Estate of Thomas H. Fry, Ruth M. Fry, Personal Representative, and Ruth M. Fry

United States Tax Court

T.C. Memo. 2024-8

ESTATE OF THOMAS H. FRY, DECEASED, RUTH M. FRY,
PERSONAL REPRESENTATIVE, AND RUTH M. FRY,
Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,
Respondent

—————

Docket No. 13242-20. Filed January 23, 2024.

—————

William M. Weintraub and Sean A. McCormick, for petitioners.

Justine S. Coleman, Vincent S. Uy, and Aely K. Ullrich, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WEILER, Judge: This case arises from a notice of deficiency dated
September 28, 2020, in which the Internal Revenue Service (IRS or
respondent) determined a deficiency in Thomas H. Fry and Ruth M.
Fry’s 2013 joint federal income tax of $1,318,597, an addition to tax
under section 6651(a)(1) 1 of $65,930, and an accuracy-related penalty
under section 6662(a) of $263,719. The issues for decision are whether
(1) the Transfers and the Payments from Crown Disposal, Inc. (Crown),
to CR Maintenance Services, Inc. (CR Maintenance), are bona fide debt
or equity, (2) Mr. Fry had an adequate basis to claim the disallowed
flowthrough loss from CR Maintenance of $3,455,006, (3) respondent is
harmed by a finding that the Transfers and the Payments are equity,

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and Rule references are to the Tax Court Rules of Practice and
Procedure. All monetary amounts are rounded to the nearest dollar.

Served 01/23/24
 2

[*2] (4) the Frys are liable for the late filing addition to tax pursuant to
section 6651(a)(1), and (5) the Frys are liable for the accuracy-related
penalty pursuant to section 6662(a) and (b)(2) for a substantial
understatement of income tax.

Respondent filed his Answer on December 31, 2020. On
November 26, 2021, respondent filed a Motion for Leave to File First
Amendment to Answer. In his First Amendment to Answer respondent
sought to assert, for the first time, two affirmative defenses: the duty of
consistency and the doctrine of election. We granted respondent’s
Motion, and the First Amendment to Answer was filed December 16,
2021.

FINDINGS OF FACT

The parties filed a First Stipulation of Facts with accompanying
Exhibits, which was admitted at trial. Respondent filed a Proposed Trial
Exhibit, which was likewise admitted at trial. Some facts have been
stipulated and are so found. The Frys resided in California when the
Petition was timely filed.

Mrs. Fry filed a joint Form 1040, U.S. Individual Income Tax
Return, with her husband, Mr. Fry, for tax year 2013. Since filing the
Petition, Mr. Fry has passed away. Mrs. Fry is authorized to represent
the estate of Thomas H. Fry in this case.

I. Background

Mr. Fry was the sole shareholder of two S corporations, Crown
and CR Maintenance, which conducted business operations in a highly
integrated manner despite being organized as separate businesses. In
2013 CR Maintenance was based in Sun Valley, California. Crown was
based in the same facility as CR Maintenance. From 2008 through 2015
Mr. Fry received an officer salary and rent payments from both
CR Maintenance and Crown.

Crown’s business operations included the collection of trash,
recyclables, and other waste from individuals, apartment buildings, and
commercial establishments for a fee. CR Maintenance’s business
operations consisted of processing the trash, recyclables, and other
waste collected by Crown into commodities such as alfalfa, olive oil, and
wheat for sale to third parties. Crown did not pay CR Maintenance for
taking possession of the waste collected, nor did Crown share collection
fees with CR Maintenance.
 3

[*3] Crown and CR Maintenance conducted an integrated business
operation, shared the same principal place of business, and used the
same maintenance, payroll, corporate officers, and accountant. Mr. Fry
was the president and treasurer of both Crown and CR Maintenance.
John Richardson was the vice president and corporate secretary for both
Crown and CR Maintenance. Gary Margolis was the accountant for Mr.
and Mrs. Fry, CR Maintenance, and Crown. Mr. Margolis had been a
certified public accountant (CPA) for 31 years and had been Mr. Fry’s
accountant for approximately 20 of those years. As Mr. Fry’s accountant,
Mr. Margolis prepared the tax returns for the Frys, CR Maintenance,
and Crown.

II. Profitability of CR Maintenance

By 2010 CR Maintenance was not profitable and required
substantial financial support to meet its obligations. During 2011 a
contract between the City of Los Angeles and CR Maintenance was
withdrawn by the City after an accident resulted in the death of two
CR Maintenance employees. Following the withdrawal of the contract
with the City, CR Maintenance was never again profitable and began
losing between $5 and $7 million per year.

Beginning in 2010 and through 2013 Crown provided financial
support to CR Maintenance to allow it to continue operating. During this
period Mr. Richardson and Mr. Fry would meet each month to review
the financial positions of Crown and CR Maintenance to determine
whether CR Maintenance required additional funds from Crown to meet
its obligations. If CR Maintenance was unable to meet its obligations for
that month, Mr. Fry would instruct Crown to transfer funds via check
or bank-to-bank transfers directly to CR Maintenance (Transfers).
Crown did not distribute cash to Mr. Fry, nor did Mr. Fry contribute
cash to CR Maintenance. CR Maintenance used the Transfers to pay
general business operating costs. During this period Crown, on behalf of
CR Maintenance, also made payments directly to CR Maintenance’s
vendors for certain expenses such as fuel, wages, payroll taxes, workers’
compensation insurance, and employee benefits (Payments). At trial Mr.
Richardson testified that Mr. Fry treated his companies like his “baby”
and wanted to ensure that both CR Maintenance and Crown continued
operating.
 4

[*4] At the end of 2013 the net total of the Transfers and the Payments
was $36,255,141, 2 which accounts for the money that CR Maintenance
transferred back to Crown by the end of 2013. CR Maintenance had not
made any transfers back to Crown of any portion of the Transfers;
however, CR Maintenance had transferred a portion of the Payments
back to Crown by the end of 2013. By the end of 2020 CR Maintenance
had transferred back to Crown the total amount of the Transfers and
the Payments it had received between 2006 and 2020.

III. Characterization of the Transfers and the Payments

Despite the Transfers and the Payments by Crown of some
$36 million, CR Maintenance did not provide any promissory notes
regarding the Transfers and the Payments and did not have any written
due dates for a return of the money. No security interest was requested
by Crown or granted by CR Maintenance. Furthermore,
CR Maintenance did not make, nor promise to make, interest payments
related to the Transfers and the Payments.

CR Maintenance accounted for each of the Transfers from Crown
as a “Loan Payable” in its general ledger liability from 2010 through
2014. From 2006 through 2013 CR Maintenance accounted for the
Payments made by Crown as “Due to Crown” in another general ledger
liability account. From 2010 through 2017 CR Maintenance documented
the Transfers and the Payments as liabilities between CR Maintenance
and Crown. From 2006 through 2013 Crown accounted for the expenses
it paid on CR Maintenance’s behalf as “Due from CR [Maintenance].”
Crown documented the Transfers and the Payments as liabilities
between Crown and CR Maintenance from 2010 through 2017.
CR Maintenance intended to repay Crown for the Transfers and the
Payments if it was profitable.

From 2010 through 2020 CR Maintenance reported the Transfers
and the Payments as a balance due to Crown on its tax returns and
characterized them as debts. On its returns filed between 2009 and 2019
CR Maintenance did not report the Transfers and the Payments as
additional capital contributions from Mr. Fry. Crown reported the
Transfers and the Payments as a liability due from CR Maintenance on

2 The net amount of the Transfers and the Payments was $12,047,558 and

$24,207,583, respectively.
 5

[*5] its tax returns for 2010 through 2020 and characterized these
transactions as indebtedness.

The Frys did not report distributions from Crown to Mr. Fry on
their tax returns filed between 2008 and 2019. However, between 2008
and 2020, Crown did report distributions and repayment of shareholder
loans on Mr. Fry’s Schedules K–1, Shareholder’s Share of Income,
Deductions, Credits, etc., as follows:

Year ended Line 16(d) property Line 16(e) repayment of
distributions other than SH Loans
dividends
2008 — —
2009 $1,993,500 —
2010 3,413,262 —
2011 443,361 —
2012 — —
2013 — $1,062,587
2014 4,634,000 584,500
2015 — —
2016 39,022,011 —
2017 11,382,695 —
2018 3,196,524 —
2019 8,511,004 —
2020 16,862,695 —

On November 10, 2014, the Frys untimely filed their joint Form
1040 for the 2013 tax year, which was due on October 15, 2014. For tax
year 2013 CR Maintenance filed Form 1120S, U.S. Income Tax Return
for an S Corporation, and reported an ordinary loss of $5,650,651. The
Frys claimed a flowthrough loss deduction of $4,733,675 from
CR Maintenance on their individual return for the 2013 tax year.

