Decision will be entered for the respondent.
Held: 1. Certain payments made by the petitioner to its shareholders are not deductible by it as interest inasmuch as such payments were made in respect of capital contributions and not in respect of debt.
2. Amounts credited to the payment of overdue interest are interest income.
3. The petitioner, a personal holding company, is not entitled to any dividends-paid deductions in computing its undistributed personal holding company income for the taxable years in question, since it has failed to show that dividends paid by it were not preferential.
4. The petitioner may not deduct additional South Carolina income taxes that may become due from it as a result of our decision in this case.
*1433 The respondent determined deficiencies in the petitioner's income taxes as follows:
| Personal holding | ||
| Corporate income | company tax, | |
| Year | 1tax, sec. 11 | sec. 541 |
| 1962 | $ 2,007.60 | $ 6,964.88 |
| 1963 | 1,275.42 | 6,598.27 |
Some issues have been settled; those remaining to be decided are:
(1) Whether certain advances by the *103 shareholders to the petitioner constitute capital contributions or loans;
(2) Whether certain amounts credited to the payment of overdue interest constitute interest income or return of principal;
(3) Whether certain distributions by the petitioner to its shareholders are deductible as dividends paid in computing the personal holding company tax; and
(4) Whether the petitioner may deduct additional South Carolina income taxes that may become due on the petitioner's corrected income as a result of our decision in this case.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
The petitioner is a South Carolina corporation, which filed its 1962 and 1963 Federal income tax returns, using the cash receipts and disbursements *1434 method of accounting, with the district director of internal revenue, Columbia, S.C.
The petitioner was organized in 1957 by W. M. Schram and Philip Meyer for the purpose of acquiring from Holiday Inns of America, Inc., a franchise to build Holiday Inn motels in Duval County, Fla.
In 1958, all of the outstanding stock of the petitioner was purchased by William Ackerman and Irvin Traub for the sum of $ 2,850. Mr. Ackerman acquired two-thirds *104 of the outstanding stock and Mr. Traub acquired the remaining one-third. At the time of the purchase of the stock, the petitioner was not actively engaged in any business operation.
When Messrs. Ackerman and Traub acquired the stock of the petitioner, its capital account was in the amount of $ 7,000 and its only assets consisted of a licensing agreement with Holiday Inns of America, Inc., dated April 1, 1957, and an option to buy certain land in Duval County, Fla. The option was not exercised; instead, the petitioner leased certain other land located in Duval County, and in 1958 and 1959 constructed a Holiday Inn motel on such land at a cost of $ 393,958.77.
In order to finance the construction of the motel, the petitioner borrowed $ 225,000 from Jefferson Standard Life Insurance Co. Such loan was secured by a mortgage on the motel. Additionally, Messrs. Ackerman and Traub advanced $ 170,000 to the petitioner as the funds were required by it in the construction of the motel. Such advances were evidenced by 5 1/2-percent demand notes issued by the petitioner.
Prior to advancing money to the petitioners, Messrs. Ackerman and Traub explored the possibility of having the petitioner borrow *105 additional funds from other sources. However, when they learned that the petitioner would have to pay interest of 13 or 14 percent on such borrowings, they personally borrowed funds from a bank for the purpose of making advances to the petitioner.
During 1962 and 1963, the petitioner paid to Messrs. Ackerman and Traub the following amounts, which were designated as interest payments by the petitioner:
| Year | Ackerman | Traub |
| 1962 | $ 810.50 | $ 810.50 |
| 1963 | 1,740.00 | 420.00 |
On October 7, 1959, the completed motel and the lease on the land were sold to Barrett Motels of Jacksonville, Inc. (Barrett), for a net sales price of $ 586,670.91, which was paid as follows:
| Cash | $ 92,821.99 |
| First mortgage assumed by purchaser | 225,000.00 |
| Note and second mortgage received by petitioner | 271,000.00 |
| Fees, stamps, etc. | (2,151.08) |
| Total | 586,670.91 |
*1435 After the sale of the motel, the only assets of the petitioner were a small amount of cash and the Barrett note; its only income for 1962 and 1963 was interest collected on the note. During such years, Barrett made monthly payments on the note either to Mr. Ackerman, Mr. Traub, or the petitioner, as follows:
| Year | To Mr. Ackerman | To Mr. Traub | To the petitioner |
| 1962 | $ 3,600 | $ 4,800 | $ 3,600 |
| 1963 | 9,600 | 9,600 |
The *106 Barrett note provides for 5 1/2-percent interest with monthly payments of $ 2,499.41 beginning November 15, 1959. It states that:
monthly payments shall be applied first to the payment of interest accrued to the date thereof on the principal sum then remaining unpaid, and then in reduction of the principal, until the entire principal sum, together with interest thereon, shall be paid in full.
