Hubert Enterprises, Inc. and Subsidiaries v. Commissioner

125 T.C. No. 6UNITED STATES TAX COURT
HUBERT ENTERPRISES, INC. AND SUBSIDIARIES, ET AL.,1 Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4366-03, 10669-03, Filed September 21, 2005.
16798-03.
A few individuals controlled a corporation (P1)
and a limited liability company (ALSL). P1 transferred
$2,440,684.38 to ALSL primarily to retransfer to a
related limited partnership for use in the construction
of a retirement community. The construction project
was discontinued, and $2,397,266.32 of the transferred
funds has not been repaid. P1 seeks to deduct those
unrecovered funds as either a bad debt or a loss of
capital/equity invested in ALSL. P2 had a subsidiary
(S) that was a member of a limited liability company
(L) that was involved in equipment leasing activities
most of which arose in different years. Ps claim that
the activities are aggregated under sec.
465(c)(2)(B)(i), I.R.C., into a single activity for the
1
Cases of the following petitioners are consolidated
herewith: Hubert Enterprises, Inc. and Subs., docket No.
10669-03; and Hubert Holding Co., docket No. 16798-03.
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purpose of applying the at-risk rules of sec. 465,
I.R.C. Ps also claim that S was at risk for portions
of L’s losses by virtue of a deficit account
restoration provision that, Ps state, made S liable for
portions of L’s recourse obligations.
Held: P1 may not deduct the unrecovered funds as
either a bad debt or a loss of equity.
Held, further, S may not aggregate all of L’s
equipment leasing activities in that sec.
465(c)(2)(B)(i), I.R.C., treats as a single activity
only those activities for which the equipment is placed
in service in the same taxable year.
Held, further, S may not increase its at-risk
amounts on account of the deficit capital account
restoration provision in that the provision was not
operative in the relevant years.
William F. Russo and R. Daniel Fales, for petitioners.2
Gary R. Shuler, Jr., for respondent.
LARO, Judge: The Court has consolidated these cases for
trial, briefing, and opinion. In docket Nos. 4366-03 and
10669-03, Hubert Enterprises, Inc. (HEI), and Subsidiaries
petitioned the Court to redetermine respondent’s determination of
Federal income tax deficiencies of $974,805, $734,093, and
$1,542,820 in its taxable years ended July 27, 1997, August 3,
1998, and July 31, 1999, respectively (HEI’s 1997, 1998, and 1999
2
The petitions in these cases were filed with the Court by
James H. Stethem (Stethem), Mark A. Denney (Denney), and
R. Daniel Fales. Stethem later died and was withdrawn from the
cases on Dec. 1, 2003. Denney withdrew from the cases on Feb. 2,
2005. William F. Russo entered his appearance in docket Nos.
4366-03 and 10669-03 on Feb. 11, 2004, and in docket No. 16798-03
on Mar. 15, 2004.
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taxable years, respectively). Respondent reflected these
determinations in notices of deficiency issued on December 17,
2002, and April 9, 2003, to HEI and its subsidiaries. Hubert
Holding Co. (HHC), HEI’s successor as parent of its affiliated
group, petitioned the Court in docket No. 16798-03 to redetermine
respondent’s determination of Federal income tax deficiencies of
$1,437,240 and $1,093,008 in its taxable years ended July 29,
2000, and July 28, 2001, respectively (HHC’s 2000 and 2001
taxable years, respectively). Respondent reflected this
determination in a notice of deficiency issued to HHC on June 30,
2003.
Following concessions by petitioners, we must decide the
following issues:
1. For HEI’s 1997 taxable year, whether HEI may deduct as
either a bad debt or as a loss of capital (equity) $2,397,266.32
of unrecovered funds that it transferred to Arbor Lake of
Sarasota Limited Liability Co. (ALSL), a limited liability
company of which HEI was not an owner but which was owned
primarily and controlled by a few individuals who also controlled
HEI. We hold HEI may not deduct the funds as either a bad debt
or a loss of capital; and
2. for HHC’s 2000 and 2001 taxable years, whether HHC may
deduct passthrough losses from leasing activities relating to
equipment placed in service in different taxable years. As an
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issue of first impression, petitioners claim that section
465(c)(2)(B)(i) aggregates these activities into a single
activity for purposes of applying the at-risk rules of section
465.3 Petitioners also claim that the members of the passthrough
entity, a limited liability company named Leasing Co., LLC (LCL),
were at risk for LCL’s losses by virtue of a deficit account
restoration provision that, petitioners state, made LCL’s members
liable for portions of LCL’s recourse obligations. We hold that
HHC may not deduct equipment leasing activity losses greater than
those allowed by respondent in the notice of deficiency.
FINDINGS OF FACT
Some facts were stipulated. We incorporate herein by this
reference the parties’ stipulation of facts and the exhibits
submitted therewith. We find the stipulated facts accordingly.
I. HEI
HEI was organized by the Hubert Family Trust (HFT) on or
about October 8, 1992. HEI’s only shareholder has always been
HFT. When HEI’s petitions were filed with the Court, its mailing
address was in Cincinnati, Ohio.
For HEI’s 1997, 1998, and 1999 taxable years, HEI was the
parent corporation of an affiliated group of corporations that
filed consolidated Federal corporate income tax returns. For
3
Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
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HEI’s 1997 and 1998 taxable years, the group’s other members,
each of which was wholly owned by HEI, were (1) Printgraphics,
Inc. (Printgraphics), (2) HBW, Inc. (HBW) (also known as Weber
Co.), (3) BES Manufacturing, d.b.a. Mr. Spray, (4) Vogt
Warehouse, Inc. (Vogt), (5) HGT, Inc. (HGT), (6) Hubert Co., and
(7) Graphic Forms and Labels, Inc. (Graphic). For HEI’s 1999
taxable year, the affiliated group of corporations in addition to
HEI consisted of the just-stated seven wholly owned subsidiaries
and two other wholly owned subsidiaries; namely, Public Space
Plus, Inc., and Hubert Development, Co.
From HEI’s organization through at least 1998, Howard Thomas
(Thomas) was HEI’s president, Edward Hubert was chairman of HEI’s
board of directors, George Hubert, Jr., was an HEI vice president
and secretary, Sharon Hubert was an HEI vice president, and J.
Gregory Ollinger (Ollinger) was an HEI vice president. From its
organization through August 1, 1998, HEI did not declare a
dividend or formally distribute any of its earnings and profits.
HEI’s undistributed earnings as of July 25, 1995, July 26, 1996,
August 2, 1997, and August 1, 1998, were $14,847,028,
$19,878,907, $25,164,181, and $31,298,257, respectively.
II. HHC
In August 1999, HEI transferred the stock of its
subsidiaries to HHC. For HHC’s 2000 and 2001 taxable years, HHC
was the parent corporation of an affiliated group of corporations
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that filed consolidated Federal corporate income tax returns.
For HHC’s 2000 taxable year, that affiliated group in addition to
HHC consisted of the nine subsidiaries that were members of the
HEI affiliated group in HEI’s 1999 taxable year. For HHC’s 2001
taxable year, the HHC affiliated group of corporations in
addition to HHC consisted of (1) Printgraphics, (2) HBW,
(3) Vogt, (4) HGT, and (5) Graphic. When HHC’s petition was
filed with the Court, its mailing address was in Cincinnati,
Ohio.
III. HFT
Thomas and Stethem are unrelated by blood or marriage to any
member of the Hubert family. Thomas and Stethem (sometimes
collectively, trustees) were HFT’s trustees. HFT’S settlors were
Anthony Hubert, Benjamin Hubert, Brian Hubert, Christopher
Hubert, Cynthia Hubert, Edward Hubert, George Hubert, Jr.,
Gregory Hubert, Joshua Hubert, Karen Hubert, Kathleen Hubert,
Kimberly Hubert, Robert Hubert, Scott Hubert, Sharon Hubert, and
Zachary Hubert (collectively, settlors). Edward Hubert, George
Hubert, Jr., and Sharon Hubert (collectively, controlling
settlors) have always held interests in HFT of 36.339 percent,
13.185 percent, and 16.488 percent, respectively. Anthony
Hubert, Benjamin Hubert, Christopher Hubert, Joshua Hubert, Karen
Hubert, Kathleen Hubert, Kimberly Hubert, Robert Hubert, Scott
Hubert, and Zachary Hubert have each always held interests in HFT
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of 3.095 percent. Brian Hubert, Cynthia Hubert, and Gregory
Hubert have each always held interests in HFT of 1.012 percent.
During their lives, the controlling settlors were to receive
annually all income attributable to their respective percentage
interests in the trust estate. Each of the other settlors was to
receive annually the income attributable to his or her trust
interest commencing as follows: (1) one-third at age 25,
(2) two-thirds at age 30, and (3) 100 percent at age 35.
Stethem died in 2003. He had been legal counsel for the
Hubert family and their companies. He drafted the trust
agreement (trust agreement) underlying HFT, and the settlors and
trustees executed the trust agreement on June 6, 1988. Under the
trust agreement, the trustees had the absolute discretion to
distribute HFT’s money, securities, or other property, either pro
rata or otherwise. The trust agreement also allowed the
controlling settlors, generally upon majority consent, to alter,
amend, or revoke the trust agreement. By amendments dated
December 30, 1988, and January 1, 1991, the settlors and the
trustees modified the trust agreement. Through the earlier
amendment, the Howard Thomas Trust acquired the rights and
privileges of a controlling settlor. Through the later
amendment, the Katherine Hubert Trust acquired the rights and
privileges of a controlling settlor.