In 2015 Crown and CR Maintenance received cash from their sale
of most of their assets for about $70 million. Crown distributed all of its
cash from the sale of its assets to Mr. Fry in 2015, 2016, and 2017. After
Crown distributed the remaining cash to Mr. Fry from the sale of its
assets to Recology, Mr. Fry received no further distributions from
Crown.
 6

[*6] Following the distributions of the cash to Mr. Fry, Crown had
insufficient assets for tax years 2017 through 2020 to make any further
distributions to Mr. Fry. The “distributions” on Crown’s tax returns
were not actual distributions but accounting entries intended to balance
Crown’s balance sheet. On Form 1120S the reductions appear as
distributions, but no such distributions actually occurred. The
reductions of amounts described as “Due from” CR Maintenance by
Crown were writeoffs of the Transfers and the Payments as “bad debts”
for 2017 through 2020. At trial it was established that Mr. Margolis
performed the adjustment to “offset between [CR Maintenance] and
Crown exactly everything that [CR Maintenance] owed Crown” for 2017
through 2020. These entries were accounting “plugs” or noncash
distributions. Without the use of accounting plugs, the bases for tax
years 2017, 2018, and 2019 would have been greater than the losses
claimed for those years.

IV. Mr. Fry’s Bases in Crown and CR Maintenance

For tax years 2006 through 2013 Mr. Fry reported stock bases in
CR Maintenance as shown in the tables below:

2006 2007 2008 2009
Stock basis before $12,846,846 $5,594,331 $3,620,530 $3,130,741
distribution
Less: distribution 7,806,000 2,150,000 1,148,000 2,752,000
Stock basis 5,040,846 3,444,331 2,472,530 378,741
available for loss
Ordinary loss per — — — —
1120S return (or as
adjusted/amended)
Nondeductible (239,535) — (50,154) —
expenses
Section 179 (108,000) — — —
expense deduction
Ending stock basis 4,693,311 3,444,331 2,422,376 378,741
Excess loss over — — — —
stock basis
 7

[*7] 2010 2011 2012 2013
Stock basis before $2,507,005 $860,865 $14,597 $2,438
distribution
Less: distribution — — — —
Stock basis 2,507,005 860,865 14,597 2,438
available for loss
Ordinary loss per (1,455,671) (2,186,500) (7,063,393) (5,650,561)
1120S return (or as
adjusted/amended)
Nondeductible (231,216) — — —
expenses
Section 179 — — — —
expense deduction
Ending stock basis 820,118 — — —
Excess loss over — (1,325,635) (7,048,796) (5,648,123)
stock basis

For tax years 2006 through 2020 Mr. Fry reported an ending basis
in Crown as shown in the tables below:

2006 2007 2008 2009 2010
Stock $5,271,709 $6,487,237 $12,506,344 $17,615,743 $21,371,956
basis
Debt — — — — 876
basis

2011 2012 2013 2014 2015
Stock $26,115,562 $33,813,557 $42,724,064 $42,845,299 $80,805,783
basis
Debt 577,000 1,647,087 584,500 — —
basis

2016 2017 2018 2019 2020
Stock $41,294,782 $35,676,709 $32,092,492 $23,285,424 $6,418,079
basis
Debt — — — — —
basis
 8

[*8] V. Notice of Deficiency and Period of Limitations

On September 28, 2020, respondent issued the Frys a notice of
deficiency for tax year 2013 determining a deficiency in income tax, an
addition to tax pursuant to section 6651(a)(1), and an accuracy-related
penalty pursuant to section 6662(a). Following the examination the IRS
determined the flowthrough loss from CR Maintenance was $1,276,231
and disallowed $3,457,444 in flowthrough loss because of Mr. Fry’s lack
of basis. Respondent has conceded that the Frys are entitled to an
additional $2,438 in flowthrough loss. Respondent’s initial
determination to assert an accuracy-related penalty was personally
approved in writing by the examiner’s immediate supervisor.

The periods of limitations for examining the Frys’ individual
income tax returns for tax years 2008 through 2012 and 2014 through
2019 have expired. 3 The periods of limitations for examining
CR Maintenance’s Forms 1120S, Schedules K–1, and amended Forms
1120S 4 for tax years 2008 through 2019 have expired. The periods of
limitations for examining Crown’s Forms 1120S and amended Forms
1120S 5 for tax years 2008 through 2019 have expired.

OPINION

I. Summary of the Parties’ Arguments

A. Petitioners’ Argument

Petitioners argue that under relevant caselaw, the Transfers and
the Payments from Crown to CR Maintenance were not bona fide debt;
rather, they were constructive equity contributions and distributions.
Petitioners further argue that if the Transfers and the Payments are
considered equity contributions, Mr. Fry had a sufficient stock basis to
deduct $3,455,006 in flowthrough losses from CR Maintenance on their
2013 tax return. Moreover, petitioners assert that if the Frys are found
liable for a penalty pursuant to section 6662(a), the Frys are entitled to
a reasonable cause defense since they relied in good faith on the advice
of their accountant.

3 The Frys filed Form 1040X, Amended U.S. Individual Income Tax Return, to

amend their 2010 tax return.
4 CR Maintenance filed an amended tax return for tax year 2010.

5 Crown filed amended tax returns for tax years 2008 and 2010.
 9

[*9] B. Respondent’s Argument

Respondent argues Mr. Fry had insufficient stock basis to claim
the disallowed flowthrough loss. Respondent further argues that
because the Frys have consistently characterized the Transfers and the
Payments between Crown and CR Maintenance as debt between the two
S corporations, they are prohibited from recharacterizing them as equity
contributions. Respondent asserts that section 385(c), the duty of
consistency, and the doctrine of election prohibit the recharacterization
of the Transfers and the Payments from debt to equity as their original
characterization was debt. Respondent avers that permitting the Frys
to recharacterize the debt as equity would result in prohibited
flowthrough losses for them for tax years 2017 and 2018. These tax years
are now closed for assessment since the period of limitations has
expired. Furthermore, respondent notes that the Frys had the prior
opportunity to characterize the Transfers and the Payments as equity
when filing their tax returns and preparing their financial
documentation, but they elected to treat the Transfers and the
Payments as loans.

II. Burden of Proof

In general, the Commissioner’s determinations set forth in a
notice of deficiency are presumed correct, and the taxpayer bears the
burden of proving otherwise. Rule 142(a)(1); Welch v. Helvering, 290
U.S. 111, 115 (1933).

The burden of proof may shift to the Commissioner if the taxpayer
introduces credible evidence with respect to any factual issue relevant
to ascertaining the proper tax liability and establishes that he or she
complied with the requirements of section 7491(a)(2)(A) and (B) to
substantiate items, to maintain required records, and to cooperate with
the Commissioner’s reasonable requests. I.R.C. § 7491(a)(1) and (2).

Petitioners argue that the burden of proof has shifted to
respondent since they claim to have cooperated with all requests for
witnesses, documents, information, meetings, and interviews during the
examination. Respondent notes that petitioners did not provide all
documents requested during the examination and contends therefore
that they failed to provide credible evidence sufficient to shift the burden
of proof to respondent.

The burden of proof is relevant only where there is equal evidence
on both sides. See Dagres v. Commissioner, 136 T.C. 263, 276 (2011). The
 10

[*10] resolution of the issues before us is not dependent on which party
has the burden of proof, since a preponderance of the evidence standard
will be used to resolve all factual issues regardless of which party has
the burden. See I.R.C. § 7491(a); Estate of Turner v. Commissioner,
138 T.C. 306, 309 (2012), supplementing T.C. Memo. 2011-209,
supplemented by 151 T.C. 160 (2018); Knudsen v. Commissioner,
131 T.C. 185, 189 (2008), supplementing T.C. Memo. 2007-340.
Nevertheless, we do not perceive an evidentiary tie in this case and need
not determine whether petitioners have successfully shifted the burden
of proof to respondent.

III. Pleadings

The purpose of pleadings is “to give the parties and the Court fair
notice of the matters in controversy and the basis for the parties’
respective positions.” Rule 31(a). Rule 36(b) provides that “the answer
must contain a clear and concise statement of every ground, together
with the facts in support thereof, on which the Commissioner relies and
has the burden of proof, as well as any special matters as required by
Rule 39.”

