T.C. Memo. 2000-50
UNITED STATES TAX COURT
ALLEN C. CHAMBERLIN AND MARTHA L. CHAMBERLIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1223-98. Filed February 11, 2000.
Lorentz W. Hansen, for petitioners.
John Aletta, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Chief Judge: Respondent determined the following
deficiencies, additions to tax, and penalties with respect to
petitioners’ Federal income tax:
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Additions to Tax and Penalties
Sec. Sec. Sec. Sec. Sec. Sec.
Year Deficiency 6651(a)(1) 6651(a)(2) 6653(a)(1) 6653(a)(1)(A) 6653(a)(1)(B)1 6662(a)
1985 $ 0 $ 212 $ 192 $ 66 $ — $ — $ —
1986 5,282 2,991 1,572 — 827 5,282 —
1987 1,376 332 52 — 74 1,376 —
1988 2,921 774 861 172 — — —
1989 16,214 2,178 2,420 — — — 3,190
1990 41,339 11,067 12,051 — — — 8,132
1991 37,713 6,681 1,710 — — — 7,543
1992 49,979 9,940 1,254 — — — 9,954
1993 141,892 30,766 1,050 — — — 28,378
1
50% of the interest due upon these amounts.
The issues for decision are: (1) The amount of losses
sustained by petitioners from their investments in, loans made
to, and loan guaranties for several pharmaceutical corporations
between 1979 and 1984; (2) the years petitioners were entitled to
recognize their losses; (3) whether the losses became part of the
personal bankruptcy estate of petitioners; (4) the amount of
carryover losses used by the personal bankruptcy estate of
petitioners; (5) the character of any remaining losses; and
(6) whether petitioners are liable for penalties and additions to
tax for 1985 through 1993. Other issues in the statutory notice
or in the petition have been abandoned by petitioners because
they failed to present any evidence or argument concerning them.
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.
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FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
At the time of the filing of their petition, petitioners
resided in Greenwich, Connecticut. Allen C. Chamberlin
(petitioner) is a doctor of orthopedic medicine, having graduated
from the Boston University School of Medicine. Petitioners filed
their joint Forms 1040, U.S. Individual Income Tax Return, for
1982 through 1993 on the following dates:
Year Filing Date
1982 07/11/84
1983 09/06/94
1984 09/06/94
1985 09/17/88
1986 09/17/88
1987 09/17/88
1988 04/17/95
1989 04/04/95
1990 04/17/95
1991 03/27/95
1992 03/27/95
1993 10/16/95
The initial 1985, 1986, and 1987 Forms 1040 were blank and
contained no financial information. Subsequently, on
December 28, 1994, petitioners filed completed Forms 1040 for
these years. Petitioners reported $1,324, $11,264, $98, $521,
$1,584, $7,849, $9,499, $10,450, and $11,057 of total tax on
their returns for 1985, 1986, 1987, 1988, 1989, 1990, 1991, 1992,
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and 1993, respectively. Petitioners prepared their returns with
the help of a certified public accountant.
Pharmacare, Inc. (Pharmacare), was a Delaware corporation
engaged in the business of manufacturing unit dose pharmaceutical
products and packaging cosmetic products and lotions. The main
manufacturing facility for Pharmacare was located in Largo,
Florida (Largo facility).
During 1978, Pharmacare was in serious financial difficulty
and was looking for investors to provide working capital for the
company. A group of investors led by Stelios Vavlitis (Vavlitis)
agreed to invest funds in Pharmacare in exchange for a
controlling interest in the outstanding stock of the corporation.
Vavlitis planned to rebuild Pharmacare under his management and
to attract other investors to provide working capital. Vavlitis
created Pharmaco Trust, which bought an 87.6-percent interest in
the outstanding stock of Pharmacare and held the acquired stock
for management and sales purposes. Vavlitis was made president,
chief executive officer, and chairman of the board of directors
of Pharmacare.
In 1978, Vavlitis persuaded petitioner to purchase three
units of Pharmaco Trust for $99,000. In doing so, Vavlitis made
material false representations and misstatements about his prior
business experience, his educational background, Pharmacare’s
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ownership of patents, and the amount of competition that
Pharmacare faced in the marketplace. In 1979 and 1980, Vavlitis
also persuaded petitioner to make substantial unsecured loans to
Pharmacare in order to keep the company running. Vavlitis failed
to provide promissory notes for these loans despite repeated
requests by petitioner.
