Russell v. Comm'r

T.C. Memo. 2008-246
UNITED STATES TAX COURT
DONALD L. AND EVELYN RUSSELL, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4425-05, 4456-05, Filed October 30, 2008.
4688-05.
Jon J. Jensen, for petitioners.
Jack Forsberg, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HAINES, Judge: These cases are before the Court
consolidated for purposes of trial, briefing, and opinion.
Donald and Evelyn Russell (the Russells), Loren and Dawn Kopseng
1
Cases of the following petitioners are consolidated
herewith: Loren R. and Dawn Kopseng, docket No. 4456-05; United
Energy Corp., docket No. 4688-05.
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(the Kopsengs), and United Energy Corp. separately petitioned the
Court for redetermination of the following deficiencies in
Federal income tax:
Donald L. & Evelyn Russell, docket No. 4425-05
TYE Deficiency
12/31/1997 $128,414
Loren R. & Dawn Kopseng, docket No. 4456-05
TYE Deficiency
12/31/1997 $278,340
United Energy Corp., docket No. 4688-05
TYE Deficiency
6/30/1998 $437,698
The issue for decision after concessions is whether
instruments entitled “notes”, “ledger debt”, and “short-term
debt” constituted “indebtedness of the S corporation to the
shareholder” for purposes of determining whether petitioners
Donald Russell (Mr. Russell) and Loren Kopseng (Mr. Kopseng) had
sufficient basis under section 1366(d)(1)(B) to claim their
distributive shares of the loss incurred by Missouri River
Royalty Corp.2
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
(continued...)
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the supplemental stipulation of
facts, together with attached exhibits, are incorporated herein
by this reference. At the time the Russells and Kopsengs filed
their petitions, they resided in North Dakota. At the time
United Energy Corp. (UEC) filed its petition, its principal place
of business was in North Dakota.
On May 18, 2005, respondent sent petitioners notices of
deficiency for the years at issue. Petitioners filed timely
petitions with this Court.
I. Members of the UEC Group and Predecessor Entities
A. United Energy Corp.
UEC was incorporated under the law of North Dakota on August
29, 1997. At all times since its incorporation, UEC has used the
accrual method of accounting for tax and financial reporting
purposes and has had a fiscal year and taxable year ending June
30. At all times from the initial issuance of stock by UEC on
September 1, 1997, through June 30, 1998, all of UEC’s
outstanding stock was owned by Mr. Russell and Mr. Kopseng.
UEC timely filed a Form 1120, U.S. Corporation Income Tax
Return, for its initial short taxable year beginning September 1,
2
(...continued)
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
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1997, and ending June 30, 1998. UEC filed its Form 1120 as the
common parent of a consolidated group of corporations consisting
of itself, Rainbow Gas Co. (RGC), Rainbow Energy Marketing Corp.
(REMC), Missouri River Royalty Corp (MRRC), and Energy Leasing
Corp. (ELC).
B. Rainbow Gas Co.
Before 1997 the assets of RGC were owned by a North Dakota
limited partnership (RGC Partnership). As of August 29, 1997,
all of the general and limited partnership interests in RGC
Partnership were owned by Mr. Russell and Mr. Kopseng. On August
29, 1997, in a transaction qualifying as a tax-free exchange
under section 351(a), all the assets of RGC Partnership were
transferred to RGC, a newly formed North Dakota corporation, in
exchange for the issuance of 375 shares of RGC stock to Mr.
Russell and 625 shares of RGC stock to Mr. Kopseng. The RGC
shares issued to Mr. Russell and Mr. Kopseng constituted all of
the outstanding shares of RGC.
C. Rainbow Energy Marketing Corp.
REMC is a North Dakota corporation. As of September 1,
1997, REMC had 4,512,205 shares outstanding, of which 1,108,056
were owned by Mr. Russell and 2,701,149 were owned by Mr.
Kopseng.
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D. Missouri River Royalty Corp.
