Arland T. Keeton A.K.A. Arland Keeton & Ima Jean Keeton

United States Tax Court
T.C. Memo. 2023-35ARLAND T. KEETON a.k.a. ARLAND KEETON AND IMA JEAN
KEETON,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 1358-21. Filed March 16, 2023.
—————
William L. Ghiorso, for petitioner.
Catherine J. Caballero, Catherine S. Tyson, and Nhi T. Luu, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LAUBER, Judge: With respect to petitioners’ Federal income tax
for 2017 and 2018 the Internal Revenue Service (IRS or respondent) de-
termined deficiencies of $119,471 and $104,479, respectively, plus accu-
racy-related penalties. 1 The principal question is whether petitioners
are entitled to a passthrough loss deduction and a carryover net operat-
ing loss (NOL) deduction claimed on their 2017 and 2018 returns, re-
spectively, corresponding to their allocable share of a business bad debt
deduction reported by a partnership of which they were members. We
sustain respondent’s disallowance of the claimed passthrough loss and
1 Unless otherwise indicated, all statutory references are to the Internal Reve-
nue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation refer-
ences are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and Pro-
cedure. We round most monetary amounts to the nearest dollar.
Served 03/16/23
2
[*2] NOL deductions, finding that petitioners failed to prove the exist-
ence of a bona fide debt. We likewise sustain the penalties.
FINDINGS OF FACT
The following facts are derived from the pleadings, four Stipula-
tions of Facts with attached Exhibits, and the documents and testimony
admitted into evidence at trial. Petitioners resided in Oregon when
their Petition was timely filed.
A. Keeton-Riemenschneider, LLC
The putative obligee on the alleged debt is Keeton-Riemenschnei-
der, LLC (KRLLC), which is treated as a partnership for Federal income
tax purposes. 2 KRLLC was formed in 1992 by petitioners and Robert
and Lorene Riemenschneider. At all relevant times each couple owned
50% of KRLLC. Robert Riemenschneider was the president of the com-
pany, and petitioner husband was its secretary. Petitioner wife initially
served as its main bookkeeper. KRLLC’s records show petitioners’ home
address as its principal place of business.
According to a 1996 operating agreement, KRLLC was formed to
“invest in various real estate and farming projects.” Its 2015–2020 tax
returns list “equipment rental” as its principal business. Regardless of
its stated purpose, KRLLC was essentially inactive during 2015–2018.
Its 2015 return shows a single item of income—$30,778 from “for-
giveness of debt”—and a single item of expense—$1,638 from “deple-
tion.” Its 2016–2020 returns reflect no business operations and report
no income of any kind.
B. Idaho Waste Systems, Inc.
The putative obligor on the alleged debt is Idaho Waste Systems,
Inc. (IWS), an Idaho C corporation incorporated in 1994 to operate a
landfill south of Boise. Most of the waste IWS accepted for processing
at its landfill came from demolition and construction projects.
2 Neither party contends that KRLLC was subject to the audit procedures of
the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). See §§ 6221–6234 (as
in effect for years before 2018). KRLLC, which appears to have qualified for small
partnership status, checked a box on its 2017 return indicating that it was not electing
to have TEFRA procedures apply. See § 6231(a)(1)(B).
3
[*3] The stock certificates show that petitioners and the Riemen-
schneiders each held 138 shares, or 34.5%, of IWS. The Riemenschnei-
ders’ children, Ron Riemenschneider and Rhonda Avery, owned 6% and
5% of IWS, respectively. An entity called Waste Not LLC, whose mem-
bers were Pam McClain and Hayden Watson, owned 20% of IWS. The
record does not reflect how (if at all) the latter two individuals were re-
lated to petitioners and the Riemenschneiders. Petitioners and the Rie-
menschneiders jointly controlled both KRLLC and IWS at all relevant
times.
Petitioner husband and Robert Riemenschneider were the princi-
pal officers and directors of IWS until at least 2007. Ron Riemenschnei-
der then became chiefly responsible for its day-to-day operations.
Rhonda Avery, who had handled the books and records for IWS since
the early 2000s, eventually took over for her brother. She managed
IWS’s operations until 2015.
C. Capitalization and Funding of IWS
IWS was poorly capitalized from the outset and lacked reliable
access to standard commercial financing. To fund its operations peti-
tioners and the Riemenschneiders funneled cash to IWS through
KRLLC. Petitioner husband, a sophisticated businessman, was engaged
in numerous other ventures, including a successful construction com-
pany, a farming operation, and an aircraft leasing business. He and
Robert Riemenschneider, acting through KRLLC, secured bank loans
and advanced cash to IWS beginning in the mid-1990s. There was no
promissory note or other debt instrument memorializing these ad-
vances.
Whenever IWS needed money, its bookkeeper, Rhonda Avery,
contacted petitioner wife, KRLLC’s bookkeeper, who arranged for
checks to be sent to IWS in the requested amounts. The record reveals
dozens of such requests for funds, in amounts ranging from $4,000 to
$500,000, between 2001 and 2005. Ms. Avery often noted that IWS’s
bank accounts were overdrawn, explaining that it urgently needed funds
to pay such basic expenses as employee payroll, purchases of equipment,
repairs, insurance, and taxes.
KRLLC tracked its advances to IWS in a QuickBooks bookkeep-
ing register captioned “Due from IWS.” The register contains 112 en-
tries beginning December 31, 1999. The first entry in the register, show-
ing a credit of $3,331,093, is described as “Investment – Idaho Waste.”
