T.C. Memo. 1998-423
UNITED STATES TAX COURT
CERAND & COMPANY, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2767-97. Filed November 24, 1998.
Gerard A. Cerand (an officer), for petitioner.
Gregory S. Matson and Warren P. Simonsen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined deficiencies in
petitioner’s Federal income tax for tax years 1990, 1991, and
1992 in the amounts of $6,994, $10,709, and $143,406,
respectively. The issue for our consideration is whether bad
debt deductions taken in 1990 and 1991 are allowable under
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section 166.1 The remainder of respondent’s determination, the
1992 net operating loss (NOL) carryforward and a charitable gift
deduction, is purely computational adjustments caused by the
reduction of petitioner’s ordinary loss deduction and the
corresponding increase in income.
Respondent contends that the extension of credit to
corporations wholly owned by petitioner’s sole shareholder
constituted equity investments in those companies. As such,
respondent argues that the corporations’ subsequent failures
resulted in capital rather than ordinary losses for petitioner.
Petitioner counters that the lines of credit were valid debt
incurred by the corporations, and the corporations’ inability to
repay the debt created an ordinary loss for petitioner under
section 166.
FINDINGS OF FACT
The stipulation of facts and the exhibits attached thereto
are incorporated herein by this reference.
Petitioner Cerand & Company, Inc., offers consulting
services concerning the operation of airport parking lots.
Petitioner was located in Washington, D.C., at the time the
petition in this case was filed. Petitioner’s president is
1
Unless otherwise stated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
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Gerard A. Cerand, who held 95 percent of the stock until 1989
when he became petitioner’s sole shareholder.
Because petitioner’s consulting business involved extensive
travel to airports with varying accessibility throughout the
United States, Mr. Cerand needed certain air taxi/charter
services. In 1984, responding to this need, he formed three new
corporations, First World Corp. (FWC), Cerand Aviation (CAI), and
Airport Service Corp. (ASC), based in Culpeper County, Virginia.
These separate corporations had a business purpose: to allow
petitioner greater growth while limiting any potential
catastrophic liability to petitioner in the event of an aviation
accident. Mr. Cerand was the president and owner of the three
new corporations, although no stock was ever issued.
The three new companies and petitioner were intertwined.
FWC provided administrative services to CAI and ASC, such as
labor, employee health benefits, and insurance. CAI provided the
air taxi/charter service to petitioner and other outside
clientele, as well as providing aviation instruction to outside
clientele. ASC provided the aviation support services.
Petitioner provided working capital to these companies
through an “open account receivable”, or line of credit, on which
the three corporations consistently drew advances. Petitioner
paid a total of $1,413,374.17 to FWC, CAI, and ASC from 1984
until 1991. No formal loan agreements or notes were drawn up,
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nor was any repayment schedule set. From time to time, the three
corporations made cash repayments, or book entry credit was made
to the advances for services rendered to petitioner. While the
corporations were viable, they repaid $414,220 to petitioner.
Petitioner accrued interest only sporadically on the advances to
two of the corporations and failed to accrue any interest against
the advances to the third, contrary to the advice of Mr. Cerand’s
tax adviser. The interest that petitioner did accrue on its
books was rolled over annually into a note receivable and
reported as income by petitioner. Because that income was never
actually received by petitioner, respondent has allowed a
deduction against ordinary income for that amount.
The three corporations used funds received from petitioner
to pay operating expenses. No capital assets were purchased by
the corporations. Instead, all assets were leased, primarily
from Mr. Cerand.
In 1989, the corporations experienced two costly and
devastating events, the loss of FWC’s lease for ASC’s operations
at Culpeper County Airport and the loss of CAI’s Government
contract comprising approximately 90 percent of its business.
These events caused the demise of CAI and ASC in 1990, with FWC
close behind in 1991.
Once the companies went out of business, there were no
assets to seize as repayment, except for a key man life insurance
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policy on Mr. Cerand held by FWC with $160,859 cash surrender
value. Petitioner recovered the cash surrender value and
reported the income as a debt reduction. No further attempts
were made to secure payment from the three defunct corporations.
In 1990, petitioner claimed a bad debt deduction for the
unpaid balances of ASC and CAI. In 1991, petitioner claimed a
bad debt deduction for FWC’s unpaid balance. In 1992, petitioner
claimed an NOL carryforward that was generated by the bad debt
claims. Respondent disallowed the following bad debt deductions
as ordinary losses, determining that they were capital losses.
1990 1991
Cerand Aviation, Inc. $174,760 ---
Aviation Services Corp. 43,331 ---
First World Co., Inc. --- $681,112
Total 218,091 681,112
Respondent asserts that the funds advanced by petitioner were
actually capital contributions to equity rather than debt. If
the bad debt deductions are not allowed as ordinary losses, then
the 1992 NOL carryforward is not allowable, and a previously
unavailable charitable deduction would be allowed.
OPINION
The sole adjustment under consideration involves the
question of whether petitioner is entitled, under section 166, to
business bad debt deductions for 1990 and 1991 due to the failure
of FWC, CAI, and ASC to repay advances made by petitioner. All
other adjustments depend on the outcome of this primary issue.
