T.C. Memo. 2009-29
UNITED STATES TAX COURT
DONALD L. AND EVELYN RUSSELL, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent2
Docket Nos. 4425-05, 4456-05, Filed February 9, 2009.
4688-05.
Jon J. Jensen, for petitioners.
Jack Forsberg, for respondent.
SUPPLEMENTAL MEMORANDUM OPINION
HAINES, Judge: In Russell v. Commissioner, T.C. Memo. 2008-
246, the Court held that instruments entitled “notes”, “REMC
1
Cases of the following petitioners are consolidated
herewith: Loren R. and Dawn Kopseng, docket No. 4456-05; United
Energy Corp., docket No. 4688-05.
2
This opinion supplements our previous Memorandum Opinion in
Russell v. Commissioner, T.C. Memo. 2008-246, filed Oct. 30,
2008.
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ledger debt”, and “short-term debt” did not constitute
“indebtedness of the S corporation to the shareholder” for
purposes of determining whether petitioners Donald Russell (Mr.
Russell) and Loren Kopseng (Mr. Kopseng) had sufficient basis
under section 1366(d)(1)(B) to claim their distributive shares of
the loss incurred by Missouri River Royalty Corp (MRRC).3
However, the Court did not determine whether United Energy Corp.
(UEC) realized gain on the Russell ledger debt and the Kopseng
ledger debt, conceded by the parties as being indebtedness of the
S corporation to the shareholders pursuant to the deemed
satisfaction rules of section 1.1502-13(g)(4), Income Tax Regs.,
when that debt was contributed to UEC. This matter is now before
the Court on respondent’s motion for supplemental opinion.
Background
Although the findings of fact are set forth in Russell v.
Commissioner, T.C. Memo. 2008-246, for completeness and
convenience we will repeat the background here, omitting only the
passages related to the financial instruments of the UEC group
other than the Russell ledger debt and the Kopseng ledger debt.
At the time the Russells and the Kopsengs filed their petitions,
3
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
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they resided in North Dakota. At the time UEC filed its
petition, its principal place of business was in North Dakota.
On May 18, 2005, respondent sent petitioners notices of
deficiency for the years at issue. Petitioners filed timely
petitions with this Court.
I. Members of the UEC Group and Predecessor Entities
A. United Energy Corp.
UEC was incorporated under the law of North Dakota on August
29, 1997. At all times since its incorporation, UEC has used the
accrual method of accounting for tax and financial reporting
purposes and has had a fiscal year and taxable year ending June
30. At all times from the initial issuance of stock by UEC on
September 1, 1997, through June 30, 1998, all of UEC’s
outstanding stock was owned by Mr. Russell and Mr. Kopseng.
UEC timely filed a Form 1120, U.S. Corporation Income Tax
Return, for its initial short taxable year beginning September 1,
1997, and ending June 30, 1998. UEC filed its Form 1120 as the
common parent of a consolidated group of corporations consisting
of itself, Rainbow Gas Co. (RGC), Rainbow Energy Marketing Corp.
(REMC), MRRC, and Energy Leasing Corp. (ELC).
B. Rainbow Gas Co.
Before 1997 the assets of RGC were owned by a North Dakota
limited partnership (RGC Partnership). As of August 29, 1997,
all of the general and limited partnership interests in RGC
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Partnership were owned by Mr. Russell and Mr. Kopseng. On August
29, 1997, in a transaction qualifying as a tax-free exchange
under section 351(a), all the assets of RGC Partnership were
transferred to RGC, a newly formed North Dakota corporation, in
exchange for the issuance of 375 shares of RGC stock to Mr.
Russell and 625 shares of RGC stock to Mr. Kopseng. The RGC
shares issued to Mr. Russell and Mr. Kopseng constituted all of
the outstanding shares of RGC.
C. Rainbow Energy Marketing Corp.
REMC is a North Dakota corporation. As of September 1,
1997, REMC had 4,512,205 shares outstanding, of which 1,108,056
were owned by Mr. Russell and 2,701,149 were owned by Mr.
