The opinion
T.C. Memo. 2003-204
UNITED STATES TAX COURT
DALE H. AND EDITH LITTLEFIELD SUNDBY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13000-01. Filed July 11, 2003.
Dale H. and Edith Littlefield Sundby, pro sese.
Michael S. Hensley, Kevin M. Brown, James A. Nelson, and
Jeffrey A. Schlei, for respondent.
MEMORANDUM OPINION
WELLS, Chief Judge: Respondent determined a deficiency in
petitioners’ 1997 Federal income tax of $77,372. The issue to be
decided is whether petitioners are entitled to a bad debt
deduction of $350,000 which they claimed on Schedule C of their
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1997 Federal income tax return.1 All section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
Background
The parties submitted the instant case fully stipulated
without trial pursuant to Rule 122. The parties’ stipulations of
fact and the accompanying exhibits are hereby incorporated by
this reference and are found as facts in the instant case.
Petitioners resided in San Diego, California, when their petition
was filed.
On April 6, 1993, Access Anytime Anywhere, Inc. (Access),
was incorporated in the State of California. Petitioners were
the sole shareholders of Access. On May 12, 1993, Access was
renamed Navis Communications (Navis). Petitioners were the sole
shareholders of Navis. Navis was assigned a Federal Employer
Identification Number. On June 1, 2001, Navis’s corporate status
was suspended by the California Franchise Tax Board.
On November 9, 1994, Search2000 was incorporated in the
State of California. Petitioner Dale H. Sundby (Mr. Sundby) was
the president of Search2000. On September 19, 1995, Search2000
was renamed PowerAgent, Inc. Mr. Sundby was the president of
PowerAgent, Inc. The California Franchise Tax Board suspended
PowerAgent, Inc.’s corporate status on January 2, 2001. Navis
1
Petitioners failed to file a brief addressing this issue.
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and Search2000 were corporations during 1995. Navis held itself
out as a corporation. Navis was engaged in limited business
activity during 1994, as reflected in a bill from a law firm,2 a
long-distance phone bill, and several shipping receipts. Navis
remained a California corporation until its corporate status was
suspended.
On July 21, 1995, Search2000 held a board of directors
meeting, and the minutes of that meeting state in part:
WHEREAS, the Corporation desires to accept the offer of
Navis Communications, a California Sole
Proprietorship,[3] to sell all of its ownership rights
to business plans and intellectual property defined as
WorkWorld and PowerAgent.
RESOLVED, that the Corporation purchase all rights to
business plans and intellectual property defined as
WorkWorld and PowerAgent for a consideration of
$300,000.00.
On July 21, 1995, Search2000 created the following
instrument in connection with the alleged purchase by Search2000
of business plans and intellectual property, defined as WorkWorld
and PowerAgent, which were owned by Navis:
2
The bill indicated that the law firm, Higgs, Fletcher &
Mack, of San Diego, California, performed services related to the
incorporation of Navis Communication.
3
We note that petitioners stipulated that Access was
incorporated under the laws of the State of California and that
it later changed its name to Navis. Petitioners stipulated that
Navis was a corporation in 1995. We shall treat Navis as a
corporation. Petitioners have not provided this Court with
evidence that Navis elected to be treated as a subchapter S
corporation under sec. 1362(a).
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PROMISSORY NOTE
July 21, 1995
$300,000.00
FOR VALUE RECEIVED, Search2000, Inc., a California
Corporation (the “Maker”), promises to pay Navis
Communication (the “Holder”), at the offices of the
Holder of this Note or at such other place as the
Holder of this Note may designate, the principal sum of
$300,000.00, together with interest on the unpaid
principal balance of this Note from time to time
outstanding at the rate of 8% per year until paid in
full. The principal sum of this Note and all accrued
interest thereon shall be payable on demand. Interest
on this Note shall be computed on the basis of a year
of 365 days for the actual number of days elapsed. All
payments by the Maker under this Note shall be in
immediately available funds.
In no event shall any interest charged, collected or
reserved under this Note exceed the maximum rate then
permitted by applicable law and if any such payment is
paid by the Maker, then such sum shall be credited by
the Holder as a payment of principal.
All payments by the Maker under this Note shall be made
without set-off or counterclaim and be free and clear
and without any deduction or withholding for any taxes
or fees of any nature whatsoever, unless the obligation
to make such deduction or withholding is imposed by
law. The Maker shall pay and save the Holder harmless
from all liabilities with respect to or resulting from
any delay or omission to make any such deduction or
withholding required by law.
Whenever any amount is paid under this Note, all or
part of the amount paid may be applied to principal,
premium or interest in such order and manner as shall
be determined by the Holder in its discretion.
In the event of any actual or deemed entry or any order
for relief with respect to the Maker under the Federal
Bankruptcy Code, this Note, all interest thereon and
all other amounts payable hereunder shall automatically
become and be due and payable, without presentation,
demand, protest, or any notice of any kind, all of
which are hereby expressly waived by the Maker.