On June 12, 1980, creditors of Pharmacare filed a chapter 7
involuntary bankruptcy petition against the company in the
U.S. Bankruptcy Court for the Middle Division of Florida. As an
unsecured creditor of Pharmacare, petitioner did not receive any
payment from the Pharmacare bankruptcy to reimburse his
investment or his loans. On their Form 1040, U.S. Individual
Income Tax Return for 1982, petitioners deducted a loss from
their Pharmacare investment and loans as a section 165 theft
loss. Respondent audited the 1982 return and disallowed the
loss.
On March 9, 1981, petitioner organized The Chamberlin
Corporation (The Chamberlin Corp.), a Delaware corporation
licensed to do business in Florida, for the purpose of continuing
the Largo, Florida, operation. Petitioner became an 80-percent
shareholder in The Chamberlin Corp., was elected chairman of the
board of directors, and was hired as the chief executive officer.
Petitioner did not receive a wage for the services he rendered in
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these positions. The Chamberlin Corp. purchased the inventory,
intangible property, personal property, and equipment of
Pharmacare from the trustee in bankruptcy for $200,000 and then
immediately transferred ownership to petitioner. On
September 18, 1981, in a three-party agreement, petitioner
purchased the Largo facility from the Pharmacare trustee in
bankruptcy by giving The Chamberlin Corp. a $183,800 promissory
note and assuming $572,046 of debt secured by the property. The
Chamberlin Corp. then paid $177,954 of Pharmacare debt on behalf
of the trustee and $4,077 of transfer expenses. Petitioner
rented the Largo facility back to The Chamberlin Corp. from 1981
until 1984.
On November 3, 1982, petitioner obtained a personal loan
from the Freedom Federal Savings & Loan Association (Freedom
Federal) in the amount of $1,750,000. This loan was secured by a
first mortgage on the principal residence of petitioners in
Greenwich, Connecticut. Four hundred fifty thousand dollars of
the loan proceeds was then reloaned by petitioner to The
Chamberlin Corp. and used to pay off debts of The Chamberlin
Corp. The Chamberlin Corp. also obtained loans from the
Ingersoll-Rand Financial Corporation (Ingersoll-Rand) in the
amount of $1,800,000, personally guaranteed by petitioner, and
loans in the amounts of $750,000 and $250,000, secured by second
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mortgages on the Greenwich residence. Petitioner also personally
guaranteed a loan of $300,000 from Ingersoll-Rand that was made
to his incorporated medical practice.
In 1983, petitioner purchased Bel-Mar Laboratories (Bel-
Mar), a company whose principal purpose was the manufacture of
parenteral products. Parenteral describes liquid medication
injected by syringe or needle directly into the bloodstream of a
patient. Petitioner became the sole shareholder and chairman of
the board of directors of Bel-Mar, and he immediately changed the
name to Chamberlin Parenteral, Inc. (Chamberlin Parenteral).
In 1984, The Chamberlin Corp. was unable to pay its debts,
and, on December 17, 1984, creditors filed an involuntary
chapter 11 bankruptcy petition against the company. Petitioner
continued to search for outside investments to save the company,
and the company continued to operate at least through March 1985.
The assets of The Chamberlin Corp., including the Largo facility
that had been surrendered to the corporation by petitioner, were
sold to pay debts of the company in June 1985.
On July 11, 1985, petitioners filed a personal chapter 11
petition in bankruptcy. Petitioners did not make a section
1398(d)(2) election to terminate their taxable year on
commencement of the bankruptcy. On the date of filing, debts of
petitioners totaled $6,319,354, while their assets totaled
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$3,785,790. On August 15, 1985, the personal residence of
petitioners was sold for $3,700,000 to satisfy creditor claims.
This residence had been purchased by petitioners for $530,000.
From the sale proceeds, the debt that was owed to Freedom Federal
in the amount of $1,750,000 plus $550,000 in past due interest
was paid in full. Ingersoll-Rand received $944,049 in partial
satisfaction of its claims. The bankruptcy estate failed to file
an estate tax return for 1985.
After filing their personal petition in bankruptcy,
petitioners moved to California. All of their personal assets,
which became the property of the bankruptcy estate, were placed
in storage. Among these items were important business documents
and tax records. Petitioners were unable to retrieve these
documents because the bankruptcy estate failed to make the proper
storage payments.
OPINION
Petitioners bear the burden of proving that the
determinations in the notice of deficiency are erroneous and that
they are entitled to any deductions claimed on their returns.