Whether an issue not raised in the pleadings will nonetheless be
considered is a matter within the Court’s discretion, taking into account
the risk of prejudice or unfair surprise to the opposing party. Smalley v.
Commissioner, 116 T.C. 450, 456 (2001); Ware v. Commissioner, 92 T.C.
1267, 1268 (1989) (allowing a party to raise a new issue for the first time
on brief). Prejudice or unfair surprise arises when the opposing party
would be prevented from presenting evidence that might have been
offered if the issue had been timely raised. See Smalley, 116 T.C.
at 456–57; Pagel, Inc. v. Commissioner, 91 T.C. 200, 211–12 (1988), aff’d,
905 F.2d 1190 (8th Cir. 1990).

Petitioners argue that it is inappropriate to allow respondent to
present a new argument, i.e., section 385(c), since he failed to present it
in his initial Answer. We disagree and find that petitioners are not
prejudiced or subject to unfair surprise as a result of respondent’s
introduction of this argument. Moreover, respondent timely filed a
Pretrial Memorandum setting forth the issues and relevant law, which
included the section 385(c) argument. Petitioners were fairly apprised
of respondent’s intent to propose this argument, and they had an
opportunity at trial and on brief to address it. Furthermore, petitioners
have used briefing to address respondent’s argument regarding
section 385(c). Therefore, we will consider respondent’s section 385(c)
 11

[*11] argument and decline to rest our disposition of this issue solely on
the ground of improper pleading. We will consider the underlying merits
of respondent’s argument that section 385(c) precludes the
characterization of the Transfers and the Payments as equity.

IV. Characterization of Debt Versus Equity

The determination as to whether a particular interest is
characterized as debt or equity is generally made with reference to
various factors that indicate the economic substance of a transaction.
See I.R.C. § 385(b) (setting forth five factors that may be included in any
regulations prescribed by the Secretary to determine, with respect to a
particular factual situation, whether a debtor-creditor relationship
exists or a corporation-shareholder relationship exists); see also
Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir. 1987) (setting
forth the 11 factors that the U.S. Court of Appeals for the Ninth Circuit
applies to characterize a taxpayer’s interest in a corporation). Absent
stipulation to the contrary pursuant to section 7482(b)(2), appeal of this
case would lie to the Ninth Circuit, and we thus follow its precedent. See
I.R.C. § 7482(b)(1)(A).

Petitioners ask us to find that the Transfers and the Payments
are equity, not debt. Petitioners contend that the Transfers and the
Payments were constructive distributions from Crown to Mr. Fry and
constructive contributions by Mr. Fry to CR Maintenance. Therefore,
petitioners argue that Mr. Fry had sufficient stock basis to allow the
Frys to claim the flowthrough losses on their 2013 tax return.

A. Section 385

Crown and CR Maintenance are S corporations taxed in
accordance with subchapter S of the Code. See I.R.C. §§ 1361–1379.
Under section 1371, the provisions of subchapter C of the Code are
applicable to S corporations. See I.R.C. §§ 301–385. Section 385(a)
authorizes the Secretary to prescribe “regulations as may be necessary
or appropriate to determine whether an interest in a corporation is to be
treated . . . as stock or indebtedness,” i.e., equity versus debt. As stated
above, section 385(b) sets forth five factors that may be included in any
regulations prescribed by the Secretary. Section 385(c) further provides
that “[t]he characterization (as of the time of issuance) by the issuer as
to whether an interest in a corporation is stock or indebtedness shall be
binding on such issuer and on all holders of such interest (but shall not
be binding on the Secretary).”
 12

[*12] Respondent argues that section 385(c) should be applied to bind
the Frys to their characterization at the time of filing the return for the
2013 tax year and that section 385(c) prohibits the recharacterization of
the interest as equity since the Transfers and the Payments were
classified by Crown and CR Maintenance as debt on their tax returns
and general ledgers. Respondent further argues that the regulations
associated with section 385 do not apply in this proceeding. 6

Petitioners counter with the position that section 385(c) does not
apply since there was no formal issuance of an instrument and the
substance of the transactions, rather than the form, should control in
deciding whether the Transfers and the Payments were equity.
Petitioners also argue that section 385(c) has never been applied to
S corporations and that the regulations promulgated under section 385
in 2016 exclude S corporations entirely from being affected by section
385.

We agree with petitioners’ primary position that section 385(c)
does not apply to the facts herein as there was no formal issuance of any
instrument evidencing the creation of an interest in stock or equity. The
issuance of an interest in debt is typically contained in a promissory note
and an equity interest is typically contained in a stock certificate.
Hardman, 827 F.2d at 1412. No such issuance of a promissory note or a
stock certificate occurred here. Thus, on the basis of a plain reading of
the statute, we hold section 385(c) inapplicable. 7

6 Although the regulations under section 385 are not binding on respondent as

the regulation in question was promulgated after the relevant tax period, we still find
it persuasive. See Bell v. Commissioner, 700 F. App’x 654, 656 n.1 (9th Cir. 2017)
(acknowledging that while the Secretary promulgated regulations, they apply only for
tax years ending on or after January 19, 2017), aff’g T.C. Memo. 2015-111; see also
Treas. Reg. § 1.385-1(f). Treasury confirmed petitioners’ argument and undermined
respondent’s argument when it opined that Congress did not intend for section 385(c)
to be applicable to S corporations. See Treas. Reg. § 1.385-1(c)(4)(i); T.D. 9897,
Preamble, 2020-23 I.R.B. 882, 885. Treasury Regulation § 1.385-1(a) states that the
section 385 regulations apply “to determine the treatment of an interest in a
corporation as stock or indebtedness . . . in particular factual situations.” These factual
situations appear to be limited to situations involving a controlled partnership, a
domestic corporation that is part of an expanded group, and a disregarded entity.
Treas. Reg. § 1.385-1(c). Treasury Regulation § 1.385-1(c)(4) excludes S corporations
from the definition of expanded groups.
7 Moreover, as petitioners correctly note, section 385(c) has never been applied

to bind any taxpayer, much less an S corporation, to the initial characterization of an
 13

[*13] B. Caselaw Factors

The substance of a transaction, not its form, “controls the
characterization of a taxable transaction.” Hardman, 827 F.2d at 1411
(citing Gregory v. Helvering, 293 U.S. 465, 469–70 (1935)). Transfers
between related parties are subject to close scrutiny but do not
necessarily lack economic substance. Id. at 1412. Whether an advance
of funds is treated as genuine debt “must be considered in the context of
the overall transaction.” Id. at 1411. The determinative question,
applying the relevant caselaw factors, is whether the taxpayer intended
to create a debt with a reasonable expectation of repayment, and if so,
whether that intent comports in substance with the creation of the
debtor-creditor relationship. Litton Bus. Sys., Inc. v. Commissioner, 61
T.C. 367, 377 (1973). “The outward form of the transaction is not
controlling; rather, characterization depends on the taxpayer’s actual
intent, as evidenced by the circumstances and conditions of the
advance.” Bauer v. Commissioner, 748 F.2d 1365, 1367–68 (9th Cir.
1984), rev’g T.C. Memo. 1983-120.

The Ninth Circuit has identified 11 factors that may be relevant
in determining whether a transfer to a corporation by a shareholder is
debt or a contribution of capital. Hardman, 827 F.2d at 1411–12;
A.R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir. 1970). No
one factor is controlling or decisive, and the Ninth Circuit directs us to
consider the “particular circumstances of each case.” Hardman, 827 F.2d
at 1412. “The object of the inquiry is not to count factors, but to evaluate
them.” Id. (quoting Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir.
1969)). The taxpayer bears the burden of establishing that the interest
should be characterized as debt or equity. Bauer v. Commissioner, 748
F.2d at 1368 (citing O.H. Kruse Grain & Milling v. Commissioner, 279
F.2d 123, 125 (9th Cir. 1960), aff’g T.C. Memo. 1959-110).

interest as equity or debt, and despite its enactment in 1992, this section has been
cited by a court on only one other occasion and merely in passing. See Bell v.
Commissioner, 700 F. App’x 654, 655 (9th Cir. 2017), aff’g T.C. Memo. 2015-111. Thus,
we will decline to apply it here. The ultimate test of the characterization of a
transaction is not necessarily the original intent of the parties. United States v. Uneco,
Inc. (In re Uneco, Inc.), 532 F.2d 1204, 1207 (8th Cir. 1976); Cuyuna Realty Co. v.
United States, 382 F.2d 298, 301 (Ct. Cl. 1967). The Court should inquire for each tax
year as to the characterization of a transaction as equity or indebtedness. Cuyuna
Realty Co., 382 F.2d at 301. We hold that the determination of an interest as equity or
debt will be based on the overall transaction in the context of the relevant factors,
rather than the initial characterization of the interest at the time of the filing of the
2013 tax return.
 14

[*14] The Ninth Circuit in Hardman identified the following factors as
potentially relevant to the debt-vs-equity inquiry: (1) the names given to
the certificates evidencing the debt; (2) the presence or absence of a fixed
maturity date; (3) the source of the payments; (4) the right to enforce
payments of principal and interest; (5) whether the advances increase
participation in management; (6) whether the “lender” has a status
equal or inferior to that of regular creditors; (7) objective indicators of
the parties’ intent; (8) whether the capital structure of the “borrower” is
thin or adequate; (9) the extent to which the funds advanced are
proportional to the shareholder’s capital interest; (10) the extent to
which interest payments come from “dividend” money; and (11) the
ability of the “borrower” to obtain loans from outside lending
institutions. See Hardman, 827 F.2d at 1412; NA Gen. P’ship & Subs. v.
Commissioner, T.C. Memo. 2012-172, 2012 WL 2344719, at *6.