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The Maker agrees to pay on demand all costs of
collection, including reasonable attorneys’ fees,
incurred by the Holder in enforcing the obligations of
the Maker under this Note.
No delay or omission on the part of the Holder in
exercising any right under this Note shall operate as a
waiver of such right or of any other right of such
Holder, nor shall any delay, omission or waiver on any
one occasion be deemed a bar to or waiver of the same
or any other right on any future occasion.
None of the terms or provisions of this Note may be
excluded, modified or amended except by a written
instrument duly executed on behalf of the Holder
expressly referring to this Note and setting forth the
provision so excluded, modified or amended.
All rights and obligations hereunder shall be governed
by the laws of the Sate of California.
Search2000, Inc.
By: [signed] Dale Sundby
Name: Dale Sundby
Title: Chairman and CEO
Neither petitioners nor Navis reported on any Federal income
tax return the sale of a business plan or intellectual property
rights. Neither petitioners nor Navis reported on any Federal
income tax return the sale of PowerAgent or WorkWorld. Moreover,
Navis did not file a Federal income tax return for 1995.
Additionally, there is no evidence suggesting that WorkWorld had
any value. Moreover, there is no evidence to suggest that the
promissory note was ever sold, transferred, or otherwise conveyed
to petitioners by Navis.
Neither petitioners nor Navis reported on any Federal income
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tax return interest income arising from the sale of a business
plan or intellectual property. Neither petitioners nor Navis
reported on any Federal income tax return interest income arising
from the sale of PowerAgent or WorkWorld.
Petitioners claimed a bad debt deduction on Schedule C of
their 1997 Federal income tax return. On Schedule C, Mr. Sundby
indicated that his principal business was that of a lender,
reporting income on the cash basis. Mr. Sundby also indicated
that he did not “materially participate” in the operation of this
business.
Discussion
Petitioners bear the burden of proving that they are
entitled to their claimed bad debt deduction. Rule 142(a);4
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). To avail
themselves of a bad debt deduction pursuant to section 166,5
4
Sec. 7491 does not apply in the instant case to shift the
burden of proof to respondent because petitioners neither alleged
that sec. 7491 was applicable nor established that they fully
complied with the requirements of sec. 7491(a)(2).
5
Sec. 166. BAD DEBTS.
(a) General Rule.--
(1) Wholly worthless debts.-–There shall be
allowed as a deduction any debt which becomes worthless
within the taxable year.
(2) Partially worthless debts.-–When satisfied
that a debt is recoverable only in part, the Secretary
may allow such debt, in an amount not in excess of the
(continued...)
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petitioners must prove (1) a bona fide debt existed between them
and Search2000, and (2) the debt became worthless in 1997, the
year in which they claimed the deduction. See also Dixie Dairies
v. Commissioner, 74 T.C. 476, 493-494 (1980); Kim v.
Commissioner, T.C. Memo. 1995-598; Hotel Continental, Inc. v.
5
(...continued)
part charged off within the taxable year, as a
deduction.
(b) Amount of Deduction.-–For purposes of subsection
(a), the basis for determining the amount of the deduction
for any bad debt shall be the adjusted basis provided in
section 1011 for determining the loss from the sale or other
disposition of property.
(d) Nonbusiness Debts.--
(1) General rule.-–In the case of a taxpayer
other than a corporation–-
(A) subsection (a) shall not apply to any
nonbusiness debt; and
(B) where any nonbusiness debt becomes
worthless within the taxable year, the loss
resulting therefrom shall be considered a loss
from the sale or exchange, during the taxable
year, of a capital asset held for not more than 1
year.
(2) Nonbusiness debt defined.-–For purposes of
paragraph (1), the term “nonbusiness debt” means a debt
other than–
(A) a debt created or acquired (as the case
may be) in connection with a trade or business of
the taxpayer; or
(B) a debt the loss from the worthlessness
of which is incurred in the taxpayer’s trade or
business.
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Commissioner, T.C. Memo. 1995-364, affd. without published
opinion 113 F.3d 1241 (9th Cir. 1997).
A bona fide debt is a debt which “arises from a debtor-
creditor relationship based upon a valid and enforceable
obligation to pay a fixed or determinable sum of money.” Sec.
1.166-1(c), Income Tax Regs.; see Dixie Dairies Corp. v.
Commissioner, supra at 494. The existence of a bona fide debtor-
creditor relationship may be determined by examination of all
relevant facts. Fisher v. Commissioner, 54 T.C. 905, 909 (1970).
In deciding whether a bona fide debt existed, we may
consider a number of factors, including: (1) Whether evidence of
indebtedness exists, such as a note; (2) whether any collateral
or security is requested; (3) whether a demand for repayment has
been made; (4) whether the parties’ records reflect the
transaction as a loan; (5) whether any repayments have been made;
and (6) whether any interest was charged. See Kim v.
Commissioner, supra; see also Dixie Dairies Corp. v.
Commissioner, supra; Baker Commodities, Inc. v. Commissioner, 48
T.C. 374 (1967), affd. 415 F.2d 519 (9th Cir. 1969); Bragg v.