MRRC is a North Dakota corporation which was incorporated on
September 7, 1984. At all times before September 1, 1997, MRRC
was an S corporation. Effective September 1, 1997, MRRC
voluntarily revoked its S corporation election. MRRC filed a
Form 1120S, U.S. Income Tax Return for an S Corporation, for the
short taxable year beginning January 1, 1997, and ending August
31, 1997. At all relevant times before September 1, 1997, MRRC
had 30,000 shares outstanding, of which Mr. Russell and Mr.
Kopseng each owned 15,000 shares.
II. The Section 351 Transaction
On September 1, 1997, Mr. Russell received 350 shares of UEC
stock and Mr. Kopseng received 650 shares of UEC stock as part of
a transaction qualifying as a tax-free exchange under section
351(a). As part of the section 351 transaction, Mr. Russell made
a contribution to UEC of 375 shares of RGC stock, 1,108,056
shares of REMC stock, and 15,000 shares of MRRC stock. Mr.
Kopseng made a contribution to UEC of 625 shares of RGC stock,
2,701,149 shares of REMC stock, and 15,000 shares of MRRC stock.
UEC’s audited consolidated financial statement for the
period ending June 30, 1998, contained the following statement
respecting the section 351 transaction:
In August, 1997 United Energy Corporation (the
company) exchanged 1,000 shares of its common stock for
100% of the shares of Rainbow Gas Company and Missouri
River Royalty and 85% of the outstanding shares of
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Rainbow Energy Marketing Corporation. This transaction
was accounted for under the requirements of
interpretation 39 of Accounting Standards Board Opinion
#16, whereby the acquisitions were treated as a
transfer of shares between companies with common
control in a manner similar to a pooling of interest.
Accordingly, all assets and liabilities of the merged
companies were recognized at historical cost and the
historical financial statements of Rainbow Gas Company,
Missouri River Royalty Corporation and Rainbow Energy
Marketing Corporation became a component of the
historical financial statements of the company.
The audited financial statement made no reference to any
assumption or contribution of liabilities being part of the
section 351 transaction.
In their capacities as the incorporators and directors
of UEC, Mr. Russell and Mr. Kopseng executed a Consent to Action
Taken in Lieu of Organizational Meeting dated September 3, 1997
(consent). With respect to the section 351 transaction, the
consent stated as follows:
The directors were authorized to issue stock
pursuant to the attached Resolution in the amount of
650 shares to Loren R. Kopseng in return for his
contribution of shares from Rainbow Gas Company,
Missouri River Royalty Corporation, and Rainbow Energy
Marketing Corporation, and has [sic] been authorized to
issue 350 shares to Donald L. Russell in return for his
contribution of shares from Rainbow Gas Company,
Missouri River Royalty Corporation, and Rainbow Energy
Marketing Corporation.
The consent made no reference to any assumption or contribution
of liabilities being part of the section 351 transaction.
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In their capacities as the directors and officers of UEC,
Mr. Russell and Mr. Kopseng executed a resolution dated September
3, 1997. The resolution stated:
Loren R. Kopseng has transferred 625 shares of
Rainbow Gas Company stock, 2,701,149 shares of Rainbow
Energy Marketing Corporation stock, and all shares of
Missouri River Royalty Corporation stock to United
Energy Corporation. In return for the transfer of
these shares, United Energy Corporation is hereby
authorized to issue 650 shares of United Energy
Corporation’s stock to Loren R. Kopseng.
Donald L. Russell has transferred 375 shares of
Rainbow Gas Company stock, 1,108,056 shares of Rainbow
Energy Marketing Corporation stock, and all shares of
Missouri River Royalty Corporation stock to United
Energy Corporation. In return for the transfer of
these shares, United Energy Corporation is hereby
authorized to issue 350 shares of United Energy
Corporation’s stock to Donald L. Russell.
The resolution made no reference to any assumption or
contribution of liabilities being part of the section 351
transaction.
III. Financial Instruments of the UEC Group
MRRC required capital to purchase and rework oil wells.
Petitioners acquired capital for MRRC through a variety of
transactions.
