to K&C. We agree with respondent.
The evidence in this case undermines the credibility of the
four written promissory notes on which petitioners rely. The
timing and the amount of the four promissory notes do not
correlate with the timing and the amount of the transfers of
funds to K&C. The four promissory notes total $129,682, and the
transfers total $132,538. The testimony regarding the promissory
notes is unclear and inconsistent.
K&C’s initial capitalization of only $5,882 is grossly
disproportionate to K&C’s purported debt obligations. K&C
appears to have been undercapitalized and unable to obtain
outside financing.
Petitioners received no repayments of any of the funds
transferred to K&C and no payments of interest thereon.
On the basis of the evidence and considering petitioners’
burden of proof, we find that petitioners have not established
that the $128,841 claimed business bad debt deduction relates to
a bona fide loan.
With regard to their alternative claim, petitioners argue
that the 40,000 shares of K&C stock were issued to petitioner’s
father due to a clerical error, that they were the real owners of
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this stock, and that they should be entitled to claim an ordinary
loss with regard thereto under section 1244.
Generally, we treat facts as they happened, not as they
could or might have happened. See Estate of Legg v.
Commissioner, 40 B.T.A. 1074, 1076 (1939), revd. and remanded on
another issue 114 F.2d 760 (4th Cir. 1940). As respondent
acknowledges, petitioners are entitled to a section 1244 ordinary
loss deduction for the 10,000 shares of stock that were issued to
them. Petitioners, however, have not established their ownership
of the 40,000 shares of K&C stock issued to petitioner’s father,
and petitioners are not entitled to the claimed section 1244
ordinary loss deduction with regard thereto.
In order to avoid the addition to tax for late filing of a
tax return, taxpayers must prove that their failure to file
timely was due to reasonable cause and not to willful neglect.
Sec. 6651(a); United States v. Boyle, 469 U.S. 241, 245 (1985);
Catalano v. Commissioner, 81 T.C. 8 (1983), affd. without
published opinion sub nom. Knoll v. Commissioner, 735 F.2d 1370
(9th Cir. 1984); sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
Petitioners present no argument to refute the section
6651(a) late filing addition to tax, and respondent’s
determination is sustained.
Under section 6662(a), a penalty is imposed equal to 20
percent of the portion of the underpayment that is attributable
to a substantial understatement of income tax (namely, an
understatement for a year in excess of 10 percent of the amount
required to be shown on the Federal income tax return or $5,000).
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Sec. 6662(d)(1). Petitioners present no credible argument as to
the section 6662(a) substantial understatement penalty, and we
sustain respondent’s imposition of this penalty.
To reflect the foregoing,
Decision will be entered
under Rule 155.