T.C. Summary Opinion 2001-176
UNITED STATES TAX COURT
ROBERT FEDEWA, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14639-99S. Filed November 21, 2001.
Lawrence P. Schweitzer, for petitioner.
Kimberly J. Webb, for respondent.
GOLDBERG, Special Trial Judge: This case was heard pursuant
to the provisions of section 7463 of the Internal Revenue Code in
effect at the time the petition was filed. The decision to be
entered is not reviewable by any other court, and this opinion
should not be cited as authority. Unless otherwise indicated,
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subsequent 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.
In a notice of deficiency, respondent determined that
petitioner is liable for deficiencies in Federal income taxes for
the tax years 1994 and 1995 in the amounts of $3,014 and $31,949,
respectively. Respondent also determined accuracy-related
penalties under section 6662(a) for the tax years 1994 and 1995
in the amounts of $603 and $6,343, respectively.
After concessions made by petitioner,1 the issues for
decision are: (1) Whether petitioner is entitled to deduct on
his 1994 Federal income tax return his pro rata share of
partnership loss attributable to a bad debt, and (2) whether
petitioner is liable for accuracy-related penalties under section
6662(a) for the tax years 1994 and 1995.
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time the petition
was filed, petitioner resided in Dewitt, Michigan.
1
Petitioner concedes all adjustments to income in the
notice of deficiency, except the disallowed partnership loss
deduction of $65,419 and accuracy-related penalties which are the
issues before us. There appears to be a mathematical error in
the partnership loss deduction amount; the correct amount should
be $64,559.
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Background
In 1976, petitioner and his brother, James Fedewa, and
cousin, Bernard Fedewa, formed a partnership known as BBJ
Investments (BBJ). BBJ is a Michigan partnership in the business
of acquiring and operating residential real estate. Initially,
the partnership was owned equally by the three partners. On July
6, 1987, James Fedewa relinquished his one-third interest in BBJ
to petitioner. Since 1987, petitioner has held a two-thirds
interest in BBJ. Petitioner was also either a shareholder or
partner in Fedewa Enterprises, Fedewa Builders, Fedewa Realty
World, and Construction Redi-Mix (collectively the related
entities). The related entities were involved in the development
and construction of residential and commercial properties through
the 1980s.
In 1975, BBJ purchased land to build a 50-unit apartment
complex known as North Scott Villa. In order to complete the
North Scott Villa project, Bernard E. Fedewa, James R. and Mary
Ann Fedewa, and Robert E. and Julia I. Fedewa, as the “borrower”
secured a $712,500 loan bearing 8.5-percent interest (FmHA loan),
from the Department of Agriculture Farmers Home Administration
(FmHA) in 1975. Pursuant to the loan agreement, the borrower was
required to provide annual budgets, annual operating plans, and
maintain books and records relating to the housing project’s
financial affairs, causing such books and records to be audited
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at the end of each fiscal year. The borrower was also required
to maintain various reserve or escrow accounts (collectively
reserve accounts) so long as the loan obligation remained
unsatisfied. In the event the borrower failed to comply with the
terms of the loan agreement, the Government could declare the
entire amount of the loan obligation immediately due and payable,
and, enforce all other available remedies. The Government also
had an option to waive any provision of the loan agreement.
On January 1, 1978, James Fedewa, on behalf of Fedewa
Builders, Inc., executed a promissory note for $28,056.41 to BBJ
(1978 promissory note). The 1978 promissory note, bearing 8-
percent interest, did not state a due date.2 Fedewa Builders and
Fedewa Enterprises ceased business operations in 1987.
In 1979, Touche Ross & Co., BBJ’s certified public
accountants, conducted an audit of BBJ’s books and records. On
its books and records appeared an asset account of $109,540 for
notes receivable due from two related entities.3 Despite the
related party transaction, Touche Ross & Co. gave BBJ a “clean”
financial opinion. However, beginning in 1982 and through 1988,
BBJ failed to obtain “clean” financial opinions and received
2
We note that the photocopy of the 1978 promissory note
is illegible and testimony by petitioner’s sole witness, Michael
A. Comito, did not provide such information.
3
It is unclear which two related entities generated the
notes receivable referenced in the Touche Ross & Co. audit.
