OREN v. COMMISSIONER

T.C. Memo. 2002-172

UNITED STATES TAX COURT

DONALD G. OREN AND BEVERLY J. OREN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2681-00. Filed July 19, 2002.

Myron L. Frans, for petitioners.

John C. Schmittdiel, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

RUWE, Judge: Respondent determined the following

deficiencies with respect to petitioners’ Federal income taxes:

Year Amount

1993 $1,375,232
1994 2,138,632
1995 1,777,271
 - 2 -

The issues for decision are: (1) Whether petitioners had

sufficient basis in indebtedness under section 1366(d)1 from

which to deduct losses from two wholly owned S corporations; and

(2) whether petitioners were at risk under section 465 for

certain loans made to the two S corporations.

FINDINGS OF FACT

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. Petitioners Donald G.

Oren (Mr. Oren) and Beverly J. Oren (Mrs. Oren) resided in

Roseville, Minnesota, at the time they filed their petition.

Petitioners owned stock in several S corporations. Those

corporations performed various functions which together formed

the nexus for petitioners’ trucking business.

Dart Transit Company (Dart) was formed in 1934 by Mr. Oren’s

father and was incorporated in 1938 under Minnesota law. In

1993, 1994, and 1995, Dart held a 48-State authority and operated

throughout the United States and in some provinces in Canada.

During that time period, Dart was in the process of expanding and

positioned itself in the “high service just-in-time” segment of

the truckload carrier industry. Dart offered premium truckload

carrier services to retailers and manufacturers of products such

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue.
 - 3 -

as haul containers, paper, department store merchandise, building

materials, appliances, plastics and rubber products, and

miscellaneous items. Dart owned no tractors of its own and used

tractors operated only by independent contractors.

The following table details some of Dart’s business

operations for 1993, 1994, and 1995:

Item
Ordinary
Year Revenues Net Income Income Employees Trailers

1993 $130,034,000 $2,858,133 $5,294,491 220 1,669
1994 149,039,000 4,539,008 10,089,762 241 1,669
1995 168,172,000 3,067,744 4,667,063 245 2,066

Mr. Oren did not become involved in the operations of Dart

until 1953. However, Mr. Oren would become the principal force

behind Dart’s and, another company, Fleetline’s position in the

truckload carrier business. Mrs. Oren was also involved in the

trucking business, for more than 20 years, and was in charge of

Dart’s human resources. Mr. and Mrs. Oren were the only

directors of Dart in 1993, 1994, and 1995. Mr. Oren also served

as president/ treasurer, and Mrs. Oren served as executive vice

president/ secretary.

Dart had two classes of common stock, class A voting stock

(33,000 shares) and class B nonvoting stock (3,267,000 shares).

Both classes had equal distribution and liquidation rights. Mr.

Oren owned all the class A voting stock. Overall, the common

stock of Dart, including both the class A voting and class B
 - 4 -

nonvoting stock, was owned by the following parties and in the

following percentages:

Common Stock Ownership Percentage
Owners 1993 1994 1995

Donald G. Oren 74.94% 54.95% 54.95%
Beverly J. Oren 6.33 6.33 6.33
David Oren 0.26 5.25 5.25
Daniel Oren 0.26 5.25 5.25
Bradley Oren 0.26 5.25 5.25
Angela Oren 0.26 5.25 5.25
Trust for David Oren 4.43 4.43 4.43
Trust for Daniel Oren 4.43 4.43 4.43
Trust for Bradley Oren 4.43 4.43 4.43
Trust for Angela Oren 4.43 4.43 4.43

David, Daniel, Bradley, and Angela Oren are petitioners’

children. In 1992, David was age 34; Daniel was 32; Bradley was

27; and Angela was 14. The trusts owning stock in Dart were all

qualified subchapter S trusts under section 1361(d)(1)(B). The

trusts were irrevocable, and all rights incident to the ownership

of the stock were exercised by trustees. None of the trustees

were employed by or held shares in any of the trucking companies;

the trustees were in all respects independent. Dart elected to

be taxed under subchapter S of the Code for taxable years 1993,

1994, and 1995.2 See sec. 1362(a).

Mr. Oren testified that he and his wife attended seminars on

estate planning and made estate planning one of their top

business priorities. As a result, Mr. and Mrs. Oren engaged in a

2
Dart was formerly a C corporation and still had accumulated
earnings and profits in 1993, 1994, and 1995, attributable to its
C corporation existence.
 - 5 -

program of annual gifting of Dart shares to their children and to

irrevocable trusts for the benefit of the children. Petitioners

reported taxable gifts in excess of $5.5 million for taxable

years 1992, 1993, and 1994 and paid approximately $2 million in

gift taxes.

In 1982, Mr. Oren established a second truckload carrier

company in Texas called Fleetline, Inc. (Fleetline). This

company performed services similar to those of Dart. Fleetline’s

stock was owned entirely by Mr. Oren.

Highway Leasing (HL) was incorporated in 1987 as a Minnesota

corporation. All the stock of HL was owned by Mr. Oren. Mr.

Oren served as the president/treasurer of HL, and Mrs. Oren

served as secretary. Mr. Oren was the only director of HL. HL

was in the business of acquiring and leasing trailers. HL leased

the trailers to Dart, Fleetline, and other parties. The

following table details some of the business operations of HL for

1993, 1994, and 1995:

Item
Ordinary
Year Revenues Net Income Income Trailers

1993 $6,295,000 $965,237 $(2,845,625) 2,068
1994 8,587,000 635,746 (4,459,488) 2,550
1995 10,919,000 2,447,233 (6,825,523) 3,847

HL elected to be taxed as an S corporation for taxable years

1993, 1994, and 1995.

Highway Sales (HS) was incorporated in 1971 as a Minnesota

corporation. All the stock of HS was owned by Mr. Oren. Mr.
 - 6 -

Oren also acted as the treasurer of the company, and Mrs. Oren

acted as vice president/secretary during 1993, 1994, and 1995.