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IV. ALSL
ALSL, also known as Seasons of Sarasota Limited Liability
Co., is a Wyoming limited liability company organized on
January 18, 1995. ALSL was organized to provide funds to a
limited partnership, Arbor Lake Development, Ltd. (ALD), to use
to construct a retirement condominium community in Sarasota,
Florida, to be known as the Seasons of Sarasota Retirement
Community (Seasons of Sarasota). For ALSL’s taxable years ended
December 31, 1995, 1996, and 1997, ALSL filed Federal partnership
returns of income. ALSL reported and had no revenue for those
years.
From January 18, 1995, through December 31, 1997, ALSL’s
units were owned as follows:
Member Units
Edward Hubert 20
George Hubert, Jr. 20
Sharon Hubert 20
Ollinger 5
Stethem 5
Sun Valley Investments 10
Thomas 20
100
According to the ALSL operating agreement, (1) ALSL and all of
its affairs were controlled by its members as a group, (2) the
members’ decisions by majority vote on the basis of membership
interests controlled, and (3) absent approval by a majority vote,
no single member had the power or authority to act on behalf of
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ALSL. During the relevant years, the owners of Sun Valley
Investments, a partnership, were Thomas and Stethem.
Pursuant to ALSL’s operating agreement, ALSL’s members were
required to contribute the following capital to ALSL:
Member Contribution
Edward Hubert $200
George Hubert, Jr. 200
Sharon Hubert 200
Ollinger 50
Stethem 50
Sun Valley Investments 100
Thomas 200
1000
None of ALSL’s members, with the exception of Thomas and Stethem,
ever contributed any capital to ALSL from his, her, or its own
funds. During 1996, Thomas and Stethem contributed $200,000 and
$50,000, respectively, to ALSL’s capital.4
As of December 31, 1995, ALSL reported for Federal income
tax purposes that it had cash of $7,298, that it owned a
$1,338,334 nonrecourse note receivable from ALD, and that it was
liable on a $1,345,684 nonrecourse note payable to HEI. ALSL
4
During HEI’s 1997 taxable year, Thomas was HEI’s most
highly compensated officer, and Edward Hubert, George Hubert,
Jr., and Sharon Hubert were its next three most highly
compensated officers. During that year, HEI paid Thomas
$420,922, and it paid $370,236 to each of the other three
officers. During HEI’s 1998 taxable year, Thomas received
significantly less compensation than these other three officers.
During HEI’s 1998 taxable year, HEI paid Edward Hubert, George
Hubert, Jr., Sharon Hubert, and Thomas $644,236, $894,236,
$644,236, and $397,342, respectively.
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reported no other asset or liability as of that date, but for a
$52 bank charge which it elected to amortize over 60 months.
As of December 31, 1996, ALSL reported for Federal income
tax purposes that its sole asset was cash of $7,298 and that it
had no liabilities. ALSL also reported for Federal income tax
purposes that it had realized a $250,000 loss for 1996. ALSL
reported that the loss was attributable to “Defeasance of Debt
Income”, “Bad Debt Losses”, and “Miscellaneous Expenses” of
$2,345,685, negative $2,588,376, and negative $7,309,
respectively.
As of December 31, 1997, ALSL reported for Federal income
tax purposes that it had no assets, liabilities, or capital.
V. ALSL Note
Pursuant to a promissory note (ALSL note) dated January 18,
1995, ALSL (under the name Seasons of Sarasota Limited Liability
Co.) promised to pay HEI “$2,500,000.00, or so much thereof as
may be advanced and outstanding pursuant to any advances made by
the Lender to the Company.” The ALSL note was drafted as a
demand note without a fixed maturity date, and it stated that it
bore interest at a rate corresponding to the applicable Federal
rate. In connection with the ALSL note, HEI transferred a total
of $2,440,684.38 to ALSL from January 18, 1995, through March 6,
1997. ALSL then transferred those funds to ALD in connection
with a January 18, 1995, nonrecourse promissory note (ALD note)
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between ALD and ALSL. ALD would repay these transferred funds to
ALSL only upon the sale of condominium units in the Seasons of
Sarasota project, and ALSL would repay HEI only when and if it
received repayment from ALD. In December 1996, HEI decided not
to devote any more funds to the Seasons of Sarasota project.
In connection with the ALSL note, HEI transferred funds to
ALSL and ALSL made repayments to HEI as follows:
Date Amount Amount Repaid Unpaid Balance
1/18/95 $20,000.00 -0- $20,000.00
1/18/95 698.00 -0- 20,698.00
2/24/95 15,000.00 -0- 35,698.00
3/3/95 20,000.00 -0- 55,698.00
3/7/95 15,000.00 -0- 70,698.00
3/10/95 10,000.00 -0- 80,698.00
3/15/95 84,302.00 -0- 165,000.00
3/24/95 7,500.00 -0- 172,500.00
3/24/95 75,000.00 -0- 247,500.00
4/4/95 25,000.00 -0- 272,500.00
4/11/95 220,000.00 -0- 492,500.00
6/9/95 100,000.00 -0- 592,500.00
6/23/95 100,000.00 -0- 692,500.00
6/26/95 50,000.00 -0- 742,500.00
6/30/95 368.40 -0- 742,868.40
7/14/95 50,000.00 -0- 792,868.40
7/31/95 1,366.58 -0- 794,234.98
8/1/95 50,000.00 -0- 844,234.98
8/15/95 50,000.00 -0- 894,234.98
8/21/95 50,000.00 -0- 944,234.98
8/31/95 356.53 -0- 944,591.51
9/5/95 50,000.00 -0- 994,591.51
10/31/95 1,092.87 -0- 995,684.38
11/27/95 50,000.00 -0- 1,045,684.38
12/7/95 50,000.00 -0- 1,095,684.38
12/27/95 50,000.00 -0- 1,145,684.38
1/8/96 50,000.00 -0- 1,195,684.38
2/5/96 50,000.00 -0- 1,245,684.38
2/12/96 50,000.00 -0- 1,295,684.38
3/6/96 75,000.00 -0- 1,370,684.38
3/8/96 75,000.00 -0- 1,445,684.38
4/12/96 50,000.00 -0- 1,495,684.38
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4/29/96 50,000.00 -0- 1,545,684.38
5/13/96 50,000.00 -0- 1,595,684.38
6/6/96 50,000.00 -0- 1,645,684.38
6/10/96 100,000.00 -0- 1,745,684.38
6/28/96 50,000.00 -0- 1,795,684.38
7/2/96 75,000.00 -0- 1,870,684.38
7/12/96 50,000.00 -0- 1,920,684.38
7/31/96 50,000.00 -0- 1,970,684.38
8/21/96 50,000.00 -0- 2,020,684.38
9/5/96 75,000.00 -0- 2,095,684.38
9/10/96 50,000.00 -0- 2,145,684.38
10/8/96 50,000.00 -0- 2,195,684.38
10/21/96 50,000.00 -0- 2,245,684.38
11/12/96 50,000.00 -0- 2,295,684.38
12/2/96 50,000.00 -0- 2,345,684.38
1/9/97 26,000.00 -0- 2,371,684.38
1/21/97 15,000.00 -0- 2,386,684.38
1/27/97 5,000.00 -0- 2,391,684.38
2/5/97 13,000.00 -0- 2,404,684.38
2/12/97 11,000.00 -0- 2,415,684.38
2/14/97 5,000.00 -0- 2,420,684.38
2/19/97 5,000.00 -0- 2,425,684.38
3/6/97 15,000.00 -0- 2,440,684.38
7/14/97 -0- $43,418.06 2,397,266.32
HEI did not establish a written schedule for repayment of any of
these transferred funds (or interest thereon), and HEI never
demanded that ALSL repay any of the funds (or interest thereon).
HEI never required that ALSL pledge any of its assets to secure
repayment of any of the transferred funds, and ALSL never pledged
any of its assets to secure such repayment. HEI never required
that ALSL’s members pledge security for repayment of any of the
transferred funds, and ALSL’s members never pledged any such
security. ALSL’s members never agreed to personally guarantee
repayment of any of the transferred funds.
On or as of July 31, 1996, HEI recorded on the ALSL note
that it was entitled to accrued interest of $93,200. This
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interest was never paid. HEI never accrued any other interest on
the HEI note.
The $43,418.06 payment that ALSL made to HEI on July 14,
1997, resulted from a reported liquidation of ALD’s assets in
1996.
VI. ALD
ALD was a Florida limited partnership formed on January 6,
1995, to develop the Seasons of Sarasota. ALD had one general
partner, ALSL, and one limited partner, James Culpepper
(Culpepper). Thomas was an ALD officer.
Pursuant to the ALD limited partnership agreement, ALSL was
to acquire a 97-percent interest in ALD in exchange for a $100
capital contribution, and Culpepper was to acquire a 3-percent
interest in ALD in exchange for a $100,000 capital contribution.
The limited partnership agreement stated that the percentages of
the partners’ interests in ALD did not have any relationship to
their respective capital contributions. Culpepper contributed
the referenced $100,000 in 1995. ALSL never contributed the
referenced $100 as such.
For its taxable years ended December 31, 1995, 1996, and
1997, ALD filed Federal partnership returns of income. ALD
reported and had no revenue for those years.
