DocketNumber: Docket No. 22506-94.
Citation Numbers: 1996 T.C. Memo. 119, 71 T.C.M. 2399, 1996 Tax Ct. Memo LEXIS 126
Judges: RUWE
Filed Date: 3/12/1996
Status: Non-Precedential
Modified Date: 11/20/2020
1996 Tax Ct. Memo LEXIS 126">*126 Decision will be entered for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE,
After concessions, 2 the sole issue remaining for decision is whether petitioners are entitled to a bad debt deduction of $ 182,451.03 for the 1988 taxable year.
1996 Tax Ct. Memo LEXIS 126">*127 FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference. Petitioners resided in Acton, Massachusetts, at the time they filed their petition.
Petitioners are the owners of Stow Laboratories, Inc. (SLI), a closely held Massachusetts corporation with its principal place of business in Hudson, Massachusetts. SLI has been engaged in the manufacturing and sale of electrical equipment since it was incorporated on April 4, 1973. Mr. Kadlec is the president and treasurer of SLI as well as a director and full-time employee. He owns 80 percent of SLI's stock. Mrs. Kadlec is the vice president, clerk, and a director, and she owns the remaining 20 percent of SLI's stock. From 1973 to the date of trial, petitioners made capital contributions to SLI in the total amount of $ 250.
From 1978 through 1982, Yana Kadlec, Mr. Kadlec's mother, made the following advances to SLI:
Amount | Date of Note | Maturity Date | Interest Rate |
$ 20,000 | 3/14/78 | 3/24/79 | 11% per annum |
10,000 | 10/15/79 | 10/24/80 | 17% per annum |
10,000 | 1/30/80 | 1/24/81 | 18% per annum |
1 40,000 | 1/24/82 | 1/24/83 | 15% per annum |
1996 Tax Ct. Memo LEXIS 126">*128 Yana Kadlec died on May 13, 1983. SLI never repaid the principal due under any of these notes to Yana Kadlec or to her heirs or assignees.
From 1979 through 1983, SLI borrowed various sums from Hudson National Bank (Hudson National) of Hudson, Massachusetts. Most of the borrowing was in the form of 90-day demand notes. In addition, on November 20, 1980, SLI borrowed $ 20,000 from Hudson National pursuant to a 3-year collateral note. Hudson National required Mr. Kadlec to guarantee these notes. On April 22, 1981, SLI's board of directors ratified Hudson National's 3-year loan. The corporate minutes indicate that Hudson National required Mr. Kadlec to personally countersign the borrowing. All notes from Hudson National were paid in full by November 1983.
During each of the years 1981 through 1990, Mr. Kadlec advanced funds to SLI to enable it to meet its payroll and current operating expenses. At the end of each year, the unpaid balance of the advances was totaled and memorialized in an interest-bearing promissory note. Between 1981 and 1985, Mr. Kadlec advanced the following amounts to SLI:
Amount | Date of Note | Maturity Date | Interest Rate |
$ 56,090.32 | 12/31/81 | 12/31/84 | 15% per annum |
17,664.76 | 12/31/82 | 12/31/85 | 15% per annum |
74,512.89 | 12/31/83 | 12/31/85 | 13% per annum |
5,111.07 | 12/31/84 | 12/31/86 | 13% per annum |
29,071.99 | 12/31/85 | 12/31/87 | 12% per annum |
1996 Tax Ct. Memo LEXIS 126">*129 The average bank prime rates for the periods at issue were as follows:
Year | Interest Rate |
1981 | 18.87% per annum |
1982 | 14.86% per annum |
1983 | 10.79% per annum |
1984 | 12.04% per annum |
1985 | 9.93% per annum |
Mr. Kadlec's 1981 and 1982 advances were subordinated to the then-outstanding Hudson National 3-year loan executed on November 20, 1980. On April 20, 1982, at a special meeting of SLI's board of directors, the board ratified Mr. Kadlec's 1981 advance. The corporate minutes state that funds needed by SLI to continue operations while SLI developed new products had become impossible to obtain from banks without Mr. Kadlec's accompanying personal guarantee. In addition, at a special meeting on May 6, 1986, SLI's board ratified Mr. Kadlec's 1985 advance. The corporate minutes indicate that Mr. Kadlec's advance was necessary, because no other sources of funds were available. SLI has never made any payments of principal or interest to Mr. Kadlec pursuant to these notes.
From 1984 through 1987, SLI subleased office space to Datatrol, producing rental income as follows:
Year | Rental Income |
1984 | $ 31,033.31 |
1985 | 65,218.95 |
1986 | 62,008.39 |
1987 | 32,168.17 |
Mr. Kadlec1996 Tax Ct. Memo LEXIS 126">*130 believed that his advance to SLI would be repaid out of profits generated by product sales and from rental income received from Datatrol. The sublease with Datatrol ended in August 1987, and SLI was unable to find another subtenant until 1990.