Mr. Oren and Mrs. Oren were the only directors of HS. HS

purchased tractors which HS then leased under a “lease-to-

purchase” program. HS leased the tractors to individuals who

wanted to become owner-operators of the tractors. The

profitability of HS was dependent on its ability to purchase a

number of tractors at wholesale prices and to lease those same

tractors to individuals willing to own their own trucks and drive

them. The following table details some of the business

operations of HS for 1993, 1994, and 1995:

Item
Ordinary
Year Revenues Net Income Income Employees Tractors

1993 $8,361,000 $1,634,071 $(1,511,830) 11 852
1994 11,202,000 322,689 (1,773,473) 19 1,231
1995 13,798,000 1,451,609 482,405 19 1,184

HS also elected to be taxed as an S corporation for taxable years

1993, 1994, and 1995.

The various entities, Dart, Fleetline, HL, and HS, were kept

separate from one another in order to: (1) Minimize exposure to

liability by keeping as many assets as possible out of the

primary truckload carriers, Dart and Fleetline; (2) promote

accountability within each segment of the trucking business; (3)

maintain flexibility of operations; (4) permit financial results

to be reported separately; and (5) facilitate family and estate

planning.
 - 7 -

On July 1, 1991, Dart, Fleetline, HS, and HL entered into a

credit agreement with First Bank National Association (First

Bank), which provided for a letter of credit, a revolving note,

and a security agreement. The credit agreement restricted

distributions from the Dart companies to petitioners’ expected

tax liability plus 10 percent of net income. On August 16, 1993,

the agreement was amended to allow distributions to petitioners

so long as they made equivalent cash contributions to one of the

other Dart companies. The agreement also stated:

Section 6.10 Investments. No Borrower [any of the
Dart Companies] will acquire for value, make, have or
hold any Investments, except:

* * * * * * *

6.10(f) Loans by Dart to Donald G. Oren, but only
so long as contemporaneous loans of equal amount from
Donald G. Oren to another Borrower remain outstanding.

Beginning in 1992, HL purchased additional trailers for use

in its business. The trailers would have given rise to

depreciation deductions that would have exceeded Mr. Oren’s basis

in his S stock. Mr. Oren would have been unable to deduct the

full amount of the losses as a result of section 1366(d), which

limits losses to the sum of a shareholder’s basis in the S

corporation stock and the shareholder’s basis in indebtedness of

the S corporation to the shareholder. Mr. Oren was advised by

his tax advisers to “restructure” his financial investments in
 - 8 -

his various companies so that he might receive the benefit of the

ordinary loss deductions. Mr. Oren followed the advice of the

tax advisers and entered into a series of lending transactions

for the purpose of increasing basis in HL.3

On December 22, 1993, Dart lent $4 million to Mr. Oren. Mr.

Oren executed a note which provided that principal was due 375

days following demand. Interest accrued at a 7-percent annual

rate and was due on December 22, 1994, and on the same day of

each year thereafter. The proceeds of the loan were distributed

in the form of a check (#133680) from Dart to Mr. Oren drawn on

Dart’s account with First Bank Havre (Havre).4

On December 22, 1993, Mr. Oren lent $4 million to HL. HL

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on December 22, 1994, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#2720) from Mr. Oren to HL drawn on Mr.

Oren’s account with Fidelity Investments (Fidelity).

3
Even though Mr. Oren ultimately chose to use funds lent by
Dart to finance his investments in HL, Mr. Oren testified that he
had the personal resources to finance the investments without
borrowing from Dart.
4
Mr. Oren testified that Dart had a zero balance account
(ZBA). With respect to a ZBA, each time that Dart wrote a check,
it would be drawing on its line of credit with the bank.
 - 9 -

On December 22, 1993, HL lent $4 million to Dart. Dart

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on December 22, 1994, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#2305) from HL to Dart drawn on HL’s account

with First Bank Minneapolis (Minneapolis).

On September 22, 1994, Dart lent $5 million to Mr. Oren.

Mr. Oren executed a note which provided that principal was due

375 days following demand. Interest accrued at a 7-percent

annual rate and was due on September 22, 1995, and on the same

day of each year thereafter. The proceeds of the loan were

distributed in the form of a wire transfer from First Bank

National Association to Mr. Oren’s Fidelity account.

On September 22, 1994, Mr. Oren lent $5 million to HL. HL

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on September 22, 1995, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#2875) from Mr. Oren to HL drawn on Mr.

Oren’s Fidelity account.

On September 22, 1994, HL lent $5 million to Dart. Dart

executed a note which provided that principal was due 375 days
 - 10 -

following demand. Interest accrued at a 7-percent annual rate

and was due on September 22, 1995, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#2402) from HL to Dart drawn on HL’s account

with Havre.

On September 15, 1995, Dart lent $4.4 million to Mr. Oren.

Mr. Oren executed a note which provided that principal was due

375 days following demand. Interest accrued at a 7-percent

annual rate and was due on September 15, 1996, and on the same

day of each year thereafter. The proceeds of the loan were

distributed in the form of a check (#164603) from Dart to Mr.

Oren drawn on Dart’s account with Havre.

On September 27, 1995, Mr. Oren lent $4.5 million to HL. HL

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on September 27, 1996, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#3066) from Mr. Oren to HL drawn on Mr.

Oren’s Fidelity account.

On September 27, 1995, HL lent $4.5 million to Dart. Dart

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on September 27, 1996, and on the same day of each
 - 11 -

year thereafter. The proceeds of the loan were distributed in

the form of a check (#2512) from HL to Dart drawn on HL’s account

with Havre.

In 1995, a similar problem arose with HS. HS purchased

tractors and the accelerated depreciation deductions from those

tractors were anticipated to exceed Mr. Oren’s basis in HS. Mr.

Oren restructured his investments to increase his basis in HS.

On December 8, 1995, Dart lent $1.9 million to Mr. Oren.

Mr. Oren executed a note which provided that principal was due

375 days following demand. Interest accrued at a 7-percent

annual rate and was due on December 8, 1996, and on the same day

of each year thereafter. The proceeds of the loan were

distributed in the form of a check (#168445) from Dart to Mr.

Oren drawn on Dart’s account with Havre.

