T.C. Memo. 1998-377
UNITED STATES TAX COURT
ROBERT C. COBORN, SR., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16842-94. Filed October 19, 1998.
Mark A. Pridgeon, for petitioner.
David L. Zoss, for respondent.
MEMORANDUM OPINION
SWIFT, Judge: Respondent determined deficiencies of
$249,919, $96,478, $5,627, and $16,300, respectively, in
petitioner's Federal income taxes for 1988, 1989, 1990, and 1991.
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The issue for decision is whether petitioner is entitled to
a claimed $1.6 million nonbusiness bad debt deduction relating to
funds transferred to a closely held corporation.
Background
Petitioner resided in St. Cloud, Minnesota, at the time the
petition was filed.
On June 16, 1972, petitioner became holder of stock in
Environmental Protection Laboratories, Inc. (EPL), a newly formed
Minnesota corporation established, among other things, to develop
products relating to laboratory testing and to environmental
monitoring equipment.
Beginning in 1983 and through January of 1990, petitioner
was the controlling shareholder of EPL. One of petitioner's
business objectives for EPL was for EPL to become sufficiently
successful and profitable so that the stock in EPL could be sold
to a third party at a large profit.
In 1983, petitioner's son, Robert C. Coborn, Jr., became
EPL's president. Over the years, petitioner invested heavily in
EPL, in part, to financially support the corporation of which his
son was president.
In the early 1980's, it was estimated that EPL would need
$1.5 to $1.9 million in additional capital funds to implement for
EPL the business plan that petitioner, his son, and others had
developed.
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Between 1972 and 1988, petitioner transferred at least
$1,571,429 to EPL.
Over the years, EPL obtained a number of loans from banks.
These loans were personally guaranteed by petitioner. Funds that
petitioner individually transferred to EPL were not secured and
were subordinated to bank loans EPL obtained.
Not until September of 1990 did petitioner take steps to
secure funds he alleges to have loaned to EPL.
Between 1973 and 1984, a series of purported promissory
notes were executed on behalf of EPL and in favor of petitioner
that apparently related to some of the funds petitioner
transferred to EPL. Neither petitioner nor EPL, however,
maintained adequate, current documentation and accounting records
reflecting funds petitioner transferred to EPL. Certain
documentation relating to the funds petitioner transferred to EPL
appears to have been originated not at the time the funds were
transferred but in later years.
Of the $1,571,429 that petitioner alleges constituted funds
he loaned to EPL, $729,248 thereof is not reflected by any
purported promissory notes.
At some point in time, an undated document was executed on
behalf of EPL and in favor of petitioner indicating that
petitioner agreed to loan over an unspecified period of time an
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unspecified amount of funds to EPL and that EPL would repay the
funds on demand with interest at a rate of 14 percent per annum.
On petitioner's Federal income tax returns for the years in
issue, the reporting of interest income by petitioner relating to
funds petitioner received from EPL and relating to the alleged
loans petitioner purportedly made to EPL is erratic and
inconsistent. In some years, petitioner received no funds from
EPL, but petitioner reported on his income tax returns interest
income received from EPL. In other years, petitioner reported on
his income tax returns more or less in interest income than the
total funds he received from EPL. In some years, petitioner
reported none of the funds he received from EPL as interest
income. The schedule below indicates, for some years, the
amounts of funds petitioner apparently received from EPL and the
amounts petitioner reported on his respective Federal income tax
returns as interest income received from EPL:
Funds Petitioner Received Funds Reported As
Year From EPL Interest Income
1979 -0- $ 4,965
1984 $ 2,400 6,286
1985 -0- 14,125
1986 52,469 -0-
1987 45,267 3,600
1988 48,454 6,000
On a final decree of divorce between petitioner and his wife
dated January 12, 1987, it is stated that petitioner is awarded
debt owed by EPL to him in the amount of $591,606.
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In July of 1988, apparently before petitioner made any claim
that the debt purportedly owed to him by EPL was worthless, EPL's
financial statements for 1986 were prepared and reflected total
assets of $3,029,877 and total stockholder equity of $552,097.
Included among the reported assets was an asset with a stated
value of $2,369,810 that was described as "Fair Market Value of
Product Rights". In September of 1990, apparently after
petitioner made the claim that purported debt owed to him by EPL
was worthless, EPL’s financial statements for 1987 and 1988 were
prepared, and the above asset was omitted from the financial
statements.
EPL experienced some degree of success. Between 1983 and
1987, EPL’s gross receipts increased by over 400 percent.
According to EPL’s books, however, from 1984 through 1987, no net
profits were realized by EPL, and EPL had a negative net worth.