On March 15, 1988, at a special meeting of SLI's board of directors, the board declared Mr. Kadlec's promissory notes for 1981 through 1985 worthless. However, at the same meeting, the board ratified a note dated December 31, 1987, to Mr. Kadlec in the amount of $ 43,900 for money that SLI had borrowed from Mr. Kadlec. Mr. Kadlec also made additional advances subsequent to the March 15, 1988, meeting. These include a $ 77,000 advance in 1988, an $ 84,400 advance in 1989, and a $ 19,350 advance in 1990. SLI has made no payments on any of these advances.
SLI was a going concern in 1988 and has continued as such through the time of trial.
Petitioners claimed the 1981 through 1985 advances as "short-term capital losses" on Schedule D of their 1988 Federal income tax return. SLI did not file a U.S. Corporate Tax Return (Form 1120) for the taxable year 1988 and, therefore, did not report any cancellation of indebtedness income as a result of these1996 Tax Ct. Memo LEXIS 126">*131 alleged canceled debt obligations.
OPINION
The only issue for decision is whether petitioners may deduct $ 182,451.03 in 1988 as a bad debt under
1996 Tax Ct. Memo LEXIS 126">*132 The characterization of advances to a corporation by a shareholder is a question of fact to be determined from all the facts and circumstances. (1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the "thinness" of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the1996 Tax Ct. Memo LEXIS 126">*133 source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation. [
These factors are only aids to be used in determining whether the investment constitutes debt or equity.
In making our determination, we recognize that heightened judicial scrutiny is appropriate when shareholders make advances to their closely held corporations. As the Court of Appeals for the Third 1996 Tax Ct. Memo LEXIS 126">*134 Circuit noted in Where the corporation is closely held * * * and the same persons occupy both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of the transaction, for the parties may mold it at their will with no countervailing pull. This is particularly so where a shareholder can have the funds he advances to a corporation treated as corporate obligations instead of contributions to capital without affecting his proportionate equity interest. * * *
We find that petitioners have failed to carry their burden of proof. Our analysis of the advances at issue under the factors listed above convinces us that these advances were contributions to capital rather than loans.
On brief, respondent concedes that Mr. Kadlec's advances possessed the formal indicia of loans. The advances were memorialized by promissory notes specifying the payment of a sum certain at a fixed maturity date with interest and providing Mr. Kadlec with the right to enforce payments. However, allegedly objective economic indicia of debt, 1996 Tax Ct. Memo LEXIS 126">*135 such as consistent bookkeeping and consistent financial reporting on balance sheets, are little more than additional declarations of intent, without accompanying objective economic indicia of debt.
In
Advances by a shareholder that are placed at the risk of the corporation's business are likely to be considered contributions to capital.
A corporation's debt-to-equity ratio compares the corporation's total liabilities to its stockholders' equity.
According to petitioners' expert, Robert J. Erickson, SLI's debt-to-equity ratios for the years ending December 31, 1981 through 1985, were as follows:
December 31 | Debt | Equity |
1981 | 6.647620 to | 1.000000 |
1982 | negative | equity |
1983 | negative | equity |
1984 | negative | equity |
1985 | negative | equity |
We believe that SLI's debt-to-equity ratios for these years, coupled with the fact that petitioners' total capital contribution since 1973 was only $ 250, indicate that SLI was thinly capitalized. Such thin capitalization suggests that the advances were equity investments.
Whether the advances have a status equal to or inferior to that of regular corporate creditors is of some importance in determining whether Mr. Kadlec was dealing as a shareholder or as a creditor.
A bona fide lender is concerned with interest.
Our review of the record convinces us that an outside creditor would not have made the advances in issue to SLI.
1996 Tax Ct. Memo LEXIS 126">*140 Accordingly, respondent's determination is sustained.
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. At trial, petitioners conceded the addition to tax pursuant to sec. 6651(a)(1) for delinquent filing of their 1988 Federal income tax return.↩
1. Petitioners allege that this note is a renewal of the previous three notes from Yana Kadlec.↩
3. Petitioners claimed a short-term capital loss deduction on Schedule D of their 1988 Federal income tax return, alleging that the loans constituted nonbusiness bad debts.
4. We note that even if the advances were loans, petitioners would still not be entitled to a bad debt deduction, because they have not proven that the advances became worthless in 1988.
Benjamin D. And Madeline Prentice Gilbert, on Review v. ... , 262 F.2d 512 ( 1959 )
Nassau Lens Co., Inc. v. Commissioner of Internal Revenue, ... , 308 F.2d 39 ( 1962 )
Fin Hay Realty Co. v. United States , 398 F.2d 694 ( 1968 )
Bernard F. Curry and Marvel I. Curry v. United States , 396 F.2d 630 ( 1968 )
United States v. Simon W. Henderson, Jr., Independent for ... , 375 F.2d 36 ( 1967 )
Benjamin D. And Madeline Prentice Gilbert v. Commissioner ... , 248 F.2d 399 ( 1957 )
Roth Steel Tube Company v. Commissioner of Internal Revenue , 620 F.2d 1176 ( 1980 )
Henry C. Mueller v. Commissioner of Internal Revenue , 496 F.2d 899 ( 1974 )
Welch v. Helvering , 54 S. Ct. 8 ( 1933 )
National Carbide Corp. v. Commissioner , 69 S. Ct. 726 ( 1949 )
Mueller v. Commissioner , 60 T.C. 36 ( 1973 )