NOBLE v. COMMISSIONER

T.C. Summary Opinion 2002-68

UNITED STATES TAX COURT

RODNEY NOBLE AND JO MARIE PAYTON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7721-00S. Filed June 10, 2002.

Rodney Noble and Jo Marie Payton, pro sese.

Jean Song, for respondent.

DEAN, 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. Unless otherwise

indicated, 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.

The decision to be entered is not reviewable by any other court,

and this opinion should not be cited as authority.
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Respondent determined deficiencies in petitioners’ 1995 and

1996 Federal income taxes of $14,789 and $12,112 respectively.

The issues presented for decision are whether corporate

distributions to Jo Marie Payton (petitioner) were loan

repayments or constructive dividends for the years in issue and

whether petitioners received imputed interest income for loans to

petitioner’s corporation.

Some of the facts have been stipulated and are so found.

The exhibits received into evidence are incorporated herein by

reference. At the time the petition in this case was filed,

petitioners resided in Los Angeles, California.

Background

Petitioner is a professional actress. She is the sole

shareholder of Payton Power Productions, Inc. (PPP), which

provides acting services. In 1995 and 1996, she served as PPP’s

president, secretary, and treasurer. Petitioner made all of

PPP’s financial decisions. At the end of the calendar year 1995

the capitalization of PPP consisted of common stock issued for

$1,000 and debt of $601,150. At the end of 1996 total

liabilities and stockholders’ equity were $649,817 of which

$1,000 was equity. “Loans from stockholders” as indicated on the

corporate returns went from $409,225 in 1995 to $530,067 in 1996.

At no time during the years in issue did either PPP or

petitioner execute notes articulating terms of a loan
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arrangement. There is no evidence in the record that any loan

terms were established. There is no payment schedule, no

interest rate, nor any recourse for late-payments. PPP did not

formally declare dividends in either 1995 or 1996.

The amount and nature of every distribution was determined

solely by petitioner. In 1995 and 1996 petitioner made a variety

of distributions including, among others, salary and expenses.

Respondent audited PPP’s returns for 1995 and 1996 and determined

that it made the following payments to or on behalf of petitioner

that were distributions with respect to her stock:

1995 1996
Taxes and licenses for Mercedes Benz $1,467 0
Auto expenses for Mercedes Benz 2,031 $4,596
Auto insurance for Mercedes Benz 2,966 0
Payments for Mercedes Benz 27,427 8,465
Interest expense for Mercedes Benz 1,747 3,882
Health club dues 0 1,263
Home security 630 0

Total Payments 36,268 18,206

PPP’s records indicate it paid the costs for three cars.

One of the cars, a 1994 Land Cruiser, is not at issue in this

case. Each of the other two cars was a Mercedes Benz. In 1995,

the first Mercedes was traded in for the second, a later model.

During the audit, petitioners could not establish a business

purpose or a business use for either Mercedes.

The parties agree that the following accurately represents

the relevant portions of PPP’s balance sheet for 1995 and 1996:
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1995 1996
Distributions $36,268 $18,206
Current Earnings and Profits 14,335 17,325
Accumulated Earnings and Profits (50,600) (39,121)
Paid-in-capital (basis) 1,000 0
Loans from stockholders1 123,645 120,842
1
These amounts reflect the amounts “loaned” by
petitioners to PPP for each tax year as reported on
Schedule L, Balance Sheets per Books, on the respective
year’s Form 1120, U.S. Corporation Income Tax Return.
These amounts are in addition to the $285,580 on PPP’s
books at the start of 1995.

Discussion

Bona Fide Debt

It is respondent’s contention that there is little evidence

of “loans” from petitioner to PPP and that the payments in

question, made to or on behalf of petitioners, must be treated as

constructive dividends and taxed as ordinary income.

Petitioners, however, claim that because PPP was indebted to

petitioner in amounts in excess of the payments herein that they

are entitled to treat the payments as loan repayments. Under

such an interpretation, the payments would not constitute

dividend income and would not be taxable as ordinary income of

petitioners.

Generally, respondent’s determination in a notice of

deficiency is presumptively correct, and petitioners bear the

burden of disproving the adjustments. Rule 142(a); Falsetti v.

