T.C. Memo. 1998-133
UNITED STATES TAX COURT
KENNETH R. AND CAROL L. BAUER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26285-96. Filed April 6, 1998.
Kenneth R. and Carol L. Bauer, pro se.
J. Scott Hargis, for respondent.
MEMORANDUM OPINION
NAMEROFF, Special Trial Judge: This case was heard pursuant
to the provisions of section 7443A(b)(3)1 and Rules 180, 181, and
182. Respondent determined a deficiency in petitioners’ 1993
Federal income tax in the amount of $2,916. The issue for
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year at issue. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
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decision is whether petitioners are entitled to a nonbusiness
bad debt deduction pursuant to section 166.
Background
Some of the facts have been stipulated, and they are so
found. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. Mr. Bauer resided in
Riverside, California, and Mrs. Bauer resided in Laughlin,
Nevada, at the time they filed their petition.
Mrs. Bauer is a real estate broker. Mr. Bauer is a
machinist. During the year at issue, Mr. Bauer spent his
weekends with Mrs. Bauer in Laughlin, Nevada, and in Bullhead
City, Arizona, a town located directly across the Colorado River
from Laughlin.
Petitioners, but especially Mrs. Bauer, frequently dined at
a restaurant in Bullhead City named The Diamond Lil’s Drunken
Lobster (the Drunken Lobster). The Drunken Lobster was an
upscale restaurant specializing in steak and lobster that opened
in 1990. The Drunken Lobster was owned and operated by father
and son, Salvatore and John Dubato (John) (collectively referred
to as the Dubatos), who also were petitioners’ personal friends.
During 1991, the Drunken Lobster was having financial
problems. The Dubatos approached petitioners for a loan, and
petitioners decided to advance them funds for use in their
business. Petitioners made a series of four interest-free loans
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to the Dubatos.2 Within the time promised (i.e., 30 or 60 days),
the Dubatos repaid petitioners the full amount of each loan.
Petitioners made the loans because they wanted to help their
friends and because Mrs. Bauer wanted a nice restaurant close by
to which she could take her real estate clients. Petitioners,
however, were not in the business of lending money.
During 1992, the Dubatos continued having financial
problems. Through a series of nine payments, petitioners
advanced a total of $10,901.39 to, or on behalf of, the Dubatos
between the months of March and August 1992.3 These advances
were not supported by written loan documents. Petitioners
expected to be repaid within 30 to 60 days and to receive an
annual interest rate of 15 percent.
2
The first of these loans was for $500, to be repaid
within 30 days.
3
Petitioners made the following advances during 1992:
Date Amount Form and Purpose of Payment
March 16 $2,000.00 Cash to cover payroll
March 28 2,800.00 Rent check to Hesling Fam. Trust
April 22 866.62 Cashier’s check for insurance
May 22 2,000.00 Cashier’s check for supplies
May 22 2,000.00 Cashier’s check for supplies
April/May 462.00 Check to publications for adver.
May/June 115.67 Check to florist for decorations
June/July 477.10 Check to publications for adver.
August 180.00 Check to publications for adver.
Total 10,901.39
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After the initial advance was made in March 1992, John
orally promised to either repay petitioners within a month or
else transfer to them a 15-percent interest in the Drunken
Lobster. John did not fulfill his promise. In May or June 1992,
John again orally promised to repay petitioners in one of three
ways: (1) Full cash repayment by May 1993; (2) the transfer of
an interest in the restaurant in lieu of payment; or (3) payment
through an installment plan of $500 per month, plus interest.
John never fulfilled his promise, and the Dubatos never repaid
petitioners for any portion of these advances. Moreover,
petitioners did not receive an equity interest in the Drunken
Lobster.
While the Drunken Lobster started out successfully, the
excitement of a new restaurant in the area quickly wore off. The
Drunken Lobster was no longer attracting the customers it once
did. Although it was consistently crowded for breakfast, the
lunch crowd was starting “to slack off a little bit” and the
dinner hour no longer had a waiting list. Beginning in April
1992, Mrs. Bauer did what she could to assist the Dubatos and
even performed work for the Drunken Lobster when it was short
staffed. She created advertisements, wrote and printed menus,
organized holiday events (i.e., a Mother’s Day and a July 4th
holiday meal), and cleared and bused tables. Mrs. Bauer was not
compensated for her time or reimbursed for her expenditures.
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By the end of May 1992, petitioners began to suspect that
the Dubatos were having serious financial problems because they
started “letting people go” and because they were not meeting
many of their expenses. At that point, Mrs. Bauer went to
Drunken Lobster once a week, not so much to assist, but to “bug”
the Dubatos for payment. Petitioners offered to accept $500
every other week, without interest, if the Dubatos would just
start paying them back. The Dubatos, offering only excuses, did
not agree with that arrangement.
Throughout 1993, the Drunken Lobster ran on a skeleton
budget and crew. In fact, there were days that the Drunken
Lobster did not open. The Dubatos permanently closed the Drunken
Lobster in October 1993. At no time during 1993, did petitioners
advance the Dubatos additional funds, despite the fact that the
Dubatos requested them to do so.
Petitioners did not take legal steps to collect on the debts
(other than possibly writing one demand letter) because the
Dubatos had no assets from which to satisfy their debts.
