Decisions will be entered under Rule 50.
1. Lessor and its sole shareholder entered into an agreement with lessee whereby the assets of the lessor and assets owned by the shareholder individually were to be leased to lessee for a 10-year period. As part of the same agreement, the lessee agreed to extend a loan to the shareholder of lessor in the amount of the aggregate rental payments due under said leases. Loan repayments coincided exactly in amount and time of payment with the rental payments due under the leases. Held, under the circumstances of this case the purported loan constituted the payment of advance rentals to the lessor and the payment of a dividend to the shareholder in the taxable year of the purported loan.
2. Held, further, the lessor is entitled to a deduction under sec. 166(g), I.R.C. 1954, for additions to a bad debt reserve upon the sale of its accounts receivable with recourse to the lessee.
3. Held, further, petitioner conducted a lumber business as a partnership rather than as a corporation. Net operating losses sustained in the operation of such business are therefore deductible by petitioner.
54 T.C. 584">*585 Respondent determined the following deficiencies and additions to tax with respect to petitioners' income taxes:
| Additions to tax | ||||
| Docket No. | Year | Deficiency | ||
| Sec. 6651(a), | Sec. 6653(a), | |||
| I.R.C. 1954 | I.R.C. 1954 | |||
| 5227-66 | 1963 | $ 42,330.33 | ||
| 5228-66 | 1962 | 1,266.41 | $ 316.60 | $ 63.32 |
| 1963 | 49,347.89 | 12,336.97 | 2,467.39 |
The issues remaining for decision are:
(1) Whether a purported loan of $ 100,000 to the individual petitioner in fact constituted the payment of advance rentals taxable to the corporate and individual petitioners herein and, if so, whether receipt by petitioner of amounts attributable to the corporate petitioner resulted in a taxable dividend;
(2) Whether the addition of $ 9,500 to a bad debt reserve by the corporate petitioner upon the sale of its accounts receivable on a guaranteed basis entitles petitioner to a bad debt deduction in that amount;
(3) Whether the individual petitioner herein is entitled to a deduction for his distributive share of net operating losses sustained in the operation of a lumber mill business;
(4) Whether said petitioner is entitled to a depreciation deduction attributable to assets owned by petitioner individually and used in the said business; 1970 U.S. Tax Ct. LEXIS 185">*187 and
(5) Whether the individual petitioner is liable for additions to tax under sections 6651(a) and 6653(a) of the Internal Revenue Code of 1954.
54 T.C. 584">*586 FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.
Blue Flame Gas Co. (hereinafter referred to as Blue Flame), the corporate petitioner herein, was incorporated under the laws of the State of Washington on December 22, 1961. At the time of the filing of the petition in this case, Blue Flame's principal place of business was located in Hoquiam, Wash. Blue Flame filed Federal income tax returns on an accrual basis for the calendar year 1963 on August 28, 1964, with the district director of internal revenue, Tacoma, Wash.
Joe and Lily Zedrick were husband and wife at the time their petition in this case was filed. They were divorced in January 1967, and thereafter, on November 30, 1967, Lily Zedrick died. Joe and Lily Zedrick filed joint Federal income tax returns on the cash basis for the years 1962 and 1963 with the district director of internal revenue, Tacoma, Wash. Joe Zedrick will hereinafter sometimes be referred to 1970 U.S. Tax Ct. LEXIS 185">*188 as petitioner.
Prior to December 1, 1963, Blue Flame was engaged in the business of distributing liquefied petroleum gas in Aberdeen, Wash., and surrounding areas. In connection with the operation of this business, Blue Flame owned and maintained certain assets, such as bulk storage tanks, customer service tanks, meters, and regulators. In addition, petitioner owned similar assets in his individual capacity, which assets were also located in the vicinity of Aberdeen, Wash.
In the conduct of its business, Blue Flame maintained a relationship with Petrolane-Blue Flame Gas Co. and Petrolane Northwest Supply Co., both of which were fully owned subsidiaries of Petrolane Gas Service, Inc. Petrolane Gas Service, Inc., and its two subsidiaries will hereinafter be referred to collectively as Petrolane. Petrolane considered Blue Flame and petitioner important customers and valued its business association with them. As a result, in order to assist petitioner in maintaining and expanding his business operations, Petrolane occasionally extended loans to him, or to Blue Flame Gas Co., a partnership of which petitioner was a principal partner and which was the predecessor of Blue Flame, as set 1970 U.S. Tax Ct. LEXIS 185">*189 forth in the following schedule: 54 T.C. 584">*587