On December 21, 1995, Mr. Oren lent $2 million to HS. HS

executed a note which provided that principal was due 375 days

following demand. Interest accrued at a 7-percent annual rate

and was due on December 21, 1996, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#3088) from Mr. Oren to HS drawn on Mr.

Oren’s Fidelity account.

On December 21, 1995, HS lent $2 million to Dart. Dart

executed a note which provided that principal was due 375 days
 - 12 -

following demand. Interest accrued at a 7-percent annual rate

and was due on December 21, 1996, and on the same day of each

year thereafter. The proceeds of the loan were distributed in

the form of a check (#16973) from HS to Dart drawn on HS’ account

with Minneapolis.

Mr. Oren signed all the above notes either in his individual

capacity or as president of Dart or HL. The only exception was

the note from HS to Mr. Oren which was signed by John Seibel,

president of HS.

Mr. Oren’s financial statements for 1993 and 1995 do not

reflect Mr. Oren’s loan obligations to Dart or the loan

obligations from HL and HS to Mr. Oren. The 1993 and 1994

combined balance sheets for the Dart companies do not reflect the

loan obligations between Dart and Mr. Oren, Mr. Oren and HL, and

HL and Dart.5 The 1995 combined balance sheet for the Dart

5
The combined schedule of balance sheet information for 1993
provides the following relevant information (in thousands):

Dart Fleetline HS HL Eliminations Total
ASSETS
Notes receivable-
affiliate $5,901 --- -–- $4,000 ($9,598) $303
LIABILITES
Notes payable-
affiliate 4,000 $1,598 --- 4,000 (9,598) ---

The total of $303,000 was listed on the combined balance sheet of
the Dart companies as an asset. The combined schedule of balance
sheet information for 1994 provides the following relevant
information (in thousands):

Dart Fleetline HS HL Eliminations Total
ASSETS
Notes receivable-
(continued...)
 - 13 -

companies does not reflect the various loans between the Dart

companies and Mr. Oren, except for the $200,000 that Mr. Oren

lent to HL and HS from his own personal resources.6 That amount

is listed as a “NOTES PAYABLE-Stockholder”.7

5
(...continued)
affiliate ($7,307) --- $181 $9,000 ($1,598) $276
LIABILITES
Notes payable-
affiliate (9,000) 1,598 --- 9,000 (1,598) ---

The total of $276,000 was listed on the combined balance sheet as
an asset of the Dart companies.
6
The combined schedule of balance sheet information for 1995
provides the following relevant information (in thousands):

Dart HS HL Total
ASSETS
Notes receivable-
affiliate $325 --- --- $325
LIABILITES
Notes payable-
stockholder (15,300) $2,000 $13,500 200
Notes payable-
affiliate 16,037 (2,000) (13,500) 537

The totals of $325,000, $200,000, and $537,000, are listed on the
combined balance sheet of the Dart companies under “Notes
receivable-Affiliate”, “NOTES PAYABLE-Stockholder”, and “NOTES
PAYABLE-Affiliate”, respectively. Note 7 to the combined balance
sheet then states: “The notes payable to stockholder and
affiliate are due 375 days from the date the holders of the notes
request payment. The interest rates of the notes are fixed at
7.0%.”
7
The parties stipulated an exhibit identified as Accounting
Research Bulletin No. 51, Consolidated Financial Statements,
which provides in relevant part:

In the preparation of consolidated statements,
intercompany balances and transactions should be
eliminated. This includes intercompany open account
balances, security holdings, sales and purchases,
interest, dividends, etc. As consolidated statements
(continued...)
 - 14 -

Mr. Oren paid interest in 1994, 1995, and 1996 on the loans

made from Dart to Mr. Oren:

Date Interest Payment Check No. (Fidelity)

12-22-94 $280,000.00 3008
10-11-95 553,288.00 3073
12-12-96 1,254,246.58 3238

HL paid interest in 1994, 1995, and 1996 on the loans from Mr.

Oren to HL:

Date Interest Payment Check No. (Havre)

12-21-94 $280,000.00 ????
09-27-95 553,288.00 2509
12-03-96 1,121,917.81 2641

HS also paid interest on the 1995 loan from Mr. Oren:

Date Interest Payment Check No. (Minneapolis)

12-04-96 $132,712.33 19438

Dart paid interest in 1994, 1995, and 1996 on the loans made from

HL to Dart:

Date Interest Payment Check No. (Havre)

12-23-94 $280,000.00 150561
09-27-95 553,288.00 164844

7
(...continued)
are based on the assumption that they represent the
financial position and operating results of a single
business enterprise, such statements should not include
gain or loss on transactions among the companies in the
group.

The various offsets of the loan obligations among Dart, HL, and
HS on the 1993, 1994, and 1995 combined schedule of balance sheet
information, are explained by this document. However, this
document does not explain the absence of the loans involving Mr.
Oren on the 1993 and 1994 statements.
 - 15 -

12-04-96 1,121,917.81 186558

Dart also paid interest to HS in 1996 on the loan made from HS to

Dart:

Date Interest Payment Check No. (Havre)

12-04-96 $132,712.33 186559

Dart paid the following amounts to HL and HS on December 19,

1996:

Payee Payment Check No. (Havre)

HL $13,549,191.78 187346
HS 2,007,287.67 187347

The notes that Dart executed for the benefit of HL were marked

“Paid 12/19/96 check # 187346”. The note that Dart executed for

the benefit of HS was marked “Paid 12/19/96 check # 187347”.

HL paid the following amounts to Mr. Oren on December 19,

1996:

Payment Check No. (Havre)

$100,364.38 2650
13,448,827.40 2651

The notes that HL executed for the benefit of Mr. Oren were

marked “Contribute to Capital * * * 12/18/96”.

HS paid the following amounts to Mr. Oren on December 19,

1996:

Payment Check No. (Minneapolis)

$100,364.38 19565
1,906,923.29 19566
 - 16 -

The note that HS executed for the benefit of Mr. Oren was marked

“Contribute to Capital * * * 12/18/96”.

On December 23, 1996, Mr. Oren satisfied his notes to Dart,

by endorsing the checks he received from HS (#19566) of

$1,906,923.29 and HL (#2651) of $13,448,827.40 to Dart’s bank

account. The notes that Mr. Oren executed for the benefit of

Dart bear a notation reflecting this payment method.