Commissioner, T.C. Memo. 1993-479. However, “Formal indicia of
debt are not in themselves sufficient to establish a bona fide
indebtedness”. Hotel Continental, Inc. v. Commissioner, supra.
The alleged debt transaction requires close scrutiny to
determine whether the parties were engaged in an arm’s-length
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transaction because petitioners controlled both corporations.6
See Baldwin v. Commissioner, T.C. Memo. 1993-433; see also Ludwig
Baumann & Co. v. Commissioner, T.C. Memo. 1961-271, affd. 312
F.2d 557 (2d Cir. 1963).
In the instant case, petitioners have failed to prove their
entitlement to the bad debt deduction claimed on their return.
Petitioners have failed to prove that Search2000 and Navis were
engaged in an arm’s-length transaction or that Navis and
Search2000 ever entered into a valid debtor-creditor
relationship. See Rule 142(a). While the record contains a
promissory note and the minutes of the July 21, 1995, Search2000
board of directors meeting authorizing Search2000 to purchase the
alleged WorkWorld and PowerAgent business plans and intellectual
property from Navis, the record contains no evidence (other than
the promissory note) that the alleged transaction actually took
place. Moreover, there is no evidence that the note was
acquired, transferred, or otherwise conveyed by Navis to
petitioners, who are claiming the bad debt deduction on Schedule
C of their personal return.
6
Mr. Sundby was the president of both Search2000 and Navis
in 1995. The minutes of the July 21, 1995, Search2000 board of
directors meeting indicate that petitioners and Mr. J. Tim Konold
were on the Search2000 board of directors. Moreover, the
promissory note indicates that Mr. Sundby was the chairman and
CEO (chief executive officer) of Search2000. The California
Franchise Tax Board’s records list Mr. Sundby as the only officer
or director of both Search2000 (later PowerAgent, Inc.) and
Navis.
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Neither Navis nor petitioners reported the sale of the
alleged business plan and intellectual property on its or their
1995 Federal income tax return. There is no indication that
Navis even filed a Federal income tax return for 1995.
Petitioners have not shown that the alleged business plan and
intellectual property, PowerAgent and WorkWorld, had any value.
Petitioners have not presented this Court with any evidence that
the alleged business plan and intellectual property even existed.
The promissory note, a demand note, lacks a date of maturity
and does not require regular interest and principal payments to
be made. There is no evidence that Search2000 made any interest
or principal payments on the promissory note. Moreover, there is
no evidence that either Navis or petitioners demanded payment
from Search2000. There is no evidence that either Navis or
petitioners required Search2000 to provide collateral for the
promissory note. Petitioners have failed to show that, when the
promissory note was created, there was a genuine intention to
create a bona fide debt.7
7
Petitioners alleged on their 1997 Federal income tax return
that Mr. Sundby was a lender. Petitioners must prove that Mr.
Sundby was in a trade or business and that the alleged debt was
connected to that trade or business in order to take their
claimed deduction. Sec. 166(d); see Commissioner v. Groetzinger,
480 U.S. 23, 35 (1987) (“the taxpayer must be involved in the
activity with continuity and regularity and * * * the taxpayer’s
primary purpose for engaging in the activity must be for income
or profit.”). Moreover, on Schedule C of their 1997 Federal
income tax return, petitioners indicated that Mr. Sundby did not
(continued...)
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Assuming arguendo that petitioners were able to prove that a
bona fide debt was created with respect to the July 21, 1995,
transaction, petitioners still would not be entitled to the bad
debt deduction. Petitioners have failed to show that they are
entitled to deductions that on their face would be allowable to
Navis, if at all. The promissory note was made between
Search2000 and Navis. Because Navis was incorporated under the
laws of the State of California and there are other indicia of
its separate status, we shall treat it as a separate entity. See
Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439
(1943).
Since the promissory note was made payable to Navis, it is
Navis that would be entitled to the bad debt deduction, if any
were to be allowed, and petitioners have not shown that the note
was transferred to them personally. Moreover, petitioners have
not shown that any S corporation election was in effect for Navis
for the year in issue.
On the basis of the foregoing, we hold that petitioners may
7
(...continued)
materially participate in the business of lending. Petitioners
have not provided this Court with any evidence which supports
their contention that Mr. Sundby was in the trade or business of
being a lender during 1995, 1996, or 1997. Petitioners have
failed to show that Mr. Sundby continually or regularly engaged
in lending for income or profit. Even though Mr. Sundby was
president of both Search2000 and Navis, full-time service to a
corporation does not necessarily amount to engaging in a trade or
business (other than the trade or business of being an employee).
See Whipple v. Commissioner, 373 U.S. 193, 203 (1963).
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not claim a deduction for a bad debt, pursuant to section 166(a).
We have considered all of the contentions and arguments of the
parties that are not discussed herein,8 and we find them to be
without merit, irrelevant, or moot.
To reflect the foregoing,
Decision will be entered
for respondent.
8
Having held that petitioners have failed to show that a
bona fide debt exists, we need not decide whether the claimed
debt became worthless in 1997.