See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Welch v. Helvering, 290 U.S. 111, 115 (1933). A
recurring problem for petitioners at trial was a failure to
provide adequate supporting documentation and receipts to
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corroborate petitioner’s testimony. The unavailability of
corroborating documents does not excuse a taxpayer’s failure to
carry the burden of proof. See Malinowski v. Commissioner, 71
T.C. 1120, 1124-1125 (1979).
Petitioners claim that they were the victims of theft at the
hands of Vavlitis and, therefore, should be entitled to deduct
their losses arising from their loans to and investment in
Pharmacare as a section 165(c) theft loss. Petitioner also
claims that he engaged in the trade or business of promoting
pharmaceutical companies from 1978 to 1985 and, therefore, that
he is entitled to deduct any losses arising from loans to or
investment in Pharmacare, The Chamberlin Corp., and Chamberlin
Parenteral as section 162(a) business expenses or section 166(a)
business bad debts.
In coming to a decision on the issues in this case, it is
necessary to calculate the amount of losses incurred by
petitioners in years predating the tax years in issue. We do not
have jurisdiction over years prior to 1985. See sec. 6214(b).
However, the Court may consider events that occurred in prior
years when such consideration is necessary to determine the tax
liability for the years in issue. See Lone Manor Farms, Inc. v.
Commissioner, 61 T.C. 436, 440 (1974), affd. without published
opinion 510 F.2d 970 (3d Cir. 1975).
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In the capacity of a creditor, a taxpayer realizes a loss
from a loan made to a corporation that becomes worthless and
uncollectible. The amount of loss from a worthless loan is the
adjusted basis of the promissory note representing the debt. See
sec. 166. The adjusted basis of a note equals the face amount of
the debt minus any principal paid back by the debtor corporation.
See sec. 1.166-1, 1.1011-1, Income Tax Regs. Where a taxpayer
borrows money from a third party and contributes or reloans the
proceeds to a corporation, the taxpayer includes the proceeds
transferred to the corporation in the basis of his stock in the
corporation or in the promissory note representing the debt. The
increase in basis occurs regardless of whether the taxpayer
repays the third-party loan. See Brenner v. Commissioner, 62
T.C. 878, 883 (1974).
Amount of Losses
Petitioners claim to have suffered a loss in the amount of
$1,255,400 from petitioner’s dealings with Pharmacare.
Respondent concedes that a loss was incurred by petitioners in
the amount of $414,000 but contests the occurrence of the
following transfers, which petitioners claim were loans made to
Pharmacare:
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Loans Date Amount
Wire transfer --/--/79 $ 25,000
Checks 10/19/79 10,000
10/19/79 10,000
10/19/79 10,000
10/19/79 10,000
10/19/79 10,000
11/19/79 16,000
11/21/79 49,500
12/05/79 33,000
12/12/79 45,000
Third-party 08/06/79 364,000
loan proceeds 08/23/79 35,000
08/24/79 120,000
09/12/79 40,000
07/01/80 30,000
Miscellaneous 05/–-/79 30,000
loans 06/–-/79 3,900
Total $841,400
Petitioners have provided five canceled checks endorsed to
Pharmacare totaling $56,000. Petitioners have also provided
evidence of third-party loans made to petitioner and Vavlitis
jointly in the amounts of $364,000, $35,000, and $40,000.
Petitioners have shown that the proceeds from these loans were
contributed or reloaned to Pharmacare by petitioner and that the
loans were repaid with property of petitioner. With respect to
the remaining contested transactions, petitioners rely on a proof
of claim filed in the Pharmacare bankruptcy and dated April 28,
1982. Under the circumstances, we conclude that petitioners’
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minimal documents and testimony are sufficient to substantiate
the amount of loss with respect to Pharmacare.
Petitioners also claim that they are entitled to recognize
losses from petitioner’s contributions to The Chamberlin Corp.
and Chamberlin Parenteral. To substantiate their losses,
petitioners have provided only a statement of net worth, prepared
in 1982, that showed that petitioners’ net worth was $6,032,052.
They argue that their net worth fell to zero in 1985 as a result
of The Chamberlin Corp. failure, and, therefore, they should be
entitled to a loss of $6,032,052. Such a statement,
uncorroborated by receipts, expenses, or other documentation that
reflects how assets were lost or disposed of, is insufficient for
determining the amount of losses sustained by petitioners. See
Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 745-746
(1973). Thus, where petitioners have failed to provide any
documentation to substantiate their loss, they have failed to
carry their burden of proving entitlement to deductions.