Mr. Oren made total contributions of $19 million to HL and

HS in 1996.8 On December 23, 1996, Mr. Oren made capital

contributions of $1,198,735.36 and $1,301,264.64 to HS. On

December 27, 1996, Mr. Oren made a capital contribution of $16.5

million to HL. Distributions from Dart provided Mr. Oren with

the funds needed to make those contributions. The distributions

were made pro rata to all shareholders of Dart.

Petitioners deducted losses from HL and HS on Form 1040,

U.S. Individual Income Tax Return, in the following amounts:

1993 1994 1995

HL ($4,000,000) ($4,614,944) ($5,605,248)
HS (146,384) (66,363) (2,046,251)

8
On the advice of their tax advisers, petitioners filed a
Form 1040X, Amended U.S. Individual Income Tax Return, for
taxable year 1996. Attached to that return is a document which
states that the return was being filed as a protective claim.
Petitioners stated that if they should lose the Tax Court case,
they were claiming sufficient basis in 1996 from which to deduct
the losses. Petitioners based their claim on the capital
contributions made in 1996 by Mr. Oren to HL and HS.
 - 17 -

On December 6, 1999, respondent issued a notice of deficiency for

taxable years 1993, 1994, and 1995 in which he determined:

7.A. Loss on Highway Leasing
The deductions of $4,000,000, $4,614,944, and
$5,605,248, shown on your returns for the taxable years
1993, 1994, and 1995, respectively, as losses from
Highway Leasing are not allowable for 1993 and 1994 and
is reduced by $4,785,056 for 1995 because the loans
from Dart Transit through Donald Oren to Highway
Leasing and then back to Dart Transit do not create
indebtedness and at-risk basis. Accordingly, your
taxable income is increased $4,000,000 for 1993,
$4,614,944 for 1994, and $4,785,056 for 1995.

7.B. Loss on Highway Sales
The deduction of $2,046,251 shown on your return for
1995 as a loss from Highway Sales is reduced by
$1,900,000 because the loans from Dart Transit through
Donald Oren to Highway Sales, Inc. and then back to
Dart Transit do not create indebtedness and at-risk
basis. Accordingly, your taxable income is increased
$1,900,000 for 1995.

OPINION

Issue 1

The first issue for decision is whether petitioners’ basis

in the indebtedness of two wholly owned S corporations was

increased under section 1366(d) as a result of certain direct

loans made by petitioners to those entities. Generally, it is

the burden of the taxpayer to establish his basis in the S

corporation under section 1366(d).9 Estate of Bean v.

Commissioner, 268 F.3d 553, 557 (8th Cir. 2001), affg. T.C. Memo.

9
Petitioners do not argue that sec. 7491(a) applies, and it
is otherwise unclear when the examination by respondent
commenced. We find sec. 7491(a) is not applicable to this case.
 - 18 -

2000-355; Parrish v. Commissioner, 168 F.3d 1098, 1102 (8th Cir.

1999), affg. T.C. Memo. 1997-474.

Section 1366(d) provides:

SEC. 1366. PASS-THRU OF ITEMS TO SHAREHOLDERS.

* * * * * * *

(d) Special Rules for Losses and Deductions.--

(1) Cannot exceed shareholder’s basis in stock
and debt.--The aggregate amount of losses and
deductions taken into account by a shareholder under
subsection (a) for any taxable year shall not exceed
the sum of–-

(A) the adjusted basis of the shareholder’s
stock in the S corporation (determined with
regard to paragraph (1) of section 1367(a) for
the taxable year), and

(B) the shareholder’s adjusted basis of any
indebtedness of the S corporation to the
shareholder (determined without regard to any
adjustment under paragraph (2) of section
1367(b) for the taxable year).

The legislative history of section 1366(d) indicates that losses

are deductible only to the extent of one’s “investment” in the S

corporation, which includes cash outlays as well as loans to the

corporation from the shareholder. The Senate Finance Committee

Report states:

The amount of the net operating loss apportioned
to any shareholder pursuant to the above rule is
limited under section 1374(c)(2) [a predecessor of
section 1366(d)] to the adjusted basis of the
shareholder’s investment in the corporation; that is,
to the adjusted basis of the stock in the corporation
owned by the shareholder and the adjusted basis of any
indebtedness of the corporation to the shareholder. * *
 - 19 -

* [S. Rept. 1983, 85th Cong., 2d Sess. (1958), 1958-3
C.B. 922, 1141; emphasis added.]

Respondent determined that the loans Mr. Oren made to HL and

HS did not involve an economic outlay by petitioners and did not

increase basis under section 1366(d). Respondent argues that the

transactions did not leave petitioners “poorer in any material

sense” and did not result in “any significant change” in

petitioners’ “economic wealth”.10

Petitioners suggest that the loans from Mr. Oren to HL and

HS, when viewed separately, were bona fide debts for purposes of

section 1366(d). Petitioners contend that the “other” loan

transactions (i.e., the loans from HL to Dart and from HS to

Dart) should not upset the validity of those loans. Petitioners

also argue that Mr. Oren’s personal economic wealth was changed

significantly as a result of the loan transactions since he was

personally indebted to Dart for repayment of the loan proceeds.

In the context of a shareholder’s guaranty of a loan for the

benefit of an S corporation, there has been some dispute as to

whether a guaranty can ever satisfy the requirements of section

1366(d)(1). Most of the cases dealing with the issue have

determined that, as a matter of law, a mere guaranty does not

give rise to basis in indebtedness under section 1366(d)(1)(B),

10
Respondent does not challenge the bona fides of the
entities created by petitioners or the overall structure of the
trucking business adopted by petitioners.
 - 20 -

because there has not been an “actual economic outlay” by the

shareholder to the corporation. See, e.g., Estate of Bean v.

Commissioner, supra at 558-559; Estate of Leavitt v.