A. The BNC Notes
On or about August 16, 1996, BNC National Bank (BNC) lent $1
million to MRRC. MRRC used the proceeds of the loan to pay off
certain prior loans that had been incurred to purchase and rework
oil wells. In consideration for the loan, MRRC gave BNC a
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promissory note for $1 million (MRRC note) and entered into a
loan agreement.
The MRRC note bore interest at the Wall Street Journal prime
rate plus 2 percent and required 47 monthly payments of $25,552
and a balloon payment of all remaining principal and interest on
August 16, 2000. Mr. Russell and Mr. Kopseng cosigned the MRRC
note. Throughout the life of the loan, interest on the MRRC note
was calculated using monthly compounding and an interest rate of
10.25 percent. At all times from August 16, 1996, through
January 3, 1997, the Wall Street Journal prime rate was 8.25
percent.
As of January 3, 1997, the principal balance of the MRRC
note was $927,936. On January 3, 1997, BNC canceled the MRRC
note in consideration for (1) a $463,968 promissory note which
Mr. Russell cosigned (the MRRC/DR note), and (2) a $463,968
promissory note which Mr. Kopseng cosigned (the MRRC/LK note).
Mr. Russell and Mr. Kopseng also indicated that they intended to
guarantee the MRRC/DR note and the MRRC/LK note.3
The MRRC/DR note and the MRRC/LK note both listed MRRC as
the borrower and indicated that they were for the renewal of the
MRRC note. The MRRC/DR note and the MRRC/LK note both bore
interest at the Wall Street Journal prime rate plus 2 percent and
3
Both the MRRC/DR note and the MRRC/LK note state that they
are “guarantied with the personal guarantys [sic] of Donald L.
Russell and Loren Kopseng dated 1/3/97.”
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required 44 monthly payments of $12,776 and a balloon payment of
the remaining principal and interest on August 16, 2000. Through
March 27, 1997, interest on both the MRRC/DR note and the MRRC/LK
note was calculated using an interest rate of 10.25 percent.
After March 27, 1997, interest was calculated using an interest
rate of 10.50 percent. Interest on both the MRRC/DR note and the
MRRC/LK note was calculated using monthly compounding. The Wall
Street Journal prime rate was 8.25 percent from January 3, 1997,
through March 26, 1997, and 8.5 percent from March 27, 1997,
through September 29, 1998.
Between January 3 and September 3, 1997, MRRC made 8 monthly
payments of $12,776 on the MRRC/DR note and 8 monthly payments of
$12,776 on the MRRC/LK note. All monthly payments on the MRRC/DR
note and on the MRRC/LK note were applied first to interest and
then to principal.
The interest which accrued on the MRRC/DR note and on the
MRRC/LK note between January 3 and September 3, 1997, was as
follows:
Interest
Accrued Through MRRC/DR Note MRRC/LK Note Total
Sept. 1, 1997 $30,009 $30,009 $60,018
Sept. 3, 1997 30,217 30,217 60,434
As of September 1 and September 3, 1997, the principal
balances of the MRRC/DR note and the MRRC/LK note were as
follows:
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Principal Balance MRRC/DR Note MRRC/LK Note
Sept. 1, 1997 $389,915 $389,915
Sept. 3, 1997 389,915 389,915
On September 3, 1997, using a telephone transfer, MRRC paid
BNC (1) the $389,915 principal balance of the MRRC/DR note, (2)
the $389,915 principal balance of the MRRC/LK note, (3) the
accrued interest of $2,042 on the MRRC/DR note, and (4) the
accrued interest of $2,042 on the MRRC/LK note.
The $60,434 of interest that was accrued and paid on the
MRRC/DR note and MRRC/LK note was reported on the 1998 UEC Form
1120 as an interest expense of MRRC. None of the $60,434 was
reported on Mr. Russell’s 1997 Form 1040, U.S. Individual Income
Tax Return, or Mr. Kopseng’s 1997 Form 1040, either as interest
income or as an interest expense.