In 1988, EPL became delinquent in the payment of employment
taxes, and EPL’s board of directors considered filing a
bankruptcy petition.
Petitioner and his son, however, decided not to file a
bankruptcy petition on behalf of EPL because such a step would
disrupt EPL’s employee, vendor, banking, and customer
relationships and would damage EPL’s trade name. Further, in
1988, petitioner and his son still considered EPL's business
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prospects good, and petitioner anticipated the possible private
or public sale of the stock of EPL.
In 1988, no appraisals relating to the value of EPL as a
business were obtained.
The evidence does not indicate that petitioner ever made
demand on EPL for repayment of his purported loans to EPL, nor
does the evidence indicate that petitioner ever undertook steps
to otherwise collect from EPL the purported loans.
In 1988, in anticipation of, among other things, a possible
sale of EPL’s stock and in an effort to enhance the financial
statements of EPL, petitioner went through the exercise of
“forgiving” $1.6 million in purported debt of EPL to petitioner
relating to funds that petitioner over the years had transferred
to EPL.
After 1988, EPL continued to operate as a business.
Petitioner and his son attempted to sell the stock of EPL in a
public offering, and petitioner continued to transfer funds to
EPL. In 1989, 1990, and 1991, petitioner transferred to EPL
funds totaling $616,169, and petitioner received from EPL funds
totaling $573,282. The evidence does not indicate the existence
of any promissory notes or other debt instruments relating to the
funds that petitioner, after 1988, transferred to EPL.
In 1989, in seeking outside investment capital, a new
comprehensive business plan for EPL was adopted.
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By 1992, EPL had changed its name to Micro Bio Logics, Inc.
(MBL), and in 1992 MBL conducted an unsuccessful public offering
of its common stock and warrants.
On EPL’s original and amended 1988 corporate Federal income
tax returns, $1.6 million in forgiveness of indebtedness income
was reported relating to the $1.6 million in purported debt to
petitioner that petitioner in 1988 allegedly forgave.
Based on EPL's 1988 corporate Federal income tax return, but
for the $1.6 million in forgiveness of indebtedness income that
was reported, EPL would have reported on its 1988 corporate
Federal income tax return a net operating loss for 1988 in the
amount of $717,119.
As a result of its 1988 operations and its net operating
loss carryforward from prior years, the $1.6 million in
forgiveness of indebtedness income that EPL reported for 1988 did
not result in any reported tax liability for EPL.
Further, in January of 1988, petitioner sold his stock in
Coborn's, Inc. (Coborn), another closely held corporation in
which petitioner had an interest, and petitioner realized from
this sale a long-term capital gain of $2,044,988. In 1988, 1989,
1990, and 1991, petitioner recognized and reported $855,089,
$451,494, $30,786 and $34,730, respectively, of this capital
gain.
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On petitioner's 1988, 1989, 1990, and 1991 Federal income
tax returns, the $1.6 million claimed nonbusiness bad debt
deduction (and the carryovers thereof) relating to petitioner’s
purported loans to EPL significantly offset the capital gains
reported from the sale of petitioner’s stock in Coborn.
Discussion
Losses on nonbusiness bad debts are treated as sustained in
a particular year only if the entire debt becomes totally
worthless during the year. Riss v. Commissioner, 478 F.2d 1160,
1165-1166 (8th Cir. 1973), affg. in part and remanding 56 T.C.
388 (1971); sec. 1.166-5(a)(2), Income Tax Regs. The taxpayer
must show some identifiable event or group of facts that proves
worthlessness. American Offshore, Inc. v. Commissioner, 97 T.C.
579, 593-594 (1991). A debt does not become worthless merely
because a creditor decides not to enforce the debt. Southwestern
Life Ins. Co. v. United States, 560 F.2d 627, 644 (5th Cir.
1977). Declining business, lack of profits, or poor financial
condition do not necessarily establish worthlessness of a debt.
Intergraph Corp. v. Commissioner, 106 T.C. 312, 323 (1996), affd.
per curiam without published opinion 121 F.3d 723 (11th Cir.
1997). This is particularly true where a debtor continues to
operate as a going concern and where the creditor continues to
extend funds to the debtor. Id. and cases cited therein.
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The evidence establishes that, after 1988, EPL continued to
operate as a business. Petitioner continued to seek a sale of
the stock of EPL, and EPL conducted ongoing business activity.
In 1989, a new business plan for EPL was formulated, and in 1992
a public offering of EPL stock occurred. Significantly, after
1988, petitioner continued to transfer funds to EPL. The
evidence does not demonstrate that EPL's purported debt to
petitioner became worthless in 1988.
For the reasons stated,
Decision will be entered for
respondent.