Petitioners have provided documentation relating to a loan
that was made from a third party to petitioner personally and
loans that were made to The Chamberlin Corp., which were secured
and satisfied by personal property of petitioner. First,
petitioners argue that they are entitled to recognize $1,750,000
of loss stemming from a personal loan from Freedom Federal.
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Petitioner claims that he contributed or reloaned the entire
amount of proceeds to The Chamberlin Corp. and Chamberlin
Parenteral. Respondent argues that only $450,000 of the
principal was reloaned to these corporations. Second,
petitioners argue that they are entitled to losses stemming from
funds that petitioner contributed to The Chamberlin Corp., which
were used for operating capital and the initial purchase of the
Pharmacare assets in 1981.
Of the principal amount of the Freedom Federal loan,
$450,000 was reloaned to The Chamberlin Corp. and used to repay a
portion of a debt owed by The Chamberlin Corp. to E.F. Hutton
Credit Corporation. Petitioner testified at trial that the
remaining $1,300,000 of the Freedom Federal loan was used to
purchase Bel-Mar, which later became Chamberlin Parenteral, and
to provide working capital or to pay debts of The Chamberlin
Corp. Petitioner also testified that he contributed all of the
funds used by The Chamberlin Corp. to buy the assets of
Pharmacare from the trustee in bankruptcy in 1981.
Petitioner has failed to provide sufficient evidence showing
that the $1,300,000 of remaining principal was reloaned or
contributed to either corporation or to show how much funding, if
any, he provided to The Chamberlin Corp. for the asset purchases
or startup costs. There is no contemporaneous corroboration of
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his generalized testimony. Therefore, petitioners’ allowable
losses from their contributions or reloans of the Freedom Federal
loan proceeds to The Chamberlin Corp. or Chamberlin Parenteral
are no more than $450,000.
The next argument of petitioners, which respondent does not
contest, is that petitioners’ bankruptcy estate is entitled to a
loss of $944,049 for its partial repayment of loans made by
Ingersoll-Rand to The Chamberlin Corp. The loans, which totaled
$2,900,000, were repaid to the extent of $944,049 by the
bankruptcy estate of petitioners. A guarantor, such as
petitioner, who pays part of a loan for a corporation in
bankruptcy is deemed to have made a loan to the corporation for
the amount paid to the creditor. The loan, deemed made to the
corporation, is deductible as a worthless debt. See sec. 1.166-
9, Income Tax Regs.
Timing of Losses of Petitioners
Petitioners argue that their $1,255,400 loss arising from
Pharmacare should be recognizable in 1985, the year that the
assets of The Chamberlin Corp. were sold in bankruptcy. This
argument hinges upon a finding that The Chamberlin Corp. and
Pharmacare should be regarded as the same entity. However,
Pharmacare terminated and ceased to exist after the closing of
its chapter 7 bankruptcy estate. The Chamberlin Corp. was a
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wholly separate organization that operated free and clear of
Pharmacare’s former debt, and any claims that petitioner had
against Pharmacare were resolved with that corporation’s
bankruptcy discharge. The latest date when the loss would have
been realized was 1982, the year petitioner filed his claim
against the bankruptcy estate of Pharmacare. At that point, he
had no realistic possibility of recovery. See Morton v.
Commissioner, 38 B.T.A. 1270, 1278-1279 (1938), affd. 112 F.2d
320 (7th Cir. 1940); Mack v. Commissioner, T.C. Memo. 1995-482;
sec. 1.165-1(d), Income Tax Regs. Therefore, the loss could only
be used by petitioners as a section 172 net operating loss (NOL)
carryover or capital loss carryover during the years in issue,
depending on the character of the loss.
The $450,000 loss, arising from the Freedom Federal loan
proceeds, was realized by petitioner in 1985. A bad debt
deduction is realized in the year it becomes worthless. See sec.
1.166-1(a), Income Tax Regs. The question of when a bad debt
becomes worthless is a factual question based on all of the
surrounding circumstances. Although bankruptcy is a strong
indicator of when a debt becomes worthless, it is not an absolute
rule that a loss becomes recognizable upon the filing of a
petition in bankruptcy. See sec. 1.166-2, Income Tax Regs.
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Creditors of The Chamberlin Corp. filed an involuntary
petition in bankruptcy against the company on December 17, 1984.
However, The Chamberlin Corp. continued to operate and sought
outside investment in a quest to avoid involuntary bankruptcy
until at least March 1985. Until the company accepted its
involuntary bankruptcy fate in 1985, there was a reasonable
possibility that the company could be saved and that petitioner
could recover some or all of his $450,000 loan to The Chamberlin
Corp. See Morton v. Commissioner, supra at 1278.