Commissioner, 85 T.C. 332, 356 (1985). However, under section

7491(a)(1), effective for court proceedings arising in connection
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with examinations commencing after July 22, 1998, the burden of

proof shifts to respondent if, among other requirements,

petitioner introduces “credible evidence with respect to any

factual issue relevant to ascertaining” her liability for the tax

deficiency at issue. Even if we were to find that petitioner has

met the requirements of section 7491(a)(1), respondent has

presented sufficient evidence to meet his burden of proof.

We shall first consider the character of the transfers made

by petitioners to PPP. For Federal income tax purposes, a

transaction will be characterized as a loan if there was "an

unconditional obligation on the part of the transferee to repay

the money, and an unconditional intention on the part of the

transferor to secure repayment". Haag v. Commissioner, 88 T.C.

604, 616 (1987), affd. without published opinion 855 F.2d 855

(8th Cir. 1988). What is important is the bona fide intent that

the debt shall be repaid, rather than the name of the transaction

or the form the transaction takes. Berthold v. Commissioner, 404

F.2d 119, 122 (6th Cir. 1968), affg. T.C. Memo. 1967-102; Patrick

v. Commissioner, T.C. Memo. 1998-30, affd. without published

opinion 181 F.3d 103 (6th Cir. 1999).

Petitioner testified that PPP and petitioners intended the

payments made by PPP to be loan repayments. The mere declaration

of intent, however, is not determinative without further evidence

substantiating the existence of bona fide debt. See Turner v.
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Commissioner, 812 F.2d 650, 654 (11th Cir. 1987), affg. T.C.

Memo. 1985-159; Cordes v. Commissioner, T.C. Memo. 1994-377. A

bona fide transaction is not invalidated by the mere fact that

the arrangement of the transaction confers tax benefits upon the

taxpayer. Gyro Engg. Corp. v. United States, 417 F.2d 437, 440

(9th Cir. 1969).

The Court of Appeals for the Ninth Circuit has identified

some objective factors to consider in determining whether bona

fide debt exists: (1) The names given to the certificates

evidencing the indebtedness; (2) the presence or absence of a

maturity date; (3) the source of the payments; (4) the right to

enforce payment of principal and interest; (5) participation in

management; (6) a status equal to or inferior to that of regular

corporate creditors; (7) the intent of the parties; (8) "thin" or

adequate capitalization; (9) identity of interest between

creditor and stockholder; (10) payment of interest only out of

"dividend" money; and (11) the ability of the corporation to

obtain loans from outside lending institutions. Hardman v.

United States, 827 F.2d 1409, 1412-1414 (9th Cir. 1987).

Each factor is not necessarily afforded equal significance

nor is any particular factor determinative. Dixie Dairies Corp.

v. Commissioner, 74 T.C. 476, 493-494 (1980). Not all of the

factors articulated by the Ninth Circuit are relevant in each

case. Id. The ultimate question is whether there was a “genuine
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intention to create a debt, with a reasonable expectation of

repayment, and did that intention comport with the economic

reality of creating a debtor-creditor relationship?” Litton Bus.

Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

Transactions between closely held corporations and their

shareholders must be examined with special scrutiny. Elec. &

Neon, Inc. v. Commissioner, 56 T.C. 1324, 1339 (1971), affd.

without published opinion 496 F.2d 876 (5th Cir. 1974).

Although the factors offer an objective measure of the

taxpayer's intent, we must examine them in light of all the

relevant facts and circumstances. Estate of Chism v.

Commissioner, 322 F.2d 956, 960 (9th Cir. 1963), affg. T.C. Memo.

1962-6. Petitioners must show that bona fide loans were created

and that the payments they received were repayment of these

loans. Welch v. Helvering, 290 U.S. 111, 114 (1933).

Here there is little tangible evidence that PPP and

petitioners intended to create a bona fide debtor-creditor

relationship. There is no written evidence substantiating the

intentions of the parties, the rate of interest to be charged,

any collateral for the “loan”, or any right of petitioner to

enforce payment from PPP. There is no evidence that the payments

made by PPP to or on behalf of petitioner were the result of, or

in satisfaction of, any established expectation of loan

repayment.
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A thinly capitalized corporation is strong evidence that

loans are not bona fide debt. This is especially true where a

very high debt-to-equity ratio exists. Gyro Engg. Corp. v.