This note is to be construed and enforced according to the laws of the State of Florida * * *
The following schedule reflects, according to the stipulation of the parties, "payments made by Barrett" on the note in 1962 and 1963:
| Adjustments | Principal | |||
| Month due | Amount paid | Interest due | to principal | balance |
| 1*107 Dec. 1961 | $ 600 | $ 1,162.81 | $ (562.81) | $ 254,452.31 |
| Jan. 1962 | 600 | 1,165.39 | (565.39) | 255,017.70 |
| Feb. 1962 | 600 | 1,167.98 | (567.98) | 255,585.68 |
| March 1962 | 600 | 1,170.58 | (570.58) | 256,156.26 |
| April 1962 | 1,200 | 1,173.19 | 26.81 | 256,129.45 |
| May 1962 | 1,200 | 1,173.07 | 26.93 | 256,102.51 |
| June 1962 | 1,200 | 1,172.75 | 27.05 | 256,075.47 |
| July 1962 | 1,200 | 1,172.83 | 27.17 | 256,048.30 |
| Aug. 1962 | 600 | 1,172.70 | (572.70) | 256,621.00 |
| Sept. 1962 | 600 | 1,175.32 | (575.32) | 257,196.32 |
| Oct. 1962 | 1,200 | 1,177.95 | 22.05 | 257,174.27 |
| Nov. 1962 | 1,200 | 1,177.86 | 22.14 | 257,152.13 |
| Dec. 1962 | 1,200 | 1,177.76 | 22.24 | 257,129.89 |
| Jan. 1963 | 1,200 | 1,177.65 | 22.35 | 257,107.54 |
| Feb. 1963 | 1,200 | 1,177.55 | 22.45 | 257,085.09 |
| March 1963 | 1,200 | 1,177.45 | 22.55 | 257,062.54 |
| April 1963 | 1,200 | 1,177.35 | 22.65 | 257,039.89 |
| May 1963 | 1,200 | 1,177.24 | 22.76 | 257,017.13 |
| June 1963 | 1,200 | 1,177.14 | 22.86 | 256,994.27 |
| July 1963 | 2,400 | 1,177.03 | 1,222.97 | 255,771.30 |
| Aug. 1963 | 2,400 | 1,171.43 | 1,228.57 | 254,542.73 |
| Sept. 1963 | 2,400 | 1,165.80 | 1,234.20 | 253,308.53 |
| Oct. 1963 | 2,400 | 1,160.15 | 1,239.85 | 252,068.68 |
| Nov. 1963 | 2,400 | 1,154.47 | 1,245.53 | 250,823.15 |
| Dec. 1963 | 0 | 1,148.77 | (1,148.77) | 251,971.92 |
The petitioner's 1962 and 1963 income tax returns include Schedule PH declaring that in those years the petitioner was a personal holding company. However, such schedules disclose no personal holding company tax liability inasmuch as the Federal income tax and dividends-paid deductions declared on such schedules result in the elimination of all undistributed personal holding company income.
*1436 OPINION
Issue 1. Interest DeductionThe petitioner contends that the advances in the amount of $ 170,000 made to it by Messrs. Ackerman and Traub in 1958 and 1959 were loans. Accordingly, it argues that payments made by it with respect to such advances in the tax years 1962 and 1963 are deductible as interest. On the other hand, the respondent contends that the advances were not loans but rather contributions to capital, and accordingly, payments made with respect to such advances were merely distributions with respect to stock and not deductible by the petitioner.
The fact that the advances were formally characterized as debt by the petitioner and Messrs. Ackerman and Traub is some evidence of their character, but is not decisive. Our inquiry must be into the true substantive *108 nature of the advances, and the petitioner has the burden of proving that its treatment of the transaction is correct. Wetterau Grocer Co. v. Commissioner, 179 F. 2d 158 (C.A. 8, 1950), affirming a Memorandum Opinion of this Court; Ambassador Apartments, Inc., 50 T.C. 236 (1968), affd. 406 F. 2d 288 (C.A. 2, 1969). It has failed to sustain such burden.
It has been stated that:
The essential difference between a stockholder and a creditor is that the stockholder's intention is to embark upon the corporate adventure, taking the risks of loss attendant upon it, so that he may enjoy the chances of profit. The creditor, on the other hand, does not intend to take such risks so far as they may be avoided, but merely to lend his capital to others who do intend to take them. [United States v. Title Guarantee & Trust Co., 133 F. 2d 990, 993 (C.A. 6, 1943).]