1. Names Given to the Certificates Evidencing the
Indebtedness

The issuance of a debt instrument such as a promissory note
indicates debt, and the issuance of an equity instrument such as a stock
certificate indicates an equity contribution. Hardman, 827 F.2d at 1412;
NA Gen. P’ship & Subs. v. Commissioner, 2012 WL 2344719, at *6. If
the document at issue includes wording typically contained in a
promissory note and does not include wording typically contained in a
stock certificate, then this factor will weigh in favor of a finding that the
transaction at issue was debt rather than equity. Hardman, 827 F.2d
at 1412. This factor does not squarely fit in the context of an
S corporation since there is generally no issuance of stock for capital;
rather, capital is accounted for internally when contributed (or retained)
by the shareholders as basis. See generally I.R.C §§ 1366 and 1367.

We find this factor to be neutral since there was no creation of a
formal debt instrument indicating indebtedness; nor was there
recognition of a capital contribution by CR Maintenance.

2. The Presence or Absence of a Maturity Date

A fixed maturity date is evidence that a debt exists because it
requires fulfillment of the financial obligation at a specific time. NA Gen.
P’ship & Subs. v. Commissioner, 2012 WL 2344719, at *6. The lack of a
fixed maturity date indicates that payment is linked to the success of
the business and is evidence of an equity interest. Hardman, 827 F.2d
at 1413. Similarly, an advance made with a fixed maturity date that has
 15

[*15] been postponed for a prolonged period suggests that “the nominal
lender does not intend to require repayment and that the transfers are
equity.” Laidlaw Transp., Inc. v. Commissioner, T.C. Memo. 1998-232,
1998 WL 345528, at *24. Here, CR Maintenance intended to make
repayments to Mr. Fry if CR Maintenance was profitable; therefore, this
factor weighs in favor of equity as the record shows that repayments
were dependent on the success of CR Maintenance and not due at any
fixed time.

3. The Source of Payments

Payments that depend on earnings or come from a restricted
source indicate an equity interest. Hardman, 827 F.2d at 1413; NA Gen.
P’ship & Subs. v. Commissioner, 2012 WL 2344719, at *7. A true lender
is concerned with a reliable return on his investment in the form of
interest and repayment of principal. See Curry v. United States, 396 F.2d
630, 634 (5th Cir. 1968). If timely payments to the alleged lender are not
made, or if they can plausibly be made only out of future earnings, an
inference arises that the advances were contributions to capital.
Hardman, 827 F.2d at 1413; Am. Offshore, Inc. v. Commissioner, 97 T.C.
579, 602 (1991). When repayment is not dependent upon earnings, the
interest is more likely to be characterized as a loan. Am. Offshore, Inc.,
97 T.C. at 602. Following the withdrawal of the contract with the City
of Los Angeles in 2011, CR Maintenance ceased to be profitable. At trial
Mr. Richardson testified that CR Maintenance would have repaid the
Transfers and the Payments if CR Maintenance had become profitable.
Therefore, the repayment of the Transfers and the Payments by
CR Maintenance was conditioned on the future profitability of
CR Maintenance. Consequently, this factor weighs in favor of equity.

4. The Right to Enforce the Payment of Principal and
Interest

The right to enforce payment of principal and interest is evidence
of debt. Hardman, 827 F.2d at 1413; Bell, T.C. Memo. 2015-111, at *13;
NA Gen. P’ship & Subs. v. Commissioner, 2012 WL 2344719, at *8.
A lender’s failure to take any of the “customary steps” to ensure
repayment, such as obtaining a security interest, despite an enforceable
right to repayment, supports a conclusion of equity. Lane v. United
States (In re Lane), 742 F.2d 1311, 1317 (11th Cir. 1984); Allen v.
Commissioner, T.C. Memo. 2023-86, at *18. Nevertheless, the lack of a
security interest in connection with a promise to repay is indicative of
an equity interest, but it may be less important where the transaction
 16

[*16] is between related parties. See, e.g., Bell, T.C. Memo. 2015-111,
at *13; Am. Underwriters, Inc. v. Commissioner, T.C. Memo. 1996-548,
1996 WL 726365, at *8.

As of December 31, 2013, CR Maintenance had failed to repay
$9,650,662 to Mr. Fry or Crown. The record does not indicate that
Mr. Fry ever made a written request to demand payment from
CR Maintenance on Crown’s behalf, nor was interest collected from
CR Maintenance on the Transfers and the Payments. Furthermore,
Crown never obtained a security interest. Thus, this factor weighs in
favor of equity.

5. Participation in Management

If a taxpayer’s advances to a corporation entitle him to greater
participation in its management, the advances are more likely to be
treated as equity. Hardman, 827 F.2d at 1413; Am. Offshore, Inc.,
97 T.C. at 603. Both Crown and CR Maintenance had only one
shareholder at the time of the relevant transactions, Mr. Fry, and his
ownership interest never changed as a result of the Transfers and the
Payments. Accordingly, this factor is neutral.

6. A Status Equal to or Inferior to That of Regular
Corporate Creditors

If a shareholder’s rights to repayment of principal and interest
are subordinated to the rights of regular creditors, then the
shareholder’s advances are generally indicative of an equity interest.
Hardman, 827 F.2d at 1413; Am. Offshore, Inc., 97 T.C. at 603. Even
absent an explicit subordination clause, the failure to demand timely
repayment or to take collateral effectively subordinates the alleged debt
to the rights of other creditors, who may receive payment or foreclose on
their security in the interim. Am. Offshore, Inc., 97 T.C. at 603.

On the basis of the record before us, we conclude that Crown’s
right to repayment was subordinated to the rights of regular creditors.
Mr. Fry and Crown never demanded payment from CR Maintenance,
and repayment of the Transfers and the Payments was subordinated to
the claims of CR Maintenance’s creditors. The Transfers and the
Payments were necessary for CR Maintenance to continue operating
and pay its creditors and operational expenses including fuel, wages,
payroll taxes, workers’ compensation insurance, and employee benefits.
There is no evidence in the record to suggest that Crown was repaid
before other creditors. Accordingly, this factor weighs in favor of equity.
 17

[*17] 7. The Intent of the Parties

In considering this factor we examine whether the parties to the
transaction intended the interest to be debt or equity. Hardman, 827
F.2d at 1413. The Court will look at the objective evidence of whether
the parties intended to create a “definite obligation, repayable in any
event.” See id.; NA Gen. P’ship & Subs. v. Commissioner, 2012 WL
2344719, at *9; Hewlett-Packard Co. & Consol. Subs. v. Commissioner,
T.C. Memo. 2012-135, 2012 WL 1673643, at *28, aff’d, 875 F.3d 494 (9th
Cir. 2017); Am. Underwriters, Inc. v. Commissioner, 1996 WL 726365,
at *9. The intent at the time of the creation of the interest is persuasive,
but the Court uses all 11 factors to determine the “true intent”
concerning the creation of the interest. Am. Underwriters, Inc. v.
Commissioner, 1996 WL 726365, at *9.