United States, supra at 439. Here, the capitalization of PPP was

at a debt-to-equity ratio of more than 600 to 1, a ratio which

does not support the existence of loans as distinguished from

capital contributions by petitioner to PPP.

Petitioner relies on a corporate resolution adopted in

January 1996, which attempts to recharacterize any corporate

deductions not allowed by the Commissioner as loan repayments.

For a corporate resolution to be determinative for Federal income

tax purposes, the company’s actions must comport with the

resolution. See Turner v. Commissioner, supra at 654. There

are, however, no bookkeeping entries which indicate that the

amounts at issue were intended as loan repayments. Also, the

corporate records do not indicate that these payments were

repayments of loans. The board’s attempt to recharacterize the

payments made in 1995 and 1996 was not reflected in the substance

of any transaction. By all indications, there is no expression

of any intent on the part of petitioners to lend money to PPP or

any obligation on the part of PPP to repay any purported loans.

See Elec. & Neon, Inc. v. Commissioner, supra.

Essentially, there are only two indicia of a loan,

petitioner’s statements indicating her intentions, and PPP’s
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Federal income tax return, neither of which persuade the Court in

the face of other evidence that a bona fide debt was created.

Upon examination of the 11 factors, we find that the cash

infusions from petitioners to PPP were contributions to capital,

not loans. See sec. 351; Fin Hay Realty Co. v. United States,

398 F.2d 694 (3d Cir. 1968). In particular, the

undercapitalization of the corporation, petitioner’s control over

the corporation, the fact that no dividends were declared, and

the lack of loan documents satisfy the Court that there were no

bona fide loans. Accordingly, we conclude that the payments made

by PPP to or on behalf of petitioners were not repayments of bona

fide debt.

Constructive Dividends

Having found the payments not to be loan repayments, we now

address respondent's contentions that the payments made by PPP to

or on behalf of petitioners are in the nature of constructive

dividends.

Section 61(a)(7) includes the receipt of any dividend in a

taxpayer’s gross income. Section 301(a) requires that any

distribution of “property” made by a corporation to a shareholder

“with respect to its stock” shall be subject to dividend

treatment for Federal income tax purposes. Secs. 301(c)(1), 316,

317.

The term “dividend” is defined in section 316(a) as:
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any distribution of property made by a corporation to
its shareholders--

(1) out of its earnings and profits
accumulated after February 28, 1913, or

(2) out of its earnings and profits of
the taxable year (computed as of the close of
the taxable year without diminution by reason
of any distributions made during the taxable
year), without regard to the amount of the
earnings and profits at the time the
distribution was made.

Except as otherwise provided in this subtitle, every
distribution is made out of earnings and profits to the
extent thereof, and from the most recently accumulated
earnings and profits. * * *

There is no requirement that the dividend be formally declared or

even intended by the corporation. Loftin & Woodward, Inc. v.

United States, 577 F.2d 1206, 1214 (5th Cir. 1978). Whether an

expenditure is a constructive dividend is a question of fact for

this Court.

It is well established that when a corporation uses its

funds to pay personal expenses of its shareholders or members of

shareholder’s families, which bear no relation to the economic

interests of the corporation, such payments constitute

constructive dividends to the shareholders to the extent of

earnings and profits. Melvin v. Commissioner, 88 T.C. 63, 79

(1987), affd. per curiam 894 F.2d 1072 (9th Cir. 1990); Falsetti

v. Commissioner, 85 T.C. at 356; Challenge Manufacturing Co. v.

Commissioner, 37 T.C. 650, 663 (1962); Am. Props., Inc. v.
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Commissioner, 28 T.C. 1100, 1115 (1957), affd. per curiam 262

F.2d 150 (9th Cir. 1958).

To constitute a constructive dividend a corporate

distribution to a shareholder must be both nondeductible to the

corporation and must confer some economic benefit or gain to the

shareholder. Palo Alto Town & Country Vill., Inc. v.

Commissioner, 565 F.2d 1388, 1391 (9th Cir. 1977), affg. in part,

revg. and remanding in part T.C. Memo. 1973-223; Falsetti v.