As of December 31, 1995, ALD reported on its 1995 return
that it had assets totaling $1,438,334 and a single liability of
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$1,338,334. The assets consisted of cash of $37,172, accounts
receivable of $1,714, deposits of $411,353, prepayments of
$11,505, work in progress of $567,705, depreciable assets of
$7,829, and intangible assets of $401,056. The single liability
was the $1,338,334 nonrecourse note payable to ALSL.
As of December 31, 1996, ALD reported on its 1996 return
that it had no assets or liabilities. On its 1996 return, ALD
wrote off its intangible assets and reported a liquidation of its
other assets.
As of December 31, 1997, ALD reported on its 1997 return
that it had no assets or liabilities.
VII. ALD Note
The ALD note was a promissory note dated January 18, 1995,
and payable to ALSL (under the name Seasons of Sarasota Limited
Liability Co.) in the amount of “$2,750,000.00, or so much
thereof as may be advanced and outstanding pursuant to any
advances made by the Lender to the Partnership.” The ALD note
was drafted as a demand note without a fixed maturity date, and
it stated that it bore interest at a rate corresponding to the
applicable Federal rate. In connection with the ALD note, ALSL
transferred a total of $2,690,531.88 to ALD from January 31,
1995, through March 31, 1997. ALSL transferred these funds to
ALD and ALD made a repayment to ALSL as follows:
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Date Amount Amount Repaid Unpaid Balance
1/31/95 $20,698.00 -0- $20,698.00
2/28/95 19,442.85 -0- 40,140.85
2/28/95 10,570.73 -0- 50,711.58
3/31/95 82,500.00 -0- 133,211.58
3/31/95 5,000.00 -0- 138,211.58
3/31/95 101,825.86 -0- 240,037.44
4/30/95 25,000.00 -0- 265,037.44
4/30/95 220,000.00 -0- 485,037.44
6/30/95 100,000.00 -0- 585,037.44
6/30/95 100,000.00 -0- 685,037.44
6/30/95 368.40 -0- 685,405.84
6/30/95 50,000.00 -0- 735,405.84
7/5/95 112.40 -0- 735,518.24
7/28/95 50,000.00 -0- 785,518.24
7/31/95 1,366.58 -0- 786,884.82
8/1/95 50,000.00 -0- 836,884.82
8/15/95 50,000.00 -0- 886,884.82
8/21/95 50,000.00 -0- 936,884.82
8/31/95 356.53 -0- 937,241.35
9/5/95 50,000.00 -0- 987,241.35
9/15/95 50,000.00 -0- 1,037,241.35
10/3/95 50,000.00 -0- 1,087,241.35
10/4/95 564.00 -0- 1,087,805.35
10/9/95 58.28 -0- 1,087,863.63
10/16/95 50,000.00 -0- 1,137,863.63
10/24/95 470.59 -0- 1,138,334.22
10/27/95 50,000.00 -0- 1,188,334.22
11/30/95 50,000.00 -0- 1,238,334.22
12/7/95 50,000.00 -0- 1,288,334.22
12/27/95 50,000.00 -0- 1,338,334.22
1/31/96 50,000.00 -0- 1,388,334.22
2/29/96 50,000.00 -0- 1,438,334.22
2/29/96 50,000.00 -0- 1,488,334.22
3/31/96 50,000.00 -0- 1,538,334.22
3/31/96 50,000.00 -0- 1,588,334.22
3/31/96 75,000.00 -0- 1,663,334.22
4/30/96 50,000.00 -0- 1,713,334.22
4/30/96 75,000.00 -0- 1,788,334.22
5/31/96 50,000.00 -0- 1,838,334.22
6/30/96 200,000.00 -0- 2,038,333.22
7/31/96 175,000.00 -0- 2,213,334.22
8/31/96 50,000.00 -0- 2,263,334.22
9/30/96 125,000.00 -0- 2,388,334.22
10/31/96 100,000.00 -0- 2,488,334.22
11/30/96 50,000.00 -0- 2,538,334.22
12/31/96 50,000.00 -0- 2,588,334.22
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1/31/97 7,197.66 -0- 2,595,531.88
1/31/97 46,000.00 -0- 2,641,531.88
2/28/97 34,000.00 -0- 2,675,531.88
3/31/97 15,000.00 -0- 2,690,531.88
7/10/97 5,000.00 $43,418.06 2,647,213.82
ALD used the transferred funds received from ALSL to pay
ALD’s operating expenses incurred in connection with the Seasons
of Sarasota project, including professional fees for site plans,
construction drawings, environmental assessments, surveying,
marketing studies, and expenses of the sales staff. ALSL did not
establish a written schedule for repayment of any of these
transferred funds (or interest thereon), and ALSL never demanded
that ALD repay any of the funds (or interest thereon). ALSL
never required that ALD pledge any of its assets to secure
repayment of any of the transferred funds, and ALD never pledged
any of its assets to secure such repayment. ALSL never required
that ALD’s members pledge security for repayment of any of the
transferred funds, and ALD’s members never pledged any such
security. ALD’s members never agreed to personally guarantee
repayment of any of the transferred funds.
The $43,418.06 payment that ALD made to ALSL on July 10,
1997, resulted from the reported liquidation of ALD’s assets in
1996.
VIII. Seasons of Sarasota
On October 24, 1994, William Shaner (Shaner) delivered
documentation to Seasons Management Co. (SMC) describing the
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Seasons of Sarasota project. Shaner later told HEI about the
possibility of investing in the project. Afterwards, in 1994,
Thomas retained an appraisal and consulting firm to prepare a
detailed analysis of the market for a retirement community in
Sarasota. The firm delivered such an analysis to Thomas on
December 23, 1994, in the form of a 39-page report (exclusive of
addenda) entitled “Analysis of Service Enhanced Retirement
Facility Market in Sarasota, Florida”. At the request of Thomas,
the firm on June 26, 1996, updated its analysis and conclusions
reflected in that report.
Eugene Schwartz (Schwartz) is unrelated by blood or marriage
to Thomas, Stethem, or any member of the Hubert family. In
January 1995, ALSL agreed to pay $3 million to Schwartz for 49.8
acres in Sarasota on which the Seasons of Sarasota was proposed
to be built. As a condition to the agreement, ALSL had to obtain
commitments from buyers of at least 59 condominium units which
were to be built on the land. Absent written notice to the
seller, ALSL had until December 31, 1995, to purchase the land
from Schwartz. Also in January 1995, SMC and ALD agreed that SMC
would direct the marketing of, manage, and operate the Seasons of
Sarasota. The duties and responsibilities of SMC were to begin
on January 1, 1995, and continue until December 31, 2004, unless
terminated earlier.
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The plan for the Seasons of Sarasota called for 298
individually owned condominium units with one to three bedrooms,
a 30,000-square-foot clubhouse, and an 80-unit assisted living
facility. Pursuant to the plan, construction of 98 condominium
units would start in the fall of 1996. The construction of the
Seasons of Sarasota was to be financed in phases with each phase
consisting of approximately one-third of the projected 298
condominium units.
On June 24, 1996, Provident Bank (Provident) relayed to
Thomas the possibility of Provident’s lending funds to ALD.
Provident would make the loan only if certain conditions were
met. One condition was that HEI be a comaker of the loan and
agree to certain financial covenants such as maintaining a stated
debt to equity ratio and a stated minimum net worth. A second
condition was that ALD procure in the first phase of construction
at least 45 firm contracts to purchase condominium units with a
total gross sale price of at least $10.8 million and total
initial earnest money deposits of at least $1.62 million. A
third condition was the monthly payment on the loan of accrued
interest and principal. A fourth condition was that the loan be
secured. A fifth condition was that the earnest money from sales
be deposited with Provident.
Through June 30, 1996, 34 condominium units in the Seasons
of Sarasota were reserved with refundable deposits. By the
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latter part of 1996, some individuals who had reserved
condominium units canceled their reservations, and the number of
cancellations exceeded the number of new reservations. By
December 31, 1996, ALD had not sold 45 of the condominium units
planned for the first phase.
ALD never purchased the land from Schwartz, and the
construction of the Seasons of Sarasota never began. Nor did
Provident ever lend any funds to ALD, ALSL, or HEI. On
December 31, 1996, the duties and responsibilities of SMC ended
when SMC and ALD agreed to terminate their agreement because the
land had not been purchased.
IX. LCL
LCL is a Wyoming limited liability company formed on
April 30, 1998. LCL filed its initial Federal partnership return
of income on the basis of a taxable year ended July 31, 1998
(LCL’s 1998 taxable year). LCL’s organizers were Thomas, in his
capacity as managing member of Hubert Commerce Center, Inc.
(HCC), and Ollinger, in his capacity as vice president of HBW.
HCC was connected with both the HEI and HHC affiliated groups.
LCL’s ownership consisted of 100 membership units. During
LCL’s 1998 taxable year, HBW received 99 of those units in
exchange for a $9,900 capital contribution, and HCC received the
last unit in exchange for a $100 capital contribution. On
April 30, 1998, HBW and LCL also executed as a contribution to
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LCL’s capital an assignment in which HBW transferred to LCL all
of HBW’s rights, title, and interest in its leases, subject to
existing loans.
Section 4.2 of LCL’s operating agreement stated that “No
Member shall be liable as such for the liabilities of the
Company.” On March 28, 2001, the LCL operating agreement was
amended and restated in its entirety (revised LCL operating
agreement), effective retroactively to January 1, 2000. The
revised LCL operating agreement is construed under Wyoming law,
and only the parties who signed the revised LCL operating
agreement (and their successors in interest) have any rights or
remedies under that agreement. The revised LCL operating
agreement stated that neither HBW nor HCC was required to make
any additional capital contribution to LCL. The revised LCL
operating agreement also stated:
7.7 Deficit Capital Account Restoration. If any
Partner has a deficit Capital Account following the
liquidation of his, her or its interest in the
partnership, then he, she or it shall restore the
amount of such deficit balance to the Partnership by
the end of such taxable year or, if later, within 90
days after the date of such liquidation, for payment to
creditors or distribution to Partners with positive
capital account balances.
