T.C. Memo. 2003-54
UNITED STATES TAX COURT
DELTA PLASTICS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10246-00. Filed February 28, 2003.
Tony L. Wilcox and David M. Graf, for petitioner.
Kirk S. Chaberski, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge: For 1996, respondent determined a deficiency
in petitioner’s Federal income tax of $31,873.
- 2 -
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue.
The issue for decision is whether certain payments
petitioner made to its shareholders in 1996 should be treated as
deductible interest on shareholder loans or as nondeductible
dividends on shareholder equity.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
At the time the petition was filed, petitioner’s principal
place of business was located in Hot Springs, Arkansas.
Petitioner was incorporated in the State of Arkansas on
October 12, 1992, and petitioner began operations in August of
1993. Petitioner manufactures and sells plastic jars and lids
for use primarily in the cosmetic and pharmaceutical industries.
From 1981 to 1987, Lothar Schweigert, petitioner’s principal
shareholder, owned a controlling interest in and was an officer
and employee of Santa Fe Plastics (Santa Fe), a successful
company based in Santa Fe Springs, California, that manufactured
and sold plastic products similar to those manufactured and sold
by petitioner.
From 1981 to 1987, other of petitioner’s shareholders,
officers, and directors (namely Robert TeSelle, William D.
Maffit, Jan A. Strand, and Chris Rakhshan) also were employed in
various capacities at Santa Fe. TeSelle was chief financial
- 3 -
officer, Maffit was production manager, Strand was head of sales
and marketing, and Rakhshan was plant manager.
In October of 1987, Schweigert and TeSelle sold their
respective stock interests in Santa Fe to Kerr Glass
Manufacturing Corp. In connection with the stock sale, both
Schweigert and TeSelle entered into covenants not to compete with
Santa Fe. The covenants not to compete had a duration of 5 years
and apparently encompassed the entire United States.
During 1991 and 1992, Maffit and Strand used their
understanding and knowledge of the plastics manufacturing
business to put together a business plan for petitioner that
projected an early likelihood of success and purported to improve
upon the model used to start and develop Santa Fe. Prior to the
startup of petitioner’s operations in August of 1993, TeSelle,
Maffit, and Strand contacted and received commitments from former
customers of Santa Fe, signed contracts with suppliers and
equipment manufacturers, and otherwise prepared for petitioner to
begin operations. The record is unclear as to Schweigert’s
participation in planning for the startup of petitioner.
Prior to August of 1993, petitioner received as initial
capital a total of $183,500 in equity contributions from its
seven original shareholders. The amount of each shareholder’s
initial equity contribution and the number and percentage of
- 4 -
shares of stock in petitioner that each shareholder received is
set forth below:
Equity Shares of Percentage of
Shareholder Contribution Common Stock Common Stock
Lothar Schweigert $ 88,000 880,000 47.96
Robert TeSelle 26,000 260,000 14.17
Jan Strand 16,500 165,000 8.99
William Maffit 16,500 165,000 8.99
Chris Rakhshan 16,500 165,000 8.99
Paul Stevenson 10,000 100,000 5.45
Daniel Kliska 10,000 100,000 5.45
$183,500 1,835,000 100.00
Also, petitioner received a total of $2,322,838 in the form
of secured startup loans -- $2,169,013 from three unrelated
creditors and $153,825 from Schweigert. Each secured loan was
evidenced by a promissory note executed on behalf of petitioner.
In addition, petitioner received from a group of individuals
consisting of six of petitioner’s shareholders and one other
individual (collectively referred to hereinafter as the
“debenture holders”) funds totaling $1,337,500 (debenture funds).
Documents entitled debenture notes, executed on behalf of
petitioner in favor of the debenture holders, reflected the
debenture funds.
The amount and percentage of total debenture funds received
by petitioner from each debenture holder are set forth below:
- 5 -
Debenture Percent of
Debenture Holders Funds Total Debenture Funds
Lothar Schweigert $ 687,000 51.35
Robert TeSelle 149,000 11.14
Jan Strand 90,500 6.77
William Maffit 90,500 6.77
Chris Rakhshan 90,500 6.77
Paul Stevenson 115,000 8.60
Bernard Kliska* 115,000 8.60
$1,337,500 100.00
*
Bernard Kliska is the father of Daniel Kliska, a shareholder of
petitioner.
The written debenture notes, executed on August 1, 1993,
provided a 10-year schedule over which petitioner was to repay
the debenture holders the debenture funds and over which
petitioner was to pay the debenture holders amounts designated as
interest on the debenture funds, with the final payment due and
payable on June 15, 2003. For the first 5 years of the debenture
notes, designated interest only was due and payable at the end of
the second, third, fourth, and fifth years at a stated interest
rate of 6 percent per year.1 For the second 5 years of the
debenture notes, principal and designated interest payments were
due and payable in equal monthly installments with a stated
interest rate of 1 percent above the prime rate of interest as
reported by the Wall Street Journal.