Commissioner, 90 T.C. 206, 211 (1988), affd. 875 F.2d 420 (4th

Cir. 1989).11 Petitioners argue that funds lent directly from a

shareholder to an S corporation create basis under section

1366(d), and an actual economic outlay is not required, even if

other transactions offset the direct loan. Petitioners argue

that an actual economic outlay is required only where there is a

shareholder guaranty. Essentially, petitioners are arguing that

the “form” of a direct loan from a shareholder to an S

corporation is sufficient to increase basis in indebtedness under

section 1366(d)(1)(B).

A shareholder must make an actual economic outlay to

increase basis in an S corporation, even if the shareholder has

made a direct loan. Bergman v. United States, 174 F.3d 928, 932

(8th Cir. 1999); Underwood v. Commissioner, 535 F.2d 309, 311-313

(5th Cir. 1976), affg. 63 T.C. 468 (1975). Indeed, in Bergman v.

United States, supra at 933, the Court of Appeals for the Eighth

Circuit stated:

The economic outlay doctrine does not apply only
to loan guarantees, but it has been used to explain
that a shareholder who guarantees a bank loan to an S
corporation does not create additional basis because he

11
But see Selfe v. United States, 778 F.2d 769 (11th Cir.
1985).
 - 21 -

is only secondarily and conditionally liable. The
principle underlying the doctrine extends beyond such
circumstances to transactions which purport to be
direct loans. * * * [Citations omitted.]

Thus, “A taxpayer claiming a deduction [under section 1366(d)(1)]

must show it was based on ‘some transaction which when fully

consummated left the taxpayer poorer in a material sense.’” Id.

at 932-933 (quoting Perry v. Commissioner, 54 T.C. 1293, 1296

(1970), affd. 27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir.

1971)). Our concern under section 1366(d)(1)(B) is whether a

shareholder has, in substance, lent money to the S corporation.

See id., at 930 n.6.

The various disbursements in 1993, 1994, and 1995 were the

equivalent of offsetting bookkeeping entries, even though they

occurred in the form of checks and a wire transfer. For example,

in 1993, Dart lent $4 million to Mr. Oren, Mr. Oren lent $4

million to HL, and HL lent $4 million to Dart. The loan

transactions did not have a net economic effect. None of the $4

million that Dart lent to Mr. Oren was retained by a party other

than Dart.12 Indeed, the loan proceeds originated with Dart and

ended with Dart. The only significance of the transactions was

the circular route of the various checks and the wire transfer

12
For an investment, we would at a minimum expect that the S
corporation would retain the loan proceeds for use in its
business operations. In this case, the loans to HL and HS simply
entered the “front door”, immediately exited through the “back
door”, and were returned to Dart.
 - 22 -

and the execution of promissory notes. The economic positions of

the parties did not change.13 The same is true of the loan

transactions in 1994 and 1995.

The execution of the promissory notes did not result in the

parties’ becoming poorer in any material sense. The promissory

notes, with the exception of the note from HS, were all executed

by Mr. Oren as president of Dart and HL, or as an individual.

The terms of the promissory notes were not the equivalent of

terms which might appear in notes executed for the benefit of

unrelated third parties, especially in light of the size of the

loans. The loans were unsecured and were in the form of notes

due 375 days following demand. Further, petitioners, in their

various roles as the only directors, principal officers, and

majority or sole shareholders of the Dart companies, and Mr. Oren

as individual-obligee, controlled when and whether a demand for

repayment would be made.

The loan principal repayments and the payments of interest

also denote the inherent lack of substance in the loans. The

repayment of loans occurred only after respondent challenged the

13
Respondent suggests that petitioners’ restructuring of
investments, if upheld, permits taxpayers to create basis “out of
thin air” and “double count” basis in two S corporations and that
there would be no limit to the amount of basis that could be
created by the simple exchange of offsetting notes.
 - 23 -

loan transactions that occurred in 1993, 1994, and 1995.14 The

repayments did not follow the procedures specified in the

promissory note; i.e., payment 375 days after demand.15 The

repayments occurred all at once and via the same circular route

as the initial disbursements. Mr. Oren simply endorsed the

checks he received from HL and HS over to Dart. The interest

payments, like the disbursements and repayments, were wholly

circular. The interest payments from Mr. Oren to Dart, from HL

and HS to Mr. Oren, and from Dart to HL and HS, were in the same

amounts and were made contemporaneously. The interest payments,

like the disbursements and repayments, were economically

14
At trial, Mr. Oren testified as follows:

Q And what did your tax adviser recommend to you once
they found out the IRS was challenging these loans?

A Well, they recommended that Dart pay a dividend to me
and that I use that dividend to pay off the loans to
Highway Sales and Highway Leasing, and so at that point
all the loans were repaid.

15
Petitioners suggest that the repayment method adopted
should not affect the substance of the original distribution of
funds. However, as we see it, the substance of the loan
transactions should be determined on the basis of all facts and
circumstances, including the circumstances surrounding repayment.
Petitioners also argue that the repayment of the loans was “fully
consistent with sound commercial practice.” However, Mr. Oren’s
testimony at trial and the record show that the only reasons for
the repayments were to unwind the previous transactions and to
salvage whatever tax results might be forthcoming for taxable
year 1996.
 - 24 -

insignificant. The parties were in exactly the same position

before the interest payments as they were afterwards.

Petitioners point to our decision in Gilday v. Commissioner,

T.C. Memo. 1982-242, and emphasize that direct shareholder loans,

like the loans in this case, create basis. Petitioners argue

that the facts in that case are similar to those herein. In

Gilday, the taxpayers substituted their own personal note for the

note of an S corporation that had been executed in favor of a

third-party bank. This Court found that the taxpayers had become

primary obligors on the loan obligation to the bank and allowed

the taxpayers to increase their basis accordingly. Id.

However, “the involvement of an independent third party

lender” was essential to the result reached in Gilday v.

Commissioner, supra. Bergman v. United States, 174 F.3d at 933.

In this case, the “lender”, Dart, was a controlled entity. Mr.

Oren owned all the voting stock and a majority of the nonvoting

stock, and, further, Mr. and Mrs. Oren were the only directors of

Dart and acted as its president/treasurer and executive vice

president/secretary, respectively. Petitioners argue that a

third-party lender is not required where there is a direct loan

to an S corporation. We agree with the rationale in Bergman v.