In 2000 and 2001, neither HBW nor HCC liquidated its
interest in LCL. Nor at those times did either member have a
deficit in its LCL capital account.
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X. Equipment Leasing Activities
A. 1991 Rapistan Conveyor System
Starwood Corp. (Starwood), Ministers Life--A Mutual Life
Insurance Co. (Ministers Life), Inter-Market Capital Corp.
(Inter-Market), and General Motors Corp. (GM) are corporations
unaffiliated with any Hubert company. Pursuant to agreements
dated April 30 and June 25, 1991, Starwood leased a 1991 Rapistan
conveyor system to GM. The term of that lease included the 180-
month period beginning November 1, 1991. For each of those 180
months, GM agreed to pay $13,659.83 on the first day of the
month, beginning November 1, 1991.
On October 1, 1991, Starwood purchased the 1991 Rapistan
conveyor system from Ministers Life for $1,327,237.89. All
payments on that purchase were to be made from proceeds from the
lease of the 1991 Rapistan conveyor system. The payment schedule
for the October 1, 1991, promissory note underlying the purchase
anticipated that the monthly payments would be $13,659.83,
starting November 1, 1991.
On October 31, 1991, Printgraphics purchased the 1991
Rapistan conveyor system (subject to the lease) from Starwood for
$1,412,468.68. On the same day, Printgraphics paid Starwood
$75,000 towards that purchase price and financed the rest by
assuming liability for the October 1, 1991, promissory note
between Starwood and Ministers Life. For each of its taxable
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years ended in 1992 through 1998, Printgraphics reported as to
the 1991 Rapistan conveyor system the following amounts of lease
income, interest expense, depreciation, and loss:
1992 1993 1994 1995 1996 1997 1998
Lease income $122,938 $163,918 $163,918 $163,918 $163,918 $163,918 $122,940
Interest expense (80,877) (117,907) (113,466) (108,596) (103,256) (97,401) (68,234)
Depreciation (201,842) (345,913) (247,041) (176,417) (126,133) (125,992) (94,228)
Loss 159,781 299,902 196,589 121,095 65,471 59,475 39,522
B. 1995 Computer Equipment
Capital Resources Group, Inc. (CRG), is a corporation
unaffiliated with any Hubert company. On April 30, 1995,
Starwood sold computer equipment (1995 computer equipment) to CRG
for $6,822,000, and CRG leased the 1995 computer equipment back
to Starwood. Pursuant to promissory notes dated April 30, 1995,
CRG promised to pay $445,538 and $6,058,983 to Starwood as to the
sale.
Also on April 30, 1995, Printgraphics purchased the 1995
computer equipment (subject to the lease) from CRG for
$6,822,000. Printgraphics paid CRG $360,000 and issued CRG a
short-term promissory note for $445,538 and an installment
promissory note for $6,016,462. The installment note stated it
was recourse to the extent of $2.2 million and that payments of
principal on the recourse portion would be reduced pro rata to
the extent the outstanding indebtedness on the note was reduced.
For each of its taxable years ended in 1995 through 1998,
Printgraphics reported as to the 1995 computer equipment the
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following amounts of lease income, interest expense,
depreciation, and income/(loss):
1995 1996 1997 1998
Lease income -0- $1,157,816 $1,646,796 $1,341,589
Interest expense ($150,412) (433,423) (490,523) (285,889)
Depreciation (1,364,400) (2,183,040) (1,309,824) (589,467)
Income/(loss) (1,514,812) (1,458,647) (153,551) 466,233
C. 1998 Amtel Equipment
Amtel Corp. (Amtel) and Third Street Services, Inc. (TSS),
are corporations that are unaffiliated with any Hubert company.
On April 30, 1998, CRG purchased from Starwood for $8,927,204.90
a 60.55-percent interest (60.55-percent interest) in certain
equipment (1998 Amtel equipment) leased by TSS to Amtel.
Pursuant to promissory notes dated April 30, 1998, CRG agreed to
pay Starwood $8,222,860.90 and $235,000. Also on April 30, 1998,
CRG leased the 60.55-percent interest back to Starwood for an
86-month term beginning August 1, 1998.
Also on April 30, 1998, LCL purchased the 60.55-percent
interest (subject to the lease) from CRG for $8,927,204.90.
Pursuant to promissory notes dated April 30, 1998, LCL agreed to
pay CRG $8,172,204.90 and $235,000. No individual member of LCL
signed or directly guaranteed these promissory notes, the first
of which stated it was recourse to the extent of $4.75 million
and that payments of principal and interest would be applied to
the recourse portion before the nonrecourse portion. The second
note stated it was nonrecourse.
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On July 31, 1998, CRG purchased from Starwood the remaining
39.45-percent interest (39.45-percent interest) in the 1998 Amtel
equipment for $5,814,720.10, and CRG leased the 39.45-percent
interest back to Starwood. Pursuant to promissory notes dated
July 31, 1998, CRG promised to pay Starwood $5,346,686.52 and
$53,932.54.
Also on July 31, 1998, LCL purchased the 39.45-percent
interest (subject to the lease) from CRG for $5,814,720.10.
Pursuant to promissory notes dated July 31, 1998, LCL promised to
pay CRG $5,310,887.56 and $53,832.54. No individual member of
LCL signed or guaranteed these notes, the first of which stated
it was recourse to the extent of $2.75 million and that payments
of principal and interest would be applied to the recourse
portion before the nonrecourse portion. The second note stated
it was nonrecourse.
For each of its taxable years ended in 1998 through 2001,
LCL reported as to the 1998 Amtel equipment the following amounts
of lease income, interest expense, depreciation, net “G&A”
expense and interest income, and loss:
1998 1999 2000 2001
Lease income -0- $1,987,157 2,167,807 $2,167,807
Interest expense ($156,167) (971,811) (877,785) (786,273)
Depreciation (2,948,385) (4,717,416) (2,830,450) (1,698,270)
Net G&A expense
and interest income -0- 4,047 32,922 13,815
Loss 3,104,552 3,698,023 1,507,506 302,921
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The portions of these losses allocated to HBW’s 99-percent
ownership interest were $3,073,507, $3,661,043, $1,492,431, and
$299,892, respectively.
D. 1999 Blisk Equipment
Relational Funding Corp. (RFC) is a corporation that is
unaffiliated with any Hubert company. On April 30, 1999, RFC
sold (subject to a lease) a Lear Precision ECM 1999 blisk machine
(1999 blisk equipment) to LCL for $2,950,382.86. At that time,
the 1999 blisk equipment was leased to General Electric Aircraft
Engines. LCL paid $133,000 towards the purchase, issued to RFC a
$30,742 short-term note, assumed a $403,505.60 long-term note of
RFC, and assumed RFC*s position with respect to lender liens on
the 1999 blisk equipment.
For each of its taxable years ended in 1999 through 2001,
LCL reported as to the 1999 blisk equipment the following amounts
of lease income, interest expense, depreciation, “G&A” expense
and interest income, and loss:
1999 2000 2001
Lease income $108,296 $433,185 $433,185
Interest expense (35,449) (172,353) (154,497)
Depreciation (421,484) (722,543) (516,022)
Net G&A expense
and interest income 221 6,579 2,761
Loss 348,416 455,132 234,573
The portions of these losses allocated to HBW’s 99-percent
ownership interest were $344,932, $440,672, and $232,227,
respectively.
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E. 2000 Computer Equipment
On April 30, 2000, CRG purchased computer equipment (2000
computer equipment) from RFC for $765,326. Pursuant to
promissory notes dated April 30, 2000, CRG agreed to pay RFC
$56,850 and $672,101. On the same day, CRG leased the 2000
computer equipment back to RFC.
Also on April 30, 2000, LCL purchased the 2000 computer
equipment (subject to the lease) from CRG for $765,326, and LCL
executed promissory notes to CRG in the amounts of $56,850 and
$667,766. No individual member of LCL signed or directly
guaranteed the notes, the latter of which stated it was recourse
to the extent of $340,000 and that payments of principal would be
applied first to the recourse portion. For each of its taxable
years ended in 2000 and 2001, LCL reported as to the 2000
computer equipment the following amounts of lease income,
interest expense, depreciation, “G&A” expense and interest
income, and loss:
2000 2001
Lease income -0- $100,341
Interest expense ($17,065) (48,816)
Depreciation (153,065) (244,904)
Net G&A expense
and interest income -0- 639
Loss 170,130 192,740
The portions of these losses allocated to HBW’s 99-percent
ownership interest were $168,429 and $190,813, respectively.
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F. 2000 RFC Equipment
On April 30, 2000, CRG purchased computer equipment (2000
RFC equipment) from RFC for $9,181,432 and leased the 2000 RFC
equipment back to RFC. Pursuant to promissory notes dated
April 30, 2000, CRG promised to pay RFC $663,400 and $8,080,320
as to the purchase.
Also on April 30, 2000, LCL purchased the 2000 RFC computer
equipment (subject to the lease) from CRG for $9,181,432.