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Section 166 provides for deductions against ordinary income
for business bad debts that become worthless during the year. To
be entitled to the deduction, the taxpayer must prove a bona fide
debtor-creditor relationship obligating the debtor to pay the
creditor-taxpayer a fixed or determinable sum of money. Calumet
Indus., Inc. v. Commissioner, 95 T.C. 257 (1990). Contributions
to capital are not considered debt. Kean v. Commissioner, 91
T.C. 575, 594 (1988); sec. 1.166-1(c), Income Tax Regs. The
classification of a payment as debt or equity for Federal tax
purposes is a question of fact. Segel v. Commissioner, 89 T.C.
816, 827 (1987).
The fact that the debtor and creditor are related parties
does not preclude the existence of a bona fide debt. Calumet
Indus., Inc. v. Commissioner, supra at 286. However, the form of
the transaction and the labels parties place on the transaction
may not have as much significance when the corporation is closely
held because the parties are free to mold the transaction. Fin
Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir.
1968). For this reason, petitioner’s characterization of the
fund transfer as an open account receivable is not determinative.
In resolving similar questions of debt versus equity,
various appellate courts have identified and considered similar
factors. See, e.g., Estate of Mixon v. United States, 464 F.2d
394, 402 (5th Cir. 1972) (13 factors); A.R. Lantz Co. v. United
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States, 424 F.2d 1330 (9th Cir. 1970) (11 factors); Fin Hay
Realty Co. v. United States, supra (16 factors); Georgia-Pacific
Corp. v. Commissioner, 63 T.C. 790 (1975) (13 factors). The
factors considered include: (1) The names given to the
certificates evidencing the indebtedness; (2) presence or absence
of a fixed maturity date; (3) source of payments; (4) right to
enforce payments; (5) participation in management as a result of
the advances; (6) status of the advances in relation to regular
corporate creditors; (7) intent of the parties; (8) identity of
interest between creditor and stockholder; (9) “thinness” of
capital structure in relation to debt; (10) ability of
corporation to obtain credit from outside sources; (11) use to
which advances were put; (12) failure of debtor to repay; and
(13) risk involved in making advances. Dixie Dairies Corp. v.
Commissioner, 74 T.C. 476, 493-494 (1980).
The identified factors are not equally significant. Estate
of Mixon v. United States, supra at 402. Nor is any one factor
determinative or relevant in each case due to the countless
factual circumstances possible. John Kelley Co. v. Commissioner,
326 U.S. 521, 530 (1946). “The various factors * * * are only
aids in answering the ultimate question whether the investment,
analyzed in terms of its economic reality, constitutes risk
capital entirely subject to the fortunes of the corporate venture
or represents a strict debtor-creditor relationship.” Fin Hay
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Realty Co. v. United States, supra at 697. The ultimate question
is whether there was a genuine intention to create a debt, with a
reasonable expectation of repayment, and if that intention
comported with the economic reality of creating a debtor-creditor
relationship. Litton Bus. Sys., Inc. v. Commissioner, 61 T.C.
367, 377 (1973).
Applying the relevant factors to the present facts, it
becomes evident that petitioner did not intend to establish a
debtor-creditor relationship with FWC, CAI, and ASC. Instead,
the contributions made by petitioner were in actuality equity
investments in the common owner’s companies.
First, we look at the particulars of the transaction,
including the name given to the certificates of debt and the
presence or absence of a maturity date or a repayment schedule to
indicate debt or equity. Petitioner never used any certificate
or instrument to memorialize the debt; no loan agreements or
notes were ever signed. Nor did petitioner set a fixed maturity
date or a repayment schedule for the three companies. The
absence of a maturity date on a note weighs against finding that
the transfers were loans. Stinnett’s Pontiac Serv. Inc. v.
Commissioner, 730 F.2d 634, 638 (11th Cir. 1984), affg. T.C.
Memo. 1982-314. Moreover, petitioner failed even to show that a
predetermined interest rate applied or that the interest accrued
on the advances was at market rate. See Rule 142(a) (petitioner
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has the burden of proof unless otherwise provided by statute or
the Court).
Second, the payments themselves may denote the nature of
debt or equity. The source, the consistency, and the enforcement
of repayment are factors to consider. The repayment to
petitioner was inconsistent and appeared dependent on financial
success. Accordingly, the source of the repayment was more like
equity rather than debt. Moreover, while petitioner insists that
there was a right to enforce payments from the three companies,
petitioner never made any efforts to do so beyond recovering the
cash surrender value of FWC’s life insurance policy on Mr.
Cerand.
The third group of factors are those factors traditionally
considered by lenders, such as capitalization, risk, the
availability of financing from outside sources and the use to
which advances are put. “[T]he touchstone of economic reality is
whether an outside lender would have made the payments in the
same form and on the same terms.” Segel v. Commissioner, supra
at 828. The three new companies were thinly capitalized, with no
capital assets, and more than $1.4 million was advanced over time
to meet operating expenses. With thin capitalization and no
historical success, there was considerable risk in advancing the
funds. That risk became reality when the three companies failed
to repay over two-thirds of the money they received from
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petitioner before going out of business. Though no outside
financing was sought, it is reasonable to assume that an outside
financier would not have accepted similar credit terms: an open,
unsecured line of credit with no set interest rate, no set
payment schedule, and no fixed maturity date to three companies
with no financial history and no capital assets.
As shown by their actions, the parties intended the funds
advanced to be an investment in FWC, CAI, and ASC. For these
reasons, we find that petitioner made an equity investment in
FWC, CAI, and ASC. When the three failed to repay petitioner the
funds it had extended, petitioner suffered a capital loss.
In light of the foregoing,
Decision will be entered under
Rule 155.