T.C. Memo. 2005-32
UNITED STATES TAX COURT
INDMAR PRODUCTS CO., INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15428-03. Filed February 23, 2005.
Matthew P. Cavitch and Gerald P. Arnoult, for petitioner.
Kirk S. Chaberski, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: By notice dated July 3, 2003, respondent
determined deficiencies in, and penalties related to,
petitioner’s 1998, 1999, and 2000 Federal income taxes. After
concessions by respondent, the remaining issues for decision are
whether: (1) The cash transfers to petitioner were loans or
capital investments; and (2) petitioner is liable for section
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66621 penalties.
FINDINGS OF FACT
Indmar Products Company Inc. (petitioner), incorporated in
1971, is a marine engine manufacturer. In 1973, petitioner was
owned equally by Richard Rowe, Sr. (Mr. Rowe), and Marty Hoffman.
In 1978, Mr. Rowe became the majority stockholder owning 51
percent of petitioner’s stock. After Mr. Hoffman died in 1985,
Mr. Rowe and Donna Rowe (the Rowes) became the major stockholders
each owning 37.22 percent of petitioner’s stock. Other
stockholders included Richard Rowe, Jr., and Diane Rowe (i.e.,
the Rowes’ son and daughter-in-law) and Kathy and Joseph Tidwell
(i.e., the Rowes’ daughter and son-in-law).
From 1986 to 2000, petitioner’s business grew significantly.
Sales and costs-of-goods sold increased from $5 million and $3.9
million to $45 million and $37.7 million, respectively. In
addition, petitioner’s working capital (i.e., current assets
minus current liabilities) increased from $471,386 to $3.8
million. Petitioner did not declare or pay formal dividends.
In 1987, the Rowes began transferring cash (transfers) to
petitioner with the intent to take the money out as they needed
it. After receiving advice from numerous estate planners, the
1
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.
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Rowes wanted to characterize the transfers as loans because the
Rowes believed that additional equity in petitioner would
increase their estate tax burden and reduce the amount of
property received by their heirs. The transfers were unsecured,
undocumented, and petitioner agreed to pay a 10-percent return on
all transfers from 1987 through 2000. During this 14-year
period, the prime rate fluctuated between 6 and 9.5 percent for
almost 12 years. Petitioner made monthly payments to the Rowes
calculated at 10 percent of the transferred funds (i.e.,
reflected in the “notes payable - stockholders” account balance).
The monthly payments represented an investment return and were
not repayments of the transfers. Petitioner’s partial
repayments, however, were sporadic, paid on demand, based on the
Rowes’ financial needs, and not subject to set or predetermined
due dates. From 1987 to 2000, the Rowes’ transfers were not
repaid in full.
Tennessee residents, pursuant to Tenn. Code Ann. sec. 67-2-
101 (2000), are taxed on the receipt of dividends and interest.
Promissory notes that mature in 6 months or less are, pursuant to
Tenn. Code Ann. sec. 67-2-101(1)(B)(i), exempt. To avoid the tax
on interest and dividends, petitioner and the Rowes took the
position that the transfers were demand notes. Petitioner,
however, reported the transfers as long-term liabilities, on its
financial statements, to avoid violating loan agreements with
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First Tennessee Bank (FTB) (i.e., petitioner’s main creditor)
requiring petitioner to maintain a certain ratio of current
assets to current liabilities.
In 1989, petitioner’s accountant, Wesley Holmes, decided
that petitioner needed documentation to support the reporting of
the transfers as long-term liabilities. Mr. Holmes determined
that the transfers could be reported as long-term liabilities if
the Rowes signed a waiver agreeing to forgo repayment for at
least 12 months. From 1989 through 2000, the notes to
petitioner’s financial statements disclosed that “The
stockholders have agreed not to demand payment within the next
year”, and in 1992 and 1993, the Rowes signed written agreements
stating that they would not demand repayment of the transfers
(waivers). Despite these disclosures and agreements, the Rowes
demanded and received seven partial repayments totaling
$1,105,169.