| Payable to -- | Original amount | |
| 1. Blue Flame Gas Co., Joe | Petrolane Northwest | $ 10,899.24 |
| Zedrick, partner, Leo J. | Supply Co. | |
| Kosinski, partner. | ||
| 2. Joe Zedrick, Leo Kosenski, | Petrolane Northwest | $ 8,000.00 |
| individually and as partners | Supply Co. | |
| d.b.a. Blue Flame Gas Co. | ||
| 3. Joseph Zedrick and Leo J. | Petrolane Northwest | (Fuel contract) |
| Kosenski (individually) and | Supply Co. | |
| d.b.a. Blue Flame Gas Co. | ||
| 4. Joe Zedrick and Lily Zedrick | Petrolane Gas Service, | $ 10,000.00 |
| Inc. | ||
| 5. Joe Zedrick and Lily Zedrick | Petrolane Northwest | $ 8,500.00 |
| d.b.a. Lily Gas Suppy. | Suppy Co. | |
| 6. Joe Zedrick and Lily Zedrick | Petrolane Gas Service, | $ 1,771.00 |
| d.b.a. Lily Gas Supply & | Inc. | |
| Equipment Co. | ||
| 7. Blue Flame Gas Co | Petrolane Northwest | Fuel account (as |
| Supply Co. | of 7/25/61) | |
| 8. Lily Gas Supply & Equipment Co. | Petrolane Northwest | Fuel account (as |
| Supply Co. | of 7/25/61) | |
| Grand total |
| Interest | Note | Due | |
| dated | Date | ||
| Percent | |||
| 1. Blue Flame Gas. Co., Joe | 6 | 6/28/60 | 4/25/62 |
| Zedrick, partner, Leo J. | |||
| Kosinski, partner. | |||
| 2. Joe Zedrick, Leo Kosenski, | 6 | 10/15/59 | 10/15/62 |
| individually and as partners | |||
| d.b.a. Blue Flame Gas Co. | |||
| 3. Joseph Zedrick and Leo J. | |||
| Kosenski (individually) and | |||
| d.b.a. Blue Flame Gas Co. | |||
| 4. Joe Zedrick and Lily Zedrick | 0 | 5/25/61 | 8/25/61 |
| 5. Joe Zedrick and Lily Zedrick | 6 | 2/ 3/61 | 4/ 3/64 |
| d.b.a. Lily Gas Supply. | |||
| 6. Joe Zedrick and Lily Zedrick | 6 | 7/11/61 | 8/ 1/62 |
| d.b.a. Lily Gas Supply & | |||
| Equipment Co. | |||
| 7. Blue Flame Gas Co | |||
| 8. Lily Gas Supply & Equipment Co. | |||
| Grand total |
| Payments | Date of last | |
| payment | ||
| 1. Blue Flame Gas Co., Joe | $ 500.00 per mo. | 7/2/61 June |
| Zedrick, partner, Leo J. | payment. | |
| Kosinski, partner. | ||
| 2. Joe Zedrick, Leo Kosenski, | $ 222.22 per mo. | 7/1/61 June |
| individually and as partners | payment. | |
| d.b.a. Blue Flame Gas Co. | ||
| 3. Joseph Zedrick and Leo J. | ||
| Kosenski (individually) and | ||
| d.b.a. Blue Flame Gas Co. | ||
| 4. Joe Zedrick and Lily Zedrick | 90 days | |
| 5. Joe Zedrick and Lily Zedrick | $ 250.00 per mo. | 7/1/61 July |
| d.b.a. Lily Gas Supply. | payment. | |
| 6. Joe Zedrick and Lily Zedrick | (Additional | |
| d.b.a. Lily Gas Supply & | part of No. 1 | |
| Equipment Co. | on schedule). | |
| 7. Blue Flame Gas Co | $ 150,000.00 | 7/25/61 |
| 8. Lily Gas Supply & Equipment Co. | $ 4,156.88 | 6/29/61 |
| Grand total |
| Balance | ||
| due | Secured | |
| principal | ||
| 7/28/61 | ||
| 1. Blue Flame Gas Co., Joe | $ 4,875.46 | Chattel mortgage |
| Zedrick, partner, Leo J. | (note) recorded. | |
| Kosinski, partner. | ||
| 2. Joe Zedrick, Leo Kosenski, | 3,333.38 | (Note) not |
| individually and as partners | recorded. | |
| d.b.a. Blue Flame Gas Co. | ||
| 3. Joseph Zedrick and Leo J. | None. | |
| Kosenski (individually) and | ||
| d.b.a. Blue Flame Gas Co. | ||
| 4. Joe Zedrick and Lily Zedrick | 10,000.00 | (Note) recorded. |
| 5. Joe Zedrick and Lily Zedrick | 7,663.74 | Chattel mortgage |
| d.b.a. Lily Gas Supply. | (note) recorded. | |
| 6. Joe Zedrick and Lily Zedrick | 1 1,771.00 | Chattel mortgage |
| d.b.a. Lily Gas Supply & | (note) recorded. | |
| Equipment Co. | ||
| 7. BLue Flame Gas Co | 18,543.86 | Open account. |
| 8. Lily Gas Supply & Equipment Co. | 13,742.41 | Open account. |
| Grand total | 59,929.85 |
54 T.C. 584">*588 As indicated in the above schedule, such loans, excluding the open accounts and the 90-day loan of $ 10,000 on May 25, 1961, bore interest at the rate of 6 percent per annum. Of the four interest-bearing loans, three were secured by chattel mortgages.
Blue Flame conducted a successful business. However, because of family problems, due primarily to the excessive drinking of Lily, petitioner approached Petrolane sometime in the 1970 U.S. Tax Ct. LEXIS 185">*191 fall of 1963 with a view to negotiating a possible disposition or lease of his business to it. The expansion-minded attitude of Petrolane, coupled with its high regard for Blue Flame as "an extremely valuable account," rendered Petrolane at once amenable to petitioner's proposal. A series of offers and counteroffers ensued, leading ultimately to the transaction described in detail below, the tax consequences of which are presently in dispute.
During the initial steps of negotiation in October of 1963, Petrolane offered to purchase the Blue Flame business for $ 350,000, consisting of a downpayment of $ 200,000 and the balance payable in installments.