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“disclaimer” opinions. FmHA raised concerns about BBJ’s failure
to maintain the reserve accounts required under the FmHA loan
agreement. FmHA refused to waive BBJ’s noncompliance under the
loan agreement. In 1989, FmHA began foreclosure proceedings
against BBJ for its failure to maintain adequate reserve
accounts.
In 1994, Yeo and Yeo, P.C., certified public accountants,
audited the North Scott Villa Apartments project for years 1992
and 1993. Yeo and Yeo provided a disclaimed opinion based on the
following:
As discussed in Note 6 to the financial statements,
North Scott Villa Apartments is in violation of certain
covenants of its loan agreements with the United States
Department of Agriculture Farmers Home Administration.
The lender has the option to demand immediate payment
of the mortgage note. On January 9, 1989, the owners
of North Scott Villa Apartments were notified by the
Untied [sic] States Department of Agriculture Farmers
Home Administration of the acceleration of the mortgage
note and immediate payment of the mortgage note. * * *
The financial statements do not include any adjustment
relating to the recoverability and classification of
recorded assets and liability amounts that might be
necessary should North Scott Villa Apartments be unable
to continue in existence.
Petitioner timely filed his 1994 Federal income tax return
wherein he reported $64,559 reflecting his pro rata share of
partnership loss attributable to a business bad debt. Petitioner
claims that the bad debt deduction is attributable to uncollected
accounts receivable due from the following entities:
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Fedewa Enterprises $20,638
Fedewa Realty World 435
Construction Redi-Mix 3,229
Fedewa Builders 72,371
FCC 165
Total $96,838[1]
1 Petitioner’s pro rata share of the accounts receivable is
$64,559 based upon his two-thirds interest in BBJ. (2/3 X
$96,838 = $64,559)
The following is a schedule of BBJ’s notes receivable ledger from
1976 through 1988:
Year Notes Receivable Principal
1976 $5,008.92
1977 32,956.41
1978 55,022.53
1979 109,540.00
1980 105,495.00
1981 91,794.00
1982 87,942.00
1983 87,895.00
1984 96,588.00
1985 96,838.00
1986 96,838.00
1987 96,838.00
1988 96,838.00
No payments of interest or principal were received after 1984.
Petitioner could not explain the origin of the initial $5,008.92
note receivable in 1976. The 1978 note receivable is reflected
in the 1977 year-end amount listed above. Besides the 1978 note
receivable, there is no documentation memorializing any additions
to principal or income and/or principal paid. Moreover, the
record does not provide a description of the surrounding
circumstances or the purpose for the increases in the notes
receivable account.
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In the notice of deficiency, respondent disallowed for
taxable year 1994 petitioner’s partnership loss deduction of
$64,559 attributable to his pro rata share of a business bad
debt.4 Respondent also determined for taxable years 1994 and
1995 accuracy-related penalties on the business bad debt and
other issues petitioner has conceded.
Discussion
Section 166(a) generally allows a deduction for bona fide
debts that become wholly or partially worthless within the
taxable year. A business bad debt is fully deductible from
ordinary income. Sec. 166(d)(1). A bona fide debt “arises from
a debtor-creditor relationship based upon a valid and enforceable
obligation to pay a fixed or determinable sum of money.” Sec.
1.166-1(c), Income Tax Regs. Whether the parties actually
intended the transactions to be loans depends on whether the
advances were made “with a reasonable expectation, belief and
intention that they would be repaid.” Goldstein v. Commissioner,
T.C. Memo. 1980-273.