Payments due on the debenture notes were not dependent upon
the profits or losses of petitioner. Priority of payment on the
1
The debenture notes executed in favor of Schweigert,
TeSelle, Stevenson, and Kliska provided for a partial repayment
of principal at the end of the fifth year.
- 6 -
debenture notes was equal among the debenture holders, and none
of the debenture holders received a management position or an
increase in management responsibilities with petitioner as a
result of the debenture funds petitioner received.
The debenture notes were unsecured and subordinated to
claims of petitioner’s secured creditors, and, if not paid, the
debenture holders could enforce payment on the debenture notes
only if the holders of more than 50 percent of the value of all
the outstanding debenture notes joined in a proceeding against
petitioner to enforce payment. From August of 1993 through the
time of trial in 2002, petitioner made all scheduled payments of
principal and designated interest due on the debenture notes.
When petitioner began operations in August of 1993, the
above initial sources of funding (treating the debenture funds as
debt of petitioner and not as equity) resulted in a debt-to-
equity ratio for petitioner of approximately 26:1. In just over
3 years, petitioner’s debt-to-equity ratio (treating the
debenture funds as debt of petitioner and not as equity) was
reduced to approximately 4:1. The rapid decrease in petitioner’s
debt-to-equity ratio from 1993 to 1996 reflected petitioner’s
success in generating operating revenue.
Comparative 1993-1996 yearend financial information for
petitioner (treating the debenture funds as debt of petitioner
and not as equity) is set forth below:
- 7 -
Yearend Financial Information
1993 1994 1995 1996
Gross Revenue $ 359,714 $5,246,515 $ 8,840,065 $13,580,098
Total Assets 4,287,799 7,391,115 12,001,652 14,611,042
Total Liabilities 4,119,859 6,638,531 10,443,799 11,392,737
Shareholder Equity 167,940 752,584 1,557,853 3,218,305
Debt-to-Equity Ratio 25:1 9:1 7:1 4:1
As of the time of trial in 2002, petitioner had yet to
declare or pay a cash dividend.
At the end of 1993, petitioner’s basis in its capital assets
including land, buildings, equipment, vehicles, tooling and
equipment was $3,598,463.
For 1993-1996 and for Federal income tax purposes,
petitioner was a cash basis taxpayer. On petitioner’s timely
filed 1996 corporate Federal income tax return, an interest
deduction of $93,746 was reflected for the payments designated as
interest that petitioner made in 1996 on the debenture notes.
On audit, respondent determined that for Federal income tax
purposes the total debenture funds of $1,337,500 represented
equity to petitioner rather than debt, and respondent denied
petitioner’s claimed $93,746 interest deduction relating to the
designated interest paid in 1996 on the debenture funds.
OPINION
As a general rule, section 163(a) provides that a deduction
shall be allowed for all interest paid on indebtedness.
- 8 -
Whether funds received by a corporation represent debt or
equity is a question of fact generally to be considered and
analyzed by reference to all of the evidence.2 Dixie Dairies
Corp. v. Commissioner, 74 T.C. 476, 493 (1980).
Courts have identified and considered various factors in
deciding questions of debt versus equity. See, e.g., In re
Uneco, Inc., 532 F.2d 1204, 1208 (8th Cir. 1976) (10 factors);
Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir.
1972) (13 factors); Am. Offshore, Inc. v. Commissioner, 97 T.C.
579, 602-606 (1991) (13 factors). The various factors are not
equally significant, however, and no one factor is determinative.
John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946).
Due to differing factual circumstances under which debt-
equity questions arise, not all of the factors are necessarily
relevant to each case. Dixie Dairies Corp. v. Commissioner,
supra at 493-494. The overall analysis of the Court seeks to
determine whether there was an intent to create a debt with a
reasonable expectation of repayment and, if so, whether that
intent comports with the economic reality of creating a debtor-
2
Whether a shift in the burden of proof is applicable in
this case is unclear. The parties do not raise the issue, and
the record does not indicate when respondent’s examination of
petitioner’s 1996 corporate Federal income tax return began. See
sec. 7491; Internal Revenue Service Restructuring and Reform Act
of 1998, Pub. L. 105-206, sec. 3001(a), 112 Stat. 726 (providing
that July 22, 1998, is the effective date of sec. 7491). In any
event, resolution of this case does not hinge on placement of the
burden of proof.
- 9 -
creditor relationship. Litton Bus. Sys., Inc. v. Commissioner,
61 T.C. 367, 377 (1973).
Of the 10 factors recognized and considered in In re Uneco,
supra, by the Court of Appeals for the Eighth Circuit (the Court
to which an appeal of this case lies), we discuss and apply below
those factors that are relevant to the facts of this case.3
Thin or Adequate Capitalization
No specific ratio of debt to equity is determinative as to
whether a corporation is adequately capitalized. 2554-58 Creston
Corp. v. Commissioner, 40 T.C. 932, 937 n.3 (1963).