Petitioners’ personal observations of the Dubatos’ financial
situation revealed that they owned no assets outright and that
they had leased everything, including the three-bedroom house in
which they lived, the premises where the Drunken Lobster was
located, and all the Drunken Lobster’s property and equipment
(i.e., kitchen equipment, tables, chairs, tablecloths,
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silverware, and dishes). Petitioners were aware that other
creditors of the Dubatos were also dunning them for payment.
This included a meat supplier, a food supplier, and a State
revenue officer who, Mrs. Bauer saw, “came in and took the money
right out of the drawer for sales tax”. The Dubatos continued
living in Bullhead City for some part of 1994, but later on
during the year, they eventually moved. At the time of trial,
petitioners were unaware of the Dubatos’ whereabouts.
On their 1993 Federal income tax return, petitioners claimed
a $10,901 business bad debt deduction. In the notice of
deficiency, respondent, inter alia, disallowed the bad debt
deduction. At trial, petitioners conceded that their advances
were nonbusiness debts, and they now seek only a nonbusiness bad
debt deduction. All other adjustments in the notice of
deficiency have been resolved.
Discussion
The Commissioner’s determinations are presumed correct, and
petitioners bear the burden of proving that those determinations
are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933).
Section 166(a) permits a deduction for any bona fide debt
that becomes worthless within the taxable year. To qualify for
the bad debt deduction, there must be a debtor-creditor
relationship. Sec. 1.166-1(c), Income Tax Regs. Whether a bona
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fide debtor-creditor relationship exists is a question of fact
which ultimately requires a determination as to whether there was
a genuine intention to create a debt, with reasonable expectation
of repayment, and whether that intent comports with the economic
reality of creating a debtor-creditor relationship. Litton Bus.
Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973); see also
A.R. Lantz Co. v. United States, 424 F.2d 1330, 1334 (9th Cir.
1970); Fisher v. Commissioner, 54 T.C. 905, 909 (1970). There
is no standard test or formula for determining worthlessness
within a given taxable year; the determination depends upon the
particular facts and circumstances of the case. Crown v.
Commissioner, 77 T.C. 582, 598 (1981). Generally, however, the
year of worthlessness is fixed by identifiable events that form
the basis of reasonable grounds for abandoning any hope of
recovery. United States v. S.S. White Dental Manufacturing Co.,
274 U.S. 398 (1927); American Offshore, Inc. v. Commissioner, 97
T.C. 579, 593 (1991); Crown v. Commissioner, supra. Moreover, a
debt will generally be considered worthless only when it can be
reasonably expected that the debt is without possibility of
future payment and legal action to enforce the debt would not
result in satisfaction. Hawkins v. Commissioner, 20 T.C. 1069
(1953); sec. 1.166-2(b), Income Tax Regs.
Respondent asserts that petitioners are not entitled to a
bad debt deduction because: (1) Petitioners have failed to
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establish that their advances were bona fide debts as opposed to
gifts; and (2) assuming the Court finds the existence of bona
fide debt, the debt did not become worthless during 1993.
Petitioners, on the other hand, contend that the debt became
worthless during 1993, thereby entitling them to a deduction.
Upon review of the record, we hold that petitioners are
entitled to a nonbusiness bad debt deduction for 1993. The
record demonstrates that there was a bona fide debtor-creditor
relationship between petitioners and the Dubatos. While
petitioners’ nine payments to, or on behalf of, the Dubatos were
not supported by notes or other physical evidence of
indebtedness, we are convinced that petitioners intended them to
be loans for which they reasonably expected repayment.
Petitioners advanced the $10,901.36 only after they were timely
and fully repaid by the Dubatos on their four previous loans.
Moreover, the Dubatos had an operating business from which
petitioners could reasonably expect repayment. Lastly,
petitioners expected to receive interest and made numerous
demands for payments once the Dubatos failed to timely repay the
loans. These facts suggest that a bona fide debtor-creditor
relationship existed. Respondent’s contention that the advances
were gifts to Dubatos is simply not supported by the record.
We also find that the debt became worthless in 1993.
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We believe that identifiable events, occurring in 1993, formed a
reasonable basis for petitioners to abandon all hope of recovery
during that year. It was during 1993 that the Drunken Lobster
ran on a skeleton crew and permanently ceased its operations.
Although the Dubatos were having financial problems during 1992,
it was not until the closure of the Drunken Lobster that the
Dubatos’ means with which to repay petitioners were eliminated.
The Dubatos had no other assets from which petitioners could
collect on their debts. Moreover, there is sufficient evidence
for us to find that legal action to enforce payment would be
futile. Accordingly, petitioners are entitled to a nonbusiness
bad debt deduction for 1993.4
To reflect the foregoing,
Decision will be entered
under Rule 155.
4
We note that a nonbusiness bad debt deduction is treated
as a short-term capital loss subject to the capital loss
limitation of sec. 1211(b). Sec. 166(d); sec. 1.166-5(a)(2),
Income Tax Regs. Sec. 1211(b) restricts petitioners’ deduction
to the extent of their capital gains plus (if losses from sales
or exchanges of capital assets exceed such gains) the lesser of
$3,000 or the excess of such losses over such gains.
Petitioners, however, are permitted to carry over any capital
loss in excess of this amount to the succeeding taxable year.
Sec. 1212(b).