T.C. Memo. 2002-119
UNITED STATES TAX COURT
GERALD L. AND ERMA L. DUNNEGAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8072-00. Filed May 14, 2002.
David K. Holmes, for petitioners.
Elizabeth Downs, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined deficiencies in
petitioners’ Federal income tax and penalties under section
6662(a) as follows:
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Penalty, I.R.C.
Year Deficiency Sec. 6662(a)
1993 $135,811 $2,815.80
1994 3,628 725.60
1995 16,088 2,042.20
After concessions by the parties, the issues remaining for
decision are: (1) Whether the monetary transfers that
petitioners made to a corporation are capital contributions or
are bona fide debts that are deductible as business bad debts
under section 166 when they became worthless; (2) whether the net
profits and losses of petitioners’ fireworks businesses are
attributable to Mr. Dunnegan or Mrs. Dunnegan for purposes of
self-employment tax; and (3) whether payments made to a
charitable organization are business expenses or charitable
contributions.
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.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Gerald L. and Erma L. Dunnegan (petitioners) resided in
Wichita, Kansas, when their petition was filed. Petitioners
filed joint Federal income tax returns for the years in issue.
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Petitioners and their son, Gregory Dunnegan, owned all of
the stock of Auto Plaza East, Inc. (Auto Plaza), which was
incorporated in April 1991. Petitioners were the majority
shareholders in Auto Plaza. Mr. Dunnegan was the president and
Mrs. Dunnegan was the secretary of Auto Plaza. The primary
business activity of Auto Plaza was the purchase and resale of
used cars.
Beginning in 1991, petitioners transferred funds to Auto
Plaza to cover operating expenses and to purchase vehicle
inventory. The funds were transferred to Auto Plaza in
increments and on an “as needed” basis, depending on the vehicles
purchased and the vehicles still in inventory. The funds
received by Auto Plaza from petitioners were recorded as “loans
from shareholders” in the bookkeeping records.
There were no notes reflecting the transfers from
petitioners to Auto Plaza. No collateral was provided by Auto
Plaza to petitioners with respect to the transfers. There was no
fixed repayment schedule between petitioners and Auto Plaza with
respect to the transfers. Petitioners received payments from
Auto Plaza only when funds were available, but they advanced more
than was repaid. No record of repayments was maintained.
Auto Plaza attempted to obtain financing from several banks
for its inventory but was not able to obtain traditional bank
financing without a personal guaranty from petitioners. Auto
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Plaza could not obtain loans from banks on the same terms as the
funds provided by petitioners.
In 1993, Mr. Dunnegan forgave, or permitted Auto Plaza to
write off, $700,000 of the accumulated transfers that were
recorded as shareholder loans, in an effort to improve the
corporation’s debt equity ratio and to make the corporation
viable. Auto Plaza discontinued its business activities in 1994.
Petitioners deducted the bad debt expense on Schedule C for
a “loans and collections” business. Petitioners filed two
separate returns for 1993 claiming $700,000 in bad debt expense
on the return filed on July 3, 1995, and $370,000 in bad debt
expense on the return filed on September 28, 1995. (The Court
requested that petitioners provide an explanation for the filing
of the two different tax returns in their brief, but no
explanation was provided.) Petitioners also claimed bad debt
expense of $246,175 in 1994.
Petitioners are in the business of selling fireworks, both
wholesale and retail. The retail stores are located in Dennings
and Moriarty, New Mexico; in Wyoming; and in Wichita and Kansas
City, Kansas.
Mr. Dunnegan worked 60 or more hours per week for Auto
Plaza, except during fireworks season when he spent half his time
performing activities related to the fireworks businesses. His
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activities included processing the orders of other wholesalers or
retailers.
Mrs. Dunnegan worked 30 to 45 hours per week for Auto Plaza
performing accounting, preparing title work, and preparing sales
tax reports. She also spent about 25 to 40 hours per week on
activities related to the fireworks businesses, except between
May and July when she worked 50 hours or more per week in the
fireworks businesses. Mrs. Dunnegan’s duties that were related
to the fireworks activities were conducted in her home and
consisted of accounting and bookkeeping services, determining the
orders for the following year, placing the overseas orders,
helping to pack the orders, and monitoring shipments.