4
[*4] An entry for December 31, 2000, showing a credit of $264,372, is
likewise captioned “Investment – Idaho Waste.” Other credit entries for
1999–2000 are captioned “capital” or “equipment” or reflect the proceeds
of bank loans. Beginning in 2001 most of the entries reflect cash ad-
vances to IWS, taking the form of checks written on KRLLC’s bank ac-
counts. Notwithstanding a few reductions, the balance shown as due
from IWS steadily increased between 1999 and 2007, reaching an apex
of $7,424,926 on December 31, 2007.
Under local law IWS was required to post a bond of $2.5 million
with the State of Idaho to insure against the need for environmental
remediation at the landfill. In August 2007 IWS entered into a $5 mil-
lion financing arrangement with Premier West Bank (Premier West) un-
der which the bank supplied the required bond and extended IWS a $2.5
million line of credit. As security for these undertakings IWS executed
a deed of trust granting Premier West a security interest in the landfill
property, which represented roughly 70% of IWS’s total assets. IWS im-
mediately began drawing down its new line of credit, and KRLLC ad-
vanced no additional funds to IWS after August 2007.
D. Purported Promissory Note
On October 31, 2008, Robert Riemenschneider, in his capacity as
president of IWS, executed a one-page document, purportedly a promis-
sory note, captioned “Idaho Waste Systems, Inc.” In this document IWS
promises to pay KRLLC, “on demand,” the sum of $3,222,076.89. The
document states that IWS will pay “interest thereon at the rate of 9%
per annum from October 31, 2008 until paid.” The document specifies
no repayment schedule, stating only that “[a]ny part hereof may be paid
at any time.”
On its yearend balance sheet for 2008, IWS reported an “N/P”
(note payable) to KRLLC of $3,217,540. Neither that amount nor the
larger amount shown on the purported promissory note can be recon-
ciled with KRLLC’s “Due from IWS” QuickBooks register. That register
has no entries whatever for calendar year 2008. And the last entry for
2007 shows that the balance allegedly due from IWS was $7,424,926.
There is no evidence that IWS ever paid interest on the purported
promissory note, at an annual rate of 9% or otherwise. KRLLC’s “Due
from IWS” register shows two interest payments from IWS (totaling
$18,402) at yearend 2005 and one interest payment from IWS (of $8,390)
at yearend 2007. The register shows no interest payments from IWS
5
[*5] after October 31, 2008, the date on which the purported promissory
note was executed.
The purported promissory note specifies no collateral to secure
repayment of principal or interest. There is no indication that KRLLC
demanded any guaranty from any IWS shareholder. The document
states only that, if demand for repayment were made, IWS would be re-
sponsible for reimbursing any collection-related attorney’s fees that
KRLLC might incur. No other enforcement mechanism for repayment
appears on the face of the document.
E. IWS’s Worsening Financial Condition
IWS’s financial statements show that it suffered consistent an-
nual losses during 2008–2011, with corresponding negative impacts on
its shareholder equity:
Year Profit or (Loss) SH Equity
2008 ($973,310) ($4,433,981)
2009 (263,508) (4,697,489)
2010 (417,977) (5,115,468)
2011 (331,995) (5,447,463)
In 2010 Premier West, suffering ill effects from the financial cri-
sis, called in the $2.5 million line of credit. IWS could not repay the loan,
and Premier West initiated foreclosure proceedings on the landfill prop-
erty. IWS sought refinancing from other banks, but no bank was willing
to extend credit.
IWS then turned to an existing creditor, Jack Yarbrough, who had
developed an interest in the landfill operation. The “Due from IWS” reg-
ister indicates that Mr. Yarbrough had lent money to IWS (or to KRLLC
for the benefit of IWS) as early as December 2005. In mid-2010 Mr.
Yarbrough agreed to extend to IWS a short-term loan of $4.2 million.
IWS used part of the proceeds to satisfy its $2.5 million obligation to
Premier West. On July 1, 2010, the bank accordingly assigned to Mr.
Yarbrough its security interest in the landfill property.
The balance of the Yarbrough loan proceeds, or $1.7 million, was
remitted to KRLLC. This action is reflected both on KRLLC’s “Due from
IWS” QuickBooks register and on its financial statements. The
6
[*6] QuickBooks register shows the balance due from IWS as being re-
duced by $1.7 million, to $2,128,696, as of May 6, 2010. IWS’s December
31, 2010, balance sheet shows an “N/P” to KRLLC of $1,298,440, reduced
from $3,052,440 at yearend 2009.
F. Conversion of Shareholder Loans to Equity
The Yarbrough “bridge loan” was due to be repaid sometime in
2012. As the due date approached, IWS’s shareholders perceived the
need to present a strengthened capital structure to potential lenders, in
the hope that they could induce a bank to refinance the Yarbrough loan.
The shareholders accordingly agreed to convert their alleged loans to
equity and to cancel all accrued interest on the loans.
This agreement was memorialized in a “Unanimous Written Con-
sent in Lieu of Special Meeting” dated January 1, 2012. This document
recites that, as of December 31, 2011, the shareholders had made loans
to IWS in the aggregate of $2,666,219 and that these loans had accrued
but unpaid interest in the aggregate of $5,719,174. The “note payable”
to petitioners was said to be $679,329, and the “note payable” to the Rie-
menschneiders was said to be $995,546, yielding a total alleged loan of
$1,674,875 from the owners of KRLLC. 3
In the Unanimous Consent document the shareholders of IWS re-
solved that, “effective January 1, 2012, the liability for the notes payable
shall be eliminated by converting the notes payable to paid in capital for
each of the respective shareholders.” They further resolved that, as of
the same date, “the liability for accrued interest shall be eliminated and
shall be shown as income to the corporation.” The document states that
these actions were “taken by unanimous written consent of all share-
holders and directors of [IWS].” The document is signed by all of IWS’s
shareholders, including petitioners.