An alternative plan suggested about the same time by John Wallace, vice president of Petrolane, consisted of a combination lease and sale arrangement under which some of the assets were to be leased to Petrolane for a 10-year period, with an option to purchase at the end of this period, while other assets such as inventory and accounts receivable were to be sold outright. A modified version of the latter plan was eventually adopted by the parties. The lease plan proposed by John Wallace at first met with resistance on the part of petitioner, 1970 U.S. Tax Ct. LEXIS 185">*192 who favored an outright sale. However, in the end Petrolane succeeded in persuading petitioner to accept a modified form of John Wallace's lease proposal. This form of the transaction was more advantageous to Petrolane. Petrolane felt that it could not meet the offers of competing gas companies unless a lease arrangement was to be adopted. As part of the lease plan, Petrolane also offered to extend the repayment period of outstanding debts of petitioner amounting to approximately $ 30,000 owed to Petrolane, for a 3-year period without interest. In a letter dated November 6, 1963, to Petrolane confirming the agreement of the parties, petitioner's attorney, Stanley J. Krause (hereinafter referred to as Krause), outlined the primary features of such agreement as follows:
| 1. Purchase of Accounts Receivable (on guaranteed basis). To be | |
| adjusted as orally agreed | $ 50,000 |
| 2. Purchase of salable and usable inventory. To be adjusted as | |
| orally agreed. | 15,000 |
| 3. Purchase of all LP gas vehicles and radios. | 40,000 |
| 4. Lease of bulk plants, office equipment, customer service | |
| tanks, tools and other equipment for $ 10,000.00 per year | |
| for a period of 10 years. The Zedricks own a part of these | |
| assets and Blue Flame Gas Company owns the remainder. The | |
| rental between the two will be adjusted as agreed. | 100,000 |
| 5. Consultant -- Non Compete Agreement with Zedrick for ten | |
| years at $ 750.00 per month | 90,000 |
| 6. Lease of present office building at $ 4,000.00 per year for | |
| five years. Rent payable in advance quarterly. | 20,000 |
| 7. Option to purchase leased assets other than office building | |
| at termination of lease. These assets are owned both by Blue | |
| Flame Gas Company and the Zedricks and the amount to be | |
| received by each will be determined through further | |
| negotiations. | 35,000 |
1970 U.S. Tax Ct. LEXIS 185">*193 54 T.C. 584">*589 The concluding paragraph of this letter reads: "It is also agreed as a condition to the closing of the above transaction that Petrolane Gas Service, Inc. is to loan to the Zedricks $ 100,000.00, without interest, payable at $ 2,500.00 per quarter." The letter was accepted and signed by an appropriate representative of Petrolane and by Joe and Lily Zedrick. The provision regarding a loan to petitioner of $ 100,000 was included in the agreement at the insistence of petitioner. Petrolane's accession to petitioner's demand with respect to the loan was attributable primarily to his superior bargaining position in the sale negotiations.
A lease incorporating the provisions of the contractual letter of November 6, 1963, was executed on December 1, 1963, by Blue Flame and Petrolane-Blue Flame Gas Co. covering assets owned and used by Blue Flame in the operation of its liquefied petroleum business. A second lease, containing similar provisions, was executed on the same day by petitioner and Petrolane Northwest Supply Co. covering assets owned by petitioner individually. Under these leases, $ 8,500 per year was the specified rental for the Blue Flame assets and $ 1,500 per year the rental 1970 U.S. Tax Ct. LEXIS 185">*194 for the Zedrick assets. Total rental payments to be made over the 10-year period of the lease were thus $ 100,000. Rental payments of $ 2,500 were due quarterly, on March 1, June 1, September 1, and December 1, of each year during the term of the leases. Following the expiration of these leases, Petrolane was given the option to purchase the leased assets for an aggregate sum of $ 35,000 ($ 29,750 under the Blue Flame lease and $ 5,250 under the Zedrick lease). A covenant not to compete within a radius of 100 miles of Aberdeen, Wash., on the part of Blue Flame and petitioner was also included in the leases.
On December 1, 1963, the date of the execution of the leases, Petrolane Northwest Supply Co. advanced $ 100,000 as per agreement, to petitioner individually. The loan was evidenced by a 54 T.C. 584">*590 promissory note dated December 1, 1963, and endorsed by Joe and Lily Zedrick as individuals. Under the terms of the note, the Zedricks were to repay the loan as follows:
Twenty Five Hundred Dollars ($ 2,500.00) or more on or before March 1, 1964, and Twenty Five Hundred Dollars ($ 2,500.00) or more on or before each June 1, September 1, December 1, and March 1 thereafter until the entire One Hundred 1970 U.S. Tax Ct. LEXIS 185">*195 Thousand Dollars ($ 100,000.00) in principal shall have been repaid on or before December 1, 1973.
The amount and date of the scheduled repayments coincided exactly with the aggregate rental payments due under the aforesaid leases.
Although petitioner testified that the parties contemplated initially that checks from Petrolane to Blue Flame and from petitioner to Petrolane, representing rental payments and loan repayments, respectively, would "cross in the mail," this is not what in point of fact occurred. Instead, the respective rental and loan payments took the form of appropriate bookkeeping entries on the part of Petrolane and Blue Flame. Payments having been accomplished in this manner, Blue Flame and Petrolane never received any cash payments. Neither Blue Flame nor petitioner included any part of the $ 100,000 loan as income in their Federal income tax returns for 1963. Respondent determined deficiencies in the income taxes of Blue Flame and petitioner on the ground that the $ 100,000 loan payment constituted prepaid rental income to the extent of $ 85,000 and $ 15,000, respectively. A further deficiency in petitioner's income tax was determined on the ground that payments 1970 U.S. Tax Ct. LEXIS 185">*196 to petitioner in excess of $ 15,000 were the equivalent of a taxable dividend to petitioner, to the extent of the earnings and profits of Blue Flame. Earnings and profits of Blue Flame in 1963 amounted to $ 66,208.70.