The objective indicia of a bona fide debt includes whether a
note or other evidence of indebtedness existed and whether
interest was charged. Clark v. Commissioner, 18 T.C. 780, 783
(1952), affd. 205 F.2d 353 (2d Cir. 1953). We also consider the
existence of security or collateral, the demand for repayment or
4
See supra note 1.
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a fixed schedule for repayment, records that may reflect the
transaction as a loan, and the borrower’s solvency at the time of
the loan. Id. at 783-784. The key factor is whether the parties
actually intended and regarded the transaction as a loan. Estate
of Van Anda v. Commissioner, 12 T.C. 1158, 1162 (1949), affd. per
curiam 192 F.2d 391 (2d Cir. 1951).
Respondent contends that petitioner failed to substantiate
the amount of the purported business bad debt and to demonstrate
that such debt was bona fide. Petitioner asserts that the notes
receivable were substantiated by the 1987 promissory note, the
1980 Touche Ross & Co. audit report, and the 1994 Yeo and Yeo
audit report. We disagree.
At trial petitioner produced the $28,056.41 promissory note
signed by James Fedewa on January 1, 1978. Although the 1978
promissory note bore interest of 8 percent, the note did not
provide a discernable due date; thus, we find the enforcement or
demand of repayment on this note highly suspect. Furthermore,
petitioner failed to provide any credible evidence to establish
the origin of the $5,008.92 note receivable in 1976, to which
principal the 1978 promissory note added, or the subsequent
increases from 1978 through 1984. Although the origin of the
notes receivable is unclear, petitioner does not dispute that the
purported debt in issue arose from related party transactions.
The record is devoid of any helpful information as to the
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creation, purpose, or payment on the notes receivable principal
balance from 1976 through 1985.
We also find petitioner’s reliance on the audit reports of
Touche Ross & Co. and Yeo and Yeo misplaced. These reports cover
a span of over a decade and clearly state that the auditors
relied on information provided by, and exclusively in the control
of the owners. There is no information in the auditing firm’s
reports that they made an independent verification of the notes
receivable account.
Likewise, FmHA’s recognition of the notes receivable debt is
inapposite to the primary issue of substantiation. The FmHA loan
is not the subject of the bad debt for which petitioner is
claiming a partnership loss deduction in this case. Pursuant to
the loan agreement, the borrower must maintain certain reserve
accounts while the loan obligation remained outstanding.
According to FmHA, petitioner and the other borrowers failed to
maintain these accounts. Although FmHA began foreclosure
proceedings for the failure to maintain adequate reserve
accounts, FmHA did not attempt collection on the notes
receivable. FmHA was not a party to any of the transactions that
gave rise to the underlying debt in issue. FmHA’s interest
focused on the funding of the reserve accounts, from whatever
source.
Based upon the above, we find that the balance in the notes
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receivable accounts was not verified and further does not
constitute a bona fide debt. Accordingly, petitioner is not
entitled to the partnership loss deduction during the years in
issue. Respondent is sustained on this issue.
Accuracy-Related Penalty
Section 6662(a) imposes an accuracy-related penalty of 20
percent of the portion of the underpayment which is attributable
to negligence or disregard of rules or regulations. Sec.
6662(b)(1). Negligence is the lack of due care or failure to do
what a reasonable and ordinarily prudent person would do under
the circumstances. Neely v. Commissioner, 85 T.C. 934, 947
(1985). The term “disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c). No penalty shall be
imposed if it is shown that there was reasonable cause for the
underpayment and the taxpayer acted in good faith with respect to
the underpayment. Sec. 6664(c).
On the basis of the record, we find that petitioner has
failed to demonstrate that he was not negligent and did not
disregard rules or regulations. We hold that petitioner is
liable for the accuracy-related penalty under section 6662(a) for
each year in issue.
We have considered all arguments by the parties, and, to the
extent not discussed above, conclude that they are irrelevant or
without merit.
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Reviewed and adopted as the report of the Small Tax Case
Division.
Decision will be entered
under Rule 155.