When the Transfers and the Payments were initially structured,
it is likely that Mr. Fry, Crown, and CR Maintenance intended them to
be debt. CR Maintenance accounted for the transfers from Crown as a
“Loan Payable” in their general ledger liability from 2010 through 2014.
From 2006 through 2013, CR Maintenance accounted for the Payments
paid by Crown as “Due to Crown” in another general ledger liability
account. From 2010 to 2017, CR Maintenance documented the Transfers
and the Payments as liabilities between CR Maintenance and Crown
but did not document the additional contributed capital or loans from
Mr. Fry on its 2009 to 2019 financial documents. Crown accounted for
the expenses it paid for CR Maintenance, from 2006 through 2013, as
“Due from CR [Maintenance].” Crown documented the Transfers and
the Payments as liabilities between Crown and CR Maintenance from
2010 through 2017. From 2010 through 2020, CR Maintenance reported
the Transfers and the Payments as a balance due to Crown on its tax
returns and characterized them as indebtedness on the return.
CR Maintenance did not report Mr. Fry’s additional capital
contributions on the returns filed between 2009 and 2019. Crown
reported the Transfers and the Payments as liabilities due from CR
Maintenance on its tax returns from 2010 through 2020 and
characterized them as indebtedness. Thus, this factor weighs in favor of
indebtedness as the ledgers and tax returns of the parties seemed to
indicate that the parties intended this to be classified as debt at the time
of creation.
 18

[*18] 8. Thin or Adequate Capitalization

The purpose of examining the alleged borrower’s debt-to-equity
ratio is to determine whether it is so thinly capitalized that it would be
unable to repay the debt if its financial condition worsened. Bauer v.
Commissioner, 748 F.2d at 1369. Thin capitalization tends to indicate
that a transaction is a capital contribution. Hardman, 827 F.2d at 1414.
A corporation’s debt-to-equity ratio is determined by comparing all of its
liabilities to the shareholders’ equity. Am. Underwriters, Inc. v.
Commissioner, 1996 WL 726365, at *9.

At trial Mr. Richardson testified that on the basis of the losses of
CR Maintenance at the end of 2013, CR Maintenance would not have
been able to repay any loans from a commercial lender. Furthermore,
after 2011 CR Maintenance was losing between $5 and $7 million per
year. This suggests that CR Maintenance was undercapitalized and
would not have been able to repay debts. However, in the absence of
financial statements, it is not possible to calculate debt-to-equity ratios
for the 2013 tax year. Thus, this factor is neutral.

9. Identity of Interest Between Creditor and
Stockholder

Advances made by shareholders in proportion to their stock
ownership indicate capital contributions. Hardman, 827 F.2d at 1414;
NA Gen. P’ship & Subs. v. Commissioner, 2012 WL 2344719, at *13;
Am. Underwriters, Inc. v. Commissioner, 1996 WL 726365, at *10.
Where a stockholder owns “debt” in the same proportion to which he
holds stock in the corporation, the characterization of his advances as
“debt” may be suspect. Bauer v. Commissioner, 748 F.2d at 1370. This
Court has previously determined that where the same family controlled
the issuing and borrowing entities, the interests between borrower and
lender were “significantly intertwined” and the factor weighed in favor
of equity. Allen, T.C. Memo. 2023-86, at *25–26 (quoting Tribune Media
Co. v. Commissioner, T.C. Memo. 2021-122, at *79–80).

Mr. Fry was the sole shareholder of both CR Maintenance and
Crown. Each month Mr. Fry reviewed the financial position of Crown
and CR Maintenance and directed Crown to transfer sufficient funds to
CR Maintenance to allow CR Maintenance to continue operating. As the
interests of Mr. Fry, Crown, and CR Maintenance were “significantly
intertwined,” there was likely an identity of interest. Accordingly, this
factor weighs in favor of equity.
 19

[*19] 10. Extent to Which Interest Payments Come from
“Dividend” Money

A true lender is concerned with reliable payments of interest.
Estate of Mixon v. United States, 464 F.2d 394, 409 (5th Cir. 1972).
A lack of interest payments and the alleged debtor’s lack of ability to
make them suggests that the party who advanced funds is looking to the
corporation’s future earnings to achieve a return on his investment,
which is indicative of equity. Am. Offshore, Inc., 97 T.C. at 605. This
factor is effectively the same as the third Hardman factor. As noted
under the third factor, there was no expectation that CR Maintenance
would make interest payments to Crown, nor did Crown make such a
demand. Thus, like the third factor, this factor favors equity.

11. The Ability of the Corporation to Obtain Loans from
Outside Lending Institutions

If the corporation is able to obtain funds from outside sources on
substantially the same terms as those imposed by the payor of the
advance, an inference arises that the advance may be debt. Hardman,
827 F.2d at 1414; Estate of Mixon, 464 F.2d at 410. Evidence that the
corporation would not have been able to obtain a loan from an
independent source indicates equity. Hardman, 827 F.2d at 1414. Where
there is no evidence that a taxpayer was unsuccessful in attempts to
obtain independent financing, the Court will consider this factor
neutral. Am. Offshore, Inc., 97 T.C. at 605–06.

At trial Mr. Richardson testified that on the basis of the losses of
CR Maintenance at the end of 2013, no lender would have loaned
$36 million to CR Maintenance to replace the Transfers and the
Payments from Crown. Mr. Richardson additionally testified that CR
Maintenance had never attempted to get a commercial loan outside of
the Transfers and the Payments from Crown. However, aside from
Mr. Richardson’s testimony, petitioners presented no evidence
regarding the credit worthiness of CR Maintenance, Crown, or Mr. Fry.
Accordingly, we find this factor to be neutral.

12. Outcome of the Hardman Factors

Of the 11 factors listed in Hardman, 4 are neutral, 6 favor equity,
and 1 favors debt. After weighing the factors in the context of this case
we conclude it is more likely than not that the Transfers and the
Payments in question do not constitute true indebtedness.
 20

[*20] Next, we must determine whether the transactions in question
can be recharacterized as constructive distributions from Crown to its
shareholder, Mr. Fry, followed by contributions of capital to
CR Maintenance.

C. Constructive Distribution/Contribution

A distribution 8 need not be formally declared or even intended by
a corporation to be deemed a constructive distribution. See Noble v.
Commissioner, 368 F.2d 439, 442–43 (9th Cir. 1966), aff’g T.C. Memo.
1965-84. “It is well established that transfers between related
corporations may result in constructive dividends to a common
shareholder.” Benson v. Commissioner, T.C. Memo. 2004-272, 2004 WL
2698858, at *17 (quoting Speer v. Commissioner, T.C. Memo. 1996-323,
1996 WL 39398, at *7), supplemented by T.C. Memo. 2006-55, aff’d, 560
F.3d 1133 (9th Cir. 2009). “A greater potential for constructive dividends
* * * exists in closely held corporations where dealings between
stockholders and the corporation are commonly characterized by
informality.” Id. (quoting Zhadanov v. Commissioner, T.C. Memo. 2002-
104, 2002 WL 731708, at *11).

Under Ninth Circuit caselaw, a constructive dividend occurs
where a two-part test is met: (1) the expenditures do not give rise to a
deduction on behalf of the distributing corporation and (2) the
expenditures create “economic gain, benefit, or income” to the
shareholder. See P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084, 1088
(9th Cir. 1987) (quoting Meridian Wood Prods. Co. v. United States, 725
F.2d 1183, 1191 (9th Cir. 1984)), aff’g T.C. Memo. 1984-549; Magnon v.
Commissioner, 73 T.C. 980, 993–94 (1980). We conclude both prongs of
this two-part test are met.

The crucial determination of whether a constructive dividend
exists turns on the question of whether the distribution was primarily
for the benefit of the shareholder. Hood v. Commissioner, 115 T.C. 172,
179–80 (2000). A showing that the corporation, rather than the
shareholder, was the primary beneficiary of a distribution is required to
avoid constructive distribution treatment. See id. at 181. Whether the
shareholder primarily benefited from the distribution is a question of

8 The Court uses the term “constructive distribution” to describe what our

caselaw has sometimes referred to as a “constructive dividend.” We use the terms
interchangeably here because of CR Maintenance and Crown’s status as
S corporations.
 21

[*21] fact. Coastal Heart Med. Grp., Inc. v. Commissioner, T.C. Memo.
2015-84, at *18.

“Generally, a constructive distribution occurs when corporate
assets are diverted to or for the benefit of a shareholder without
adequate consideration for the diversion.” CTM Constr., Inc. v.
Commissioner, T.C. Memo. 1988-590, 1988 Tax Ct. Memo LEXIS 619,
at *11 (citing Sammons v. Commissioner, 472 F.2d 449 (5th Cir. 1972),
aff’g in part, rev’g in part, and remanding T.C. Memo. 1971-145).
A transfer between related corporations can be a constructive dividend
to common shareholders even if those shareholders do not personally
receive the funds. See, e.g., Benson v. Commissioner, 2004 WL 2698858,
at *18–22 (finding payments for purported royalties and nonexistent
services between related entities were a constructive dividend); Shedd
v. Commissioner, T.C. Memo. 2000-292, 2000 WL 1337177, at *6–7
(finding advance of funds between shareholder’s entities was a
constructive dividend); see also Stinnett’s Pontiac Serv., Inc. v.
Commissioner, 730 F.2d 634, 641 (11th Cir. 1984), aff’g T.C. Memo.
1982-314.