Personal Bankruptcy
Having decided the amount and timing of losses sustained by
petitioners and the amount of losses sustained by their
bankruptcy estate, the next issue for decision is the effect that
petitioners’ personal chapter 11 bankruptcy had on these losses.
Upon the filing of a voluntary chapter 11 petition in
bankruptcy, certain tax attributes listed in section 1398(g)
become property of the bankruptcy estate and are no longer tax
attributes of the taxpayer. Section 1398(g) reads as follows:
SEC. 1398(g) Estate Succeeds to Tax Attributes of
Debtor.--The estate shall succeed to and take into
account the following items (determined as of the first
day of the debtor’s taxable year in which the case
commences) of the debtor--
(1) Net operating loss carryovers.--The net
operating loss carryovers determined under section
172.
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(2) Charitable contributions carryovers.--The
carryover of excess charitable contributions
determined under section 170(d)(1).
(3) Recovery of tax benefits items.--Any
amount to which section 111 (relating to recovery
of tax benefit items) applies.
(4) Credit carryovers, etc.--The carryovers
of any credit, and all other items which, but for
the commencement of the case, would be required to
be taken into account by the debtor with respect
to any credit.
(5) Capital loss carryovers.--The capital
loss carryover determined under section 1212.
(6) Basis, holding period, and character of
assets.--In the case of any assets acquired (other
than by sale or exchange) by the estate from the
debtor, the basis, holding period, and character
it had in the hands of the debtor.
(7) Method of accounting.--The method of
accounting used by the debtor.
(8) Other attributes.--Other tax attributes
of the debtor, to the extent provided in
regulations prescribed by the Secretary as
necessary or appropriate to carry out the purposes
of this section.
The bankruptcy estate uses any tax attribute received from
the taxpayer plus its own attributes to reduce its taxable
income. See sec. 1398(g). Certain tax attributes not used by
the bankruptcy estate are returned to the taxpayer upon
termination of the estate. See sec. 1398(i).
From 1982 until 1985, petitioners could not use any of their
$1,255,400 carryover loss from Pharmacare to reduce taxable
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income. Under section 1398(g), the bankruptcy estate received
the carryover loss from petitioners upon the filing of the
bankruptcy petition. The bankruptcy estate of petitioners is
also entitled to any loss arising from the payment of $141,429 of
interest, the amount of interest paid by the estate that was
proportional to the $450,000 loan made to The Chamberlin Corp.
from the Freedom Federal loan proceeds. Combined with the
$944,049 worthless debt from the Ingersoll-Rand loan payment, the
bankruptcy estate of petitioners had a combined loss of
$2,340,878 available to reduce its taxable income beginning in
1985, the year the estate came into being.
The entire amount of loss is carried to the earliest taxable
years to which such loss may be carried. See Lone Manor Farms,
Inc. v. Commissioner, 61 T.C. at 441. The portion of such losses
that is carried to other taxable years is the excess, if any, of
the amount of loss over the sum of the taxable income for each of
the prior taxable years to which such loss may be carried. See
id. Therefore, when a taxpayer claims carryover losses for the
year in issue, it is necessary to determine whether the carryover
losses, claimed as a deduction for that year, are still available
or were absorbed as allowable deductions in prior taxable years.
See id. A carryover loss deduction for a prior year, which would
have been allowed if claimed, must be considered as actually
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having been allowed when determining the availability of a loss
carryover to a subsequent year. See id.
The bankruptcy estate of petitioners did not file a tax
return for 1985 and, therefore, did not use any allowable losses
to offset taxable income in that year. During the later taxable
years of the bankruptcy estate, 1986 to 1994, the bankruptcy
estate filed tax returns but could not use any of the carryover
losses to reduce its income.
Petitioners have failed to produce the evidence necessary to
calculate the taxable income of the bankruptcy estate for 1985,
thus making it impossible to determine how much of the loss
belonging to the bankruptcy estate was absorbed. Because we
cannot determine whether any or all of the loss was absorbed by
the bankruptcy estate, we conclude that petitioners have failed
to prove that any amount thereof may be carried forward to the
years in issue. However, even if we were to assume that the
bankruptcy estate had no more income in 1985 than what the record
before us reflects, the taxable income of the bankruptcy estate
in 1985 would be more than enough to absorb completely $2,340,878
of deductible loss.