Petitioner recorded in its books and records, all transfers
as “notes payable - stockholders” and reported, on its Federal
income tax returns, the monthly payments to stockholders as an
interest expense deduction. Consistent with petitioner’s
treatment of the monthly payments, the Rowes reported (i.e., on
their individual income tax returns), these payments as interest
income. Outstanding “notes payable - stockholders” delineated in
petitioner’s 1986 financial statements totaled $209,500 and
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reached a high of $1,779,169 in 1991. In 1993, Richard Rowe,
Jr., and Joseph Tidwell made a transfer of $25,000 and $18,000,
respectively, but also demanded repayment of $110,000 and
$26,000, respectively, for education expenses. In 1998, Donna
Rowe demanded repayment of $180,000 for boat repairs. Mr. Rowe,
in 1994 and 1995, demanded repayment of $15,000 and $650,000,
respectively, to pay his taxes and purchase a home. Mr. Rowe
also demanded repayment of $84,948, $80,000, $25,000, and $70,221
in 1997, 1998, 1999, and 2000, respectively, to pay litigation,
boat repair, and tax expenses. The Rowes, in 1997 and 1998, made
additional transfers to petitioner of $500,000 and $300,000,
respectively. The balance of “notes payable - stockholders” on
December 31, 2000, totaled $1,166,912.2
In 1993, Mr. Holmes determined that a promissory note should
be executed for a portion of the previously undocumented
transfers from the Rowes. Petitioner, on December 31, 1993,
executed a promissory note (1993 note) with Donna Rowe for
$201,400 (i.e., her outstanding balance) of the $1.5 million
total outstanding balance of the transfers. The 1993 note was
payable on demand, was freely transferable, had no maturity date
or payment schedule, and had a stated interest rate of 10
2
This amount also reflects a net decrease of $214,088 that
was reported in 1992. The record, however, is not clear as to
how many transfers and/or repayments were made during that year
or which stockholders were involved in the 1992 transactions.
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percent. On November 21, 1995, petitioner executed a promissory
note (1995 note) with Mr. Rowe for $605,681 (i.e., his
outstanding balance) of the $807,081 total outstanding balance of
the transfers. The 1995 note was payable on demand, was freely
transferable, had no maturity date or payment schedule, and had a
stated interest rate of 10 percent.
On January 1, 1998, when the outstanding transfers totaled
$1,222,133, petitioner executed two written line of credit
agreements with the Rowes for $1,000,000 and $750,000. The line
of credit agreements provided that the balances were payable on
demand, and the notes were freely transferable. In addition, the
agreements provided a stated interest rate of 10 percent and had
no maturity date or payment schedule.
Petitioner was profitable, and numerous banks sought to lend
petitioner money. As a result, FTB worked diligently to retain
petitioner’s business, made funds immediately available upon
petitioner’s request, and was willing to lend petitioner 100
percent of the transferred amounts. FTB, however, required
petitioner to subordinate (i.e., to FTB’s outstanding loans with
petitioner) all transfers.
In 1993, FTB lent petitioner $1,850,000. The loan agreement
stated “no payments shall be made by Borrower to satisfy any
* * * [stockholder] indebtedness for so long as the Loans shall
remain unpaid.” Petitioner, however, made partial repayments to
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stockholders while FTB loans remained outstanding. On November
21, 1995, when the prime rate was 8.5 percent, petitioner
borrowed $650,000 from FTB, at 7.5 percent, to pay Mr. Rowe. In
1997, petitioner and FTB executed a promissory note for
$1,000,000 that was modified in 1998. The interest rate on the
note was below the prime rate. At the time the petition was
filed, petitioner’s principal place of business was located in
Millington, Tennessee.
OPINION
Respondent contends that petitioner’s interest expense
deductions relating to payments made to the Rowes should be
disallowed because the transfers were capital investments and not
loans. Petitioner contends that the transfers were loans.
Taxpayers are entitled to a deduction for payments made on
bona fide indebtedness that relates to an existing,
unconditional, and legal obligation to repay. Sec. 163(a);
Burrill v. Commissioner, 93 T.C. 643 (1989). Petitioner bears
the burden of proving that the transfers are debt and not
equity.3 Rule 142(a); Smith v. Commissioner, 370 F.2d 178, 180
(6th Cir. 1966), affg. T.C. Memo. 1964-278.
Transfers between related parties are examined with special
scrutiny when taxpayers contend that such transfers are loans.