Such evidence as is available to us clearly indicates that the advances were made with the intention of embarking on the corporate adventure and not of making a loan. See Zilkha & Sons, Inc., 52 T.C. 607 (1969).
The prospects for the repayment of the advances were very much dependent on the success of the petitioner's venture. The evidence *109 indicates that the intention of Messrs. Ackerman and Traub was to acquire a Holiday Inn franchise, construct a motel to operate such franchise, and then to sell both the motel and the franchise at a profit. Although Mr. Ackerman testified to the effect that the profitability of such a venture was assured, we think that the advances by him and Mr. Traub were placed at a substantial risk. Delays or unexpected increases in the cost of construction, decline in the tourist business, unavailability of a purchaser with sufficient capital to purchase the franchise and motel all might result in the petitioner's suffering a considerable loss at the time it was ready to sell the motel. With only $ 7,000 equity to support the advances of $ 170,000, losses on such advances could easily be sustained if the petitioner encountered any serious *1437 financial problems or difficulty in finding a responsible purchaser. Although the petitioner did in fact realize a handsome profit, such success was not assured when it launched upon the venture in 1958.
Along with the substantial risk of loss incurred by Messrs. Ackerman and Traub in making the advances, they, as the shareholders of the petitioner, stood *110 to increase substantially their profit on the venture in the event it was successful. Had the petitioner borrowed the additional $ 170,000 necessary for construction of the motel from a third party, it would have had to pay between 13- and 14-percent interest. The cost of borrowing the necessary funds at such high interest rates would have increased considerably the cost of constructing the motel. By personally borrowing $ 170,000 (presumably at 5 1/2-percent interest) and advancing it to the petitioner, Messrs. Ackerman and Traub would realize a significantly greater profit on the sale.
Other factors indicating that the advances were in the nature of capital contributions rather than debt are: (1) The lack of a fixed maturity date in the purported debt instrument ( United States v. Title Guarantee & Trust Co., supra;Parisian, Inc. v. Commissioner, 131 F.2d 394">131 F.2d 394 (C.A. 5, 1942), affirming a Memorandum Opinion of this Court); (2) the fact that the noteholders and the shareholders were the same persons, and, so far as we know, may have had identical interests ( Fin Hay Realty Co. v. United States, 398 F.2d 694">398 F.2d 694 (C.A. 3, 1968)); (3) the fact that the notes were not secured by property of *111 the petitioner ( Fin Hay Realty Co. v. United States, supra; 1432 Broadway Corporation, 4 T.C. 1158">4 T.C. 1158 (1945), affirmed per curiam 160 F.2d 885">160 F.2d 885 (C.A. 2, 1947)); and (4) the thin capitalization of the petitioner that would result from classifying the advances as debt ( Ambassador Apartments, Inc., supra).
With respect to the thin capitalization of the petitioner, Mr. Ackerman testified that the franchise from Holiday Inns was worth $ 100,000 at the time the advances were made. If the franchise was worth that amount, the debt-equity ratio would be reasonable. See Ainslie Perrault, 25 T.C. 439">25 T.C. 439 (1955). However, we find Mr. Ackerman's valuation unconvincing; other evidence tends to indicate that the franchise had much less value. Messrs. Ackerman and Traub purchased all of the petitioner's stock in 1958 for $ 2,850. At that time, the petitioner owned the Holiday Inn franchise and an option to purchase certain land in Duval County. Even if the land option was completely valueless, the franchise was sold for $ 2,850. There is nothing to indicate that the sellers were wholly unaware of the value of the franchise, nor to indicate that it increased in value some 4,000 percent between 1958 *112 and the dates of the advances. Thus, the sale *1438 of the franchise for $ 2,850 provides objective evidence of its value, and that evidence negates Mr. Ackerman's unsupported statement. We therefore reject the petitioner's contention that the true debt-equity ratio of the petitioner would be less than $ 395,000 to $ 7,000, or 56 to 1, if we treated the advances as debt.