Pursuant to promissory notes dated April 30, 2000, LCL promised
to pay CRG $663,400 and $8,029,222. No individual member of LCL
signed or directly guaranteed the notes, the latter of which
stated it was recourse to the extent of $3.225 million and that
payments of principal and interest would be applied first to the
recourse portion. For each of its taxable years ended in 2000
and 2001, LCL reported as to the 2000 RFC equipment the following
amounts of lease income, interest expense, depreciation, “G&A”
expense and interest income, and loss:
2000 2001
Lease Income -0- $1,545,155
Interest expense ($205,190) (508,995)
Depreciation (1,836,287) (2,938,058)
Net G&A expense and
interest income -0- 9,848
Loss 2,041,477 1,892,050
The portions of these losses allocated to HBW’s 99-percent
ownership interest were $2,021,062 and $1,873,130 respectively.
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OPINION
I. Transferred Funds
A. Overview
Petitioners argue primarily that HEI’s transfers to ALSL
created debt which became uncollectible in HEI’s 1997 taxable
year, thus for that year entitling HEI to a bad debt deduction
under section 166.5 Alternatively, petitioners argue, the
transfers were HEI’s contribution to the capital of ALSL, which
entitled HEI for its 1997 taxable year to deduct an ordinary loss
resulting from a loss of that capital. Respondent argues that
the transfers were not debt. Respondent also argues that the
transfers were not capital contributions made by HEI, noting that
ALSL was owned not by HEI but primarily by the individuals who
controlled HEI.
We agree with respondent that HEI is not entitled to either
of its desired deductions with respect to the transfers. We
conclude that the transfers were not deductible for HEI’s 1997
taxable year as debt nor as contributions made by HEI to the
capital of ALSL.
5
Sec. 166(a)(1) provides that a taxpayer may deduct as an
ordinary loss a debt which becomes worthless during the taxable
year.
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B. Petitioners’ Claim to a Bad Debt Deduction
Petitioners bear the burden of proving that the transfers
are debt.6 See Rule 142(a)(1); Roth Steel Tube Co. v.
Commissioner, 800 F.2d 625, 630 (6th Cir. 1986), affg. T.C. Memo.
1985-58; Smith v. Commissioner, 370 F.2d 178, 180 (6th Cir.
1966), affg. T.C. Memo. 1964-278. Debt for Federal income tax
purposes connotes an existing, unconditional, and legally
enforceable obligation to repay. See Roth Steel Tube Co. v.
Commissioner, supra at 630; First Natl. Co. v. Commissioner,
289 F.2d 861, 864-865 (6th Cir. 1961), revg. and remanding
32 T.C. 798 (1959); Burrill v. Commissioner, 93 T.C. 643, 666
(1989); see also AMW Invs., Inc. v. Commissioner, T.C. Memo.
1996-235. Transfers between related parties are examined with
special scrutiny. Cf. Roth Steel Tube Co. v. Commissioner, supra
at 630. A transfer’s economic substance prevails over its form,
see Smith v. Commissioner, supra at 180; Byerlite Corp. v.
Williams, 286 F.2d 285, 291 (6th Cir. 1960), and a finding of
economic substance turns on whether the transfer would have
followed the same form had it been between the transferee and an
6
Petitioners have not raised the issue of sec. 7491(a),
which shifts the burden of proof to the Commissioner in certain
situations, and we conclude that sec. 7491(a) does not apply.
In the case of a corporation such as each petitioner, sec.
7491(a)(2) limits the shifting of the burden of proof to
situations where, among other things, the corporation shows that
upon filing its petition in this Court, its net worth was no more
than $7 million. See also 28 U.S.C. sec. 2412(d)(2)(B) (2000).
Neither petitioner has made such a showing.
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independent lender, see Scriptomatic, Inc. v. United States,
555 F.2d 364 (3d Cir. 1977). The more a transfer appears to
result from an arm’s-length transaction, the more likely the
transfer will be considered debt. See Bayer Corp. v. Mascotech,
Inc. (In re Autosytle Plastics, Inc.), 269 F.3d 726, 750 (6th
Cir. 2001). The subjective intent of the parties to a transfer
that the transfer create debt does not override an objectively
indicated intent to the contrary. See Stinnett’s Pontiac Serv.,
Inc. v. Commissioner, 730 F.2d 634, 639 (11th Cir. 1984), affg.
T.C. Memo. 1982-314.
In the case of transfers from shareholders to their
corporations, courts generally refer to numerous factors to
determine whether the transfers create debt. Petitioners argue
that such an approach is irrelevant where, as here, a transfer is
made to a partnership rather than a corporation. Petitioners
assert that the Court in a case such as this must focus solely on
the form of the document connected with the transfer (here, the
ALSL note) and decide whether that document establishes a debtor-
creditor relationship under applicable State law. We disagree.
Petitioners have cited no authority to support their view, and we
believe that the relevant factors distinguishing debt from equity
are most helpful to us in deciding whether HEI transferred the
disputed funds to ALSL in an arm’s-length transaction made with a
genuine intention to create a debt. See Berthold v.
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Commissioner, 404 F.2d 119, 122 (6th Cir. 1968) (“Established
authority holds that the intention of the parties is the
controlling factor in determining whether or not advances should
be termed loans.”), affg. T.C. Memo. 1967-102; cf. Recklitis v.
Commissioner, 91 T.C. 874, 905 (1988).
The Court of Appeals for the Sixth Circuit, to which an
appeal of this case most likely lies, refers primarily to eleven
factors in distinguishing debt from equity. See Roth Steel Tube
Co. v. Commissioner, supra at 630. These factors are: (1) The
name given to an instrument underlying a transfer of funds;
(2) the presence or absence of a fixed maturity date and a
schedule of payments; (3) the presence or absence of a fixed
interest rate and actual interest payments; (4) the source of
repayment; (5) the adequacy or inadequacy of capitalization;
(6) the identity of interest between creditors and equity
holders; (7) the security for repayment; (8) the transferee’s
ability to obtain financing from outside lending institutions;
(9) the extent to which repayment was subordinated to the claims
of outside creditors; (10) the extent to which transferred funds
were used to acquire capital assets; and (11) the presence or
absence of a sinking fund to provide repayment. Id. No one
factor is controlling, and courts must consider the particular
circumstances of each case. Id.
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We turn to analyzing and weighing the relevant facts of this
case in the context of the 11 factors set forth in Roth Steel
Tube Co. v. Commissioner, supra.
1. Name of Certificate
We look to the name of the certificate evidencing a transfer
to determine whether the parties thereto intended that the
transfer create debt. Although the issuance of a note weighs
toward a finding of bona fide debt, see Bayer Corp. v. Mascotech,
Inc. (In re Autostyle Plastics, Inc.), supra at 750; Estate of
Mixon v. United States, 464 F.2d 394, 403 (5th Cir. 1972), the
mere fact that a taxpayer issues a note is not dispositive. The
issuance of a demand note is not indicative of genuine debt when
the note is unsecured, without a maturity date, and without
meaningful repayments. See Stinnett’s Pontiac Serv., Inc. v.
Commissioner, supra at 638; Tyler v. Tomlinson, 414 F.2d 844, 849
(8th Cir. 1969).
We give little weight to the fact that ALSL issued the ALSL
note to HEI. The ALSL note was a demand note with no fixed
maturity date, no written repayment schedule, no provision
requiring periodic payments of principal or interest, no
collateral, and no meaningful repayments. In addition, HEI never
made a demand for repayment or otherwise sought enforcement of
the ALSL note. See Stinnett’s Pontiac Serv., Inc. v.
Commissioner, supra at 640 (the fact that notes were due on
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demand but that the obligee never demanded payments supports a
strong inference that the obligee never intended to compel the
obligor to repay the notes). Although both HEI and ALSL posted
in their records that the transfers were loans, those postings
provide little if any support for a finding of bona fide debt.
Roth Steel Tube Co. v. Commissioner, 800 F.2d at 631 (citing
Raymond v. United States, 511 F.2d 185, 191 (6th Cir. 1975)).
Petitioners argue that HEI asserted its rights as a lender
by receiving all of the existing capital of ALSL upon its demise.
According to petitioners, had the transfers not been debt, then a
portion of that capital would have gone to Stethem and Thomas,
who together contributed $250,000 of capital to ALSL. We
consider this argument unpersuasive. We find nothing in the
record to support petitioners’ claim that HEI asserted its rights
as a lender by receiving all of the existing capital of ALSL upon
its claimed demise.7 We also find nothing in the record to
support petitioners’ claim that Stethem and Thomas failed to
receive anything of value as to their capital contributions.
Stethem and Thomas were fixtures in most of the financial
ventures of the Hubert family and their companies. In addition
7
Nor do we find that the business of either ALSL or ALD
ceased in 1996 or 1997, as petitioners claim. Indeed, in and
after December 1996, HEI made to ALSL nine transfers totaling
$145,000, and ALSL made to ALD six transfers totaling
$157,197.66. HEI also did not receive the reported liquidation
proceeds until July 14, 1997.
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to serving with Thomas as a trustee of the HFT, Stethem was legal
counsel for the Hubert family and their companies and presumably
made a good living in that capacity. Thomas was HEI’s longtime
president and in that capacity received more than $800,000 in
compensation in just HEI’s 1997 and 1998 taxable years alone.