Kopseng.
D. Missouri River Royalty Corp.
MRRC is a North Dakota corporation which was incorporated on
September 7, 1984. At all times before September 1, 1997, MRRC
was an S corporation. Effective September 1, 1997, MRRC
voluntarily revoked its S corporation election. MRRC filed a
Form 1120S, U.S. Income Tax Return for an S Corporation, for the
short taxable year beginning January 1, 1997, and ending August
31, 1997. At all relevant times before September 1, 1997, MRRC
had 30,000 shares outstanding, of which Mr. Russell and Mr.
Kopseng each owned 15,000 shares.
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II. The Section 351 Transaction
On September 1, 1997, Mr. Russell received 350 shares of UEC
stock and Mr. Kopseng received 650 shares of UEC stock as part of
a transaction qualifying as a tax-free exchange under section
351(a). As part of the section 351 transaction, Mr. Russell made
a contribution to UEC of 375 shares of RGC stock, 1,108,056
shares of REMC stock, and 15,000 shares of MRRC stock. Mr.
Kopseng made a contribution to UEC of 625 shares of RGC stock,
2,701,149 shares of REMC stock, and 15,000 shares of MRRC stock.
UEC’s audited consolidated financial statement for the
period ending June 30, 1998, contained the following statement
respecting the section 351 transaction:
In August, 1997 United Energy Corporation (the
company) exchanged 1,000 shares of its common stock for
100% of the shares of Rainbow Gas Company and Missouri
River Royalty and 85% of the outstanding shares of
Rainbow Energy Marketing Corporation. This transaction
was accounted for under the requirements of
interpretation 39 of Accounting Standards Board Opinion
#16, whereby the acquisitions were treated as a
transfer of shares between companies with common
control in a manner similar to a pooling of interest.
Accordingly, all assets and liabilities of the merged
companies were recognized at historical cost and the
historical financial statements of Rainbow Gas Company,
Missouri River Royalty Corporation and Rainbow Energy
Marketing Corporation became a component of the
historical financial statements of the company.
The audited financial statement made no reference to any
assumption or contribution of liabilities being part of the
section 351 transaction.
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In their capacities as the incorporators and directors
of UEC, Mr. Russell and Mr. Kopseng executed a Consent to Action
Taken in Lieu of Organizational Meeting dated September 3, 1997
(consent). With respect to the section 351 transaction, the
consent stated as follows:
The directors were authorized to issue stock
pursuant to the attached Resolution in the amount of
650 shares to Loren R. Kopseng in return for his
contribution of shares from Rainbow Gas Company,
Missouri River Royalty Corporation, and Rainbow Energy
Marketing Corporation, and has [sic] been authorized to
issue 350 shares to Donald L. Russell in return for his
contribution of shares from Rainbow Gas Company,
Missouri River Royalty Corporation, and Rainbow Energy
Marketing Corporation.
The consent made no reference to any assumption or contribution
of liabilities being part of the section 351 transaction.
In their capacities as the directors and officers of UEC,
Mr. Russell and Mr. Kopseng executed a resolution dated September
3, 1997. The resolution stated:
Loren R. Kopseng has transferred 625 shares of
Rainbow Gas Company stock, 2,701,149 shares of Rainbow
Energy Marketing Corporation stock, and all shares of
Missouri River Royalty Corporation stock to United
Energy Corporation. In return for the transfer of
these shares, United Energy Corporation is hereby
authorized to issue 650 shares of United Energy
Corporation’s stock to Loren R. Kopseng.
Donald L. Russell has transferred 375 shares of
Rainbow Gas Company stock, 1,108,056 shares of Rainbow
Energy Marketing Corporation stock, and all shares of
Missouri River Royalty Corporation stock to United
Energy Corporation. In return for the transfer of
these shares, United Energy Corporation is hereby
authorized to issue 350 shares of United Energy
Corporation’s stock to Donald L. Russell.