Consistently with the Unanimous Consent document, IWS’s bal-
ance sheet at yearend 2012 reports no notes payable to shareholders and
3 There is an unexplained difference of $60,218 between these amounts and the
amounts shown on IWS’s December 31, 2011, balance sheet. The balance sheet shows
total notes payable to shareholders of $2,606,001, as opposed to $2,666,219 in the
Unanimous Consent document. And the balance sheet shows that petitioners and the
Riemenschneiders had aggregate notes payable of $1,614,657, with $1,298,440 due to
KRLLC and $316,217 due to Robert Riemenschneider separately. The Unanimous
Consent document, by comparison, shows the aggregate amount of such loans as
$1,674,875.
7
[*7] no note payable to KRLLC. It records “additional paid-in capital”
of $2,666,219, up from zero at yearend 2011. On the other hand, the
actions the IWS shareholders took on January 1, 2012, are not reflected
on the QuickBooks register in which KRLLC tracked the amount alleg-
edly “Due from IWS.” That register has no entries between May 6, 2010
(reporting a balance due of $2,128,696), and April 8, 2013 (reporting a
balance due of $2,164,757).
G. Continued Downward Slide
Despite conversion of all shareholder loans to equity, IWS was
unable to obtain refinancing for the Yarbrough loan. During 2015 and
2016 it explored financing options with several institutions, including
Park Place Equity and Lyon Capital. Petitioner husband conducted
these negotiations in his alleged capacity as “president, founder and ma-
jority shareholder” of IWS. The term sheets for these proposed loans
would have required guaranties from all shareholders who owned 20%
or more of the company. None of these institutions ultimately agreed to
extend credit.
Although Mr. Yarbrough deferred the due date for repayment of
his loan several times, IWS ultimately defaulted. In 2017 Mr. Yar-
brough instituted foreclosure proceedings against the landfill property,
which served as collateral for the loan. An Idaho state court entered a
judgment of foreclosure against IWS on May 25, 2018, and the property
was sold in October 2018. IWS was essentially moribund thereafter.
H. Claimed Bad Debt Deduction
The amount of the business bad debt deduction that KRLLC re-
ported on its 2017 return was derived from its QuickBooks register,
which purported to show the amount “Due from IWS.” Entries on this
register were made by various people at various times. Petitioner wife
handled KRLLC’s books and records until 2007. She made numerous
entries on the register between 2001 and 2006, mostly showing cash
transfers to IWS. Michael Holland, IWS’s outside accountant and orig-
inal tax return preparer, made yearend entries from 1999 through 2009,
apparently based on computer printouts he received from IWS. Entries
bearing his initials are all dated December 31; they typically refer to
items described as investments, equipment, capital items, interest pay-
ments, adjusting entries, and reclassifications. Petitioners’ daughter,
Lynn Gilmore, who took over much of the bookkeeping from her mother
in 2007, appears to have made several entries after 2009, including
8
[*8] those showing the $1.7 million remittance of Yarbrough loan pro-
ceeds in 2010.
The May 6, 2010, entry is the last entry on the “Due from IWS”
register before the January 2012 debt-to-equity conversion. The alleged
balance due as of May 6, 2010, was $2,128,696. There are no entries
recorded during the remainder of 2010 or during 2011–2012. Three en-
tries during 2013, all minor, reduced the alleged balance to $2,095,757
as of July 2, 2013. That is the penultimate entry on the register. The
final entry, showing a balance due of zero, was recorded on December
31, 2017. It zeroes out the previous entry by recording $2,095,757 as a
“bad debt loss.”
For 2017 KRLLC filed a return on Form 1065, U.S. Return of
Partnership Income. On line 22 of that return it reported an ordinary
business loss of $2,095,757, wholly attributable to a $2,095,757 deduc-
tion claimed on line 12 for “bad debts.” Schedule B–1, Information on
Partners Owning 50% or More of the Partnership, which requests infor-
mation about partners, showed petitioners and the Riemenschneiders
as each owning 50% of KRLLC.
KRLLC issued to petitioners for 2017 a Schedule K–1, Partner’s
Share of Income, Deductions, Credits, etc., reporting an ordinary busi-
ness loss of $1,047,878, corresponding to their 50% stake in the partner-
ship ($2,095,757 × 0.5 = $1,047,878.50). On their Form 1040, U.S. Indi-
vidual Income Tax Return, for 2017, petitioners reported that loss on
Schedule E, Supplemental Income and Loss. By way of explanation they
attached the following statement:
An unsecured loan was made to an individual, Rob-
ert Riemenschneider. Keeton and Riemenschneider have
had business and investment dealings in the past. At-
tempts were made to collect and a few payments were
made. However, in 2016, Riemenschneider notified Keeton
that he was filing for bankruptcy and payments
stopped. . . . The remaining loan balance is no longer col-
lectible.
This explanation was incorrect in at least three respects. First,
the loan allegedly giving rise to the bad debt deduction was not made to
Robert Riemenschneider. The alleged loan was made by the Rie-
menschneiders and petitioners, through KRLLC, to IWS. Second,
KRLLC made no “attempts to collect” any loan. Petitioners have
9
[*9] stipulated that KRLLC “never made any formal or informal de-
mand for repayment of any debt to IWS” and “did not take any actions
against IWS to collect upon any outstanding loans.” Third, there was no
“remaining loan balance” as of 2017 because all loans extended to IWS
by petitioners and the Riemenschneiders, directly or through KRLLC,
were canceled and converted to equity on January 1, 2012.
The Schedule E loss reported on petitioners’ 2017 return resulted
in taxable income of negative $1,077,101 and zero tax due. On their
return for 2018 petitioners claimed a carryover NOL deduction, likewise
originating in the alleged bad debt loss, in excess of $1 million. The 2018
return also reported zero tax due.