In order to meet the second prong of the Ninth Circuit’s test, the
shareholder must receive an actual, direct benefit. Stinnett’s Pontiac
Service, Inc. v. Commissioner, 730 F.2d at 641; Gilbert v. Commissioner,
74 T.C. 60, 67–69 (1980); see also Povolny Grp., Inc. v. Commissioner,
T.C. Memo. 2018-37, at *14 (finding that where there was no discernable
business reason to make a transfer between related entities, as there
was no expectation of interest or repayment, the primary benefit was to
the shareholder because it reduced the liabilities of his other entities);
J.F. Stevenhagen Co. v. Commissioner, T.C. Memo. 1975-198, 1975 Tax
Ct. Memo LEXIS 175, at *23 (finding that where advances were made
from one corporation to another to further the latter’s business as a
“viable and profitable corporation,” they constituted a primary benefit
to the 50% shareholder rather than a business purpose), aff’d, 551 F.2d
106 (6th Cir. 1977).

Petitioners argue that the second prong is met since the Transfers
and the Payments primarily benefited Mr. Fry. The Transfers and the
Payments allowed CR Maintenance to continue operating, reduced the
need for Mr. Fry to continue CR Maintenance’s operations with his
personal funds, and allowed him to continue collecting salary and rent
from CR Maintenance. Petitioners further argue that because of the
interlinked business operations of CR Maintenance and Crown, had
CR Maintenance failed, Crown would not have been profitable.
 22

[*22] We agree with petitioners that the Transfers and the Payments
primarily benefited Mr. Fry. There was no discernable business reason
for Crown to make the Transfers and the Payments, which is in
accordance with our finding of no true expectation of interest or timely
repayment. The Transfers and the Payments directly benefited Mr. Fry
since it allowed his other business entity, CR Maintenance, to continue
operations. At trial Mr. Richardson testified that Mr. Fry treated Crown
and CR Maintenance “like his baby” and he wanted to ensure that both
continued operating. Thus, we find that petitioners have shown that the
Transfers and the Payments were for the primary benefit of Mr. Fry.

The first prong of the Ninth Circuit test requires that the
expenditures not give rise to a deduction on behalf of the distributing
corporation. P.R. Farms, Inc. v. Commissioner, 820 F.2d at 1088. Under
this prong the Court seeks to determine whether some benefit existed
for the corporation to make the distribution. The Court has found that a
distribution was made for the benefit of the corporation when it claimed
a deduction as a result of the distribution. See Benson v. Commissioner,
2004 WL 2698858, at *18. As discussed above, there was no discernable
business reason for or business deduction attributable to Crown’s
Transfers. And respondent does not dispute that the Payments were
business deductions attributable to CR Maintenance, not Crown.

We find that both prongs of the constructive dividend test are
satisfied as the constructive distributions were made primarily for
Mr. Fry’s benefit. Accordingly, we conclude that the Transfers and the
Payments constituted constructive distributions from Crown to Mr. Fry,
followed by constructive contributions from Mr. Fry to CR Maintenance.

V. Mr. Fry’s Basis

Subchapter S corporations are flowthrough entities.
A shareholder in an S corporation is entitled to deduct his share of entity
level losses in accordance with the flowthrough rules of subchapter S.
See I.R.C. § 1366(a). Section 1366(d)(1) limits the amount of losses and
deductions the shareholder may deduct as not exceeding the sum of the
shareholder’s adjusted basis in his stock and the shareholder’s adjusted
basis in indebtedness of the S corporation to the shareholder.

Respondent argues that Mr. Fry has insufficient stock basis to
claim the flowthrough loss of $4,733,675 for the 2013 tax year.
Petitioners argue that the Transfers and the Payments, when
reclassified as deemed distributions from Crown to Mr. Fry and deemed
 23

[*23] capital contributions from Mr. Fry to CR Maintenance, provide
additional basis in CR Maintenance to claim these losses.

The parties agree that at the end of 2013, Mr. Fry’s debt basis in
CR Maintenance was $1,276,231 and his stock basis was $2,438. At the
end of 2013 Mr. Fry’s debt basis in Crown was $42,724,064 and his stock
basis was $584,500. As noted above, the Court agrees with petitioners’
contentions that the Transfers and the Payments in question were
deemed distributions from Crown to Mr. Fry followed by deemed capital
contributions from Mr. Fry to CR Maintenance. The record reflects
adequate basis in Crown; however, this calculation is before the
Transfers and the Payments in question are recharacterized as
distributions from Crown to Mr. Fry.

The record contains insufficient information for the Court to
recalculate Mr. Fry’s adjusted bases in CR Maintenance and Crown.
Accordingly, we instruct the parties to calculate Mr. Fry’s bases in
CR Maintenance and Crown beginning in 2013 through 2020, in the
light of this Court’s decision, pursuant to Rule 155. This calculation
should also be used to determine the appropriate amount of flowthrough
loss the Frys are entitled to for tax year 2013 and determine the harm
(if any) facing respondent, which is addressed below.

VI. Harm to Respondent

Respondent argues that if the Transfers and the Payments from
Crown to CR Maintenance are recharacterized as distributions followed
by contributions, Mr. Fry would have had a zero basis in Crown by the
end of 2017, resulting in an insufficient basis for Mr. Fry to claim losses
in subsequent years from Crown. Respondent alleges harm because of
the closed period of limitations precluding him from examining the tax
returns of Crown, CR Maintenance, and the Frys. On their 2017 and
2018 tax returns the Frys reported losses from Crown of $712,495 and
$411,577, respectively. Respondent argues that allowing the Frys to
recharacterize the debt as equity would let them claim flowthrough
losses on their tax returns that they were otherwise ineligible for. At
trial respondent called Revenue Agent (RA) Lydia Park, CPA, who
prepared a spreadsheet reflecting how Mr. Fry’s basis in Crown goes
below zero in 2017 and a financial harm to respondent, should the Frys
 24

[*24] be permitted to reclassify both the Transfers and the Payments as
equity in CR Maintenance. 9

Petitioners dispute respondent’s argument of harm by contending
that the basis calculations respondent presented and relied upon to
demonstrate that the distributions from Crown beginning in 2017,
purportedly in excess of Mr. Fry’s basis in Crown, were not actual
distributions. Rather, petitioners contend that these adjustments were
merely “accounting entries, not economic transactions.” Petitioners
argue that Mr. Margolis adjusted Crown’s account to correct these
incorrect prior characterizations of the Transfers and the Payments as
“due from” CR Maintenance on Crown’s balance sheet and returns. Mr.
Margolis “wrote down” the purported loans from CR Maintenance as
they were incorrectly classified as assets on Crown’s balance sheet
thereby reducing Crown’s shareholder equity. On Form 1120S, this
reduction appears as a “distribution,” but no such distribution actually
occurred as Crown lacked sufficient cash and assets beginning in 2017
to make the distributions alleged to have occurred and never deducted
any interest on their returns. At trial Mr. Margolis testified that he
performed the adjustment to “offset between [CR Maintenance] and
Crown exactly everything that [CR Maintenance] owed Crown” for 2017
through 2020.

We find the rebuttal testimony of Mr. Margolis compelling and
sufficient to dispute respondent’s calculations reflecting an alleged
financial harm. Therefore, and as found above, the parties will submit
revised basis calculations, pursuant to Rule 155, reflecting Mr. Fry’s
bases in CR Maintenance and Crown and confirming adequate bases
remain in both entities to support the positions claimed by the Frys with
respect to the closed tax years. 10

A. Whipsaw

This Court has allowed the Commissioner “the right to make
inconsistent assessments so as to protect the public fisc and ‘insure
against a potential “whipsaw” effect.’” Gerardo v. Commissioner, 552

9 The foregoing basis dispute and cited harm (based on respondent’s
calculations) appears to begin in 2016 with the distribution of some $39 million
reported on the Frys’ Schedule K–1.
10 The goal of this basis calculation should be to show that Mr. Fry held

adequate bases in CR Maintenance and Crown to claim the flowthrough loss at issue
in 2013, as well as the future positions claimed by the Frys for subsequent tax years
that are now closed to audit and would result in harm to respondent.
 25

[*25] F.2d 549, 555 (3d Cir. 1977) (quoting Cannon v. Commissioner,
533 F.2d 959, 962 (5th Cir. 1976) (Clark, J., dissenting), aff’g T.C. Memo.
1974-219), aff’g in part, rev’g in part, and remanding T.C. Memo. 1975-
341. Generally, whipsaw issues arise where “both parties to a taxable
event avoid taxation by taking inconsistent tax reporting positions for
the same transaction.” United States v. Daum, 968 F. Supp. 1037, 1043
(W.D. Pa. 1997); Maggie Mgt. Co. v. Commissioner, 108 T.C. 430, 446
(1997). The Commissioner is harmed in such a whipsaw event because
the parties take inconsistent approaches and receive different tax
benefits. Daum, 968 F. Supp. at 1043. Often, one party to the transaction
claims taxation based on the form, and another party to the transaction
claims taxation based on the substance. See Comdisco Inc. v. United
States, 756 F.2d 569, 578 (7th Cir. 1985); Estate of Durkin v.
Commissioner, 99 T.C. 561, 575 (1992).