3
Sec. 7491(a) is inapplicable because petitioner does not
meet the net worth requirements of sec. 7430(c)(4)(A)(ii), which
are cross-referenced in sec. 7491(a)(2)(C).
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Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 630 (6th Cir.
1986), affg. T.C. Memo. 1985-58. In determining the economic
reality of a related party transfer, “‘the ultimate issue is
* * * whether the transaction would have taken the same form had
it been between the corporation and an outside lender’”. Fed.
Express Corp. v. United States, 645 F. Supp. 1281, 1290 (W.D.
Tenn. 1986) (quoting Scriptomatic, Inc. v. United States, 555
F.2d 364 (3d Cir. 1977)). The more a transfer appears to result
from an arm’s-length transaction, the more likely the transfer
will be considered debt. Bayer Corp. v. Mascotech, Inc., 269
F.3d 726, 750 (6th Cir. 2001).
In distinguishing between debt and equity, courts also
analyze whether the contemporaneous facts establish an
unconditional obligation to repay. Roth Steel Tube Co. v.
Commissioner, supra at 630; Smith v. Commissioner, supra at 180;
see Burrill v. Commissioner, supra at 669. In Roth Steel, the
Court of Appeals for the Sixth Circuit used an 11-factor test to
determine whether the transfer was debt or equity.4 No factor is
4
The 11 factors are: (1) Identity of interest between
creditor and stockholder, (2) adequacy or inadequacy of
capitalization, (3) source of payments, (4) name given
instruments evidencing indebtedness, (5) presence or absence of
fixed maturity date and schedule of payments, (6) presence or
absence of a fixed rate of interest and interest payments, (7)
presence or absence of security, (8) inability to obtain outside
financing, (9) subordination of transfers, (10) presence or
absence of a sinking fund, and (11) extent to which the transfers
were used to acquire capital assets. Roth Steel Tube Co. v.
(continued...)
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controlling or decisive by itself and the particular
circumstances of each case must be considered by the court. Roth
Steel Tube Co. v. Commissioner, supra at 630. “These factors are
merely tools to be used in evaluating whether the transaction as
a whole was effected with a genuine intention to create a debt,
with a reasonable expectation of repayment, and within the
economic realities of a debtor-creditor relationship.” Recklitis
v. Commissioner, 91 T.C. 874, 905 (1988).
I. The Rowes’ Objectives for Characterizing the Cash Transfers
as Debt
The Rowes’ characterized the cash transfers as debt because
they wanted to receive a 10-percent return on their investment
and minimize estate taxes. Mr. Rowe testified that they received
advice from numerous estate planners and decided to characterize
the transfers as loans because “we felt additional equity would
only hurt the family at our death.” For nearly 12 of the 14
years, from 1987 to 2000, the 10-percent rate charged by the
Rowes was above the market and prime interest rates. For
example, in 1998 when the prime rate was 8.5 percent, petitioner
executed loan agreements with the Rowes and FTB at fixed rates of
10 and 7.5 percent, respectively. Mr. Rowe testified,
unconvincingly, that the higher rate charged by the Rowes
4
(...continued)
Commissioner, 800 F.2d 625, 630-632 (6th Cir. 1986), affg. T.C.
Memo. 1985-58.
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balanced out over time because the prime rate fluctuated above
and below 10 percent. The prime rate, however, exceeded 10
percent only from November 28, 1988, to January 8, 1990. Indeed,
the prevailing interest rate was irrelevant. The Rowes simply
wanted to receive a 10-percent return.
II. Petitioner and the Rowes Manipulated Facts and Violated
Legal Agreements
To avoid being subject to the Tennessee tax on interest and
dividends, petitioner and the Rowes took the position that the
transfers were demand notes. Petitioner, however, reported the
transfers as long-term liabilities on its financial statements.
Mr. Holmes readily admitted that the transfers were reported
incorrectly. In addition, petitioner and Mr. Holmes knowingly
mischaracterized the transfers as long-term liabilities to comply
with FTB’s loan agreements.
To justify the reporting of the transfers as long-term
liabilities, petitioner and the Rowes executed annual waivers.
Mr. Rowe, however, testified that he did not consider the waivers
to be legally binding and that the waivers would not prevent
petitioner from repaying him on demand. While the waivers were
disclosed in the financial statements from 1989 to 2000,
petitioner paid the Rowes on demand.