On December 1, 1963, Blue Flame also sold its accounts receivable to Petrolane-Blue Flame Gas Co., which transaction was evidenced by a written agreement. Under the terms of this agreement, Blue Flame undertook to --
repurchase such of the accounts receivable purchased this date by PETROLANE from [Blue Flame] as shall, after the employment of reasonable and customary non-legal collection efforts by PETROLANE during the course of six (6) months, remain uncollected at the close of business on May 31, 1964 * * * The book value of any such accounts receivable tendered by PETROLANE for repurchase by [Blue Flame] shall be deducted from any lease or other payments then or next due [Blue Flame], or may be paid in cash by [Blue Flame] to PETROLANE.
Blue Flame was paid the full face value of the accounts receivable sold to Petrolane. However, with the contingent liability to Petrolane under the above-quoted repurchase clause in mind, Blue 54 T.C. 584">*591 Flame deducted $ 9,500 as an addition 1970 U.S. Tax Ct. LEXIS 185">*197 to bad debt reserve in 1963. Prior to the sale, Blue Flame had also employed the reserve method of deducting bad debt losses.
Zedrick conducted businesses in various forms -- proprietorship, partnership, and corporation -- prior to and during the taxable years in question. In 1962, Zedrick became involved in the operation of a lumber business with two individuals, Herbert J. Schumacher (hereinafter referred to as Schumacher) and Raleigh DeBruler (hereinafter referred to as DeBruler). In setting up the business, it was contemplated that Zedrick would contribute the use of a vacant building he owned and that Schumacher and DeBruler would contribute certain sawmill equipment which they owned and operated prior to that time as the S & W partnership. On June 27, 1962, a preliminary meeting of organization was held by Joe and Lily Zedrick, Schumacher, and DeBruler, in the presence of Krause, for the purpose of organizing a corporation to carry on the lumber mill business. Pursuant to an appropriate resolution passed at this meeting, the articles of incorporation of Forest Specialties of Aberdeen, Inc., were filed on July 2, 1962, with the Department of State, State of Washington. In 1970 U.S. Tax Ct. LEXIS 185">*198 addition, the secretary was directed to file a copy of the articles with the county auditor of Grays Harbor County, Wash. However, such filing never occurred. The articles of incorporation specify the business purposes of the corporation, as follows:
ARTICLE II
The general nature of the business of the corporation and the objects and purposes proposed to be transacted, promoted and carried on by it are as follows:
(1) To engage in the business of manufacturing and selling wood products and other products and to engage in any and all incidental businesses thereto. That without limiting the said purpose of the corporation, it shall have the power to engage in any activity in connection with wood or forest products from the acquisition of timber or forest land, the logging thereof, and the engaging in any activity in connection with the manufacturing or processing of wood or forest products into a finished product and the sale thereof and the engaging and sale of products which are made of wood or other material, which have been manufactured by the corporation or by others.
Capital stock in the amount of $ 50,000, consisting of 500 shares of common stock at a par value of $ 100 per share 1970 U.S. Tax Ct. LEXIS 185">*199 was authorized, and paid-in capital with which the corporation was to start business was set at $ 1,000. The articles of incorporation further provided that management of the corporation was to be vested in a board of directors, consisting of from three to nine directors. The following five individuals were named as directors of the corporation from July 2, 1962, to January 1963: Joe and Lily Zedrick, Krause, 54 T.C. 584">*592 Schumacher, and DeBruler. Each of the above-enumerated persons subscribed to two shares of stock. However, the subscriptions were never fulfilled and no stock was ever issued by the corporation.
On July 10, 1962, Forest Specialties of Aberdeen, Inc., opened a bank account with the National Bank of Commerce of Seattle and deposited $ 1,000 cash. Also in July 1962, the corporation filed an application for a Federal employer identification number as required by section 301.6011(b), Income Tax Regs., and an identification number was assigned pursuant to such request.
Shortly after the formation of Forest Specialities of Aberdeen, Inc., the sawmill equipment owned by the S & W partnership was relocated to the aforementioned premises owned by petitioner. Thereafter the business 1970 U.S. Tax Ct. LEXIS 185">*200 operations were expanded considerably, chiefly through the further purchase of sawmill equipment by Zedrick. The equipment originally contributed to the business by Schumacher and DeBruler was worth several thousand dollars and was generally suitable only for "band stick" operations. Zedrick's equipment extended the business operations to include the manufacture of dimension lumber and constituted the bulk of the assets used in the lumber mill operations. All the machinery and real property used in the business were owned individually by petitioner, Schumacher, and DeBruler. Neither the real property and equipment owned by the organizers of Forest Specialties of Aberdeen, Inc., nor the equipment subsequently purchased by them, was ever transferred to the corporation. The original intention of the parties to convey the assets to the corporation was never carried out primarily because of their inability to agree on the proper valuation of the assets.