In spite of petitioner’s initial debt-to-equity ratio of
26:1, prior to startup of petitioner, petitioner’s officers and
directors understood petitioner’s business and the plastics
manufacturing industry and reasonably projected that petitioner
would be successful. As a result of revenues quickly generated
by its operations, petitioner’s debt-to-equity ratio was reduced
in just over 3 years to 4:1. This reduction indicates to us, in
this case, that petitioner was adequately capitalized from its
inception.
3
We omit a discussion of whether a sinking fund was
established to retire the debenture notes. This factor was not
addressed by either party. Our discussion of the risk factor
involves a number of the In re Uneco, Inc., 532 F.2d 1204 (8th
Cir. 1976), factors.
- 10 -
Extent to Which Funds Were Used To Acquire Capital Assets
The record is unclear as to exactly for what purpose the
debenture funds received by petitioner were used. A substantial
portion of the debenture funds appears to have been used to
acquire capital assets.
Proportionality of Interest
Funds received from shareholders in proportion to their
respective stock ownership interests may indicate equity
investments. Am. Offshore, Inc. v. Commissioner, supra at 604
(citing Estate of Mixon v. United States, supra at 409).
Each of petitioner’s debenture holders was either a
shareholder of petitioner or was related to a shareholder of
petitioner. The debenture funds were transferred to petitioner
by the debenture holders, not in exact proportion, but in
comparable proportion to the respective stock interests of the
debenture holders.
Risk
Petitioner’s obligation to repay the debenture funds was
unconditional. Payments of principal and designated interest on
the debenture notes were not dependent upon profits of
petitioner, nor were payments excused or forgiven in the event
petitioner sustained losses. Respondent argues that because the
debenture notes were unsecured and subordinated to the secured
- 11 -
debts of petitioner, payments on the debenture notes depended
solely on future earnings of petitioner which put the debenture
funds at an equal amount of risk as petitioner’s equity.
Reliance, however, upon future earnings for payment of a
purported debt generally does not cause the funds received by a
corporation to be treated as equity. See J.S. Biritz Constr. Co.
v. Commissioner, 387 F.2d 451, 458-459 (8th Cir. 1967), revg.
T.C. Memo. 1966-227.
Third-Party Loans
Funds are more likely to be treated as debt if at the time
the funds were received the corporation had credit available from
outside sources. Am. Offshore, Inc. v. Commissioner, supra at
605 (citing Estate of Mixon v. United States, supra at 410).
The evidence indicates that petitioner was successful in
obtaining secured loans from outside creditors, and at no time
was petitioner refused a loan from a third party.
Management Participation
Funds received by a corporation will be more likely treated
as equity if, as a result of such receipt, the person
transferring the funds had a right to participate in the
management of the corporation. Am. Offshore, Inc. v.
Commissioner, supra at 603.
- 12 -
The credible evidence indicates that none of the debenture
holders was granted a management position or an increase in
voting rights as a result of the receipt of the debenture funds
by petitioner.
Payments
A significant debt-equity factor is whether a corporation
repays its obligations on time. See Fries v. Commissioner, T.C.
Memo. 1997-93 (citing In re Lane, 742 F.2d 1311, 1317 (11th Cir.
1984)).
Petitioner has timely made all scheduled payments of
principal and designated interest due on the debenture notes.
Intent of the Parties
In resolving debt-equity questions, both objective and
subjective evidence of a taxpayer’s intent are considered and
given weight in light of the particular circumstances of a case.
See In re Uneco, Inc., 532 F.2d 1204, 1209 (8th Cir. 1976).
With regard to the debenture funds, credible trial testimony
was offered that a debtor-creditor relationship was intended
between petitioner and the debenture holders with regard to the
debenture funds. The debenture notes were executed in favor of
each of the debenture holders. The debenture holders expected
repayment of the debenture funds. The fixed dates for the
- 13 -
payment of principal and designated interest set forth by the
debenture notes were honored by petitioner.
The debenture holders’ expectation of repayment at the time
the debenture notes were executed was reasonable because the
debenture holders had an understanding and knowledge of
petitioner’s business and a reasonable expectation of its likely
success. For 1993 through the time of trial in 2002, petitioner
timely made the principal and designated interest payments due on
the debenture notes, and a majority of the objective factors
indicate that a debtor-creditor relationship existed between
petitioner and the debenture holders with regard to the debenture
funds.
We conclude that petitioner properly treated the $1,337,500
in debenture funds as debt. For 1996, petitioner is entitled to
an interest deduction for the $93,746 it paid as interest on the
debenture notes.
To reflect the foregoing,
Decision will be entered
for petitioner.