KRLLC’s 2017 return, as well as petitioners’ 2017 and 2018 re-
turns, were prepared by Jennifer Werner, a certified public accountant
(CPA). She was employed by the same CPA firm as Mr. Holland and
gradually took over for him, preparing returns for KRLLC and petition-
ers beginning in 2011 or 2012.
When seeking information for use in preparing the 2017 and 2018
returns, Ms. Werner did not communicate directly with petitioners. Ra-
ther, she communicated with their daughter, Ms. Gilmore, who had
served as KRLLC’s chief bookkeeper since 2007. Ms. Gilmore did not
testify at trial.
As far as the record reveals, Ms. Werner based the $2,095,757 bad
debt deduction solely on KRLLC’s QuickBooks register, which showed
an alleged balance “Due from IWS” in that amount as of December 31,
2017. Petitioners did not supply Ms. Werner, at the time she prepared
the 2017 returns, with the January 2012 Unanimous Consent resolution
by which petitioners and IWS’s other shareholders agreed to convert all
outstanding shareholder loans to equity.
On October 8, 2020, the IRS issued petitioners a timely notice of
deficiency for 2017 and 2018. The notice included a copy of Form 886–A,
Explanation of Items, issued to KRLLC, which disallowed the
$2,095,757 bad debt deduction because “it was determined that a bona
fide debt did not exist” between KRLLC and IWS. The notice accord-
ingly disallowed $1,047,878 of the Schedule E loss deduction that peti-
tioners had claimed for 2017—representing their 50% share of the part-
nership’s reported loss—and all of the carryover NOL deduction
($1,066,001) that petitioners had claimed for 2018. The notice also made
several computational adjustments that are not at issue.
10
[*10] In consequence of these adjustments the notice determined defi-
ciencies of $119,471 and $104,479 for 2017 and 2018, respectively. The
IRS also determined accuracy-related penalties for both years of $23,894
and $20,895, respectively. The notice included a copy of a Civil Penalty
Approval Form prepared by Revenue Agent (RA) Michael Balding on
February 11, 2020. On that Form RA Balding recommended assertion,
for each year, of a 20% penalty for “substantial understatement of in-
come tax.” See § 6662(b)(2), (d). The Form was digitally signed on Feb-
ruary 11, 2020, by Joshua Cook, RA Balding’s “immediate supervisor.”
OPINION
I. Burden of Proof
The IRS’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer bears the burden of proving them
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
The taxpayer likewise bears the burden of proving entitlement to deduc-
tions allowed by the Code and of substantiating the amounts of any
claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Treas. Reg. § 1.6001-1(a). Petitioners do not contend, and the
evidence does not establish, that the burden of proof shifts to respondent
under section 7491(a) as to any issue of fact.
II. Bad Debt Deduction
A. Governing Legal Principles
Section 166(a)(1) allows as an ordinary loss deduction any bona
fide debt that becomes worthless within the taxable year, except in the
case of certain nonbusiness debts defined in section 166(d). A bona fide
debt is a debt that arises from “a debtor-creditor relationship based upon
a valid and enforceable obligation to pay a fixed or determinable sum of
money.” Zimmerman v. United States, 318 F.2d 611, 612 (9th Cir. 1963)
(quoting Treas. Reg. § 1.166-1(c)); Kean v. Commissioner, 91 T.C. 575,
594 (1988); Treas. Reg. § 1.166-1(c). A contribution to capital is not con-
sidered a “debt” for purposes of section 166. Kean, 91 T.C. at 594.
Whether an advance of funds is treated as genuine debt “must be
considered in the context of the overall transaction.” Hardman v. United
States, 827 F.2d 1409, 1411 (9th Cir. 1987). Our inquiry typically fo-
cuses on whether the taxpayer intended to create a debt with a reason-
able expectation of repayment and (if so) whether that intent comports
in substance with the creation of a debtor-creditor relationship. Litton
11
[*11] Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973); Ill. Tool
Works Inc. & Subs. v. Commissioner, T.C. Memo. 2018-121, 116 T.C.M.
(CCH) 124, 130–31. “The outward form of the transaction is not control-
ling; 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.
Absent stipulation to the contrary, appeal of this case would lie to
the U.S. Court of Appeals for the Ninth Circuit. See § 7482(b)(1)(A).
That court has identified 11 factors that may be relevant in determining
whether a transfer to a corporation by a shareholder is a debt or a con-
tribution to capital. No one factor is controlling or decisive, and the
Ninth Circuit directs us to look to 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 Bauer v. Commis-
sioner, 748 F.2d at 1368)). “The burden of establishing that the ad-
vances were loans rather than capital contributions rests with the tax-
payer.” 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).
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 purported debt; (2) the presence or absence
of a maturity date; (3) the source of the payments, and in particular
whether they are dependent upon earnings; (4) the right to enforce pay-
ment of principal and interest; (5) whether the advances increase par-
ticipation in management; (6) whether the “lender” has a status equal
or inferior to that of regular creditors; (7) objective indicators of the par-
ties’ 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 “bor-
rower” to obtain loans from outside lending institutions. See Hardman,
827 F.2d at 1411–12.
B. Analysis
Our examination of the bad debt issue is greatly simplified in this
case by the January 1, 2012, Unanimous Consent resolution executed
by the shareholders of IWS. By that resolution all shareholder loans in
existence on that date were canceled and converted to paid-in capital,
12
[*12] i.e., equity. Petitioners do not contend that they or the Rie-
menschneiders advanced any funds to IWS, directly or through KRLLC,
after January 1, 2012. As of 2017, therefore, there existed no debt from
IWS that could have gone bad.
By way of reply petitioners note that KRLLC was not itself a
shareholder in IWS. They accordingly argue that the Unanimous Con-
sent resolution, while canceling all shareholder loans as of January
2012, left the alleged loan from KRLLC intact. The business records of
IWS unambiguously refute this argument.