Respondent argues that one of the principal purposes behind the
enactment of section 385(c) is to bind issuers to their initial
characterizations in order to prevent whipsaw. In making this argument
respondent quotes a report from the Committee on Ways and Means of
the U.S. House of Representatives:

It has come to the attention of the committee that
certain issuers and holders may be taking inconsistent
positions with respect to the characterization of a corporate
instrument as debt or equity. For example, a corporate
issuer may designate an instrument as debt and deduct as
interest the amounts paid on the instrument, while a
corporate holder may treat the instrument as equity and
claim a dividends received deduction . . . .

H.R. Rep. No. 102-716, at 3 (1992).

As noted above, we decline to apply section 385(c) in this case.
Section 385(c) has never been applied by this Court (or other courts) to
an S corporation seeking to recharacterize debt as equity, and its
associated regulations appear to preclude section 385 from applying to
S corporations. Regardless of the apparent inapplicability of section
385(c) to S corporations, respondent points out that the purpose behind
the enactment of section 385(c) was to prevent whipsaw from taxpayers
who deduct interest or claim the dividends received deduction. If
Congress sought to prevent whipsaw in the form noted above, then no
whipsaw occurred in this case and this argument has no relevance here.
CR Maintenance never promised or paid interest on the Transfers and
 26

[*26] the Payments, and Crown never requested interest be paid.
Respondent has not introduced any evidence that Crown or CR
Maintenance deducted interest. Furthermore, the Frys, as individuals,
would not have been eligible to claim the dividends received deduction
under section 243. Moreover, S corporations do not typically issue
dividends to shareholders, and there is no evidence that Crown or CR
Maintenance ever issued any. Under respondent’s own argument, the
whipsaw Congress sought to prevent in enacting section 385(c) never
occurred. The question before us is not as much whether the Frys took
inconsistent tax reporting positions. Rather, the more precise question
is whether the Transfers and the Payments from Crown are properly
reclassified as equity, creating sufficient basis in CR Maintenance for
the losses the Frys claimed for 2013. 11 Accordingly, we decline to apply
the whipsaw doctrine in this case.

B. Duty of Consistency

The Ninth Circuit has held that for the duty of consistency to
apply, the following elements must exist: (1) a representation or report
by the taxpayer, (2) reliance by the Commissioner, and (3) an attempt
by the taxpayer after the period of limitations has run to change the
previous representation or to recharacterize the situation in such a way
as to harm the Commissioner. Estate of Ashman v. Commissioner, 231
F.3d 541, 545 (9th Cir. 2000), aff’g T.C. Memo. 1998-145, 1998 WL
188936. If all three elements are present, the Commissioner may act as
if the previous representation, on which he relied, continues to be true,
even if it is not. Id. The taxpayer is estopped to assert the contrary. Id.

The duty of consistency is an affirmative defense. See Squeri v.
Commissioner, T.C. Memo. 2016-116, at *10; Estate of Ashman v.
Commissioner, 1998 WL 188936, at *2. Therefore, the party asserting
the duty of consistency bears the burden of proving that it applies; thus,
respondent bears the burden here. See Rule 142(a). Respondent properly
pleaded the duty of consistency in filing an Amended Answer, wherein
the duty of consistency was asserted as an affirmative defense.

11 To be clear, we do not intend to permit the Frys to take a tax benefit from a

flowthrough loss in CR Maintenance that would undermine or otherwise be
inconsistent with the prior tax reporting positions taken by Crown. We are under the
impression, notwithstanding the recharacterization of the Transfers and the
Payments, that Mr. Fry would still hold a sufficient basis in Crown.
 27

[*27] 1. Representation by the Taxpayer

In applying the first element of the duty of consistency, the Ninth
Circuit requires that a taxpayer made a representation of fact or
reported an item for tax purposes. Estate of Letts v. Commissioner, 109
T.C. 290, 299 (1997). A taxpayer’s treatment of an item on a return can
be a representation that facts exist which are consistent with how the
taxpayer reports the item on the return. Id. at 299–300. Here, Crown
and CR Maintenance made clear representations on their tax returns
that the Transfers and the Payments between Crown and
CR Maintenance were indebtedness. This element of the duty of
consistency has been met.

2. Reliance by the Commissioner

The second element of the duty of consistency is reliance by the
Commissioner on the taxpayer’s representation, which occurs where a
taxpayer’s return is accepted as filed and examination of the return is
not required. Arberg v. Commissioner, T.C. Memo. 2007-244, 2007 WL
2416230, at *13. The Commissioner may rely on a presumption of
correctness of a return or report that is given to the Commissioner under
penalties of perjury. Estate of Letts, 109 T.C. at 301. Here, respondent
relied upon petitioners’ representation that the interest at issue was
debt rather than equity and allowed the period of limitations to expire
for subsequent tax years for the returns of the Frys, Crown, and
CR Maintenance. This element of the duty of consistency has been met.

3. Recharacterization by the Taxpayer Resulting in
Harm to the Commissioner

The third element of the duty of consistency requires an attempt
by the taxpayer, after the period of limitations has expired, to change
the previous representation or to recharacterize the situation in such a
way as to harm the Commissioner. Courts have previously found that
this element was met in cases where allowing the taxpayers to
recharacterize a previous representation would result in significant tax
avoidance as a result of the closed period of limitations. See Estate of
Ashman v. Commissioner, 231 F.3d at 546 (allowing a taxpayer to
recharacterize her previous representation would have resulted in
“$100,502.21 tax free by misleading [the Commissioner]”); Squeri, T.C.
Memo. 2016-116, at *13 (“[A]llowing [the taxpayers] to recharacterize
their income . . . would allow [them] to avoid tax on $1,634,720.”). The
duty of consistency was created to avoid “tax gamesmanship” where “the
 28

[*28] Commissioner can no longer collect the tax deficiency occasioned
by [the taxpayers’] turnabout.” Janis v. Commissioner, 461 F.3d 1080,
1087 (9th Cir. 2006), aff’g T.C. Memo. 2004-117. This Court has declined
to apply the duty of consistency in cases where a taxpayer did not receive
any benefit and the Commissioner did not suffer any detriment. Cleo
Perfume, Inc. v. Commissioner, T.C. Memo. 1998-155, 1998 WL 201761,
at *5.

As he pleads the duty of consistency as an affirmative defense,
respondent bears the burden of proving that the duty of consistency
applies here. Respondent has not sufficiently demonstrated that he
would suffer any harm upon a finding by this Court that the Transfers
and the Payments were equity rather than debt. As noted above, at trial
and on brief, respondent has not successfully shown that the
recharacterization of the Transfers and the Payments would cause him
harm.

Respondent repeatedly alleges harm and relies on the
spreadsheet created by RA Park which was introduced at trial as
Exhibit 102-R purportedly showing distributions in excess of Mr. Fry’s
basis. Exhibit 102-R was created by RA Park after the Frys did not
provide a basis calculation for Mr. Fry in CR Maintenance. At trial
RA Park testified that the spreadsheet was created using assets from
Schedules L, Balance Sheet per Books, and Schedules K–1 of Crown’s
tax returns. She testified only as to what information she gleaned from
the returns and not as to the nature of the distributions. She further
indicated that she did not have information on whether the distribution
was a cash or other property distribution or what the source of the
distribution was.

In rebuttal Mr. Margolis testified that the distributions on this
spreadsheet were in reality accounting “plugs” to the balance sheet, and
not actual distributions of cash or property. Mr. Margolis indicated that
this occurred for tax years 2017 through 2020. At the conclusion of his
rebuttal testimony, respondent had the opportunity to cross-examine
Mr. Margolis on this issue but declined to do so.