As of September 1 and September 3, 1997, the fair market
value of the MRRC/DR note was equal to the MRRC/DR note’s
principal balance of $389,915. As of September 1, 1997, and as
of September 3, 1997, the fair market value of the MRRC/LK note
was equal to the MRRC/LK note’s principal balance of $389,915.
B. The Russell and Kopseng Ledger Debt
Before April 5, 1996, Mr. Russell made a series of cash
advances to MRRC which MRRC used for working capital (the Russell
ledger debt). As of April 5, 1996, the principal balance of
these advances totaled $562,705. In MRRC’s books, the Russell
ledger debt was recorded as a liability in a ledger account
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entitled “Notes Payable Russell” (the notes payable Russell
account).
On April 5, 1996, MRRC issued a $562,705 note to Mr. Russell
for the Russell ledger debt (the Russell ledger debt note). As
of September 1, 1997, the principal balance of the Russell ledger
debt was $65,527.
Before April 5, 1996, Mr. Kopseng made a series of cash
advances to MRRC which MRRC used for working capital (the Kopseng
ledger debt). As of April 5, 1996, the principal balance of
these advances totaled $611,144. In MRRC’s books, the Kopseng
ledger debt was recorded as a liability in a ledger account
entitled “Notes Payable Kopseng” (the notes payable Kopseng
account).
On April 5, 1996, MRRC issued a $611,144 note to Mr. Kopseng
for the Kopseng ledger debt (the Kopseng ledger debt note). As
of September 1, 1997, the principal balance of the Kopseng ledger
debt was $117,438.
The Russell ledger debt and the Kopseng ledger debt were
demand obligations. Interest on the Russell ledger debt and the
Kopseng ledger debt was calculated using monthly compounding.
There was no requirement that interest accruing on the Russell
ledger debt and Kopseng ledger debt be paid at least annually.
As of September 1, 1997, the fair market value of the
Russell ledger debt was equal to the Russell ledger debt’s
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principal balance of $65,527. Likewise, the fair market value of
the Kopseng ledger debt was equal to the Kopseng ledger debt’s
principal balance of $117,438.
Respondent concedes that the Russell ledger debt and the
Kopseng ledger debt constituted indebtedness of MRRC to Mr.
Russell and Mr. Kopseng for purposes of section 1366(d)(1)(B).
C. The REMC Ledger Debt
REMC lent MRRC $57,000 on April 1, 1996, and $37,000 on
April 11, 1996 (REMC ledger debt). MRRC used the REMC ledger
debt for working capital. In MRRC’s books, the REMC ledger debt
was recorded as a liability in a ledger account entitled “Notes
Payable Kopseng/Russell Partnership.” The REMC ledger debt was a
demand obligation. There was no requirement that interest
accruing on the REMC ledger debt be paid at least annually.
A note was prepared in connection with the REMC ledger debt
(the REMC note). The REMC note stated, in part, that “Effective
April 1, 1996, Missouri River Royalty Corporation promises to pay
Kopseng/Russell Partnership $94,000.00 at an interest rate of the
applicable Federal Rate Table.” Interest on the REMC ledger debt
was in fact calculated at a rate that varied from the Wall Street
Journal Prime Rate plus 1 percent to the Wall Street Journal
Prime Rate plus 2 percent. Interest on the REMC ledger debt was
calculated using monthly compounding. At all times, the rates
used to calculate interest on the REMC ledger debt exceeded the
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short-term, monthly-compounding Applicable Federal Rate as then
in effect. There was no requirement that interest accruing on
the REMC ledger debt be paid at least annually.
As of September 1, 1997, the principal balance of the REMC
ledger debt was $75,750.
On June 30, 1998, an adjusting journal entry to MRRC’s books
reclassified $22,042 of the $75,750 balance of the REMC ledger
debt to the notes payable Russell account and $53,708 of the
balance to the notes payable Kopseng account. The adjusting
journal entry allocated the balance of the REMC ledger debt
between the notes payable Russell account and the notes payable
Kopseng account in proportion to the interests held by Mr.