The trial evidence includes IWS’s financial statements from 2008
onwards. Each yearend balance sheet includes, among IWS’s long-term
liabilities, “Notes Payable – Stockholders.” Each balance sheet includes
in this category all loans made in substance by stockholders, whether
directly or through an entity wholly owned by stockholders. For each
year, therefore, the “N/P – Keeton Riemenschneider” is classified as a
“Note[] Payable – Stockholder[].” The balance sheets accord the same
treatment to the loan extended by Ron Riemenschneider, a 6% share-
holder, who made advances through Ideal Tractor, Inc., an entity he con-
trolled. For each year, the “N/P Ideal Tractor, Inc.” is classified as a
“Note[] Payable – Stockholder[].”
For 2008–2011 the IWS balance sheets classify the following
amounts allegedly owed to KRLLC as “Notes Payable – Stockholders”:
Year Balance Due
2008 $3,217,540
2009 3,052,440
2010 1,298,440
2011 1,298,440
Each balance sheet separately shows, among “Notes Payable –
Stockholders,” a loan from Robert Riemenschneider captioned “N/P – RL
Riemenschneider.” The balance of that loan, as of yearend 2011, was
shown as $316,217. According to IWS’s balance sheet, therefore, the
total amount shown as due to petitioners and the Riemenschneiders,
through KRLLC or directly, was $1,614,657 at yearend 2011 ($1,298,440
+ $316,217 = $1,614,657).
13
[*13] In the Unanimous Consent resolution the shareholders resolved
that “the liability for the notes payable [to IWS] shall be eliminated by
converting the notes payable to paid in capital for each of the respective
shareholders.” The resolution states that, as of January 1, 2012, the
loans thus canceled included the following:
Shareholders Note Payable
Robert and Lorene Riemenschneider $995,546
Arland and Jean Keeton 679,329
Total $1,674,875
The loans thus canceled clearly included the loans that petition-
ers and the Riemenschneiders extended through KRLLC. Petitioners
admitted at trial that they advanced no funds to IWS directly; rather,
all their advances were made through KRLLC. The debt to petitioners
shown as canceled in the Unanimous Consent document, $679,329, is
roughly half the amount shown as “N/P – Keeton Riemenschneider” in
the company’s 2011 balance sheet, $1,298,440 (the record does not ex-
plain the $60,218 difference). The debt to petitioners shown as canceled
thus corresponds to their 50% ownership interest in KRLLC. And the
aggregate debt to petitioners and the Riemenschneiders shown as can-
celed in the Unanimous Consent document, $1,674,875, roughly equals
the sum of the notes payable to KRLLC and Robert Riemenschneider
reported on the 2011 balance sheet, $1,614,657 (again the record does
not explain the $60,218 difference).
Consistently with this analysis, IWS’s balance sheet for yearend
2012 shows no notes payable to shareholders and no note payable to
KRLLC. Rather, it shows $2,606,001—the total amount of “Notes Pay-
able to Stockholders” that appeared on the 2011 balance sheet—as hav-
ing been converted to “paid in capital.” Petitioners do not contend that
they or the Riemenschneiders advanced any funds to IWS, directly or
through KRLLC, after January 1, 2012. As of 2017, therefore, there ex-
isted no debt from IWS for which a bad debt deduction could be claimed.
This conclusion by itself supplies a sufficient basis on which to
sustain respondent’s disallowance of the $2,095,757 bad debt deduction
that KRLLC claimed for 2017. For purposes of completeness, however,
we will also consider whether a bona fide debt existed between IWS and
KRLLC as of December 31, 2011, immediately before the debt-to-equity
conversion. In so doing we consider the factors identified by the Ninth
14
[*14] Circuit in Hardman. The factors with greatest salience here
clearly point to characterization of KRLLC’s advances as capital contri-
butions rather than debt. 4
1. Terminology Used by the Parties
Genuine indebtedness is typically indicated by the issuance of a
bond, debenture, or promissory note. See Hardman, 827 F.2d at 1412;
Am. Offshore, Inc. v. Commissioner, 97 T.C. 579, 602 (1991). However,
where a corporate “debtor” is closely held and is related to its putative
creditor, the form of the transaction and the labels the parties used may
have less significance. That is because related parties are free to mold
the transaction using whatever labels they wish. See Fin Hay Realty
Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968); Anchor Nat’l Life
Ins. Co. v. Commissioner, 93 T.C. 382, 406–07 (1989).
KRLLC advanced funds to IWS from the mid-1990s through Au-
gust 2007. During the decade in which these advances were made, there
were no promissory notes, debentures, or other “certificates evidencing
the indebtedness.” Hardman, 827 F.2d at 1412. Rather, the advances
were made on open account, tracked in a QuickBooks register main-
tained by petitioner wife. This register was a product of KRLLC’s inter-
nal bookkeeping. It was not promissory note or other binding instru-
ment that KRLLC could take to court to establish an enforceable prom-
ise to pay.
The terminology used in recording these advances, moreover, is
hostile to the notion that they created a genuine debt. The first entry in
the QuickBooks register, made on December 31, 1999, shows a credit of
$3,331,093 in KRLLC’s favor. This entry was apparently designed to
capture advances KRLLC had made to IWS since the latter’s inception
in 1994, and it is captioned “Investment – Idaho Waste.” An entry for
December 31, 2000, showing a credit of $264,372, is likewise captioned
“Investment – Idaho Waste.” These entries suggest capital contribu-
tions.
4 Besides disputing the existence of a bona fide debt, respondent contends that
petitioners have failed to prove (1) that any debt owed by KRLLC became worthless
during 2017, the year for which the deduction was claimed; (2) that $2,095,757 was the
correct dollar amount of any debt that became worthless; or (3) that any debt held by
KRLLC was a business debt, as opposed to a nonbusiness debt qualifying for only lim-
ited deductibility under section 166(d). Given our disposition we need not consider
these additional arguments.