United States, supra, and hold that a third-party lender is

generally required. With a third-party lender, “there is no

question that * * * [the] lender * * * intends to force
 - 25 -

repayment, truly placing the shareholder’s money at risk.” Id.

at 933. But, with a controlled entity, “it may be unclear

whether the shareholder or the corporation is placed at risk.”

Id. In such a case, the taxpayer must overcome a “a heavy

burden” and demonstrate that the loans were bona fide and had

“economic impact”. Id.

Petitioners attempt to overcome this heavy burden and cite

several factors which suggest that Mr. Oren would be required to

make repayment to Dart in all events. Petitioners claim that a

default on the part of Dart, HL, or HS on the various loan

obligations could have triggered a chain reaction that would have

forced Mr. Oren to pay Dart out of his own assets. We cannot

agree.

Dart was a financially stable and expanding company.

Petitioners presented no evidence that would lead us to believe

that Dart would have been unable to repay its loan obligations to

HL and HS. The same is true of HL and HS. Both companies were

financially viable and expanding. Further, given Mr. Oren’s

multicompany structure, HL’s and HS’s assets did not face the

same risks that were associated with the carrier companies, Dart

and Fleetline. We can conclude that a default on the notes by

any of the Dart companies was highly unlikely. In any event, it

is highly improbable that Dart would have made demand on Mr. Oren

to repay his loans from Dart. Any demand on Mr. Oren would
 - 26 -

surely have triggered a demand by Mr. Oren of HL and HS.

Assuming a demand by HL or HS of Dart, the entire series of

demands would simply offset, leaving the parties exactly where

they started. Any demands for repayment would have been futile,

because each party would have had equivalent rights of demand

against other parties in the circular chain of obligations.16

The loans in this case were nothing more than a tripartite,

interconnected arrangement that, as a practical matter, would not

have given rise to an obligation on the part of Mr. Oren to repay

from his personal resources.

Petitioners also argue that the Dart minority shareholders

had rights under Minnesota law allowing them to recover on the

loans made from Dart to Mr. Oren.17 Petitioners contend that the

minority shareholders would have forced Mr. Oren to repay the

loans, even if HL or HS were unable to repay their loans to Mr.

Oren. We disagree. A demand for repayment on the part of the

minority shareholders of Dart would surely have triggered a

demand on HL or HS for repayment which would in turn trigger

16
Compare this result to the facts in Gilday v.
Commissioner, T.C. Memo. 1982-242. After the substitution of
notes, the taxpayers, as primary obligors, would have to repay
the loans whether the S corporation was or was not able to supply
the taxpayers with equivalent amounts. In that case, the
taxpayers might truly have to repay with personal funds.
17
Petitioners cite to Minn. Stat. Ann. sec. 302A.467 (West
1985) and Minn. Stat. Ann. sec. 302A.751 (West Supp. 2001), which
discuss equitable relief and shareholder suits.
 - 27 -

Dart’s loan obligations to HL or HS. In the end, the parties

would have advanced no further nor taken any steps back from

where they had started. In any event, the minority shareholders

of Dart were petitioners’ children and trusts for the benefit of

those children. We cannot agree that the children or the

trustees would have made demand for repayment premature to Mr.

Oren’s own wishes, especially considering other circumstances

which demonstrate that Mr. Oren had exclusive control of all

matters within the Dart companies: Mr. Oren’s ownership of all

voting stock in the Dart companies, his orchestration of the loan

transactions in 1993, 1994, and 1995, his exclusive control over

repayment in 1996, his initiation of the First Bank credit

amendments in 1993, and the distributions that occurred in 1996

from Dart to its shareholders.

Petitioners also argue that the loan transactions had

economic substance because of “the need to finance HL and HS” and

strengthen the financial statements of the companies. However,

the loan transactions themselves did not result in an infusion of

finances into HL and HS given that the loan proceeds were

immediately returned to Dart. Further, petitioners have not

presented any credible evidence to substantiate the claim that

the balance sheets of the Dart companies were strengthened as a

result of the loans or that Mr. Oren adopted the form of the loan

transactions in order to accomplish such a result. Petitioners’
 - 28 -

assertion that the combined balance sheets were made stronger by

the loan transactions adopted, without more, is insufficient.

Indeed, at trial, Mr. Oren was unable to explain exactly how the

balance sheets were made stronger as a result of the loan

transactions. Further, the combined balance sheets of the Dart

companies do not reflect the various loan obligations as assets

of the corporations. In fact, the obligations simply offset one

another on the combined schedule of balance sheet information.

See supra notes 5 and 6. We cannot see how the combined balance

sheets were strengthened, or could even be perceived as

strengthened by Mr. Oren or any financial institution.

We agree with respondent that Mr. Oren was nothing more than

a “conduit through which Dart funneled money to HL and HS and

back to itself.”18 The financial statements compiled for Mr.

Oren and for the Dart companies are consistent with this finding.

Mr. Oren’s financial statements for 1993 and 1995 do not list the

loans from Dart to Mr. Oren or the loans from Mr. Oren to HL and

HS. The combined balance sheets of the Dart companies for 1993

and 1994 do not reflect the loan transactions. The combined

18
In such a case, shareholders cannot claim an increase in
basis for the entity investment, even if the entity is controlled
or wholly owned. Estate of Bean v. Commissioner, 268 F.3d 553,
556-557 (8th Cir. 2001), affg. T.C. Memo. 2000-355; Bergman v.
United States, 174 F.3d 928, 932 (8th Cir. 1999) (“No basis is
created for a shareholder, however, when funds are advanced to an
S corporation by a separate entity, even one closely related to
the shareholder.”).
 - 29 -