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The resolution made no reference to any assumption or
contribution of liabilities being part of the section 351
transaction.
III. The Russell and the Kopseng Ledger Debts
MRRC required capital to purchase and rework oil wells.
MRRC acquired capital through a variety of transactions discussed
in Russell v. Commissioner, T.C. Memo. 2008-246. The only
instruments relevant to the current proceedings are the Russell
ledger debt and the Kopseng ledger debt.
Before April 5, 1996, Mr. Russell made a series of cash
advances to MRRC which MRRC used for working capital (the Russell
ledger debt). As of April 5, 1996, the principal balance of
these advances totaled $562,705. In MRRC’s books the Russell
ledger debt was recorded as a liability in a ledger account
entitled “Notes Payable Russell” (the notes payable Russell
account).
On April 5, 1996, MRRC issued a $562,705 note to Mr. Russell
for the Russell ledger debt (the Russell ledger debt note). As
of September 1, 1997, the principal balance of the Russell ledger
debt was $65,527.
Before April 5, 1996, Mr. Kopseng made a series of cash
advances to MRRC which MRRC used for working capital (the Kopseng
ledger debt). As of April 5, 1996, the principal balance of
these advances totaled $611,144. In MRRC’s books the Kopseng
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ledger debt was recorded as a liability in a ledger account
entitled “Notes Payable Kopseng” (the notes payable Kopseng
account).
On April 5, 1996, MRRC issued a $611,144 note to Mr. Kopseng
for the Kopseng ledger debt (the Kopseng ledger debt note). As
of September 1, 1997, the principal balance of the Kopseng ledger
debt was $117,438.
The Russell ledger debt and the Kopseng ledger debt were
demand obligations. Interest on the Russell ledger debt and the
Kopseng ledger debt was calculated using monthly compounding.
There was no requirement that interest accruing on the Russell
ledger debt and the Kopseng ledger debt be paid at least
annually.
As of September 1, 1997, the fair market value of the
Russell ledger debt was equal to the Russell ledger debt’s
principal balance of $65,527. Likewise, the fair market value of
the Kopseng ledger debt was equal to the Kopseng ledger debt’s
principal balance of $117,438.
Respondent concedes that the Russell ledger debt and the
Kopseng ledger debt constituted indebtedness of MRRC to Mr.
Russell and Mr. Kopseng for purposes of section 1366(d)(1)(B).
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IV. Mr. Russell’s and Mr. Kopseng’s Bases in Indebtedness and
MRRC Stock
As of the beginning of MRRC’s short taxable year ending
August 31, 1997, Mr. Russell’s basis in his MRRC stock was
$150,151, and Mr. Kopseng’s basis in his MRRC stock was zero.
The MRRC 1997 Form 1120S reported an ordinary loss of
$1,117,540, interest income of $250, and dividend income of $208.
Consistent with the MRRC 1997 Form 1120S, the following items
from MRRC’s taxable year ended August 31, 1997, were reported on
Mr. Russell’s 1997 return and on Mr. Kopseng’s 1997 return.
Item Amount
Ordinary loss $558,770
Interest income 125
Dividend income 104
As of the end of MRRC’s taxable year ended August 31, 1997:
(1) Mr. Russell’s basis in the Russell ledger debt was $65,527
less the amount by which his basis in the Russell ledger debt was
properly reduced under section 1367(b)(2) on account of items of
MRRC for its taxable year ending August 31, 1997, and (2) Mr.
Kopseng’s basis in the Kopseng ledger debt was $117,438 less the
amount by which his basis in the Kopseng ledger debt was properly
reduced under section 1367(b)(2) on account of items of MRRC for
its taxable year ending August 31, 1997.