We also note that Thomas as of the time of trial continued to
work for the Hubert enterprise as its chief executive officer and
that his $200,000 contribution to ALSL’s capital was
contemporaneous with his receipt from HEI of an amount of officer
compensation that appears to have been inflated to enable him to
make that contribution.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
2. Fixed Maturity Date and Schedule of Payments
The absence of a fixed maturity date and a fixed obligation
to repay weighs against a finding of bona fide debt. See Bayer
Corp. v. Mascotech, Inc. (In re Autostyle Plastics, Inc.), 269
F.3d at 750; Roth Steel Tube Co. v. Commissioner, supra at 631.
The ALSL note had no fixed maturity date. While petitioners
assert that the ALSL note was a demand note for which payment
could have been requested at any time, the fact of the matter is
that HEI never made any such demand and, more importantly, ALSL
never had the ability to honor such a request had one been made.
ALSL made its first (and only) payment on the ALSL note
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approximately 2-1/2 years after HEI’s first transfer to ALSL and
did so only on account of ALD’s claimed liquidation. Moreover,
notwithstanding this lack of repayments throughout the referenced
2-1/2-year period, HEI continued to transfer funds to ALSL
without any schedule for repayment. HEI even transferred a total
of $95,000 to ALSL in 1997 even though in December 1996 HEI
decided to stop funding the Seasons of Sarasota project and ALSL
treated the “debt” as discharged on its Federal income tax return
for 1996.
Petitioners ask the Court to conclude that the issuance of
the ALSL note as a demand note strongly supports a finding of
debt because the obligeee of a demand note, unlike an equity
holder, may at any time demand repayment. We decline to reach
such a conclusion. As noted by the Court of Appeals for the
Eleventh Circuit, “an unsecured note due on demand with no
specific maturity date, and no payments is insufficient to
evidence a genuine debt.” Stinnett’s Pontiac Serv., Inc. v.
Commissioner, 730 F.2d at 638; cf. Bayer Corp. v. Mascotech, Inc.
(In re Autostyle Plastics, Inc.), supra at 750 (“use of demand
notes along with a fixed rate of interest and interest payments
is more indicative of debt than equity” (Emphasis added.)).
Repayment of the ALSL note was unsecured, HEI never prepared a
written repayment schedule as to the transfers, and ALSL never
had assets available to pay all, or even a significant part, of
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the ALSL note. Whether or when to make demand for repayment of
the transfers was within the discretion of HEI and was not
conditioned upon the occurrence of any stated event. See
Stinnett’s Pontiac Serv., Inc. v. Commissioner, supra at 639.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
3. Interest Rate and Actual Interest Payments
A reasonable lender is concerned about receiving payments of
interest as compensation for, and commensurate with, the risk
assumed in making the loan. See id. at 640; cf. Deputy v. du
Pont, 308 U.S. 488, 498 (1940) (in the business world, interest
is paid on debt as “compensation for the use or forbearance of
money”). The absence of an adequate rate of interest and actual
interest payments weighs strongly against a finding of bona fide
debt. See Bayer Corp. v. Mascotech, Inc. (In re Autostyle
Plastics, Inc.), supra at 750; Roth Steel Tube Co. v.
Commissioner, supra at 631.
Although the ALSL note on its face bore a rate of interest,
the facts of this case persuade us that the parties to the note
did not intend that ALSL actually pay HEI any (let alone a market
rate of) interest for the use of the transferred funds unless the
Seasons of Sarasota project was successful. We do not believe
that a reasonable lender would have lent unsecured funds to ALSL,
a company with no revenues and few liquid assets, at the rate of
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interest stated in the ALSL note. A transferor of funds who does
not insist on reasonable interest payments as to the use of the
funds may not be a bona fide lender. See Stinnett’s Pontiac
Serv., Inc. v. Commissioner, supra at 640.
ALSL never paid any interest to HEI as to the transferred
funds and made but a single, nominal payment as to the principal
of those funds. Petitioners assert that payments were not made
because neither principal nor interest was ever due under the
terms of the ALSL note. We consider this assertion unavailing.
Indeed, HEI did not even report that accrued interest was owing
on the ALSL note until more than 18 months after the first
transfer of funds.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
4. Source of Repayment
Repayment that depends solely upon the success of the
transferee’s business weighs against a finding of bona fide debt.
Repayment that does not depend on earnings weighs toward a
finding of debt. See Bayer Corp. v. Mascotech, Inc. (In re
Autostyle Plastics, Inc.), supra at 751; Roth Steel Tube Co. v.
Commissioner 800 F.2d at 632; Lane v. United States, 742 F.2d
1311, 1314 (11th Cir. 1984). “An expectation of repayment solely
from * * * earnings is not indicative of bona fide debt
regardless of its reasonableness.” Roth Steel Tube Co. v.
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Commissioner, supra at 631 (citing Lane v. United States, supra
at 1314); see also Stinnett’s Pontiac Serv., Inc. v.
Commissioner, supra at 638-639; Raymond v. United States,
511 F.2d at 191; Segel v. Commissioner, 89 T.C. 816, 830 (1987);
Deja Vu, Inc. v. Commissioner, T.C. Memo. 1996-234.
HEI’s transfers to ALSL were placed at the risk of ALSL’s
business. ALSL’s ability to repay these transfers depended
primarily (if not solely) on its earnings, which in turn rested
on the success of ALD and the Seasons of Sarasota project. ALSL
was unable to repay the ALSL note as ALSL had no revenue and
virtually no liquid assets.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
5. Capitalization
Thin or inadequate capitalization to fund a transferee’s
obligations weighs against a finding of bona fide debt. See Roth
Steel Tube Co. v. Commissioner, supra at 630; Stinnett’s Pontiac
Serv., Inc. v. Commissioner, supra at 639.
The record indicates that ALSL was inadequately capitalized
to be, as it was, the funding vehicle for ALD and that ALSL had
no meaningful capital, apart from the transferred funds, either
before or when it received the transferred funds. While ALSL
received capital contributions totaling $250,000 from Thomas and
Stethem, that amount was small in comparison to the amount of the
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transferred funds and minuscule in comparison to the cost of the
Seasons of Sarasota project. As to that project, ALD agreed to
pay $3 million for land and had agreed to pay construction-
related costs potentially totaling millions of dollars more. For
its own equity capitalization, ALD had only $100,000 from its
limited partner Culpepper.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
6. Identity of Interest
Transfers made in proportion to ownership interests weigh
against a finding of bona fide debt. A sharply disproportionate
ratio between an ownership interest and the debt owing to the
transferor by the transferee generally weighs toward a finding of
debt. See Bayer Corp. v. Mascotech, Inc. (In re Autostyle
Plastics, Inc.), 269 F.3d at 751; Stinnett’s Pontiac Serv., Inc.
v. Commissioner, 730 F.2d at 630; Estate of Mixon v. United
States, 464 F.2d at 409.
HEI was not an owner of ALSL. HFT’s controlling settlors
and trustees were. In fact, the only portion of ALSL not owned
by those individuals was the 5-percent interest owned by
Ollinger, an HEI vice president, who never made any contribution
of capital to ALSL in return for his interest. The individuals
who controlled HEI effectively caused HEI to fund their
investment in ALSL.
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This factor is either inapplicable or does not support a
finding that the transfers created bona fide debt.
7. Presence or Absence of Security
The absence of security for the repayment of transferred
funds weighs strongly against a finding of bona fide debt. See
Bayer Corp. v. Mascotech, Inc. (In re Autostyle Plastics, Inc.),
supra at 752; Roth Steel Tube Co. v. Commissioner, supra at 632;
Lane v. United States, supra at 1317; Raymond v. United States,
supra at 191; Austin Village, Inc. v. United States, 432 F.2d
741, 745 (6th Cir. 1970).
The disputed transfers were unsecured.
This factor weighs toward a finding that the transfers did
not create bona fide debt.
8. Inability To Obtain Comparable Financing
The question of whether a transferee could have obtained
comparable financing from an independent source is relevant in
measuring the economic reality of a transfer. See Roth Steel
Tube Co. v. Commissioner, supra at 631; Estate of Mixon v. United
States, supra at 410; Nassau Lens Co. v. Commissioner, 308 F.2d
39, 47 (2d Cir. 1962), remanding 35 T.C. 268 (1960). Evidence
that a transferee could not at the time of the transfer obtain a
comparable loan from an arm’s-length creditor weighs against a
finding of bona fide debt. See Roth Steel Tube Co. v.
Commissioner, supra at 631; Stinnett’s Pontiac Serv., Inc. v.
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Commissioner, supra at 640; Calumet Indus., Inc. v. Commissioner,
95 T.C. 257, 287 (1990).
We do not believe that a creditor dealing at arm’s length
would have made the transfers to ALSL under the terms that
petitioners allege were entered into between ALSL and HEI. In
fact, ALD discussed borrowing funds from a commercial lender;
i.e., Provident. Although Provident did not lend any funds to
ALD, the terms of the proposed financing arrangement were
different in many regards from those contained in the ALSL note.
First, Provident would have required that HEI be a co-maker of
the note. Second, Provident would have required that HEI agree
to certain financial covenants such as the maintenance of a
stated debt to equity ratio and a stated minimum net worth.
Third, Provident would have required the borrower to provide
security, collateral, and earnest money and to pay accrued
interest and principal monthly. Fourth, Provident would have
required that ALD have in the first phase of construction at
least 45 firm contracts to purchase condominium units with a
total gross sale price of at least $10.8 million and total
initial earnest money deposits of at least $1.62 million. Fifth,
Provident would have required that any earnest money from the
sales be deposited with Provident. None of these requirements,
or anything like them, was contained in the financing arrangement
between ALSL and HEI.
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This factor weighs toward a finding that the transfers did
not create bona fide debt.