schedules of balance sheet information for those years do reflect

the loans; however, they show the loans as having been made from

Dart to HL and from HL to Dart. See supra note 5. Mr. Oren’s

involvement in the loans is not shown. The 1993 and 1994

financial statements of the Dart companies certainly support

respondent’s position that Mr. Oren was a mere conduit among

Dart, HL, and HS.19

We hold that Mr. Oren did not make an actual economic outlay

to HL and HS. Accordingly, the increase in Mr. Oren’s basis in

the S corporations, attributable to the loans, was limited to

$200,000, the amount lent from Mr. Oren’s personal assets.20

Issue 2

The second issue for decision is whether for purposes of

section 465 petitioners were at risk for the amounts lent to the

19
Only the 1995 financial statements note Mr. Oren’s
involvement in the various loans. On the 1995 combined balance
sheet, Mr. Oren’s $200,000 loan to HL and HS from his personal
resources is reflected; his role with respect to the loan amounts
that originated with Dart is not listed. The combined schedule
of balance sheet information for 1995 does note Mr. Oren’s
involvement with respect to those amounts: Dart is shown to hold
a “Notes payable-stockholder” of $15.3 million and HL and HS are
shown to owe “Notes payable-stockholder” of $13.5 million and $2
million. See supra note 6. Petitioners have not explained why
the methodology employed in the 1995 combined schedule differs
from that employed on the 1993 and 1994 combined schedules.
Certainly, the form of the loans in 1993, 1994, and 1995 was
identical. We are at a loss in identifying any nontax reasons
why the methodology for the 1995 schedule was so abruptly
changed.
20
In the notice of deficiency, respondent has recognized
this $200,000 increase in basis.
 - 30 -

S corporations. Respondent determined that the loans from Mr.

Oren to HL and HS were part of a loss-limiting arrangement under

section 465(b)(4), and, therefore, Mr. Oren was not at risk for

those amounts.21 Respondent argues that where loan transactions

are structured so as to remove “any realistic possibility” of

economic loss, taxpayers are not at risk for those amounts.

Petitioners contend that the existence of circular payments is

not per se a loss-limiting arrangement. They argue that the

notes from Mr. Oren to Dart were fully recourse, and Mr. Oren’s

obligation to repay the loans was absolute even if HL or HS

failed to repay.

Generally, a taxpayer is at risk in an activity to the

extent of money contributed or amounts borrowed for use in the

activity. Sec. 465(b)(1). A taxpayer is at risk with respect to

borrowed amounts if he or she is personally liable for repayment

of the loans or, otherwise, if he or she has pledged property as

security for loan repayment. Sec. 465(b)(2). However, a

taxpayer is not at risk, even for amounts received in a fully

recourse loan, if he or she is protected by a loss limiting

arrangement. Sec. 465(b)(4). Section 465(b)(4) provides:

“Exception.--Notwithstanding any other provision of this section,

21
HL and HS were both involved in the leasing of equipment;
HL leased trailers and HS leased tractors. Respondent argues,
and petitioners do not dispute, that equipment leasing is an
activity which is subject to the at risk provisions. See sec.
465(c)(1)(C).
 - 31 -

a taxpayer shall not be considered at risk with respect to

amounts protected against loss through nonrecourse financing,

guaranties, stop loss agreements, or other similar arrangements.”

(Emphasis added.) Respondent claims that Mr. Oren was protected

from loss on the loans by “other similar arrangements” within the

meaning of section 465(b)(4).

In the Eighth Circuit, to which this case is appealable, in

other circuits, and in prior opinions of this Court, the “any

realistic possibility of loss” standard has been adopted for

determining whether a taxpayer is at risk under section

465(b)(4). See Young v. Commissioner, 926 F.2d 1083, 1089 n.14

(11th Cir. 1991), affg. T.C. Memo. 1988-440; Moser v.

Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990), affg. T.C.

Memo. 1989-142; Am. Principals Leasing Corp. v. United States,

904 F.2d 477, 483 (9th Cir. 1990); Levien v. Commissioner, 103

T.C. 120, 126 (1994), affd. 77 F.3d 497 (11th Cir. 1996);

Thornock v. Commissioner, 94 T.C. 439, 453 (1990). Thus, where a

transaction is structured so as to remove any realistic

possibility of the taxpayer suffering a loss, the taxpayer is not

at risk for the borrowed amounts. Levien v. Commissioner, supra

at 126.

Petitioners argue that the any realistic possibility test is

applied only in sale-leaseback cases and should not be applied in

this case which does not involve a sale-leaseback. Petitioners
 - 32 -

argue that the sale-leaseback cases are distinguishable from the

circular payment scenario in this case, because: (1) The sale-

leaseback cases involved “identical and offsetting obligations of

the loan and rental payments” whereas no rental payments are

involved in this case; and (2) the sale-leaseback cases generally

involved depreciation deductions whereas, in this case, Mr. Oren

did not claim any such deductions. However, the facts in this

case are decidedly similar to those involved in the typical sale-

leaseback scenario. We cannot distinguish, for purposes of

section 465(b)(4), the circular arrangements found in Moser v.

Commissioner, supra; Am. Principals Leasing Corp. v. United

States, supra; Levien v. Commissioner, supra; etc., from the

circular arrangement found in this case. Accordingly, we find

that the any realistic possibility standard is applicable.

Petitioners argue that, in any event, there was a realistic

possibility that the circular chain of loan and interest payments

would be broken and that Mr. Oren would be forced to repay the

loans from Dart without collecting on the loans he made to HL and

HS. Respondent claims that petitioners are simply hypothesizing

about scenarios that might occur, none of which were likely to

occur given the peculiar set of facts in this case including the

circularity of payments, Mr. Oren’s unlimited control over the

companies, and the 375-day payment following demand provision in

the notes. Respondent also argues that hypothetical events that
 - 33 -

have not in fact occurred are not relevant for purposes of

section 465(b)(4).

Given the particular arrangement in this case, Mr. Oren was

insulated from actually repaying the Dart loans from his own

personal resources except if: (1) Mr. Oren should choose to

repay the Dart loans without enforcing the notes against HL and

HS; or (2) one of the Dart companies was to become insolvent or

bankrupt, and the chain of circular payments was to be broken.

Obviously, the former is not sufficient to place Mr. Oren at

risk. Thus, after considering all the facts and circumstances,

we must determine whether there was any realistic possibility

that the Dart companies would become insolvent or bankrupt and

the chain of circular payments would be broken.

Much of Mr. Oren’s testimony at trial was devoted to

explaining the potential risks that he was exposed to by

borrowing money from Dart and loaning money to HL and HS.