Management of the business was generally the responsibility of Zedrick or Schumacher. Orders were usually directed to these individuals, rather than to Forest Specialties of Aberdeen, Inc. Business obligations were often discharged 1970 U.S. Tax Ct. LEXIS 185">*201 by petitioner from his personal funds before and after the liquidation of the business. Checks used in the operation of the business, such as payment of salaries, however, were drawn against the Forest Specialties of Aberdeen, Inc., account. Many of the sales invoices bear the rubber-stamped title of the corporation.
In 1963, a board of directors meeting was called for the purpose of discussing the affairs of Forest Specialties of Aberdeen, Inc., and its plans for the future. The undated minutes of this meeting recite the failure of the subscribers to the stock of the corporation to pay for subscriptions or to transfer any money or property, excluding the costs of organization, to such corporation. The reasons for such inaction are stated to be the inability of the parties to agree 54 T.C. 584">*593 as to the valuation of certain property and their failure to obtain a Federal loan, as anticipated at the time of the formation of the corporation. After noting that the lumber mill business was, in fact, carried on in partnership form and that due to disagreement among the parties as to the valuation of the assets owned by each, the partners have decided to dissolve the partnership, a resolution to 1970 U.S. Tax Ct. LEXIS 185">*202 dissolve the partnership as of July 3, 1963, was adopted and recorded in the minutes.
The board of directors meeting was followed by the execution of a dissolution of the partnership agreement on September 20, 1963, undersigned by Zedrick, Schumacher, and DeBruler. The agreement reads in part:
Whereas, during the month of July, 1962, Forest Specialties of Aberdeen, Inc. was incorporated in anticipation of transferring to it certain assets owned by the parties to this agreement, and
Whereas, said assets were not transferred to said corporation due to the failure of the parties to agree on a price, and
Whereas, it was anticipated that the said corporation obtain a loan from the Federal government, which purpose was not accomplished, and
Whereas, the parties operated the said Forest Specialties of Aberdeen as a co-partnership in anticipation of later transferring their assets to the corporation and operating as a corporation, now, therefore,
It Is Hereby Agreed that from June 18, 1962, until July 3, 1963, the parties hereto operated Forest Specialties of Aberdeen as a co-partnership and engaged in the business of constructing and operating a mill on the property owned by Joe Zedrick.
It Is 1970 U.S. Tax Ct. LEXIS 185">*203 Further Agreed that Forest Specialties of Aberdeen, Inc. did neither own any mill equipment nor did it construct nor operate said mill but the same was owned, constructed and operated by the partners engaged in the business of constructing and operating a mill. * * *
* * * *
It is Further Agreed that the said partnership was dissolved on the 3rd day of July, 1963, and that as soon as an accounting can be had the partnership shall be wound up and that the rights and the liabilities of the said partners shall be determined by said accounting. * * *
Forest Specialties of Aberdeen, Inc., filed corporate Federal income tax returns for its taxable years ending June 30, 1963, and June 30, 1964, but in each case reported no income with the explanation that business activities were not carried on during the taxable year. Partnership returns were also filed for the calendar years 1962 and 1963 in the name of Forest Specialty Co. of Aberdeen, reporting net losses of $ 21,656.91 and $ 31,129.46, respectively.
On their joint Federal income tax returns for the taxable years 1962 and 1963, Joe and Lily Zedrick deducted $ 17,325.52 and $ 24,903.57 as their distributive share of losses sustained by such 1970 U.S. Tax Ct. LEXIS 185">*204 partnership. The Commissioner disallowed such deductions on the ground that the losses were, in fact, losses of Forest Specialties of Aberdeen, Inc. The Commissioner further disallowed a depreciation 54 T.C. 584">*594 deduction for the taxable year 1963 in the amount of $ 3,700 with respect to assets used in the lumber business, taken by Joe and Lily Zedrick, individually, on the ground that this deduction belongs to Forest Specialties of Aberdeen, Inc.
Petitioner's financial records, as well as the books and records of Blue Flame, were maintained by his wife, Lily Zedrick. Petitioner also engaged an accountant to audit his books and prepare income tax returns. Petitioner's income tax returns for the calendar years 1962 and 1963 were filed on December 9, 1963, and September 10, 1964, respectively. Petitioners requested and received an extension of time for filing their Federal income tax return for the calendar year 1963 to May 15, 1964. No further extensions of time were requested or granted. Respondent has conceded on brief that petitioners are subject to a maximum addition to tax under section 6651(a) for late filing of 20 percent for the taxable year 1963.
OPINION
The first issue for decision 1970 U.S. Tax Ct. LEXIS 185">*205 is whether the purported loan to petitioner in fact represented advance rentals taxable to petitioner and Blue Flame and, if so, whether the receipt by petitioner of amounts attributable to Blue Flame resulted in a taxable dividend. Respondent has treated the purported loan as the prepayment of rentals due under the leases executed by Blue Flame and petitioner contemporaneously with the loan and pursuant to the same agreement.