15
[*15] Other credit entries for 1999–2001—captioned “capital,” “capital
gains,” “equipment,” and “equipment lease income”—are difficult to rec-
oncile with debt characterization. 5 A pair of entries for 1999 and 2001,
totaling $1,893,437, are captioned “loan from Wells Fargo.” These en-
tries do not evidence loans from KRLLC to IWS. Rather, they denote
bank loans extended to KRLLC or its partners, the proceeds of which
the partners contributed to IWS.
The only “certificate[] evidencing the indebtedness,” Hardman,
827 F.2d at 1412, is the October 31, 2008, document captioned “Idaho
Waste Systems, Inc.” In this document IWS promises to pay KRLLC “on
demand” the sum of $3,222,076.89. Robert Riemenschneider signed this
document in his capacity as president of IWS; there are no other signa-
tories.
For several reasons we accord this document little weight. IWS
received no funds from KRLLC in consideration of executing this docu-
ment. Quite the contrary: KRLLC had ceased advancing funds to IWS
in August 2007, 14 months previously. The purported promissory note
thus represents an apparent effort to convert into debt, retroactively,
the open-account advances that KRLLC had made to IWS on dozens of
occasions during the prior decade. As explained above, there is little or
no evidence that these advances constituted debt.
There are other problems with the October 31, 2008, document.
The amount shown as due, $3,222,076.89, bears no discernible relation-
ship to the “Due from IWS” QuickBooks register in which KRLLC rec-
orded its advances. That register has no entries whatever for calendar
year 2008, and the last entry for 2007 shows an alleged balance due from
IWS of $7,424,926. At trial petitioner husband did not recognize the
purported promissory note. He stated that he had no “knowledge or in-
volvement about that note at the time” and “wasn’t involved in it[s] be-
ing written or anything else.”
Finally, the October 31, 2008, document clearly reflected a re-
lated-party transaction. Robert Riemenschneider, who signed the note
for the putative obligor, owned with his wife 50% of KRLLC, the putative
obligee. The labels he assigned are thus far from dispositive. See Fin
Hay Realty Co., 398 F.2d at 697; Anchor Nat’l Life Ins. Co., 93 T.C.
at 406–07. For all these reasons, we give little weight to the purported
5 Some of these entries are rather cryptic. All were yearend entries made by
Mr. Holland, KRLLC’s outside accountant at the time. He did not testify at trial.
16
[*16] promissory note and find that the first Hardman factor strongly
favors respondent.
2. Presence or Absence of Maturity Date
“[A] definite maturity date on which the principal falls due for
payment, without reservation or condition, . . . is a fundamental charac-
teristic of a debt.” Monon R.R. v. Commissioner, 55 T.C. 345, 359 (1970).
On the other hand, “[t]he absence of a fixed maturity date indicates that
repayment is tied to the fortunes of the business” and thus tends to sup-
port equity characterization. Hardman, 827 F.2d at 1413; Am. Offshore,
Inc., 97 T.C. at 602.
KRLLC’s advances to IWS between 1994 and 2007 were reflected
in no promissory note or other debt instrument and thus necessarily
lacked a fixed maturity date. The purported 2008 promissory note like-
wise has no fixed maturity date. It states only that IWS will repay the
principal “on demand” and that interest will accrue at 9% “until paid.”
The document imposes no repayment schedule, stating only that “[a]ny
part [of the principal] may be paid at any time.” The implication of this
demand note is that KRLLC would be repaid only if and when IWS was
sufficiently profitable to make repayment.
Petitioners seek to explain the absence of a maturity date by char-
acterizing KRLLC’s advances as a “working line of credit.” We do not
find this characterization apt. A line of credit necessarily has a limit;
when the limit is reached, no further borrowing is possible. There was
no set limit (and no apparent limit) to KRLLC’s cash advances, which
continued inexorably for a decade, topping out with an alleged balance
due of $7,424,926 at yearend 2007. In any event, a line of credit must
be repaid at some point, and neither the pre-2008 advances nor the pur-
ported 2008 promissory note contains the remotest suggestion of a re-
payment date. We find that this second Hardman factor likewise favors
equity treatment.
3. Source of Payments
A true lender is concerned with a reliable return on his invest-
ment in the form of interest and repayment of principal. Curry v. United
States, 396 F.2d 630, 634 (5th Cir. 1968); Dev. Corp. of Am. v. Commis-
sioner, T.C. Memo. 1988-127, 55 T.C.M. (CCH) 455, 483. If timely pay-
ments 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
17
[*17] were contributions to capital. Hardman, 827 F.2d at 1413; Am.
Offshore, Inc., 97 T.C. at 602.
IWS did not make consistent payments of interest to KRLLC at
any time. The QuickBooks register shows only three interest payments
between 1999 and 2007: two payments totaling $18,411 at yearend 2005
and a payment of $8,390 at yearend 2007. On those dates the register
showed the alleged balances due from IWS as $6,109,521 and
$7,424,926, respectively. If the interest reported as paid was recorded
on the alleged balance due, it would have been paid at a rate of 0.3% and
0.1%, respectively. That is a far cry from the 9% rate specified in the
2008 purported promissory note. And there is no evidence, in the Quick-
Books register or elsewhere, that IWS after October 31, 2008, ever made
a single interest payment on that purported note, at a rate of 9% or oth-
erwise.
Petitioner husband testified at trial that all cash advances made
by KRLLC to IWS included unstated interest at a rate of 9%. But vir-
tually all these advances were in round numbers ($10,000, $45,000,
$190,000, $460,000, etc.). Mathematically speaking, it is hard to imag-
ine how such amounts could have included an interest charge. In any
event, interest on the advances could not have been calculated ab initio
because the term of the “loan” was unknowable.