9. Subordination
Subordination of purported debt to the claims of other
creditors weighs against a finding of bona fide debt. See Roth
Steel Tube Co. v. Commissioner, 800 F.2d at 631-632; Stinnett’s
Pontiac Serv., Inc. v. Commissioner, supra at 639; Raymond v.
United States, 511 F.2d at 191; Austin Village, Inc. v. United
States, supra at 745.
ALSL has never had any creditors. Given that the transfers
were unsecured, however, their right to repayment would have been
subordinate to the interests of any secured creditors.
This factor is either inapplicable or does not support a
finding that the transfers created bona fide debt.
10. Use of Funds
A transfer of funds to meet the transferee’s daily business
needs weighs toward a finding of debt. A transfer of funds to
purchase capital assets weighs against a finding of bona fide
debt. See Roth Steel Tube Co. v. Commissioner, supra at 632;
Stinnett’s Pontiac Serv., Inc. v. Commissioner, supra at 640;
Raymond v. United States, supra at 191.
The transfers were not used to pay ALSL’s daily operating
expenses because ALSL had no operating expenses. Although the
transfers also were not used to acquire tangible capital assets,
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the transfers were used by ALSL in a similar sense in that they
were retransferred to ALD to use on the Seasons of Sarasota
project. But for the transfers of the funds from HEI to ALSL,
ALSL would not have been able to make most of the transfers to
ALD.
This factor is either inapplicable or does not support a
finding that the transfers created bona fide debt.
11. Presence or Absence of a Sinking Fund
The failure to establish a sinking fund for repayment weighs
against a finding of bona fide debt. See Bayer Corp. v.
Mascotech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d at
753; Roth Steel Tube Co. v. Commissioner, supra at 632; Lane v.
United States, 742 F.2d at 1317; Raymond v. United States, supra
at 191; Austin Village, Inc. v. United States, supra at 745.
ALSL did not establish a sinking fund for repayment of the
ALSL note. While petitioners invite this Court to disregard this
factor, asserting that the Court of Appeals for the Sixth Circuit
“is out of touch with economic reality” in relying upon this
factor, we decline to do so. As is true with respect to all of
these factors, this factor is not controlling in and of itself
but is merely one factor that we consider in determining the
objectively indicated intent of ALSL and HEI as to the
characterization of the transferred funds.
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This factor weighs toward a finding that the transfers did
not create bona fide debt.
12. Conclusion
On the basis of our review of the entire record, we find it
extremely improbable that an arm’s-length lender at the time of
the transfers would have lent unsecured, at a low rate of
interest, and for an unspecified period of time to an entity in
ALSL’s questionable financial condition. Security, adequately
stated interest, and repayment arrangements (or efforts to secure
the same) are important proofs of intent, and here such proofs
are notably lacking. Economic realities require that HEI’s
transfers be characterized as capital contributions for Federal
income tax purposes, and we so hold. Thus, we also hold that HEI
is not entitled to any bad debt deduction with respect to the
transfers.
C. Petitioners’ Claim to a Deduction for a Loss of Capital
Petitioners argue alternatively that HEI may deduct the
transfers as a loss on an abandonment of its equity interest in
ALSL. We disagree. We are unable to find in the record that HEI
had any equity interest in ALSL, let alone any such interest that
it may deduct as a loss.
HEI and its owners and advisers were experienced in many
lines of business conducted in many ways. In structuring its
involvement in the Seasons of Sarasota project, HEI chose not to
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become an owner of ALSL and never became such an owner. ALSL’s
owners, on the other hand, who were themselves indirect owners
and insiders of HEI, did choose to become ALSL’s owners. They
did this not by using their personal funds to pay for their
equity but by using HEI’s funds. Distributions by a corporation
are treated as dividends to a shareholder (to the extent of the
corporation’s earnings and profits, see Estate of DeNiro v.
Commissioner, 746 F.2d 327, 332 (6th Cir. 1984)) if the
distributions are made for the shareholder’s personal benefit
without any expectation of repayment. See Hagaman v.
Commissioner, 958 F.2d 684, 690-691 (6th Cir. 1992), affg. and
remanding T.C. Memo. 1987-549; J.F. Stevenhagen Co. v.
Commissioner, T.C. Memo. 1975-198, affd. 551 F.2d 106 (6th Cir.
1977); see also Shedd v. Commissioner, T.C. Memo. 2000-292; Davis
v. Commissioner, T.C. Memo. 1995-283. Such is so even if the
funds are not distributed directly to the shareholder. See Rapid
Elec. Co. v. Commissioner, 61 T.C. 232, 239 (1973); see also J.F.
Stevenhagen Co. v. Commissioner, supra.
HEI had no equity in ALSL, and HEI’s transfers of the funds
to ALSL enhanced the controlling settlors’ investments in ALSL;
e.g., the controlling settlors never made any capital
contributions to ALSL from their personal funds but still
received interests in ALSL totaling 60 percent. The transfers
also were made without a reasonable expectation of repayment.
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Instead, we find in the record that the primary purpose of HEI’s
transfers to ALSL, an entity controlled by the same individuals
who controlled HEI, was to benefit those individuals, see Sammons
v. Commissioner, 472 F.2d 449, 451, 456 (5th Cir. 1972), affg. in
part, revg. in part on another ground T.C. Memo. 1971-145; Wilkof
v. Commissioner, T.C. Memo. 1978-496, affd. 636 F.2d 1139 (6th
Cir. 1981); McLemore v. Commissioner, T.C. Memo. 1973-59, affd.
494 F.2d 1350 (6th Cir. 1974), and was without regard to any
business purpose or benefit to HEI.8
II. Losses From Equipment Leasing Activities
A. Overview
During the relevant years, petitioners were connected with
the following leasing activities: (1) In 1991, Printographics
began the activity concerning the 1991 Rapistan conveyor system;
(2) in 1995, Printographics began the activity concerning the
1995 computer system; (3) in 1998, LCL began the activities
concerning the 1998 Amtel equipment; (4) in 1999, LCL began the
activity concerning the 1999 blisk equipment; (5) in 2000, LCL
began the activities concerning the 2000 computer equipment and
the 2000 RFC equipment.
8
We need not and do not decide whether the transfers were
in fact dividends to HEI’s nonparty shareholder. For even if
they were not, HEI could not deduct the outlay made primarily for
the benefit of its shareholder rather than for a business or
investment purpose of its own. See Hood v. Commissioner,
115 T.C. 172, 179 (2000).
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B. Aggregation
Petitioners argue that section 465(c)(2)(B)(i) allows LCL to
aggregate its 1998, 1999, and 2000 activities into a single
activity for purposes of the at-risk rules of section 465. (The
relevant provisions of section 465(c) are set forth in an
appendix to this Opinion.) Petitioners argue that section
1.465-1T, Temporary Income Tax Regs., 50 Fed. Reg. 6014 (Mar. 11,
1985), interprets section 465(c)(2)(B)(i) to the contrary and
assert that these regulations are invalid as inconsistent with
the statute. Respondent argues that the referenced regulations
preclude LCL from aggregating one year’s leasing activities with
another year’s leasing activities and asserts that the referenced
regulations are consistent with section 465(c)(2)(B)(i). We
agree with respondent that section 465(c)(2)(B)(i) does not allow
for the aggregation desired by petitioners. Because we do not
read the referenced regulations to address the issue at hand, we
do not discuss them further.
Section 465(c)(2)(A)(ii) generally provides that a taxpayer
may not aggregate its equipment leasing activities for purposes
of the at-risk rules. An exception is found, however, in the
case of partnerships and S corporations. Under this exception,
all activities of a partnership or S corporation with respect to
section 1245 properties are considered to be a single activity to
the extent that the “properties are leased or held for lease, and
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* * * are placed in service in any taxable year of the
partnership or S corporation”. Sec. 465(c)(2)(B)(i).
Petitioners read the quoted text, with a focus especially on
the word “any”, to mean that all of LCL’s equipment leasing
activities are viewed as a single activity, notwithstanding the
fact that all of the activities did not arise in the same taxable
year. We read that text differently. While petitioners focus
primarily on the single word “any” to support their
interpretation, the word “any” may not be construed in isolation
but must be construed in the context of the statute as a whole.
See Small v. United States, U.S. , 125 S. Ct. 1752 (2005);
United States v. Alvarez-Sanchez, 511 U.S. 350, 357 (1994).
Statutes should be interpreted as a whole to give effect to every
clause, sentence, and word therein, see Market Co. v. Hoffman,
101 U.S. 112, 115 (1879), and the duty of a court is to render
that type of interpretation whenever possible, cf. United States
v. Menasche, 348 U.S. 528, 538-539 (1955); Montclair v. Ramsdell,
107 U.S. 147, 152 (1883). Such an approach is a “cardinal
principle of statutory construction”. Williams v. Taylor,
529 U.S. 362, 404 (2000).
In accordance with that approach, we apply the plain meaning
of the words set forth in section 465(c)(2)(B), see Venture
Funding, Ltd. v. Commissioner, 110 T.C. 236, 241-242 (1998),
affd. without published opinion 198 F.3d 248 (6th Cir. 1999), and
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we do so mindful of the statute as a whole. We conclude that
Congress’s use of the word “any” denotes one (i.e., the same)
taxable year and that LCL’s aggregated activities are only those
activities that relate to leased personal property placed in
service in the same taxable year.9 As we understand petitioners’
contrary interpretation, its effect would be that virtually “all
activities [of a partnership or S corporation] with respect to
section 1245 properties which * * * are leased or held for lease
* * * shall be treated as a single activity.” Petitioners do not
explain how that interpretation does not render section
465(c)(2)(B)(i)(II) surplusage, and we are unable to give such an
explanation either. Nor do petitioners explain how their
interpretation harmonizes with section 465(c)(2)(B)(ii) and, more
particularly, the reference in that section to section
465(c)(3)(B). Under petitioners’ interpretation, section
465(c)(2)(B)(ii) also would be surplusage in that all equipment
leasing activities of a partnership or S corporation would
already be considered to be a single activity under section
465(c)(2)(B)(i).