It is too well established to require discussion, and petitioner does not contend otherwise, that the receipt of advance rentals constitutes income to the lessor in the year of receipt regardless of the method of accounting he employs. Sec. 1.61-8(b), Income Tax Regs.; Roby Realty Co., 19 B.T.A. 696">19 B.T.A. 696 (1930); A. P. Schiro, Inc., 20 B.T.A. 1026">20 B.T.A. 1026 (1930); Neils Schultz, 44 B.T.A. 146">44 B.T.A. 146 (1941). Petitioner has taken the position at trial, however, but has failed to file a brief in support thereof, that the advance in question did not constitute an integral part of the lease transaction and therefore was justifiably treated by petitioner as a loan. While petitioner's premise that a bona fide loan from the lessee to the lessor will not constitute taxable income is fundamentally 1970 U.S. Tax Ct. LEXIS 185">*206 sound, we have concluded on the basis of the record before us that the transaction in question more closely resembled payment of advance rentals rather than a loan. The assertion that payment from a lessee constitutes a loan will normally invite the close scrutiny of the Court to determine the true nature of such transaction. The burden of proof in respect of such issue is particularly heavy where the purported loan is received from the lessee under circumstances suggesting the payment 54 T.C. 584">*595 is, in effect, of advance rentals. Petitioner must in the very least establish the independence of the loan from the lease transaction. On the state of the record before us, however, not only has petitioner failed to satisfy his burden of proof in this respect, but the evidence plainly points in the opposite direction.
We have determined that the cash receipt of $ 100,000 by petitioner constitutes advance rentals to Blue Flame and to petitioner, to the extent of rental payments due under the respective leases. Thus, the sums of $ 15,000 due under the Zedrick-Petrolane lease and $ 85,000 due under the Blue Flame-Petrolane lease constitute taxable income to petitioner and Blue Flame, respectively. 1970 U.S. Tax Ct. LEXIS 185">*207 We have so concluded, notwithstanding the existence of a promissory note terming the advance a loan. Contemporaneous labels applied by the parties to a transaction, while evidence of their intent, are not conclusive as to the legal effect of the transaction. See, e.g., Oesterreich v. Commissioner, 226 F.2d 798 (C.A. 9, 1955); and United States v. Williams, 395 F.2d 508 (C.A. 5, 1968).
We note initially the absence of some of the usual attributes of a loan. Despite the substantial period of the purported loan, provision was made neither for the payment of interest nor for security. See Kohler-Campbell Corporation v. United States, 298 F.2d 911 (C.A. 4, 1962). In this regard, John Wallace, vice president of Petrolane, testified that Petrolane was satisfied that the lease provided adequate security. This attitude is indicative, we think, of prepaid rent rather than a loan. The failure to provide interest and security is to be considered particularly against the background of prior loans in which interest and security were generally provided.
More significantly for our determination, however, is the fact that repayment of the advance was neither initially contemplated, nor in 1970 U.S. Tax Ct. LEXIS 185">*208 fact occurred. Petitioner testified that the respective payments took the form of appropriate bookkeeping entries on the part of Petrolane and Blue Flame. It appears that for this reason the transaction was designed so that payments of like amount would be due from Petrolane and Zedrick on the same dates. Even accepting the truth of petitioner's assertions that the parties initially contemplated that checks of like amount would cross in the mail, we could not properly regard such conduct as repayment of the loan without closing our eyes to the realities of the transaction. The fact remains, in either case, that petitioner's receipt of the purported loan from Petrolane amounted to the receipt of funds for his immediate and unrestricted enjoyment, which by the nature of the transaction, would never have to be repaid. The fact that no repayment would ultimately be necessary, due to the contemporaneous lease obligations incurred by 54 T.C. 584">*596 Petrolane, strongly supports characterization of the cash receipt as advance rentals. See United States v. Williams, supra.
Moreover, we think the interdependence of the purported loan and lease transactions which is plainly evident from the record marks 1970 U.S. Tax Ct. LEXIS 185">*209 the receipt of cash from the lessor as "profit arising from the [lease] transaction" rather than a loan and it should therefore be taxable as advance rentals when received. See O'Day Investment Co., 13 B.T.A. 1230">13 B.T.A. 1230 (1928); 19 B.T.A. 696">Roby Realty Co., supra. Petitioner exerted special efforts to realize a substantial amount of cash upon the disposition of Blue Flame's business assets. Petitioner favored an outright sale of the business to Petrolane for this reason, although he eventually yielded to Petrolane's desire that the transaction take the form of a lease. The requirement that a loan be extended to petitioner in the sum of $ 100,000 was incorporated into the agreement respecting the lease at the insistence of the petitioner. The arithmetic of the transaction is particularly damaging to the petitioner's position since, as indicated earlier, the loan was in the exact amount of the aggregate rent due under the terms of the leases. United States v. Williams, supra.In addition, repayment dates of the loan and the rental payments were intentionally designed to coincide. In this factual setting, the only reasonable inference that can be drawn is that the loan and lease transactions were entirely 1970 U.S. Tax Ct. LEXIS 185">*210 interdependent. Furthermore, we are convinced from the record before us that the parties themselves did not, in truth, view the transaction in question other than as the prepayment of rent.
In United States v. Williams, supra, petitioner leased his property to another for a term of 66 years. The lease agreement provided that the lessee was to pay $ 19,575 the first year plus $ 176,175, which was termed a loan from the lessee to the lessor although no promissory note was executed. The loan was to be repaid at 3-percent interest by crediting against it the yearly payments due from the lessee under the lease. The Fifth Circuit, citing the obvious interdependence of the loan and lease transactions, and particularly noting the fact that the loan bore a direct relation to the annual rental payments, held that amounts received constituted advance rentals. The court stated, "The terms of the agreement, its formality and structure, cannot disguise the economic reality of the transaction."