Petitioners did not introduce into the record any IWS financial
statements for years before 2008. But for 2008 IWS reported retained
earnings of negative $5,460,671, indicating that it had suffered substan-
tial losses in prior years. Petitioner husband admitted at trial that, dur-
ing the 2007–2010 timeframe, IWS was not “in any kind of position to
pay back [KRLLC] anything.” Given this track record, no reasonable
third-party lender could have viewed IWS as financially sound enough
to make regular interest payments at a 9% rate. We thus view the third
Hardman factor as strongly favoring equity treatment.
4. Right to Enforce Payment
The existence of a right to enforce payment of principal and inter-
est is a further indicator of bona fide debt. Hardman, 827 F.2d at 1413;
Gokey Props., Inc. v Commissioner, 34 T.C. 829, 835 (1960), aff’d, 290
F.2d 870 (2d Cir. 1961). KRLLC lacked any meaningful enforcement
rights. The purported promissory note had no repayment schedule and
no fixed maturity date. IWS’s true creditors, including Premier West
and Mr. Yarbrough, demanded a security interest in the landfill
18
[*18] property, IWS’s most valuable asset. KRLLC demanded from IWS
no security interest of any kind. And unlike the financial institutions
from which IWS sought financing in 2015 and 2016, which required
guaranties from all 20% shareholders, KRLLC foreswore that enforce-
ment mechanism as well. This factor strongly favors respondent.
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. Petitioners and the Riemenschneiders, who jointly owned
100% of KRLLC, jointly owned 69% of IWS. But KRLLC’s advances did
not explicitly entitle them to any greater role in IWS’s management. We
regard this factor as neutral.
6. Status Compared to Regular Creditors
If a shareholder’s rights to repayment of principal and interest
are subordinated to the rights of regular creditors, then such advances
are likelier to merit equity treatment. Hardman, 827 F.2d at 1413.
Even absent an explicit subordination clause, the failure to demand
timely repayment or to take collateral effectively subordinates the al-
leged 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.
According to its QuickBooks register, KRLLC advanced more
than $7 million to IWS, on an unsecured basis, between 1999 and 2007.
All of those advances were subordinated to the claims of IWS’s later
creditors. In 2007 IWS put up its landfill property as collateral for a $5
million loan from Premier West. When IWS could not repay that loan,
the landfill property became security for a $4.2 million loan from Mr.
Yarbrough, who ultimately foreclosed on the collateral when IWS de-
faulted. At no point did KRLLC secure collateral from IWS, make de-
mand for the payment of interest or principal, or otherwise take steps to
collect its alleged debt. Such behavior is wholly inconsistent with a typ-
ical debtor-creditor relationship, and this factor thus favors respondent.
7. Objective Indicators of the Parties’ Intent
The parties’ words and actions may supply evidence as to whether
they intended cash advances to be debt or equity. Hardman, 827 F.2d
at 1413. Because petitioners did not submit into evidence IWS’s
19
[*19] pre-2008 financial statements, the principal evidence of their in-
tent regarding advances through August 2007 appears in the “Due from
IWS” QuickBooks register. As noted supra pp. 14–15, several million
dollars’ worth of entries on that register are described as items such as
“Investment – Idaho Waste,” “capital,” “capital gains,” “equipment,” and
“equipment lease income.” None of these descriptions favors debt treat-
ment.
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. A true creditor desires robust capital-
ization to guard against this risk. Thin capitalization thus suggests that
shareholder advances to a corporation are capital contributions. Hard-
man, 827 F.2d at 1414; Hubert Enters., Inc. v. Commissioner, 125 T.C.
72, 96–97 (2005), aff’d in part, vacated in part, and remanded on other
grounds, 230 F. App’x 526 (6th Cir. 2007).
IWS was severely undercapitalized at all times. In the absence of
financial statements for years before 2008, it is impossible to calculate
debt-to-equity ratios for that period. But at yearend 2008, after execut-
ing the purported promissory note to KRLLC, IWS reported liabilities of
$12,615,390 and shareholder equity of negative $4,433,981. This com-
putes to a debt-to-equity ratio nearing infinity. See, e.g., Dunmire v.
Commissioner, T.C. Memo. 1981-372, 79 T.C.M. (CCH) 1769, 1774 n.24
(noting that, where shareholder equity is a negative number, the debt-
to-equity ratio approaches infinity). This factor strongly favors
respondent.
9. Identity of Interest
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.
Petitioners and the Riemenschneiders owned 100% of KRLLC, the al-
leged obligee. Petitioners and the Riemenschneiders owned 69% of IWS,
the alleged obligor, and the Riemenschneiders’ children owned another
11% of IWS. Petitioners and the Riemenschneiders thus had complete
control over both entities at all times. Cf. § 318(a)(1) (providing that an
individual is deemed to own the shares of any spouse and children for
purposes of determining corporate control). While the record does not
20
[*20] reveal an identity of interest, it reveals a strong overlapping of
interest, and this factor thus offers little help to petitioners.
10. Relatedness of Payments to Profits
A true lender is concerned with reliable payment of interest. A
lack of interest payments—and the alleged debtor’s lack of current abil-
ity to make them—suggests that the party advancing funds is looking to
the corporation’s future earnings to achieve a return on his investment.
Hardman, 827 F.2d at 1414; Am. Offshore, Inc., 97 T.C. at 605. This
factor, like the third Hardman factor, thus favors respondent. See supra
pp. 16–17.
11. Ability to Borrow from Other Sources
If the corporation is able to borrow funds from third-party lenders
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; Segel v. Commissioner, 89 T.C. 816, 828 (1987); Ill.