Mr. Rowe also testified that the informal undocumented
agreements with petitioner were consistent with a history of
“handshake deals” he had with petitioner and other business
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associates. His testimony, however, was contradictory,
inconsistent, and unconvincing. For example, Mr. Rowe testified
that either “a handshake” or “a signature” was sufficient to bind
him to an agreement. Yet, he readily failed to honor his
“agreements” not to demand repayment. In addition, despite the
FTB loan restrictions on repayments to stockholders, when the
Rowes needed cash for personal needs, petitioner paid them on
demand. In essence, the Rowes simply wanted to receive a 10-
percent return on, and ready access to, the transferred funds.
As a result, petitioner, along with the Rowes, manipulated facts
to attempt to make the transfers appear as debt and avoid certain
legal consequences.
III. The Transactions Were Not Arm’s Length
The transfers between petitioner and the Rowes were not
arm’s-length transactions. First, because the Rowes wanted a 10-
percent return, the interest rate paid by petitioner was above
the market and prime rates for almost 12 years. Second, the
Rowes began transferring funds to petitioner in 1987 but did not
begin reducing the “handshake deals” to a writing until December
31, 1993, and the outstanding balance was not fully documented
until November 21, 1995. In 1997, the Rowes made additional
transfers, but they were not evidenced by a writing until 1998.
Third, petitioner and the Rowes executed waivers that were
violated, and, at their convenience, considered nonbinding.
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Thus, the transactions between petitioner and the Rowes did not
take the same form as transactions between unrelated parties.
IV. The Roth Steel Test
In addition to the transfers not being arm’s-length
transactions, the 11-factor test set forth in Roth Steel Tube Co.
v. Commissioner, 800 F.2d 625 (6th Cir. 1986), establishes that
the transfers were equity. First, petitioner did not pay any
formal dividends. Jaques v. Commissioner, 935 F.2d 104, 106 (6th
Cir. 1991), affg. T.C. Memo. 1989-673. Second, pursuant to 12
consecutive years of waivers, there was no fixed maturity date or
fixed obligation to repay. Roth Steel Tube Co. v. Commissioner,
supra at 631; Jaques v. Commissioner, supra at 108 (stating that
a taxpayer’s failing to repay debt within a reasonable time and
making “sporadic” principal payments are factors that weigh in
favor of equity). Third, Mr. Rowe testified that petitioner was
expected to make a profit and that repayment “has to come from
corporate profits or else the company couldn’t pay for it.” Roth
Steel Tube Co. v. Commissioner, supra at 631 (stating “An
expectation of repayment solely from corporate earnings is not
indicative of bona fide debt regardless of its reasonableness.”
(citing Lane v. United States, 742 F.2d 1311, 1314 (11th Cir.
1984))). Fourth, the transfers were unsecured. Roth Steel Tube
Co. v. Commissioner, supra at 631. Finally, petitioner never
established a sinking fund. Id. at 632. These factors certainly
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outweigh the factors in favor of characterizing the transfers as
debt (e.g., petitioner reported the payments on its Federal
income tax returns as interest expense, external financing was
available, petitioner was adequately capitalized, the transfers
were not subordinated to all creditors, and the Rowes did not
make the transfers in proportion to their respective equity
holdings). Moreover, petitioner failed to establish that, at the
time the transfers were made, it had the requisite unconditional
and legal obligation to repay the Rowes (e.g., the transfers were
not documented). Thus, we conclude that the Rowes’ transfers
were equity. Accordingly, petitioner is not entitled to an
interest expense deduction relating to the years in issue.
Respondent also determined that petitioner is liable for a
section 6662(a) accuracy-related penalty. The penalty applies to
the portion of petitioner's underpayment that is attributable to
a substantial understatement of income tax. Sec. 6662(b)(2).
Respondent established that petitioner understated its income tax
liability, and thus, respondent has met his burden of production,
pursuant to section 7491(c). Petitioner, however, failed to
address this issue on brief and did not present any credible
evidence to establish that it acted in good faith or that there
was reasonable cause for claiming the interest expense
deductions. Accordingly, the accuracy-related penalty is
applicable to the underpayment attributable to the stockholder
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payments.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decision will be entered
under Rule 155.