Mrs. Dunnegan performed 100 percent of the bookkeeping for the
Moriarty store.
The fireworks businesses are operated as sole
proprietorships, and the income and expense for each location is
reported on a Schedule C, Profit or Loss From Business. On
petitioners’ Schedules C for 1993, both Mr. and Mrs. Dunnegan are
listed as the proprietors of the Moriarty, Dennings, and Kansas
City fireworks businesses. Petitioners attributed 50 percent of
the net profit and loss from these fireworks businesses to
Mrs. Dunnegan.
J&G Enterprise is a sole proprietorship of Mr. Dunnegan that
engages in the sale of fireworks. The income and expenses of the
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activities of J&G Enterprise are reported on a separate
Schedule C. Two checks in the amount of $2,500 each were written
to Big Brothers/Big Sisters. The checks bore notations that they
were for “donations”. Big Brothers/Big Sisters is a charitable
organization. Big Brothers/Big Sisters assisted J&G Enterprise
in finding a place for people to use the fireworks products,
provided the labor to help with parking and traffic, and provided
labor to meet the customers who came into the retail store.
Petitioners deducted the $5,000 that was paid to Big Brothers/Big
Sisters as promotions expense on their Schedule C for J&G
Enterprise in 1993.
Among the adjustments determined in the notice of
deficiency, respondent disallowed deductions for bad debts of
$370,000 and $246,175 for 1993 and 1994, respectively, on the
Schedule C for the “loans and collections” business. Respondent
determined that the net income or loss from the Schedule C
businesses was solely attributable to Mr. Dunnegan for self-
employment tax. Respondent disallowed $5,000 of the promotions
expense that related to J&G Enterprise in 1993.
OPINION
Petitioners expressly conceded some of the adjustments that
were determined by respondent in the notice of deficiency. Those
adjustments support the penalties imposed under section 6662(a).
All of the other adjustments that were not addressed by
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petitioners at trial or on brief are deemed conceded. The issues
that petitioners addressed at trial or in their brief are
considered below. Petitioners failed to file a reply brief
ordered by the Court.
I. Business Bad Debt
The first issue is whether the monetary transfers that
petitioners made to Auto Plaza are capital contributions or are
bona fide debts that are deductible as business bad debts under
section 166 when they became worthless.
Generally, taxpayers are allowed deductions for bona fide
debts owed to them that become worthless during a year. Sec.
166(a). Bona fide debts generally arise from valid
debtor-creditor relationships reflecting enforceable and
unconditional obligations to repay fixed sums of money. Sec.
1.166-1(c), Income Tax Regs. For purposes of section 166,
contributions to capital and equity investments in corporations
do not constitute or qualify as bona fide debts. Kean v.
Commissioner, 91 T.C. 575, 594 (1988).
The question of whether transfers of funds to closely held
corporations constitute debt or equity in the hands of the
recipient corporations must be decided on the basis of all of the
relevant facts and circumstances. Dixie Dairies Corp. v.
Commissioner, 74 T.C. 476, 493 (1980). Courts have established a
list of nonexclusive factors to consider when evaluating the
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nature of transfers of funds to closely held corporations, as
follows: (1) The names given to the documents that would be
evidence of the purported loans; (2) the presence or absence of
fixed maturity dates with regard to the purported loans; (3) the
likely source of any repayments; (4) whether the taxpayers could
or would enforce repayment of the transfers; (5) whether the
taxpayers participated in the management of the corporations as a
result of the transfers; (6) whether the taxpayers subordinated
their purported loans to the loans of the corporations’
creditors; (7) the intent of the taxpayers and the corporations;
(8) whether the taxpayers who are claiming creditor status were
also shareholders of the corporations; (9) the capitalization of
the corporations; (10) the ability of the corporations to obtain
financing from outside sources at the time of the transfers;
(11) how the funds transferred were used by the corporations;
(12) the failure of the corporations to repay; and (13) the risk
involved in making the transfers. Calumet Indus., Inc. v.