Tool Works Inc., 116 T.C.M. (CCH) at 135. IWS allegedly borrowed more
than $7 million from KRLLC, for a period of more than a decade, at an
effective interest rate of zero, offering no collateral and no guaranties
from its shareholders.
It is obvious that IWS could not have secured such terms from an
unrelated third party. Although IWS sought credit from many financial
institutions during this period, most turned it down. The two third-
party lenders that did extend credit, Premier West and Mr. Yarbrough,
demanded a security interest in the landfill property, which represented
more than 70% of IWS’s assets. And when IWS approached outside fi-
nancial institutions (unsuccessfully) during 2015 and 2016, they de-
manded guaranties from all shareholders owning 20% or more of the
company. The final Hardman factor thus favors respondent.
In sum, we conclude that KRLLC’s advances to IWS from incep-
tion through August 2007 did not give rise to bona fide debt, but rather
constituted capital contributions on behalf of petitioners and the Rie-
menschneiders. Assuming arguendo that some portion of these ad-
vances constituted debt, that debt was extinguished by the Unanimous
Consent resolution in January 2012, when all loans from shareholders
were converted to paid-in capital. For both of these reasons, there re-
mained no debt from IWS to KRLLC that could have become worthless
in 2017, the year for which the bad debt deduction was claimed. We
thus sustain the IRS’s disallowance of that deduction and of the pass-
21
[*21] through loss deduction and carryover NOL deduction claimed on
petitioners’ 2017 and 2018 returns, respectively.
III. Accuracy-Related Penalties
Section 6662 imposes a 20% accuracy-related penalty on any un-
derpayment of tax required to be reported on a return attributable to,
among other things, any “substantial understatement of income tax.”
§ 6662(a), (b)(2). An understatement is “substantial” if it exceeds the
greater of $5,000 or 10% of the tax required to be shown on the return.
§ 6662(d)(1)(A).
Respondent bears the burden of production with respect to this
penalty. See § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446–47
(2001). Petitioners’ returns for 2017 and 2018 reported zero tax due.
Respondent’s notice of deficiency, whose determinations we have sus-
tained, determined deficiencies of $119,471 and $104,479, respectively.
Petitioners’ understatements of income tax thus exceeded $5,000 and
10% of the tax required to be shown on their returns. Respondent has
thus met his burden of production to show a “substantial understate-
ment of income tax.”
Respondent’s burden of production also requires that he show
compliance with section 6751(b)(1). See § 7491(c); Graev v. Commis-
sioner, 149 T.C. 485, 492–93 (2017), supplementing and overruling in
part 147 T.C. 460 (2016). That section provides that no penalty “shall
be assessed unless the initial determination of such assessment is per-
sonally approved (in writing) by the immediate supervisor of the indi-
vidual making such determination.” The parties have stipulated that
the examining agent, RA Balding, secured timely approval from his im-
mediate supervisor, Joshua Cook, for assertion of accuracy-related pen-
alties under section 6662(a). Respondent has thus met his burden of
production in all respects.
Section 6664(c)(1) provides that the accuracy-related penalty will
not be imposed with respect to any portion of an underpayment “if it is
shown that there was a reasonable cause for such portion and that the
taxpayer acted in good faith.” The decision whether the taxpayer acted
with reasonable cause and in good faith is made on a case-by-case basis,
taking into account all facts and circumstances. See Treas. Reg.
§ 1.6664-4(b)(1). Generally, the most important factor is the taxpayer’s
effort to assess his proper tax liability. Other circumstances include the
experience, knowledge, and education of the taxpayer, as well as the
22
[*22] extent to which he reasonably and in good faith relied on the ad-
vice of a competent professional tax adviser. Id. paras. (b)(1), (c)(1); see
Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98–99, aff’d, 299
F.3d 221 (3d Cir. 2002).
Petitioners contend that they relied in good faith on advice from
their return preparer, Jennifer Werner. As a preliminary matter, we do
not know what advice petitioners actually received from Ms. Werner.
She did not communicate with petitioners directly; rather, she commu-
nicated with petitioners’ daughter, Ms. Gilmore, in connection with
preparation of the 2017 and 2018 tax returns. Petitioners did not make
Ms. Gilmore available to testify about the advice she received from Ms.
Werner or about the advice (if any) that she relayed to petitioners. Nor
did petitioners testify about the second-hand advice (if any) that they
got from Ms. Gilmore. Petitioners have thus failed to establish that they
actually received and relied on professional advice.
In order for reliance on professional advice to be reasonable, the
professional must have “arrive[d] at that advice independently.” Neo-
natology Assocs., P.A., 115 T.C. at 98. Ms. Werner testified that she
essentially transposed the $2,095,757 “bad debt” number from KRLLC’s
QuickBooks register to line 11 of KRLLC’s 2017 tax return, without in-
vestigating the propriety of either the amount or the nature of the loss
it purported to represent. Because the claimed bad debt was the product
of petitioners’ own bookkeeping, any advice Ms. Werner may have ren-
dered was not “independent.”
To establish reasonable cause, a taxpayer must also have pro-
vided the adviser with all necessary and accurate information. Id. at 99.
Petitioners did not inform Ms. Werner, at the time she prepared the
2017 tax returns, that they had executed in 2012 a Unanimous Consent
resolution that converted all shareholder loans to equity. At trial Ms.
Werner admitted that knowledge of this resolution would have been rel-
evant to her analysis of whether KRLLC could properly claim a bad debt
loss deduction for 2017.
For these reasons, we are unable to conclude that petitioners had
reasonable cause for their substantial understatements of income tax.
We accordingly sustain respondent’s determination of accuracy-related
penalties for both years.
To reflect the foregoing,
Decision will be entered for respondent.