Specifically, Mr. Oren suggested that the truckload carriers were

exposed to considerable risks from potential tort claims that

might arise from automobile accidents.22 If Dart, HL or HS, were

22
At trial, Mr. Oren recounted an accident involving one of
Dart’s carriers. Dart was found liable and a jury verdict of $7
million was rendered in that case. Mr. Oren emphasized that the
verdict could have been substantially greater if it had involved
the death of more than one person. For example, Mr. Oren
recalled that the carrier narrowly missed a bus which was full of
passengers. If the carrier had hit the bus, Mr. Oren speculated
that a considerable verdict (in excess of $34 million) would not
(continued...)
 - 34 -

to be involved in such an accident, the circle of loan payments

might be broken, and Mr. Oren might be forced to repay Dart with

his own resources.

After examining all the facts and circumstances, we cannot

conclude that there was a realistic possibility that Mr. Oren

would be required to repay the Dart loan with his own personal

resources. There were significant cashflow and assets available

in Dart, HL, and HS from which to satisfy any potential claims of

up to $2 million without upsetting the circular offsets created

by the loan transactions. And, claims of up to $34 million would

be covered by a general insurance policy owned by the Dart

companies.23 With respect to claims in excess of $34 million;

i.e., claims that might break the circular arrangement with the

introduction of outside creditors, petitioners have produced no

evidence of the frequency of such claims except the self-serving

and speculative testimony of Mr. Oren. Indeed, at trial, Mr.

Oren could testify only to one accident, an accident in which a

verdict of $7 million was delivered. This figure in no way

approaches $34 million. We cannot agree that there was a

22
(...continued)
have been out of the question.
23
The Dart Companies owned an insurance policy which
provided general liability coverage. The policy provided that
the Dart Companies were self-insured for the first $2 million of
any claim but were covered for claims of up to $34 million. For
claims over $34 million, the Dart Companies were self-insured.
 - 35 -

realistic possibility of a greater than $34 million claim that

would have rendered one of the Dart companies insolvent and

caused the circularity of payments to be broken.

Petitioners also suggest that a small decline in the

equipment values of HL and HS, or an economic slowdown in the

trucking business may have resulted in the elimination of

shareholder equity. Petitioners claim that with shareholder

equity gone, HL and HS may have been unable to repay Mr. Oren.

We disagree. Even if all the assets of HL and HS were to become

worthless, those companies would still hold the notes executed by

Dart. To repay its loans to Mr. Oren, HL and HS could have

simply passed on the Dart notes to Mr. Oren. Mr. Oren could then

offset his own obligations to Dart by canceling the Dart notes.

Only in a case where HL and HS were to become insolvent or

bankrupt; i.e., where outside liabilities were to exceed the

value of existing assets in those companies, might the chain of

offsetting obligations be upset. As stated above, this was

highly unlikely.24

24
We also point out that Dart regained possession of the
funds it lent to Mr. Oren within days of the initial
disbursements. Following the return of the funds, Dart no longer
faced the risks normally associated with funds lent and retained
by third parties. The benefit of Dart’s “repossession” of the
loan proceeds not only accrued to Dart, but also to Mr. Oren
since it would be unlikely that Dart would pursue repayment of
the loan proceeds if it already possessed them.
 - 36 -

Furthermore, we do not believe it appropriate to engage in

the type of speculation petitioners would have us make. Indeed,

the legislative history of section 465(b)(4) indicates that

Congress intended to exclude financial difficulties from the at-

risk determination:

For purposes of * * * [section 465(b)(4)], it will
be assumed that a loss-protection guarantee, repurchase
agreement or insurance policy will be fully honored and
that the amounts due thereunder will be fully paid to
the taxpayer. The possibility that the party making
the guarantee to the taxpayer, or that a partnership
which agrees to repurchase a partner’s interest at an
agreed price, will fail to carry out the agreement
(because of factors such as insolvency or other
financial difficulty) is not to be material unless and
until the time when the taxpayer becomes
unconditionally entitled to payment and, at that time,
demonstrates that he cannot recover under the
agreement. [S. Rept. 94-938, at 50 n.6 (1976), 1976-3
C.B. (Vol. 3) 49, 88.]

In the Eighth Circuit, to which this case is appealable, and in

at least one other circuit,25 examination of “the worst-case

25
See, e.g., Am. Principals Leasing Corp. v. United States,
904 F.2d 477, 483 (9th Cir. 1990):

A theoretical possibility that the taxpayer will suffer
economic loss is insufficient to avoid the applicability
of this subsection. We must be guided by economic
reality. If at some future date the unexpected occurs and
the taxpayer does suffer a loss, or a realistic
possibility develops that the taxpayer will suffer a loss,
the taxpayer will at that time become at risk and be able
to take the deductions for previous years that were
suspended under this subsection. [Citations omitted.]

See also Thornock v. Commissioner, 94 T.C. 439, 454 (1990) (“the
potential bankruptcy of entities providing guarantees or loss
protection to investors is not a consideration in determining the
(continued...)
 - 37 -

scenario” is generally inappropriate for purposes of section

465(b)(4). Moser v. Commissioner, 914 F.2d at 1048.26 Examining

whether a greater than $34 million lawsuit was plausible would

require us to utilize such a “doomsday” approach. We decline

petitioners’ invitation to do so.

Accordingly, we hold that the loans that Mr. Oren made to HL

and HS did not increase petitioners’ basis in those companies for

purposes of section 1366(d)(1)(B). Petitioners’ ability to

deduct losses for taxable years 1993, 1994, and 1995 is therefore

limited to basis amounts determined under section 1366(d) that do

not include those loans. We also hold that petitioners were not

at risk for the amounts borrowed by Mr. Oren for use in HL and

HS. Therefore, petitioners’ loss deductions from those companies

are limited under section 465(a) to amounts for which petitioners

are otherwise at risk.

Decision will be

entered for respondent.

25
(...continued)
application of sec. 465(b)(4) unless and until the bankruptcy
actually occurs”).
26
But see Emershaw v. Commissioner, 949 F.2d 841, 845-848
(6th Cir. 1991), affg. T.C. Memo. 1990-246.