The bankruptcy trustee sold the personal residence of
petitioners on August 20, 1985. The amount realized from the
sale was equal to the $3,700,000 purchase price, and the adjusted
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basis was equal to the $530,000 cost basis. Although petitioner
testified that he made several improvements to the property
during his years of ownership that would adjust the basis upward,
he presented no supporting receipts or documentation. Thus, the
gain that was realized by the bankruptcy estate was equal to
$3,170,000. See sec. 1001(a).
Petitioners argue that the estate should be allowed to use
the $125,000 one-time exclusion of gain under section 121.
However, we need not address the issue of whether the one-time
exclusion is available for use by a bankruptcy estate because an
election was not made by the estate under section 121(c). An
election to use the one-time exclusion must be made prior to the
expiration of the period for making a claim for refund of Federal
income tax for the taxable year in which the sale or exchange
occurred. See sec. 1.121-4(a), Income Tax Regs. Any attempt by
petitioners to make the election currently for the bankruptcy
estate would be untimely.
The $3,170,000 of income from the sale of the personal
residence in 1985 completely absorbs the $2,340,878 loss
belonging to the bankruptcy estate. Thus, petitioners would have
no carryover losses surviving the estate upon its termination to
reduce petitioners’ income during the years in issue. Having
concluded that none of the losses belonging to the bankruptcy
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estate survived 1985, it is not necessary for us to determine
their character.
Section 1398(g), however, prevents certain attributes from
passing from a taxpayer to the bankruptcy estate. The $450,000
loss of funds borrowed from Freedom Federal and reloaned to The
Chamberlin Corp., recognizable by petitioners in 1985, was a bad
debt under section 166 at the time of the filing of the personal
chapter 11 petition in bankruptcy. A section 166 deduction is
not specifically mentioned in section 1398(g) as being an
attribute that becomes part of the estate. Because petitioners
did not make a section 1398(d)(2) election to split 1985 into 2
taxable years, the section 166 deduction did not become part of
an NOL upon the filing of the petition in bankruptcy. Section
1398(g) thus preserves the section 166 deduction for the debtor.
The $450,000 loss was recognizable by petitioners on their 1985
tax return, and any unused portion became a carryover NOL or
capital loss belonging to petitioners and is available for use by
petitioners as an offset of taxable income in later years.
Character of the $450,000 Loss
Whether the $450,000 loss was a business bad debt under
section 166(a)(1) or a nonbusiness bad debt under section
166(d)(2) depends on whether petitioner was engaged in a trade or
business with respect to his endeavors with The Chamberlin Corp.
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See Fincher v. Commissioner, 105 T.C. 126, 136 (1995). A
nonbusiness bad debt is deductible as a short-term capital loss,
while a business debt is deductible as an ordinary loss. See
sec. 166.
Petitioners contend that, from 1978 until 1984, petitioner
was engaged in the trade or business of promoting business
ventures in the health care industry. Respondent argues that
petitioner’s dominant motive for acquiring and guaranteeing loans
for The Chamberlin Corp. was for investment purposes and that the
activities of petitioner with regard to his promotion of business
ventures do not rise to the level of a trade or business.
In order to be engaged in carrying on a trade or business,
the taxpayer must be involved in the activity with continuity and
regularity, and the taxpayer’s primary purpose for engaging in
the activity must be for income or profit. See Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987). Activities that are
sporadic do not qualify as a trade or business. See Polakis v.
Commissioner, 91 T.C. 660, 670-672 (1988). The management of
one’s own investments is not considered a trade or business no
matter how extensive or substantial the investment activities
might be. See King v. Commissioner, 89 T.C. 445, 458 (1987).
Resolution of this issue requires an examination of the facts of
each case. See Commissioner v. Groetzinger, supra at 36.
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In Whipple v. Commissioner, 373 U.S. 193 (1963), the Supreme
Court determined whether loans made by a shareholder to a
corporation, in which he held a substantial interest, were
deductible as business bad debts. In holding that the debts were
not incurred in a trade or business of the taxpayer, the Supreme
Court stated:
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.
Even if the taxpayer demonstrates an independent trade
or business of his own, care must be taken to
distinguish bad debt losses arising from his own
business and those actually arising from activities
peculiar to an investor concerned with, and
participating in, the conduct of the corporate
business.
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
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his own services rather than indirectly through the
corporate enterprise * * *.
Id. at 202-203. This Court has interpreted this language to mean
that, in order for a taxpayer to be engaged in a trade or
business of promoting business ventures, he must undertake such
activity for compensation other than a normal investor’s return.