We are thus led to conclude that the receipt of $ 100,000 constituted rental income to the extent due under the leases. We do not think the fact that petitioner rather than Blue Flame was the recipient of 1970 U.S. Tax Ct. LEXIS 185">*211 the $ 85,000 due under the Blue Flame-Petrolane lease in any way precludes the taxability of that amount to Blue Flame in 1963. We think it elementary to tax law that a transaction may be 54 T.C. 584">*597 properly broken down to its component steps to reflect the true tax consequences thereof. 1 See George R. Tollefson, 52 T.C. 671">52 T.C. 671, 52 T.C. 671">681 (1969), on appeal (C.A. 2, Oct. 24, 1969). We view in the circumstances of this case, the passage of consideration attributable to the Blue Flame lease to Blue Flame's sole shareholders, as the receipt of advance rentals by Blue Flame, followed by the payment of a dividend to its shareholders, as the respondent maintains. For reasons articulated in connection with the characterization of the transaction as a loan or prepaid rent, amounts received by petitioner for his unrestricted use and enjoyment must be regarded as a dividend. 21970 U.S. Tax Ct. LEXIS 185">*212 52 T.C. 671">George R. Tollefsen, supra.
The next issue presented is whether petitioner, Blue Flame, is entitled to a bad debt deduction under section 166(g), 3 I.R.C. 1954, for additions of $ 9,500 to a bad debt reserve upon the sale of its accounts receivable with recourse to Petrolane in 1963. Respondent, on brief, has characterized this issue as a "purely legal one * * * controlled by [section 166(g)]."
Section 166(g) provides in part:
(g) Reserve for Certain Guaranteed Debt Obligations. --
(1) Allowance of deduction. -- In the case of a taxpayer who is a dealer in property, in lieu of any deduction under subsection (a), there shall be allowed (in the discretion 1970 U.S. Tax Ct. LEXIS 185">*213 of the Secretary or his delegate) for any taxable year ending after October 21, 1965, a deduction --
(A) for a reasonable addition to a reserve for bad debts which may arise out of his liability as a guarantor, endorser, or indemnitor of debt obligations arising out of the sale by him of real property or tangible personal property (including related services) in the ordinary course of his trade or business; and
(B) for the amount of any reduction in the suspense account required by paragraph (4)(B)(1).
(2) Deduction Disallowed in Other Cases. -- Except as provided in paragraph (1), no deduction shall be allowed to a taxpayer for any addition to a reserve for bad debts which may arise out of his liability as guarantor, endorser, or indemnitor of debt obligations.
Respondent expresses his position as follows:
Sec. 166(g)(2) specifically disallows deductions by a taxpayer for bad debt reserve additions except as provided by § 166(g)(1). Sec. 166(g)(1) is limited in its application to a taxpayer who is a "dealer in property." According to 54 T.C. 584">*598 the House Committee Report, the intention of the section is to permit those taxpayers who are dealers in property to obtain a bad debt reserve deduction 1970 U.S. Tax Ct. LEXIS 185">*214 when they guarantee the factoring of accounts which arise in the ordinary course of their business. H. Rept. 2157 at C.B. 1966-2, 909. Here, where the petitioner sold all of its business, it obviously does not so qualify.
We think respondent has misconstrued the statute. Prior to the enactment of section 166(g), the Internal Revenue Service maintained the position that a taxpayer is not entitled to a current deduction for the use of reserve with respect to anticipated losses upon his sale of customer obligations with recourse. Rev. Rul. 62-214, 1962-2 C.B. 72. See generally 5 Mertens, Law of Federal Income Taxation, secs. 30.69 and 30.69(a). Section 166(g) was enacted to settle the controversy which had arisen with regard to deductibility of such bad debt reserves. H. Rept. No. 2157, 89th Cong., 2d Sess. (1966), 1966-2 C.B. 905. There is no suggestion in this provision or in the legislative history thereof, cited above, that factoring of accounts receivable must be made in the ordinary course of business as respondent asserts. Section 166(g) requires only that the debt obligations which are later discounted arise out of the sale of real property or tangible personal property in 1970 U.S. Tax Ct. LEXIS 185">*215 the ordinary course of business. In the instant case, Blue Flame's accounts receivable concededly arose from the sale of personal tangible property in the ordinary course of business. Blue Flame therefore qualifies for a deduction with respect to the additions to the bad debt reserve occasioned by the sale of such accounts with recourse in 1963.
The next issue presented involves the deductibility of losses sustained in the operation of a lumber mill business. Respondent disallowed such deduction on the ground that these business operations were conducted by a corporation. Respondent has also denied a depreciation deduction with respect to assets owned by petitioner individually but used in the conduct of this business for the same reason. Petitioner maintains that the losses in question were sustained by a partnership so that his distributive share of such losses, as well as the depreciation sustained on the assets, is deductible.
The issue presented is primarily one of fact upon which petitioner bears the burden of proof. We think petitioner has successfully borne his burden on this issue, notwithstanding the organization of Forest Specialties of Aberdeen, Inc., in 1962. We are 1970 U.S. Tax Ct. LEXIS 185">*216 satisfied on the basis of the record before us that the business operations which gave rise to the claimed losses were conducted outside the sphere of the existing corporate shell. The losses having been produced by a partnership rather than the corporation, petitioner's distributive share of such losses is properly deductible. 4Woods 54 T.C. 584">*599 ., 44 B.T.A. 88">44 B.T.A. 88 (1941), acq. 1941-1 C.B. 11; Paymer v. Commissioner, 150 F.2d 334 (C.A. 2, 1945); John A. Mulligan, 16 T.C. 1489">16 T.C. 1489 (1951). Cf. P. O'B. Montgomery, 1 T.C. 1000">1 T.C. 1000 (1943), affd. 144 F.2d 313 (C.A. 5, 1944).