The petitioner contends that it could have obtained loans from third parties to cover completely the costs of construction of the motel. However, it is not altogether clear as to what would have been the conditions of those loans, but from the evidence which is available, it appears that they would not have been at all comparable to the conditions under which Messrs. Ackerman and Traub made their advances to the petitioner. Had loans been obtained from other sources, the petitioner would have had to pay between 13- and 14-percent interest. Additionally, we wonder whether outside lenders would have been willing to place $ 170,000 at the risk of this venture without the additional security of having the loans guaranteed by the shareholders, Messrs. Ackerman and Traub. Since the petitioner is attempting to convince us *113 that the advances by Messrs. Ackerman and Traub should be treated as debts because it could have borrowed the funds from outside lenders, it has the burden of proving that the loans by outsiders would have been made under comparable conditions. Compare Malone & Hyde, Inc., 49 T.C. 575">49 T.C. 575 (1968). The mere fact that nonshareholders would have made loans to the corporation does not prove that the advances by the shareholders were loans without showing that the conditions are comparable. No such showing of comparability has been made; to the contrary, the evidence before us indicates that no third party would have made loans on conditions analogous to the advances by the shareholders.
The evidence fails to indicate whether the advances by Messrs. Ackerman and Traub were proportional to their stockholdings in the petitioner. Proportionality would serve to strengthen the respondent's case, whereas disproportionality between advances and stockholdings would be a significant factor indicating debt. Compare 2554-58 Creston Corp., 40 T.C. 932">40 T.C. 932 (1963), with Charles E. Curry, 43 T.C. 667 (1965). Since the burden of proof is on the petitioner in this proceeding, we cannot, from the lack of evidence, *114 make any inference in favor of the petitioner.
In deciding this case, we have carefully considered Piedmont Corp. v. Commissioner, 388 F.2d 886">388 F.2d 886 (C.A. 4, 1968), reversing a Memorandum Opinion of this Court, especially since it was decided by the Court of Appeals for the Fourth Circuit, which might be the proper venue in an appeal of this case. Although there are some similarities between this case and Piedmont, we have concluded that they are distinguishable. Both cases involved new ventures which turned out to be very *1439 profitable, but in this case, the risk, at the time the advances were made, appears to have been significantly greater. Moreover, in Piedmont, the debt instruments called for payment within a relatively short time, and the terms of the obligations were satisfied; whereas, the notes in this case had no fixed maturity dates. Finally, in Piedmont, the Court of Appeals found that the shareholders' loans were not subordinated to the debts due other creditors; in this case, there was a first mortgage on the motel property, and in case the petitioner could not meet all its obligations, any debt due Messrs. Ackerman and Traub could not be satisfied out of such property until *115 the first mortgage was paid. In view of these differences, we have concluded that Piedmont does not control our decision in this case. Jack E. Golsen, 54 T.C. 742">54 T.C. 742 (1970).
We thus hold the advances made by Messrs. Ackerman and Traub were contributions to capital and not loans. 2*116 Accordingly, the payments by the petitioner with respect to such advances were nondeductible distributions with respect to stock and not interest.
Issue 2. Interest IncomeIn 1962, Barrett made payments totaling $ 12,000 on account of its note payable to the petitioner. Each installment was substantially less than the amount called for under the note, and no payment exceeded the amount of interest which accrued on the principal of the loan from the beginning of 1962 to the date of such payment and which was unpaid. During 1962, the interest accrued with respect to the principal balance of the loan exceeded the amount of the total payments by $ 3,240.19. In 1963, Barrett made payments on the note totaling $ 19,200. Interest accrued during 1963 totaled $ 12,893.26.
The respondent contends that the petitioner received interest income of $ 12,000 in 1962 and $ 16,133.45 in 1963 ($ 12,893.26 accrued in 1963, plus $ 3,240.19 accrued in 1962 but paid in 1963). The petitioner reported as interest income only $ 6,929 for 1962 and $ 14,042.03 for 1963. Its position appears to be that under local law, when accrued interest is not paid, it is added to principal. Thus, it contends, when it receives a payment which exceeds the amount of interest due that *1440 month, it should report only the interest *117 due for that month as income and treat the excess as a nontaxable return of principal.
Even if the petitioner is correct in its interpretation of local law, we do not agree with its position in this case. In reaching this conclusion, we start from two basic premises. The first is that interest is compensation for the use of money. Deputy v. DuPont, 308 U.S. 488">308 U.S. 488 (1940). The second is the fundamental proposition of tax law that in determining the tax treatment of a transaction, substance governs form. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935). Viewed substantively, we can perceive no reason why defaulted interest should be transformed into principal for purposes of tax law. Such interest, no matter when paid, is clearly compensation for the use of money, and its character as such does not change merely because it is not timely paid. The fact that a payment is not called "interest" is not controlling for tax purposes if, in substance, it is such. See Wilshire Holding Corporation v. Commissioner, 262 F. 2d 51 (C.A. 9, 1958), reversing a Memorandum Opinion of this Court.