Commissioner, 95 T.C. 257, 285 (1990); Dixie Dairies Corp. v.
Commissioner, supra at 493.
The above factors serve only as aids in evaluating whether
taxpayers’ transfers of funds to a closely held corporation
should be regarded as risk capital subject to the financial
success of the corporation or as bona fide loans made to the
corporation. Fin Hay Realty Co. v. United States, 398 F.2d 694,
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697 (3d Cir. 1968). No single factor is controlling. Dixie
Dairies Corp. v. Commissioner, supra at 493.
Petitioners argue that all of the funds that petitioners
transferred to Auto Plaza constituted bona fide business loans
that became worthless and therefore the bad debts qualify for a
business bad debt deduction under section 166. Respondent argues
that petitioners’ transfers of funds to Auto Plaza should be
treated as capital contributions and, thus, petitioners should
not be allowed to claim a bad debt deduction under section 166.
When petitioners made the transfers to Auto Plaza, no loan
agreements or promissory notes were drafted or executed. The
absence of notes or other instruments favors respondent. See
Calumet Indus., Inc. v. Commissioner, supra at 286.
Petitioners argue that the transfers were recorded as “loans
from shareholders” on the corporation’s books and records.
Transfers to closely held corporations by controlling
shareholders are subject to heightened scrutiny, and labels
attached to such transfers by the controlling shareholders
through bookkeeping entries or testimony have limited
significance unless these labels are supported by objective
evidence. Fin Hay Realty Co. v. United States, supra at 697;
Dixie Dairies Corp. v. Commissioner, supra at 495. Here,
petitioners were the majority shareholders of the corporation
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and, thus, the recordation of the loan was merely a bookkeeping
entry that is of little significance.
There was no fixed repayment schedule, and petitioners did
not produce a record of the repayments. Additionally, the
repayment of petitioners’ transfers depended upon Auto Plaza’s
financial success, and the lack of repayment indicates that the
transfers did not constitute bona fide loans. See Stinnett’s
Pontiac Serv., Inc. v. Commissioner, 730 F.2d 634, 639 (11th Cir.
1984), affg. T.C. Memo. 1982-314. “If the expectation of
repayment depends solely on the success of the borrower’s
business, the transaction has the appearance of a capital
contribution.” Roth Steel Tube Co. v. Commissioner, 800 F.2d
625, 631 (6th Cir. 1986), affg. T.C. Memo. 1985-58.
Petitioners never demanded repayment of the transfers, and
their continued lending of additional funds tends to refute the
existence of a valid debtor-creditor relationship between Auto
Plaza and petitioners with regard to the funds transferred to
Auto Plaza. See, e.g., Boatner v. Commissioner, T.C. Memo. 1997-
379, affd. without published opinion 164 F.3d 629 (9th Cir.
1998).
Auto Plaza tried to obtain financing from banks but could
not obtain financing on the same terms as the funds provided by
petitioners. Where the banks would have required a personal
guaranty from petitioners, Auto Plaza did not give any security
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or execute any security agreements to collateralize the monetary
transfers.
Petitioners rely on Litwin v. United States, 983 F.2d 997
(10th Cir. 1993); however, Litwin decided whether a bona fide
debt was business or nonbusiness, not a question of whether a
bona fide debt existed. Our conclusion is consistent with the
analysis and holding in Jensen v. Commissioner, T.C. Memo. 1997-
491, affd. without published opinion 208 F.3d 226 (10th Cir.
2000). In Jensen, the Court held that the funds transferred by
the taxpayers to a closely held corporation were not bona fide
debts and not deductible as business bad debts under section
166(a). The Court of Appeals affirmed this Court’s holding in
Jensen, which applied the relevant factors to the facts of that
case as set forth in Calumet Indus., Inc. v. Commissioner, supra
at 285.
Based on the evidence, we conclude that petitioners’
monetary transfers to Auto Plaza did not constitute bona fide
loans, and, therefore, the transfers should be treated as capital
contributions. Petitioners may not take a deduction for bad debt
under section 166.