Russell and Mr. Kopseng in REMC at the time the loans were made
in April of 1996.
As of September 1, 1997, the fair market value of the REMC
ledger debt was equal to the REMC ledger debt’s principal balance
of $75,750.
D. The Short-Term Debt
During the period between March 7, 1997, and June 16, 1997,
MRRC received a series of loans totaling $1,830,597 (short-term
debt) as follows:
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Date Amount Borrowed
Mar. 7, 1997 $300,500
Mar. 13, 1997 236,000
Mar. 14, 1997 20,000
Apr. 2, 1997 447,750
Apr. 4, 1997 8,200
Apr. 29, 1997 336,000
May 15, 1997 2,500
June 3, 1997 455,647
June 16, 1997 24,000
Total 1,830,597
MRRC used the proceeds of the short-term debt for working
capital.
Between May 13, 1997, and August 27, 1997, MRRC repaid
$629,000 of principal on the short-term debt as follows:
Date Amount Repaid
May 13, 1997 $200,000
July 3, 1997 165,000
Aug. 15, 1997 90,000
Aug. 25, 1997 200,000
Aug. 27, 1997 37,000
Total 692,000
No interest was paid on the short-term debt before September 3,
1997.
The loans making up the short-term debt were transferred
directly from the checking account of RGC Partnership to the
checking account of MRRC. The repayments were transferred
directly from the checking account of MRRC to the checking
account of RGC Partnership. Before August 31, 1997, the short-
term debt was recorded in MRRC’s books as a liability in a ledger
account entitled “Notes Payable RGC”. As of August 31, 1997, an
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adjusting journal entry to MRRC’s books reclassified $569,298 of
the short-term debt to the notes payable Kopseng account and
$569,298 to the notes payable Russell account.
With respect to each of the nine loans comprising the short-
term debt, four notes were prepared: (1) One from Mr. Russell to
RGC Partnership (Russell/RGC notes), (2) one from Mr. Kopseng to
RGC Partnership (Kopseng/RGC notes), (3) one from MRRC to Mr.
Russell (MRRC/Russell notes), and (4) one from MRRC to Mr.
Kopseng (MRRC/Kopseng notes). The face amount of each note was
half of the amount transferred from RGC Partnership to MRRC on
the date of the respective transfer.
The face amounts of the Russell/RGC notes, the Kopseng/RGC
notes, the MRRC/Russell notes, and the MRRC/Kopseng notes
(collectively the short-term notes) were set forth as follows:
Short-Term Debt
Date Lent Amount
March 7, 1997 $300,500
March 13, 1997 236,000
March 14, 1997 20,000
April 2, 1997 447,750
April 4, 1997 8,200
April 29, 1997 336,000
May 15, 1997 2,500
June 3, 1997 455,647
June 16, 1997 24,000
Total 1,830,597
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Face Amount of Shareholder/RGC Notes
Russell to RGC Kopseng to RGC
$150,250 $150,250
118,000 118,000
10,000 10,000
223,875 223,875
4,100 4,100
168,000 168,000
1,250 1,250
227,823 227,823
12,000 12,000
915,298 915,298
Face Amount of MRRC/Shareholder Notes
MRRC to Russell MRRC to Kopseng
$150,250 $150,250
118,000 118,000
10,000 10,000
223,875 223,875
4,100 4,100
168,000 168,000
1,250 1,250
227,823 227,823
12,000 12,000
915,298 915,298
Each of the short-term notes bore an “effective” date which
was identical to the date on which the corresponding loan was
made to MMRC. Both Mr. Kopseng and Mr. Russell signed each of
the short-term notes, either in their individual capacities or on
behalf of RGC or MMRC, but none of their signatures were dated.
The short-term debt was a demand obligation.