For these reasons, we conclude that the third element of the duty
of consistency has not been met under the facts herein.

C. Doctrine of Election

The doctrine of election is an equitable principle that generally
precludes a taxpayer who makes a conscious election from revoking or
 29

[*29] amending that election without the consent of the Commissioner.
See, e.g., Pac. Nat’l Co. v. Welch, 304 U.S. 191 (1938). The doctrine
consists of the following two elements: (1) there must be a free choice
between two or more alternatives and (2) there must be an overt act by
the taxpayer communicating the choice to the Commissioner, i.e., a
manifestation of choice. See Grynberg v. Commissioner, 83 T.C. 255, 261
(1984); Hodel v. Commissioner, T.C. Memo. 1996-348, 1996 WL 426845,
at *4. We fail to see how this doctrine applies here. Petitioners do not
have a “free choice” or election to deem the Transfers or the Payments
either debt or equity. Rather, and as detailed above, the characterization
of the Transfers and the Payments is based on various factors that
indicate the true economic substance of a transaction.

The doctrine of election is often applied in situations where a
taxpayer has filed or seeks to file an amended return or is pursuing a
suit for refund and seeks to change the treatment of the contested items
inconsistently with the treatment of the items on the original return.
Pac. Nat’l Co., 304 U.S. 191; Grynberg, 83 T.C. 255; Goldstone v.
Commissioner, 65 T.C. 113, 114 (1975); Hodel v. Commissioner, 1996 WL
426845, at *4–5.

This case is not a situation where a taxpayer has filed or seeks to
file an amended return or a refund suit treating contested items
inconsistently with how the taxpayer previously treated them on the
originally filed return.

Moreover, the applications of the doctrine of election by this Court
are few and far between. The most recent opinion to cite the doctrine of
election determined that the doctrine was inapplicable. Ag Processing,
Inc. v. Commissioner, 153 T.C. 34, 54–55 (2019). Respondent does not
cite any caselaw indicating that the Ninth Circuit has adopted the
doctrine of election and would apply it to the facts herein. Accordingly,
we decline to apply the doctrine of election to the facts before us.

We are not persuaded by respondent’s allegation of whipsaw, nor
are we convinced of the applicability of the duty of consistency and the
doctrine of election. We decline to bind the Frys to the original
characterization of the Transfers and the Payments as debt based on
these three arguments. An analysis of the factors under Hardman
clearly demonstrates that the Transfers and the Payments should have
been classified as equity. Furthermore, respondent repeatedly alleges
harm but has not shown the Court what specific detriment would befall
him. Petitioners have persuasively and successfully rebutted
 30

[*30] respondent’s allegation that Mr. Fry received distributions in
excess of basis for subsequent tax years. Accordingly, we hold that the
Transfers and the Payments were interests in equity rather than
genuine indebtedness and the Frys will be eligible for the entire
flowthrough loss, provided Rule 155 computations support their claim of
adequate bases.

VII. Addition to Tax and Accuracy-Related Penalty

A. Addition to Tax

Section 6651(a)(1) imposes an addition to tax if the taxpayer fails
to file an income tax return by the required due date, including any
extension of time for filing. The addition to tax under section 6651(a)(1)
is imposed on the net amount due, meaning that the amount of tax
required to be shown on the return is reduced by the amount of tax paid
on or before its due date and allowed as a credit on the return. I.R.C.
§ 6651(b); Treas. Reg. § 301.6651-1(d). Under section 7491(c), the
Commissioner bears the burden of production with respect to the
liability of the taxpayer for additions to tax. See Higbee v. Commissioner,
116 T.C. 438, 446–47 (2001). If the Commissioner meets the burden, the
taxpayer has the burden of proving that failure to timely file was due to
reasonable cause and not willful neglect. See I.R.C. § 6651(a)(1); United
States v. Boyle, 469 U.S. 241, 243 (1985); Higbee, 116 T.C. at 447;
Williams v. Commissioner, T.C. Memo. 2022-7, at *4. However, “the
failure to make a timely filing of a tax return is not excused by the
taxpayer’s reliance on an agent, and such reliance is not ‘reasonable
cause’ for a late filing” under this section. Boyle, 469 U.S. at 252.

Petitioners have conceded that the return for the 2013 tax year
was filed late. The due date for the return was October 15, 2014, but the
return was not filed until November 10, 2014. Accordingly, we hold that
the Frys are liable for the addition to tax pursuant to section 6651(a)(1)
as determined by the amount of unpaid tax, if any, due to respondent
following the submission of Rule 155 computations.

B. Accuracy-Related Penalty

Respondent determined that the Frys are liable for an accuracy-
related penalty under section 6662(a) and (b)(2) for the 2013 tax year on
the basis of a substantial understatement of income tax.

Section 6662(a) and (b)(2) imposes a penalty equal to 20% of the
portion of an underpayment of tax required to be shown on a taxpayer’s
 31

[*31] return that is attributable to a “substantial understatement of
income tax.” An understatement of income tax is a “substantial
understatement” if it exceeds the greater of 10% of the tax required to
be shown on the return or $5,000. I.R.C. § 6662(d)(1)(A).

The Commissioner bears the burden of production with respect to
a penalty imposed on an individual taxpayer under section 6662(a) and
is required to present sufficient evidence showing that the penalty is
appropriate. See I.R.C. § 7491(c); Higbee, 116 T.C. at 446–47. This
includes showing compliance with the procedural requirements of
section 6751(b)(1). See I.R.C. § 7491(c); Laidlaw’s Harley Davidson
Sales, Inc. v. Commissioner, 29 F.4th 1066, 1072–74 (9th Cir. 2022),
rev’g and remanding 154 T.C. 68 (2020); Graev v. Commissioner, 149
T.C. 485, 493 (2017), supplementing and overruling in part 147 T.C. 460
(2016).

Section 6751(b)(1) provides that no penalty shall be assessed
unless “the initial determination” of such assessment was “personally
approved (in writing) by the immediate supervisor of the individual
making such determination.” The parties stipulated, and we have found,
that the accuracy-related penalty for the 2013 tax year was personally
approved, in writing, by the RA’s immediate acting supervisor, Glenn
Hamanaka, on September 10, 2019. Accordingly, respondent has
satisfied his burden with regard to the supervisory approval
requirement of section 6751(b), and petitioners do not contend
otherwise.

Under section 7491(c), respondent has the burden of production
with respect to the section 6662(a) penalty. To meet this burden,
respondent must produce sufficient evidence indicating that it is
appropriate to impose the penalty. See Higbee, 116 T.C. at 446. If the
Rule 155 computations show an underpayment and a substantial
understatement of tax, these computations will satisfy respondent’s
burden of production under section 7491(c).

A taxpayer may avoid a section 6662(a) penalty by showing that
there was reasonable cause for any portion of the underpayment and
that the taxpayer acted in good faith. I.R.C. § 6664(c)(1). Reasonable
cause requires that the taxpayer has exercised ordinary business care
and prudence. Boyle, 469 U.S. at 246. Whether a taxpayer acted with
reasonable cause and in good faith within the meaning of section
6664(c)(1) is determined on a case-by-case basis, taking into account all
relevant facts and circumstances. Treas. Reg. § 1.6664-4(b)(1). The most
 32

[*32] important factor is the extent of the taxpayer’s effort to assess his
proper tax liability for the year. Id.

Where a taxpayer claims reliance on professional advice, section
6664(c) will apply if “the taxpayer meets each requirement of the
following three-prong test: (1) The adviser was a competent professional
who had sufficient expertise to justify reliance, (2) the taxpayer provided
necessary and accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment.” Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221
(3d Cir. 2002).

As noted above, this Court has previously permitted new issues
to be raised for the first time on brief, so long as the opposing party was
not subject to prejudice or unfair surprise. Ware, 92 T.C. at 1268.
Petitioners did not raise the defense of reasonable cause based on
reliance on a professional until filing their Answering Briefs. This
defense was not raised in petitioners’ Pretrial Memorandum, at trial, or
in petitioners’ Opening Brief. We find that allowing petitioners to assert
this argument for the first time in their Answering Brief would subject
respondent to prejudice. Accordingly, we conclude that petitioners are
not entitled to the reasonable cause defense to the section 6662(a)
accuracy-related penalty and sustain respondent’s determination.
Therefore, we hold that the Frys are liable for a section 6662(a) penalty
to the extent the Rule 155 computations show there is an underpayment
of tax attributable to a substantial understatement of income tax.

VIII. Conclusion

We have considered all of the arguments that the parties made,
and to the extent they are not addressed herein, we find the arguments
to be moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.