Having concluded that defaulted interest does not become principal for tax purposes, we must next consider when such *118 interest is treated as paid. Partial payments on a note are generally treated as first applying to interest and then to reduce principal. Estate of Daniel Buckley, 37 T.C. 664">37 T.C. 664 (1962); Estate of Paul M. Bowen, 2 T.C. 1">2 T.C. 1 (1943); Theodore R. Plunkett, 41 B.T.A. 700">41 B.T.A. 700 (1940), affd. 118 F. 2d 644 (C.A. 1, 1941). This rule was expressly included in the Barrett note. Since each payment made in 1962 was less than the interest accrued and unpaid to the date of the payment, the entire amount of the payments made in that year were allocable to the payment of interest and taxable as such. Since $ 16,133.45 of the amounts paid in 1963 is applicable to interest accrued and unpaid at the date of the payments, that amount is allocable to the payment of interest in that year and taxable as such.
Moreover, we do not think the petitioner's construction of local law is correct. The note provides that it is to be construed and enforced in accordance with Florida law. Under such law, although unpaid interest may bear simple interest until paid, provisions for compounding interest on interest by adding it to principal are invalid. Morgan v. Mortgage Discount Co., 100 Fla. 124">100 Fla. 124, 129 So. 589">129 So. 589 (1930). See *119 also American Brake Shoe & F. Co. v. Interborough R. T. Co., 26 F. Supp. 954 (S.D. N.Y. 1939). Therefore, even under the applicable local law, when a payment on the note exceeded the interest due for the month, the excess would not be treated as a payment of principal if there was accrued interest due for previous months.
*1441 Issue 3. Personal Holding Company TaxThe petitioner filed Schedule PH along with its 1962 and 1963 income tax returns, indicating that it was, in those years, a personal holding company. However, such schedules disclosed no liability for personal holding company tax since deductions taken thereon for income taxes and dividends result in the elimination of all undistributed personal holding company income. The respondent denied the claimed dividends-paid deductions and accordingly determined a personal holding company tax. Sec. 541.
Dividends which are not pro rata with respect to stockholdings are considered preferential dividends, and as such, they are not allowable as a dividends-paid deduction. Secs. 545(a), 561(b), 562(c). Mr. Ackerman owned two-thirds and Mr. Traub owned one-third of the petitioner's stock. Under no reasonable interpretation of the facts *120 before us is it possible to conclude that dividends paid them by the petitioner were in proportion to their stockholdings. Accordingly, we hold that the petitioner was not entitled to any dividends-paid deduction in either 1962 or 1963.
On brief, the petitioner argues that it was not a personal holding company in 1962 or 1963, since its only income in those years, interest on the Barrett note, should be treated as rental income under the provisions of section 543(b)(3). However, the petitioner admitted its personal holding company status by filing Schedule PH with its 1962 and 1963 tax returns; it did not assign as error in its petition the respondent's determination that it was a personal holding company; and it raised this issue for the first time in its brief. Under these circumstances, we hold that the petitioner has raised the issue too late. J. William Frentz, 485">44 T.C. 485 (1965), affd. 375 F. 2d 662 (C.A. 6, 1967); Rule 7, Tax Court Rules of Practice. The respondent had no opportunity to consider, at or before the trial, whether it wished to offer evidence to meet this argument or to question the petitioner's witnesses regarding it.
Issue 4. State Income TaxesThe petitioner *121 contends that it should be allowed to deduct additional South Carolina income taxes that may become due as a result of our decision in this proceeding. However, the petitioner has not shown that additional South Carolina taxes will become due as a result of our decision. Moreover, since the petitioner uses a cash method of accounting, and since any additional South Carolina taxes would not be paid in either 1962 or 1963, it is clear that no deduction *1442 for additional State tax may be allowed for the years 1962 and 1963. See Eugene Vassallo, 23 T.C. 656 (1955).
Decision will be entered for the respondent.
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954.↩
1. Payment made in January 1962.
2. The stipulation of facts in this case contains statements that the petitioner had "an indebtedness payable to Ackerman and Traub of $ 170,000" and that "During the taxable years 1962 and 1963, the petitioner made interest payments on the demand notes held by Ackerman and Traub in the amounts as indicated below." It is obvious to us that by these statements the respondent did not intend to concede that the advances of $ 170,000 were debt rather than equity. The Petitioner has at no point argued that the statements in the stipulation constituted a concession by the respondent. Accordingly, we have interpreted such statements as meaning that the petitioner had a formal indebtedness to Messrs. Ackerman and Traub and that the petitioner made payments to Ackerman and Traub which were designated as interest.