Each short-term note stated that it bore interest at “an
interest rate of the applicable Federal Rate Table.” However,
interest on the short-term debt was calculated at a rate that
varied from the Wall Street Journal Prime Rate plus 1 percent to
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the Wall Street Journal Prime Rate plus 2 percent. Interest on
the short-term debt was calculated using monthly compounding. At
all times, the rates used to calculate interest on the short-term
debt exceeded the short-term, monthly-compounding Applicable
Federal Rate as then in effect. There was no requirement that
interest accruing on the short-term debt be paid at least
annually.
As of September 1, 1997, and September 3, 1997, the
principal balance of, and the accrued interest on, the short-term
debt was as follows:
Date Interest Principal
Sept. 1, 1997 $61,923 $1,138,597
Sept. 3, 1997 62,578 1,138,597
On September 3, 1997, the $1,138,597 principal balance of
the short-term debt, along with accrued interest thereon of
$62,578, was paid by using a $1,201,175 cashier’s check from MRRC
to RGC. The $1,201,175 payment was reflected in MRRC’s books by
(1) debiting the notes payable Russell account for $569,298, (2)
debiting the notes payable Kopseng account for $569,298, and (3)
debiting the loan interest account for $62,578 with the memo
notation “Interest paid to Kopseng & Russell for Note.” The
$1,201,175 payment was reflected in RGC’s books by (1) crediting
the “Notes Payable Don Russell” ledger account for $569,298, (2)
crediting the “Notes Payable Loren Kopseng” ledger account for
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$569,298, and (3) crediting the interest income account for
$62,578 with the memo notation “Interest on Note Rec. from MRRC.”
The $62,578 of accrued interest on the short-term debt was
reported on the 1998 UEC Form 1120 as an interest expense of MRRC
and interest income of RGC. None of the $62,578 was reported on
Mr. Russell’s 1997 Form 1040 or Mr. Kopseng’s 1997 Form 1040,
either as interest income or interest expense.
As of September 1, 1997, and as of September 3, 1997, the
fair market value of the short-term debt was equal to the short-
term debt’s principal balance of $1,138,597.
The MRRC note, the MRRC/DR note, the MRRC/LK note, the
Russell ledger debt, the Kopseng ledger debt, the REMC ledger
debt, and the short-term debt were not “publicly offered” within
the meaning of that term as used in section 1273(b)(1), nor were
they property of the type described in section 1273(b)(3).
IV. Russell and Kopseng’s Basis in Indebtedness and MRRC Stock
As of the beginning of MRRC’s short taxable year ending
August 31, 1997, Mr. Russell’s basis in his MRRC stock was
$150,151, and Mr. Kopseng’s basis in his MRRC stock was zero.
The MRRC 1997 Form 1120S reported an ordinary loss of
$1,117,540, interest income of $250, and dividend income of $208.
Consistent with the MRRC 1997 Form 1120S, the following items
from MRRC’s taxable year ended August 31, 1997, were reported on
Mr. Russell’s 1997 return and on Mr. Kopseng’s 1997 return.
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Item Amount
Ordinary loss $558,770
Interest income 125
Dividend income 104
As of the end of MRRC’s taxable year ended August 31, 1997:
(1) Mr. Russell’s basis in the Russell ledger debt was $65,527
less the amount by which his basis in the Russell ledger debt was
properly reduced under section 1367(b)(2) on account of items of
MRRC for its taxable year ending August 31, 1997, and (2) Mr.
Kopseng’s basis in the Kopseng ledger debt was $117,438 less the
amount by which his basis in the Kopseng ledger debt was properly
reduced under section 1367(b)(2) on account of items of MRRC for
its taxable year ending August 31, 1997.
OPINION
Petitioners contend that they had bases in certain
indebtedness of MRRC4 sufficient to permit them to deduct their
pro rata shares of MRRC’s ordinary loss of $1,117,540 for its
final, short taxable year ending August 31, 1997. We disagree.
For the reasons set forth below, none of the MRRC Debts, save the
Russell ledger debt and Kopseng ledger debt, constituted
shareholder debt for purposes of section 1366(d)(1)(B). We need
not decide whether the burden of proof shifts to respondent under
4
Namely the MRRC/DR note, the MRRC/LK note, the Russell
ledger debt, the Kopseng ledger debt, the REMC ledger debt, and
the short-term debt (collectively the MRRC Debts).