Such compensation must be in the form of a fee or commission or
from the sale of the corporation for a profit in the ordinary
course of business. See Deely v. Commissioner, 73 T.C. 1081,
1093 (1980), supplemented by T.C. Memo. 1981-229. Buying and
selling businesses for profit can constitute a trade or business
if the taxpayer shows that the entities were organized or
acquired with the intent to make a quick and profitable sale
after each business has become established, rather than with a
view toward long-range investment gains. See Id.
In Farrar v. Commissioner, T.C. Memo. 1988-385, this Court
found that a taxpayer was engaged in the trade or business of
promoting business ventures. The taxpayer in Farrar bought and
sold over 31 businesses, acquiring each one with the intent to
bring in his own management staff, rebuild the company, and then
sell it once the business became viable. Of the three businesses
involved for which the taxpayer was claiming losses, the taxpayer
had a plan aimed at earning a profit through the sale of the
business.
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In Fleischaker v. Commissioner, T.C. Memo. 1999-427, this
Court found that a taxpayer was not engaged in the trade or
business of promoting business ventures. In Fleischaker, the
taxpayer guaranteed several loans made to an adult assisted-
living center so that the corporation could build its facilities
and cover operating expenses. The taxpayer based his investments
on his belief that the demand for adult assisted-living centers
would steadily increase due to the growing population of American
senior citizens. The taxpayer intended to acquire interests in
multiple adult assisted-living centers throughout the country and
profit from his long-term stock ownership.
Petitioner has failed to show that he acquired his business
ventures with an intent to sell them in the near future for
profit. Instead, petitioner testified that he intended to build
The Chamberlin Corp. into a much larger corporation and to hold
the corporation for an extended amount of time. Petitioner
testified that his motive for engaging in The Chamberlin Corp.
venture was his belief that the demand for generic
pharmaceuticals would steadily increase throughout the 1980's and
that anyone positioned in the generic pharmaceutical market would
stand to make a large sum of money. Petitioner was not paid
compensation for his services to the corporation. His activities
are more analogous to those of an investor attempting to reap
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profits through dividends and the increase in value of his
investment than to that of a promoter who buys and sells
companies as if they were inventory. We conclude that petitioner
was not in the trade or business of promoting business ventures
in the health care industry. Thus, petitioners may not deduct as
a business bad debt the $450,000 loss.
We have considered all other arguments of petitioners, and
they are addressed by the consideration of lack of remaining
carryover losses belonging to the bankruptcy estate or otherwise
lack merit.
Additions to Tax and Penalties
Respondent determined additions to tax for failure to file
tax returns under section 6651(a)(1) and additions to tax for
failure to make timely payment of taxes under section 6651(a)(2).
Respondent also determined additions to tax for negligence under
section 6653(a)(1), additions to tax for negligence under section
6653(a)(1)(A) and (B), and accuracy-related penalties for
negligence or substantial understatements under section 6662(a).
Additions to Tax for Failure To File Timely
a Tax Return and Pay Tax Liability
Section 6651(a)(1) provides for an addition to tax of
5 percent of the tax required to be shown on the return for each
month or fraction thereof for which there is a failure to file,
not to exceed 25 percent. Section 6651(a)(2) provides for an
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addition to tax of 0.5 percent per month up to 25 percent for
failure to pay the amount shown or required to be shown on a
return. A taxpayer may fail to file and pay a tax and thus be
subject to both section 6651(a)(1) and (2). See sec. 6651(c)(1).
If that occurs, the amount of the addition to tax under section
6651(a)(1) is reduced by the amount of the addition to tax under
section 6651(a)(2) for any month to which an addition to tax
applies under both paragraphs (1) and (2). The combined amounts
under paragraphs (1) and (2) cannot exceed 5 percent per month.
See sec. 6651(c)(1).
To escape the additions to tax for filing late returns,
petitioners have the burden of proving that the failure to file
did not result from willful neglect and that the failure was due
to reasonable cause. See United States v. Boyle, 469 U.S. 241,
245 (1985). Reasonable cause requires taxpayers to demonstrate
that they exercised "ordinary business care and prudence" but
nevertheless were "unable to file the return within the
prescribed time." Sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
Petitioners argue that they used ordinary business care and
prudence because they were acting at all times upon the advice of
a certified public accountant who prepared their returns.
Petitioners also claim that, due to their financial crisis at the
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time, any failure on their part to file returns or pay tax
liability was unavoidable and excusable.