Discussion
At issue is whether the Russell ledger debt and the Kopseng
ledger debt were contributed to UEC as part of the section 351
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transaction and whether section 1.1502-13(g)(3) or (4), Income
Tax Regs., applies to govern the transaction. Petitioners argue
that UEC realized no gain from the Russell ledger debt and the
Kopseng ledger debt by virtue of section 1.1502-13(g)(5), Example
(2), Proposed Income Tax Regs., 63 Fed. Reg. 70356 (Dec. 21,
1998). Respondent argues that the transaction is instead
governed by section 1.1502-13(g)(4), Income Tax Regs., which
would cause UEC to recognize gain upon the contribution of the
Russell ledger debt and the Kopseng ledger debt to the extent
that the value of each debt exceeds its basis. See sec. 1.1502-
13(g)(5), Example (4), Income Tax Regs. We agree with
respondent. We need not decide whether the burden of proof
shifts to respondent under section 7491(a) because we decide this
case on the basis of the preponderance of the evidence.
Mr. Russell and Mr. Kopseng were entitled to deduct
additional loss from MRRC after the section 351 transaction
because MRRC’s Russell ledger debt and Kopseng ledger debt each
constituted an “indebtedness of the S corporation to the
shareholder”. Sec. 1366(d)(1)(B). However, their respective
bases in the Russell ledger debt and the Kopseng ledger debt were
each reduced by an amount equal to the additional loss allowed.
Sec. 1367(b)(2)(A). As a result, UEC’s bases in the indebtedness
transferred to it by Mr. Russell and Mr. Kopseng under section
362(a) were less than the indebtedness’ principal balance,
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creating the potential for the recognition of built-in gain.4
The outcome depends on which provision of the consolidated return
regulations governs the transaction.
The consolidated return regulations provide special rules
that apply to intercompany obligations. For purposes of these
rules, an “intercompany obligation” is defined as “an obligation
between members, but only for the period during which both
parties are members.” Sec. 1.1502-13(g)(2)(ii), Income Tax Regs.
In cases where a nonintercompany obligation becomes an
intercompany obligation, such as through a section 351
transaction, there is a deemed satisfaction and reissuance of the
obligation immediately after the transaction. Sec. 1.1502-
13(g)(4), Income Tax Regs. If the obligation is debt, the debt
is treated as satisfied and a new debt issued to the holder with
a new holding period in an amount determined under the principles
of section 1.108-2(f), Income Tax Regs. Sec. 1.1502-13(g)(5),
Example (4), Income Tax Regs. Where, as here, the debt was not
acquired by purchase less than 6 months before the acquisition
date, the deemed satisfaction will result in the realization of
income by the holder to the extent that the fair market value of
the indebtedness on the acquisition date is greater than the
4
See the discussion of sec. 1.108-2(f)(2), Income Tax Regs.,
infra.
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transferred basis of the indebtedness. Sec. 1.108-2(f)(2),
Income Tax Regs.
By contrast, in certain cases where an intercompany
obligation remains an intercompany obligation or becomes a
nonintercompany obligation through a transaction, the obligation,
if it is debt, is treated as satisfied immediately before the
transaction. Sec. 1.1502-13(g)(3), Income Tax Regs.
The MRRC debts became intercompany obligations when they
were transferred to UEC along with MRRC stock in the section 351
transaction on September 1, 1997. See sec. 1.1502-13(g)(2)(ii),
Income Tax Regs. Before this transaction, the MRRC debts were
obligations between a nonmember (MRRC) and other nonmembers (Mr.
Russell and Mr. Kopseng). Thus, the transaction is governed by
section 1.1502-13(g)(4), Income Tax Regs. Accordingly, the
Russell ledger debt and the Kopseng ledger debt were contributed
by MRRC to UEC on September 1, 1997, and UEC realized gain on its
deemed satisfaction after the debts became an intercompany
obligation. UEC realized an amount on the deemed satisfaction of
the debt equal to the debts’ fair market value over its
transferred basis. Sec. 1.1502-13(g)(4)(ii)(B), Income Tax Regs.
In reaching our holdings herein, we have considered all
arguments made, and, to the extent not mentioned above, we
conclude they are moot, irrelevant, or without merit.
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To reflect the foregoing,
Decisions will be entered
under Rule 155.