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section 7491(a) because we decide this case on the basis of the
preponderance of the evidence.
Section 1366(a) provides that a shareholder of an S
corporation shall take into account his pro rata share of the S
corporation’s items of income, loss, deduction, or credit.
However, a shareholder may deduct his share of the S
corporation’s losses only to the extent of his adjusted basis in
his stock of the S corporation, sec. 1366(d)(1)(A), and “the
shareholder’s adjusted basis of any indebtedness of the S
corporation to the shareholder”, sec. 1366(d)(1)(B). Any S
corporation losses so limited may be carried forward
indefinitely. Sec. 1366(d)(2).
The jurisprudence in this area has fleshed out certain
principles relating to the limitation set forth in section
1366(d)(1)(B) and the situations under which a shareholder
acquires basis with respect to indebtedness. See Hitchins v.
Commissioner, 103 T.C. 711, 715 (1994); Grojean v. Commissioner,
T.C. Memo. 1999-425, affd. 248 F.3d 572 (7th Cir. 2001). First,
a shareholder must make an actual economic outlay. Underwood v.
Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468
(1975); Perry v. Commissioner, 54 T.C. 1293, 1296 (1970), affd.
27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir. 1971).5 The
5
The economic outlay requirement stems from the concept
that an S corporation shareholder should be entitled to basis to
(continued...)
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economic outlay must leave the taxpayer “poorer in a material
sense” in order for its bona fides to be respected. Perry v.
Commissioner, supra at 1296; see also Bergman v. United States,
174 F.3d 928, 933 (8th Cir. 1999)
Second, the S corporation’s indebtedness must run directly
to the shareholder; an indebtedness to a passthrough entity that
advanced the funds and is closely related to the taxpayer does
not satisfy the statutory requirements. Frankel v. Commissioner,
61 T.C. 343 (1973), affd. without published opinion 506 F.2d 1051
(3d Cir. 1974); Burnstein v. Commissioner, T.C. Memo. 1984-74.
Furthermore, no form of indirect borrowing, be it a guaranty,
surety, accommodation, comaking or otherwise, gives rise to
indebtedness from the corporation to the shareholders
until and unless the shareholders pay part or all of the
5
(...continued)
the extent of his investment in the S corporation. S. Rept.
1983, 85th Cong., 2d Sess. 219-220 (1958), 1958-3 C.B. 922, 1141
(“The amount of the net operating loss apportioned to any
shareholder * * * is limited under [former] section 1374(c)(2)
[the predecessor of sec. 1366(d)(1)] to the adjusted basis of the
shareholder’s investment in the corporation; that is, to the
adjusted basis of the stock in the corporation owned by the
shareholder and the adjusted basis of any indebtedness of the
corporation to the shareholder.”); see also Perry v.
Commissioner, 54 T.C. 1293, 1296 (1970) (concluding that
the word “investment” indicated an intent to limit a
shareholder’s basis to that shareholder’s "actual economic
outlay”), affd. 27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir.
1971).
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existing obligation. Before that crucial act, “liability” may
exist, but not debt to the shareholders. Raynor v. Commissioner,
50 T.C. 762, 770-771 (1968).
I. The MRRC/DR Note and the MRRC/LK Note
Mr. Russell and Mr. Kopseng cosigned and guaranteed the
MRRC/DR note and the MRRC/LK note. However, neither were
required to make any payments with respect to the MRRC notes. In
the absence of any discernable economic outlay, Mr. Russell and
Mr. Kopseng’s cosigning and guaranteeing of the MRRC notes did
not give rise to “indebtedness of the S corporation to the
shareholder” under section 1366(d)(1)(B). See Raynor v.