Petitioners’ reliance on the word “any” to reach their
interpretation also is misplaced. The word “any” denotes “One,
some, every, or all without specification”, The American Heritage
9
By cross-reference from sec. 465(c)(1)(C), sec. 1245(a)
provides that the term “section 1245 property” as used in sec.
465 includes personal property.
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Dictionary of the English Language 81 (4th ed. 2000), and
Congress’s use of the word “any” “can and does mean different
things depending upon the setting”, Nixon v. Mo. Municipal
League, 541 U.S. 125, 132 (2004). In this setting, we simply do
not understand Congress’s use of that word to establish its
intent that section 465(c)(2)(B)(i) allow LCL to treat all of its
equipment leasing activities as a single activity regardless of
the year in which the equipment was placed in service. The fact
that Congress prescribed in the statute the singular form of the
word “year” adds to our belief.
While the legislative history underlying the enactment of
section 465(c)(2)(B) as applied to section 1245 properties is
sparse and of little benefit to our inquiry, see H. Conf. Rept.
98-861, at 1122 (1984), 1984-3 C.B. (Vol.2) 1, 376, we believe
that the setting surrounding the enactment of section
465(c)(2)(B) also is consistent with our conclusion. Section
465(c)(2) was enacted as part of the Deficit Reduction Act of
1984 (DEFRA), Pub. L. 98-369, sec. 432(b), 98 Stat. 814, which
changed the aggregation rules for partnerships and S corporations
with respect to equipment leasing activities (as well as the
other activities listed in section 465(c)(1)) for taxable years
beginning after December 31, 1983. Before DEFRA, partnerships
and S corporations aggregated all activities within each of five
specified categories for purposes of section 465. Thus, a
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partnership or S corporation could aggregate all of its leased
section 1245 property, while other taxpayers treated each of
their properties in that category as a separate activity. As
amended by DEFRA, section 465(c)(2) generally requires, except as
provided in section 465(c)(2)(B), that partnerships and S
corporations separate equipment leasing activities (and the other
activities listed in section 465(c)(1)) on a property-by-property
basis, as do other taxpayers. If petitioners’ interpretation
were adopted, permitting all leased section 1245 properties of a
partnership or S corporation to be aggregated into one activity
for purposes of the at-risk rules, section 465(c)(2), as amended
by DEFRA, would largely be ineffective.
We conclude by noting that our interpretation of section
465(c)(2)(B)(i) to refer to a single taxable year rather than all
of a taxpayer’s taxable years coincides with the views of
commentators. Since the enactment of section 465(c)(2)(B),
commentators have consistently agreed with the interpretation
that we espouse today. See, e.g., Starczewski, 550-2nd Tax
Management Portfolio (BNA), "At-Risk Rules" A-18 n.153 (“For the
leasing of § 1245 property that is all placed in service in a
single taxable year, § 465(c)(2)(B)(i) specifically provides for
aggregation.”) & A-19 (“The partnership aggregation rule
apparently does not apply to a partnership or S corporation that
leases equipment that is placed in service in different years.”)
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(2003); McGovern, “Liabilities of the Firm, Member Guaranties,
and the At Risk Rules: Some Practical and Policy Considerations”,
7 J. Small & Emerging Bus. L. 63, 81 (Spring 2003) (“Section 465
[more specifically identified in a footnote as section
465(c)(2)(B)] provides that if equipment leasing is carried on by
a partnership or subchapter S corporation, all items of equipment
that are placed in service during the same taxable year are
treated as constituting a single activity.”); Pennell, “Separate
Treatment of At-Risk Activities Under Section 465 Delayed”, 62 J.
Taxn. 372 (1985) (“For that category [section 1245 property],
aggregation based on the taxable year the properties were placed
in service is allowed under the special rule in Section
465(c)(2)(B).”). We have not found (nor have petitioners cited)
any treatise or article that sets forth a contrary
interpretation.
C. At-Risk Amounts
Petitioners argue that the deficit capital account
restoration provision in the revised LCL operating agreement
exposed LCL’s members to liability for their respective shares of
LCL’s recourse debt. Respondent argues that this provision was
not operative during the relevant years because it required that
an LCL member first liquidate its interest in LCL, an event that
never occurred during the relevant years. Respondent argues
alternatively that the provision, if operative, did not make the
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members liable for LCL’s recourse obligations in that a third
party lender did not under the revised LCL operating agreement
have the right to force the members to abide by any obligation
that LCL failed to honor. We agree with respondent that LCL’s
members were not at risk for any of the disputed amounts.
Congress enacted section 465 to limit the use of artificial
losses created by deductions from certain leveraged investment
activities. Such losses may be used only to the extent the
taxpayer is at risk economically. Generally, the amount at risk
includes (1) the amount of money and the adjusted basis of
property contributed to the activity by the taxpayer and
(2) borrowed amounts for which the taxpayer is personally liable.
Sec. 465(b).
The aspect of petitioners’ dispute with respondent’s
application of the at-risk rules rests on whether LCL’s members
may take into account any part of LCL’s recourse obligations. We
agree with respondent that they may not. The recourse notes
signed by LCL were not personally guaranteed by LCL’s members,
and applicable State (Wyoming) law provides that the members of a
limited liability company are not personally liable for the
debts, obligations, or liabilities of the company. See Wyo.
Stat. Ann. sec. 17-15-113 (LexisNexis 2005). The agreements of
LCL also contain no provisions obligating its members to pay
LCL’s debts, obligations, or expenses. Because LCL’s members did
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not assume personal liability for the notes, the members are not
at risk under section 465(b)(1)(B) and (2)(A) with respect to
LCL’s recourse obligations. Cf. Emershaw v. Commissioner,
949 F.2d 841 (6th Cir. 1991), affg. T.C. Memo. 1990-246.
Petitioners seek a contrary result, focusing on the deficit
capital account restoration provision in section 7.7 of the
revised LCL operating agreement. Petitioners argue that this
provision made LCL’s members personally liable for LCL’s recourse
obligations for purposes of applying the at-risk rules. We
disagree. As observed by respondent, section 7.7 contains a
condition that must be met before the deficit capital account
restoration obligation arises. In accordance with that
condition, an LCL member must first liquidate its interest in LCL
before the member has any obligation to the entity. Neither HBW
nor HCC liquidated its interest in LCL during the relevant years.
III. Conclusion
We sustain respondent’s determinations. We have considered
all of petitioners’ arguments for holdings contrary to those set
forth in this Opinion and have rejected those arguments not
discussed herein as meritless. We have considered respondent’s
arguments only to the extent discussed herein.
Decisions will be entered
for respondent.
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APPENDIX
SEC. 465(c). Activities to Which Section Applies.--
(1) Types of activities.--This section applies to
any taxpayer engaged in the activity of--
(A) holding, producing, or distributing
motion picture films or video tapes,
(B) farming (as defined in section 464(e)),
(C) leasing any section 1245 property
(as defined in section 1245(a)(3)),
(D) exploring for, or exploiting, oil
and gas resources or
(E) exploring for, or exploiting,
geothermal deposits (as defined in section
613(e)(2))
as a trade or business or for the production of income.
(2) Separate activities.--For purposes of this
section--
(A) In general.--Except as provided in
subparagraph (B), a taxpayer's activity with
respect to each--
(i) film or video tape,
(ii) section 1245 property
which is leased or held for
leasing,
(iii) farm,
(iv) oil and gas property (as
defined under section 614), or
(v) geothermal property (as
defined under section 614),
shall be treated as a separate activity.
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(B) Aggregation rules.--
(i) Special rule for leases of
section 1245 property by
partnerships or S corporations.--In
the case of any partnership or S
corporation, all activities with
respect to section 1245 properties
which--
(I) are leased or
held for lease, and
(II) are placed in
service in any taxable
year of the partnership
or S corporation,
shall be treated as a single activity.
(ii) Other aggregation
rules.--Rules similar to the rules
of subparagraphs (B) and (C) of
paragraph (3) shall apply for
purposes of this paragraph.
(3) Extension to other activities.--
(A) In general.--In the case of taxable
years beginning after December 31, 1978, this
section also applies to each activity--
(i) engaged in by the taxpayer
in carrying on a trade or business
or for the production of income,
and
(ii) which is not described in
paragraph (1).
(B) Aggregation of activities where
taxpayer actively participates in management
of trade or business.--Except as provided in
subparagraph (C), for purposes of this
section, activities described in subparagraph
(A) which constitute a trade or business
shall be treated as one activity if --
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(i) the taxpayer actively
participates in the management of
such trade or business, or
(ii) such trade or business is
carried on by a partnership or an S
corporation and 65 percent or more
of the losses for the taxable year
is allocable to persons who
actively participate in the
management of the trade or
business.
(C) Aggregation or separation of
activities under regulations.--the secretary
shall prescribe regulations under which
activities described in subparagraph (A)
shall be aggregated or treated as separate
activities.