Moline Properties v. Commissioner, 319 U.S. 436">319 U.S. 436 (1943), cited by respondent states the basic and well recognized proposition that --
The doctrine of corporate entity fills a useful purpose in business life. * * * so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. * * * [Emphasis supplied. 319 U.S. 436">319 U.S. at 438, 439.]
While 1970 U.S. Tax Ct. LEXIS 185">*217 we recognize the sanctity of the corporate entity, our conclusion rests upon the factual determination that the intentions of the organizers of Forest Specialties of Aberdeen, Inc., to activate the corporate shell by transferring their partnership and personal assets to it and conducting a business within the framework of such corporation did not, in fact, materialize. Cases relied upon by respondent, such as Waldron Co., 2 B.T.A. 715">2 B.T.A. 715 (1925); Hinz & Landt, Inc., of Los Angeles, 8 B.T.A. 375">8 B.T.A. 375 (1927); Donald M. Perry, 49 T.C. 508">49 T.C. 508 (1968); and Ernest H. Weigman, 47 T.C. 596">47 T.C. 596 (1967), affirmed per curiam 400 F.2d 584 (C.A. 9, 1968), are plainly distinguishable on their facts since the corporation whose existence the taxpayer sought to disregard, in each case, had at some time owned property and engaged to some degree in business activities. See Paymer v. Commissioner, supra.
The facts upon which we have based our conclusion have been set forth in considerable detail in our findings. Petitioner had become interested in the lumber business through his acquaintance with Schumacher and DeBruler. With the prospect of joining these individuals in the operation of a lumber business, a corporation 1970 U.S. Tax Ct. LEXIS 185">*218 was formed in mid-1962. Articles of incorporation were filed and a State certificate issued. However, due to discord which immediately arose among the parties regarding the value of assets to be contributed, assets owned by Schumacher and DeBruler and operated prior to incorporation by the S & W partnership, and real property owned by petitioner individually, were never transferred to the corporation. Stock authorized in the articles of incorporation, including the qualifying shares subscribed to therein by Schumacher, DeBruler, and petitioner, was never issued or paid for. Following the organizational meeting of the board of directors, no meeting was again held except for the purpose of declaring the corporation inactive. Although filing a copy of the articles of incorporation with the local county clerk's office was mandatory to limited-liability status, such filing was intentionally omitted. Instead, petitioner and the other individuals commenced operation of the lumber business, utilizing the equipment and machinery owned individually. Manufacturing 54 T.C. 584">*600 operations were made possible through the purchase of additional equipment by petitioner individually. The manner in which 1970 U.S. Tax Ct. LEXIS 185">*219 the business functioned more closely resembled a partnership or joint venture than any other form. Orders were normally directed to petitioner individually rather than to Forest Specialties of Aberdeen, Inc. Letters of collection respecting outstanding debts of the business were directed to petitioner individually and were paid out of his personal funds. The record is clear that petitioner did not seek the protective shield of corporate existence against business creditors, but in fact paid off all debts incurred in the course of the unsuccessful operation of the business following its liquidation in 1963.
We are satisfied from the record as a whole, paying close attention to the numerous detailed exhibits entered into evidence, that the business operations in question were sufficiently disjoint from the corporation originally formed, to properly attribute its losses to the partnership or joint venture which, in fact, carried on such business.
Petitioner has contested the imposition of additions to tax under sections 6651(a) for late filing and 6653(a) for negligence on the ground that his failure to file was due to reasonable cause. He explains that the late filing was attributable 1970 U.S. Tax Ct. LEXIS 185">*220 to the chronic alcoholism of his wife, who maintained his financial records. However, petitioner did not file a request for a further extension following the expiration of the prior extension period. In addition, petitioner employed an accountant who could have filed a timely return on the basis of the well kept records of petitioner's wife. We think petitioner's explanation falls short of the reasonable cause requirement of the statute and we therefore uphold the determination of respondent in this regard.
Decisions will be entered under Rule 50.
Footnotes
1. Not paid by us to date (pending approval for payment).↩
1. Our conclusion also finds support in the judicially recognized assignment-of-income doctrine. See Commissioner v. P. G. Lake, Inc., 356 U.S. 260">356 U.S. 260↩ (1958). However, we do not think the application of this rule is required under the facts of the instant case.
2. The dividend should be reduced by the portion which Zedrick expended for the benefit of the corporation, but the record furnishes no basis for such determination. Petitioner has not expressed himself on this point and has not filed a brief.
3. Sec. 166(g) was added by sec. [1](a) of Pub. L. 89-722, Nov. 2, 1966, several years after the taxable years in question. (Former subsec. (g) was redesignated (h).) However, respondent argues that "it was the intention of Congress to settle all controversies in this area both for prior and future years" citing H. Rept. No. 2157, 89th Cong., 2d Sess. (1966), 1966-2 C.B. 906↩.
4. The facts of this case are strikingly similar to Estate of L. E. Faris, T.C. Memo. 1955-268, wherein we reached a similar result, citing and discussing Paymer v. Commissioner, 150 F.2d 334↩ (C.A. 2, 1945).