Commissioner, supra at 770 (holding that a shareholder’s guaranty
of a loan to an S corporation, in the absence of actual payments,
does not create indebtedness); Keech v. Commissioner, T.C. Memo
1993-71 (holding that a shareholder’s co-signing of a loan to an
S corporation may not be treated as an equity investment in the
corporation absent an economic outlay by the shareholder).
Further, cosigning and guaranteeing the notes did not create
an indebtedness running directly from MRRC to Mr. Russell and Mr.
Kopseng. MRRC’s only indebtedness ran to BNC. The mere
possibility that MRRC could become obligated to Mr. Russell and
Mr. Kopseng at some future time is irrelevant for purposes of
determining indebtedness of the S corporation to the shareholder.
See Maloof v. Commissioner, 456 F.3d 645 (6th Cir. 2006), affg.
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T.C. Memo. 2005-75. Accordingly, Mr. Russell and Mr. Kopseng did
not obtain basis in the MRRC notes.
II. The REMC Ledger Debt
The REMC ledger debt was originally lent to MRRC in April
1996, by REMC, a C corporation owned by Mr. Russell and Mr.
Kopseng. A loan to an S corporation by another entity owned by
the S corporation’s shareholder is not an indebtedness of the S
corporation to the shareholder. See, e.g., Frankel v.
Commissioner, supra at 350 (holding that loans to an S
corporation from a partnership owned by the same shareholders
does not constitute indebtedness of the S corporation to the
shareholders); Burnstein v. Commissioner, supra (holding that
loans between two S corporations owned by the same shareholders
do not create a debt running directly to the shareholders).
Although the REMC ledger debt was eventually reclassified in
MRRC’s books on June 30, 1998, as notes payable to Mr. Russell
and Mr. Kopseng, the record is devoid of any evidence suggesting
that this treatment was intended at the time REMC made the loans.
Standing by itself, this adjustment of a journal entry several
years after the actual transaction is insufficient to reclassify
the source of a loan. See Burnstein v. Commissioner, supra.
Because the REMC ledger debt did not run directly to Mr. Russell
and Mr. Kopseng, it did not increase their bases in MRRC.
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III. The Short-Term Debt
Respondent contends that the short-term debt should be
classified as a direct loan from RGC Partnership to MRRC.
Petitioners contend that the short-term debt constituted a series
of back-to-back loans from RGC Partnership to Mr. Russell and Mr.
Kopseng and from Mr. Russell and Mr. Kopseng to MRRC. We agree
with respondent.
The only evidence in the record supporting petitioners’
characterization consists of (1) the short-term notes themselves
and (2) the August 31, 1997, adjusting journal entry to MRRC’s
books reclassifying the short-term debt. The four short-term
notes have little probative value as nothing in the record
indicates that they were executed contemporaneously with the nine
advances to MRRC. Although each short-term note bears an
effective date which is identical to the date on which RGC
Partnership made a corresponding advance to MRRC, Mr. Russell’s
and Mr. Kopseng’s signatures on the notes are not themselves
dated, and petitioners failed to present evidence indicating when
the notes were executed.
Petitioners’ reclassification of the short-term debt on
MRRC’s books is insufficient by itself to prove the loans’
origin. The reclassification occurred on the last day of MRRC’s
final taxable year and only one day before the section 351
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transaction. Petitioners offered no explanation for the timing
of the reclassification. Not being contemporaneous with
the actual advances, the adjusting journal entry cannot
establish that the short-term debt constituted back-to-back loans
at the time the advances were made. See Burnstein v.
Commissioner, T.C. Memo. 1984-74.
Finally, none of the interest paid on the short-term debt
was included in gross income or deducted as an expense by Mr.
Russell or Mr. Kopseng. For these reasons, the short-term debt
is best characterized as a series of loans from RGC Partnership
to MRRC. The issuance of the short-term debt did not constitute
an economic outlay by MRRC’s shareholders, and did not create
basis in MRRC stock.
In reaching our holdings herein, we have considered all
arguments made, and, to the extent not mentioned above, we
conclude they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155 in docket Nos.
4425-05, 4456-05, and 4688-05.