II. Self-Employment Tax
The next issue is whether the net profits and losses of
petitioners’ Schedule C businesses are attributable to
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Mr. Dunnegan or Mrs. Dunnegan for purposes of self-employment tax
under section 1401.
Petitioners attributed 50 percent of the profit and loss
from the Schedules C for the fireworks businesses located in
Moriarty, Dennings, and Kansas City to Mrs. Dunnegan in 1993.
Respondent determined that 100 percent of the net profits and
losses from the Schedules C for the fireworks businesses was
attributable to Mr. Dunnegan for self-employment tax purposes.
Respondent argues that there is no evidence that Mrs. Dunnegan
was involved in the management of the businesses or had any
significant responsibility for the income-generating activities
of the businesses.
Section 1401(a) imposes a tax on an individual’s self-
employment income. See also sec. 1402(b). Net earnings from
self-employment is the gross income derived by an individual from
a trade or business carried on by that individual, less certain
deductions. See O’Rourke v. Commissioner, T.C. Memo. 1993-603,
affd. without published opinion 60 F.3d 834 (9th Cir. 1995). We
have previously stated:
With respect to individuals who are married, only the
spouse carrying on the trade or business will be
subject to the self-employment taxes. The question of
which spouse carries on the trade or business is a
question of fact to be determined on a case-by-case
basis. * * *
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Jones v. Commissioner, T.C. Memo. 1994-230, affd. without
published opinion 68 F.3d 460 (4th Cir. 1995); see O’Rourke v.
Commissioner, supra.
Mrs. Dunnegan testified that she was intensely involved in
the operation and management of the fireworks businesses. She
spent approximately 25 to 40 hours per week performing services
for the Schedule C businesses, such as bookkeeping, placing
orders to suppliers, and packing and shipping orders.
Petitioners listed both Mr. Dunnegan and Mrs. Dunnegan as the
proprietors of the fireworks businesses on their Schedules C for
1993. We conclude that both spouses were carrying on the
fireworks business and 50 percent of the net profits and losses
from the fireworks businesses should be attributable to
Mrs. Dunnegan for purposes of self-employment tax under section
1401.
III. Business Expenses
The last issue is whether the $5,000 paid by petitioners to
Big Brothers/Big Sisters is deductible as a business expense
under section 162 or as a charitable contribution under section
170. Petitioners claim that they are entitled to the deduction
for business expense under section 162 for the payments because
they were made in exchange for promotional services and labor
rendered to J&G Enterprise.
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The term “charitable contribution” as used in section 170
has been generally held synonymous with the term “gift”.
Considine v. Commissioner, 74 T.C. 955, 967 (1980). A gift is
generally defined as a voluntary transfer of property by the
owner to another without consideration therefor. If a payment
proceeds primarily from the incentive of anticipated benefit to
the payor beyond the satisfaction that flows from the performance
of a generous act, it is not a gift. If the transfer is impelled
primarily by the anticipation of some economic benefit or is in
fact an exchange in the form of a substantial quid pro quo, it is
not a contribution. Id.
In determining whether a statutory contribution or gift was
made, the primary factor is the transferor’s dominant motive or
intention in making the transfer. Commissioner v. Duberstein,
363 U.S. 278, 286 (1960). Identification of the dominant motive
for the transfer must be made on the basis of all of the facts.
United States v. Am. Bar Endowment, 477 U.S. 105, 116-118 (1986);
Commissioner v. Duberstein, supra at 289.
We are persuaded that the payments to the charitable
organization were not charitable contributions under section 170,
because petitioners’ business expected to receive certain
services in return. The understanding between Mr. Dunnegan and
Big Brothers/Big Sisters was that Big Brothers/Big Sisters would
provide promotional services and labor to J&G Enterprise, and
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such services were actually received. In addition, the services
rendered by the charitable organization were ordinary and
necessary to the operation of J&G Enterprise. We conclude that
the payments are deductible as a business expense under section
162.
To reflect the foregoing and the concessions of the parties,
Decision will be entered
under Rule 155.