From 1982 to 1993, petitioners have shown a pattern of
willful neglect in failing to file their Federal income tax
returns in a timely manner. Although petitioners employed a paid
tax preparer to prepare their returns, petitioners did not offer
any evidence to show that the paid preparer was the cause of
petitioners’ failing to file and pay the tax shown on their
returns on time. Also, petitioner is a well-educated individual
who knew or should have known that a tax return was due in a
timely fashion during all of the years in issue. See United
States v. Boyle, supra at 249-250.
Petitioners maintain that they lost some of their financial
records when they placed them in storage in 1985. Although the
loss of records was an involuntary action, it does not relieve
petitioners of their duty to file a timely return. See Zivnuska
v. Commissioner, 33 T.C. 226, 239-241 (1959). Therefore, we
sustain the determinations of respondent with respect to the
section 6651(a)(1) and (2) additions to tax.
Negligence Additions to Tax and Penalties
Respondent determined negligence additions to tax or
penalties for all of the years in issue. For 1985, section
6653(a)(1) imposes an addition to tax equal to 5 percent of the
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underpayment if any part of the underpayment is attributable to
negligence. For 1986 and 1987, section 6653(a)(1)(A) and (B)
replaced former section 6653(a) but is similar in form. Section
6653(a)(1)(A) imposes an addition to tax equal to 5 percent of
the underpayment if any part of the underpayment is attributable
to negligence. Section 6653(a)(1)(B) imposes an addition to tax
equal to 50 percent of the interest payable on the portion of the
underpayment attributable to negligence. For 1988, Congress
replaced former section 6653(a)(1)(A) and (B) with section
6653(a). Section 6653(a) was similar to former section
6653(a)(1)(A). Section 6653(a) imposes an addition to tax equal
to 5 percent of the portion of the underpayment attributable to
negligence. Section 6653(a)(1)(B), however, has no counterpart
for 1988. For 1989, 1990, 1991, 1992, and 1993, section 6662
replaced former section 6653(a). Section 6662(a) and (b)(1)
imposes a penalty equal to 20 percent of the portion of the
underpayment that is attributable to negligence or disregard of
rules or regulations. For purposes of all of these provisions,
negligence is defined as a lack of due care or failure to do what
a reasonable or ordinarily prudent person would do under similar
circumstances. See Neely v. Commissioner, 85 T.C. 934, 947
(1985).
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For the years in issue, petitioners must show that they
acted reasonably and prudently and exercised due care in
reporting their taxes. See id. Petitioners assert that their
actions were not negligent, and, therefore, they are not liable
for additions to tax or penalties. They argue that they relied
on the advice of a certified public accountant in calculating
their tax liability during all years.
Taxpayers may satisfy their burden of proof as to negligence
by showing that they reasonably relied on the advice of a
competent professional adviser. See United States v. Boyle,
supra at 250-251; Freytag v. Commissioner, 89 T.C. 849, 888
(1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 869
(1991). Reliance on professional advice, standing alone, is not
an absolute defense but rather is a factor to be considered.
Although any reliance by petitioners on the advice of their
paid preparer was unreasonable with respect to the failure to
file a timely return, it was reasonable to rely on the advice of
the paid preparer regarding the amount of tax liability to report
during the years in issue. The facts of this case created
genuine issues as to whether petitioners are entitled to use NOL
carryovers on their returns for 1985 through 1993. Due to the
complexity of the bankruptcy issues involved, it was reasonable
for petitioners to rely upon the incorrect advice of their paid
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preparer, who told them that they could deduct NOL’s for their
investments in and loans made to Pharmacare, The Chamberlin
Corp., or Chamberlin Parenteral. Therefore, petitioners are not
liable for negligence penalties from 1985 through 1993.
Substantial Understatement
Taxpayers are liable for penalties for substantial
understatement of tax liability pursuant to section 6662(b)(2) if
the understatement exceeds the greater of 10 percent of the
correct tax or $5,000. See sec. 6662(d)(1)(A) and (B). The term
"understatement" is defined as the excess of the amount of tax
required to be shown on the return for the taxable year over the
amount of tax shown on the return for the taxable year. Sec.
6662(d)(2)(A). An exception exists where the taxpayer has relied
on invalid advice of a paid tax preparer if, under all
circumstances, such reliance was reasonable and the taxpayer
acted in good faith. See sec. 1.6662-4(g)(4), Income Tax Regs.
For the reasons previously discussed under the negligence
analysis above, we conclude that petitioners’ reliance on the tax
liability calculated by their paid tax preparer was reasonable.
Therefore, penalties for substantial understatement shall not
apply.
To reflect the foregoing,
Decision will be entered
under Rule 155.