Commissioner, supra at 357. Not every corporate expenditure

conferring an economic benefit to the shareholder is a

constructive dividend. The deciding factor is whether the

expenditure was primarily for the shareholder’s benefit and there

was no expectation of repayment. Crosby v. United States, 496

F.2d 1384, 1388-1389 (5th Cir. 1974); Noble v. Commissioner, 368

F.2d 439 (9th Cir. 1966), affg. T.C. Memo. 1965-84.

Petitioners rely on the adoption of a corporate resolution

dated January 15, 1996, stating that the board intends any amount

of expenses which are disallowed by the Internal Revenue Service

to be treated as repayment of shareholder loans. Petitioners’

reliance on the corporate resolution is misplaced. The

resolution was adopted after the 1995 tax year and was intended

to recharacterize payments already made. The fact that there is

no evidence of loan treatment on PPP’s books vitiates the

resolution. The resolution is merely an after-the-fact statement
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of intent and does not control our decision. See Turner v.

Commissioner, 812 F.2d at 654; Cordes v. Commissioner, T.C. Memo.

1994-377. Constructive dividends are more likely to originate

from a closely held corporation where decisions between a single

stockholder and the corporation are often one and the same.

Zhadanov v. Commissioner, T.C. Memo. 2002-104.

Petitioner argues that she could not have received dividends

from PPP for either 1995 or 1996 because PPP had deficits in its

accumulated earnings and profits for both years. Section 316 and

its regulations provide that distributions to shareholders with

respect to their stock must be treated as dividends to the extent

of both current and accumulated earnings and profits. “To the

extent that a corporation has current earnings and profits as of

the close of its taxable year, any distribution made in that year

will be presumed to be made out of such current earnings and

profits.” Brock v. Commissioner, T.C. Memo. 1982-335; see sec.

316(a); sec. 1.316-1(a)(1), Income Tax Regs. If the

distributions for the year exceed the amount of current earnings

and profits the excess is deemed to have been made out of any

accumulated earnings and profits. Prescott v. Commissioner, T.C.

Memo. 1983-709. Any portion of the distribution that does not

qualify for dividend treatment shall be applied against the

shareholders’ basis in their stock, and any excess shall be

treated as gain. Sec. 301(c). Thus, petitioner was able to
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receive constructive dividends because PPP had current earnings

and profits in both 1995 and 1996. The distributions in excess

of earnings and profits first reduce her basis in PPP’s stock and

second, are treated as capital gain for the respective years.

The distributions in question were for personal expenses

such as the cost of petitioner’s personal vehicles, home

security, and health club dues. At trial, however, petitioner

testified that she is entitled to the deductions for the Mercedes

because she used the car for business purposes. When asked to

identify how the Mercedes was used, petitioner indicated that it

was used to “drive to work” and to attend “formal functions”.

She maintains that the use of the Mercedes helped her earn money

and thus should be a deductible business expense. Despite

petitioner’s urging to the contrary, driving her vehicle from

home to work and to receptions does not establish, by itself, a

business use for that vehicle. See Fausner v. Commissioner, 413

U.S. 838 (1973); Commissioner v. Flowers, 326 U.S. 465 (1946);

Feistman v. Commissioner, 63 T.C. 129, 134 (1974); secs. 1.162-

2(e), 1.262-1(b)(5), Income Tax Regs. Since the corporate

expenditures in question were solely for petitioner’s benefit,

she is taxable on the amounts distributed.

The evidence introduced by respondent supports the

determination that the payments by PPP were made to or on behalf

of petitioner and were constructive dividends. Petitioners have
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failed to offer sufficient evidence to counter respondent’s

determination with respect to the payments from PPP. We hold,

therefore, that the payments from PPP to petitioner in 1995 and

1996 were constructive dividends and are taxable, to the extent

of earnings and profits, as ordinary income.

Imputed Interest Income

Respondent determined that petitioners have unreported

imputed interest income under section 7872 resulting from

petitioner’s “loans” to the corporation. Section 7872, entitled

“Treatment of loans with below-market interest rates”, operates

on the assumption that a bona fide debt is in existence.

(Emphasis provided.) Although petitioners did not specifically

address respondent’s contention, because there were no loans,

bona fide debt, or debtor-creditor relationship, we are unable to

sustain respondent’s determination.

Reviewed and adopted as the report of the Small Tax Case

Division.

Decision will be entered

under Rule 155.